Many traditional venture capitalists have begun exploring filmed entertainment and related media businesses for new investment opportunities. Hollywood is an industry from which these technology-savvy investors have long shied away. It was deemed too dependent on hits and too esoteric in the way in which business is conducted. The new thinking, however, is that the technological revolution brought about by the Internet and the ever-advancing media capabilities of computers has the potential to fundamentally alter the business characteristics of movie-making. The rapid changeover to broadband, the lower costs of digital production and the wonders of modern day special effects are the types of developments driving this thinking.
These venture capitalists envision the industry going from one that is project-oriented to one that is based more on a traditional type of business model, not unlike that of a mature technology company where revenue and cash flow are relatively stable and predictable. In my opinion, this thinking is flawed. Technological advances have never meaningfully impacted the intrinsic hit-or-miss nature of the movie business, and it is unlikely that they ever will.
I base my view on the enormous technological advances that have already occurred in the industry over the past century. Let's look at a few. First came Kinetoscope parlors, a primitive forerunner of the movie theater. Patrons would drop a penny through a slot and then peer through an eyepiece at a flickering image that usually lasted about a minute. Then, in 1905, the nickelodeon was born. For a nickel, patrons sat in folding chairs and were treated to five or so "full-length" movies, roughly about 12 minutes each, which were projected onto a screen. Of course, the films they saw were all silent. But through further technological innovation, it wasn't long before talkies were invented. Then films went from black-and-white to color. Today, movies are shown on super-wide screens in multiplex theaters with stadium seating and Dolby sound.
On related fronts, there was the advent of radio, followed by TV-again, first in black and white and then color. (The technological change in TV sets alone is nothing short of amazing, going in a scant 50 years from small snowy, black-and-white pictures to vibrantly colored, large screen plasma displays.) Wind-up phonographs with large external horns that amplified sound were replaced by phonographs with internal horns, commonly referred to as Victrolas. Electricity would change the phonograph further still, as would the development of stereo technology. Vinyl LPs and reel-to-reel tape machines would be augmented by audiocassettes and then replaced outright by CD-ROMs. There was also the invention of VCRs and now the ongoing transition to DVD players and digital video recorders. Today, there are literally hundreds of television stations with the emergence of cable, satellite and digital services, and the commencement of HDTV broadcasts has begun.
These changes highlight the incredible technological advances that have taken place in the entertainment industry over the past 100 years. Yet, while all these changes undoubtedly helped to open new markets, none changed the fact that entertainment is a creative process that by its very nature remains a hit-or-miss proposition. Because of the many new markets brought into being by the latest technological advances, the stakes, and potential returns, are unquestionably higher than ever. But that doesn't diminish the fact that you still need a successful movie, television program or song-otherwise all the technology and all the new markets are for naught.
The following example illustrates the inherent flaws in pursuing a strategy in Hollywood that is overly reliant on technological innovation. I will not reveal the identity of the company or its principals, but will simply refer to it as Company X. It was founded in 2001 with the expressed goal of producing about a dozen films annually that could be made at relatively low cost by taking advantage of emerging digital production and distribution technologies, including broadband delivery systems. Instead of budgets in the tens of millions of dollars, Company X would be able to leverage new technologies to produce and distribute feature-quality films for a fraction of that amount. The smaller budgets ($2 million and under) would enable the company to recoup its costs on a given film more quickly, resulting in less risk. In addition, the low-cost model would provide greater potential returns-since the amount of capital deployed would be much less than if traditional production techniques were used. Or so the theory went.
According to published reports, Company X quickly received an equity infusion of around $10 million from a group of investors led by a European venture fund. The investors bought into the strategy whole-heartedly. However, it seems to have become apparent fairly quickly that the financial model was not working. It's true that leveraging new technologies enabled Company X to produce and distribute visually appealing films at a reduced cost, but the technology in and of itself was not enough to compensate for the fact that these films lacked wide commercial appeal, as measured by box office success. A new strategy seemed in order. The management of Company X decided to acquire a troubled, publicly listed production/distribution company through a reverse merger. The deal was to be the first step in a plan to turn Company X into a major integrated film company with production, financing and distribution capabilities. There was no longer any mention in the press about leveraging digital production and distribution technologies. This was a perfectly legitimate new strategy on which to embark, but it was clearly Plan B.
Company X continues to struggle, having suffered cumulative losses in fiscal 2004 and 2005 in excess of $35 million. None of this has escaped the market's attention: The stock is currently trading for around 5 cents a share, resulting in a market cap of less than $8 million. Company X is now trying to reinvent itself once more. The production side of the business has been jettisoned and the focus is now on turning the operation into a traditional film and TV distribution and acquisitions company.
Time will tell if this latest strategy will be successful, but one thing seems evident: No amount of technologically derived efficiencies can make up for the lack of commercially successful content when it comes to success in the movie business.
By contrast, my business associate, Robert Davidoff, who runs the venture capital arm of Carl Marks & Co., was an early investor in New Line Cinema. Bob's decision to invest was based on his confidence in management's ability to produce and distribute great content, not on their being able to take advantage of new technologies. New Line went on to produce many commercially successful films and was eventually acquired by Turner Broadcasting. Today, it is a major Hollywood studio owned by Time Warner.
The bottom line is that the entertainment industry in general-and movie-making in particular-have experienced phenomenal technological advances during the past century without any change in the basic hit-or-miss nature of the business. There seems to me no reason to believe that the Internet or broadband or computer improvements in general will change that most fundamental characteristic (something for investors to consider given all the excitement these days about delivering video to the Web and to mobile devices such as the iPod). Obviously, these are just one person's thoughts, and subsequent developments could prove me wrong.
Although hit-or-miss in nature, filmed entertainment is still an enormous global industry with excellent growth prospects that venture capitalists would be well advised to consider when making investment decisions. But they should bear in mind that if in real estate, it's all about location, location, location, in Hollywood it's all about content, content, content.
Richard A. Dorfman is an investor and dealmaker with holdings in the media, entertainment and information services industries.