May 242016
 

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Earl R Smith II, PhD
DrSmith@Dr-Smith.com

Dr-Smith.com

Customers can be one of your best, lower-cost sources of the financial resources essential to building your business – yet many early-stage companies totally ignore them.

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One of my suggested rules, ‘If your product or service is as good as you think it is, and they want it badly enough, they will pay for developing it’ … that your customers could supply the financing for your company’s launch and early growth, drew a number of requests for a practical example. I’m going to devote this article to responding to those requests by describing the evolution of one of my own companies.

This company started, much like the others, because I had identified a major set of problems that a significant group of potential customers had. You will notice that I did not use the term ‘market’ … I have believed from the beginning that amateurs have ‘markets’ and pros have ‘customers’. I began with potential customers and a series of face-to-face contacts with senior executives at those companies. I talked with them extensively, developed a solution to a set of challenges that they admitted they had, presented that solution for review and then launched a company based on an agreed upon model. In other words, my new company was not a solution is search of a problem.

In this case, the group of potential customers was the major US movie studios. Their challenge was the confluence of the rise of the independent film producers and the financial limits on their ability to produce and distribute films. The studios need to make and distribute as many films as possible in order to spread the risk. They do this to assure a higher probability that enough of them will be winners to pay for the ‘dogs’, the studio’s overhead and generate a nice profit. The independent producers constituted an additional source of film projects. That was the good news. But there was an Ethiopian in the fuel supply.

In the late seventies the movie business was truly bicoastal. Production was centered on the west coast and mostly at the studio lots. Financing was provided by the money center banks, principally those in New York City … where I was living at the time. The banks’ position was that the credit lines of the studios were pretty much tapped out. Even though they recognized that producing and distributing more films would increase the chances of studio profits, they were uncomfortable significantly expanding the lines.

I had a number of friends in the ‘business’ who made me aware of the restrictions on the studios. I suppose, given my reputation for not being able to put down a complex problem until I’d come up with a viable solution, they conspired to prod me into going to work. Well, their strategy succeeded.

The problem was interesting, indeed challenging, as it involved two major industries with radically different cultures and perspectives on the world. The money center banks, although they had been providing financing to the film industry for decades, were mostly ‘belts-and-suspenders’ types who kept a very close eye on risk. The film industry was populated by significantly more entrepreneurial types who were willing to roll the dice ten times in order to win big two or three times. The two different cultures had been locked in a mutually beneficial relationship which was increasingly being stressed.

My first step was to get a thorough understanding of the problem and the dynamics of both perspectives. I talked to a wide range of bankers familiar with the industry and with senior executives in the film business. The principal result was that I now could see the world through the eyes of both the bankers and the studios … I could begin to craft a solution. A collateral result of this process was a partnership with a man who, at the time of our meeting, was CFO of Columbia Pictures.

My second step (and only after determining that there was a ready group of customers eager to pay for the solution we might develop) was to build a team of subject matter experts to take advantage of the knowledge I had gathered … and to mount an assault on the challenge. We met over a period of several months and the group was expanded to include other skill sets. Each time we encountered a new area that needed to be covered I went on a search for the best in the field.

Finally we hit on a solution which would allow off balance sheet financing of the top twenty five percent of the risk column of each film project. Although the solution was complex, the underlying enabling conditions were quite simple. In those days the top marginal tax rate in New York City was somewhere around one hundred and three percent … in other words, above a certain level of income, and if you lived in NYC, the combined governments would actually take more than you earned. But more broadly, the combined top marginal federal and state rates approached eighty to ninety percent.

So I involved some of the top tax lawyers in the City and we focused on refining the model. Working with the tax code made the challenge more difficult as it involved not only tax lawyers but the Internal Revenue Service … without their blessing the approach to the innovative financing would bring an unacceptable risk.

Well, to jump ahead a bit, we came up with a solution that passed muster all around and presented it to both the studios and the banks. The banks loved it because they would now be able to spread their risk over a larger number of projects and be protected by taking the lower seventy five percent of the risk column. The studios were equally attracted to the idea because they could now finance and distribute a third more films. All that was needed at that point was a source of funds that would take the top twenty five percent of the risk in each project.

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