A New Model for Music Finance
by Josh Kaplan*
A pdf version of this article may be downloaded here.
In recent years, the music industry has morphed at an alarming pace. The music label system has failed to evolve with equal speed, and the result is the demise of the music label and its surrounding infrastructure. The music label system has traditionally sold physical records at inflated prices while sharing a very small percentage of such sales with the musician. With the advent of digital music, the utilities that the labels possess have become available to any musician with a good internet connection. A band no longer needs a label to manufacture, promote and distribute its new LP.
Today’s indie bands are resourceful, and tap into every free and inexpensive resource readily available. Bands utilize websites, social networking tools, street teams, e-stores and digital distribution companies to “break” into the business. Even still, the band needs one thing to take it to a national or international level: money.
In the past, artists would access such capital by signing with a label in exchange for a loan, creatively coined an “advance.” The band, excited by the prospect of national exposure, would give the label the rights to its music and its name, with a contractual obligation to provide the label with six to ten more albums. The label would then control the manufacture, release and promotion of the band’s music. Any royalties that the band received from the sale of its music would be credited toward the “advance” that the band initially received from the label. The label would also reimburse itself for expenses incurred in producing and exploiting the record. Consequently, the band would remain in debt for the length of its contract with the label, and sometimes for years after.
Physical record sales have been steadily declining for the past decade. Digital sales will soon eclipse physical sales. [FN1] In order to re-capture the bloated advances and investments that labels made in artists’ physical records, labels’ legal departments have constructed the “360 record deal.”
In a 360 deal, the label lures a band to sign with the promise of an advance and label support. A percentage of all revenue generated by the band – from record and merchandise sales, touring, licensing, video and book sales, music rights, etc. – goes to the label. Regardless of the amount of money the label spends on the band or the band’s development in activities outside of music, the band (and usually the individual band members) will owe a percentage of its earnings for a set amount of time to the label. The advance that the label initially paid to entice the band to sign still functions as a loan that the band must repay to the label.
The new generation of do-it-yourself musicians has an understandably tough time stomaching the terms of a 360 deal. How can a band “take the next step” without signing such a deal?
In a recent trend that has emerged from the rubble of the label system, an independent investor looks to capitalize on the work that an independent musician has already accomplished. Recognizing buzz bands as valuable and legitimate start-ups, savvy individuals and companies increasingly try their hands in the music business. They bring with them corporate experience and non-industry lawyers, and have developed new models for signing, developing and exploiting independent bands. The investment model that has been used for decades by most other industries in the United States is thus finally making its way into the stubborn music industry.
The best corporate vehicle to establish a partnership between an investor and a musician is the limited liability company (“LLC”). A band will have normally incorporated an LLC prior to soliciting an investment. In this scenario, we will refer to the band’s LLC as “Band LLC,” and assume it is owned jointly by the band members. The investor will also have established a corporate entity through which it will make its investment. We will refer to the investor’s company as “Investor LLC.”
A third entity – typically another LLC – will be formed for purposes of the investment. We will call this third entity “Partners LLC.” Band LLC will be the initial owner (i.e. Member) of Partners LLC, and will assign and transfer all of its assets, copyrights, trade names and other intellectual property to the new entity. Band LLC, together with its legal and managerial team, will then determine the amount of ownership it is willing to cede in exchange for Investor LLC’s investment of money into Partners LLC. Let us assume that Band LLC decides to give Investor LLC 25% ownership in Partners LLC in exchange for an investment of $100,000.
It is important to note that ownership percentages do not necessarily determine the way that a company’s profits are split. In a risky business investment such as ours, Investor LLC will expect to recoup its capital contribution ($100,000) in Partners LLC plus a preferred return (for example, ten percent of the initial $100,000) before Band LLC receives any distribution of profit. After recoupment, the profits may continue to slant in favor of Investor LLC, but should gradually move toward division based on ownership percentages of Partners LLC. During the time that Investor LLC is receiving all of Partners LLC’s profits, the musicians themselves make ends meet via salary. The members of Band LLC work for Partners LLC by performing, recording, making appearances, and developing new merchandise, and will thus draw a reasonable salary from Partners LLC until Band LLC starts to earn income from Partners LLC’s profit distributions. Depending on the needs of Band LLC, a sizeable percentage of Investor LLC’s capital contribution will cover the living expenses of the band members.
Partners LLC will derive its income from the band’s activities. From royalties to touring to licensing to merchandise sales, all income will go into the Partners LLC pot. If Partners LLC is successful, the distribution of profits will enable Investor LLC to fully recoup its capital contribution plus make handsome profit. Investor LLC’s investment will allow Band LLC to purchase equipment, tour, work with a producer, secure a distribution arrangement, and get to the “next level” without falling into the deep debt that would result from a 360 deal.
If we take this plan long term, there may be situations where Band LLC requires an additional investment (for example, to record and release a new album). Rather than giving up more and more ownership of Partners LLC, Band LLC can reinstate the same “waterfall” distribution scenario with a preferred return. This will allow an investor to feel more secure in its investment and allow Band LLC to keep the ownership percentage of Partner LLC at the status quo.
If the relationship does not go well and Investor LLC does not recoup its investment in Partners LLC, the capital contribution will not function as a loan and Band LLC will not be responsible or liable for repayment. If Band LLC is concerned with partnering with Investor LLC for a long period of time, other distribution terms may be established. For example, once Investor LLC has received a 150% return on its investment, it may be removed as a Member of Partners LLC. Band LLC could also cap the profits of Investor LLC or limit the participation of Investor LLC through this structure.
For today’s DIY bands that continue to work tirelessly on developing their music into a viable business, this type of structure may be ideal. It is a true partnership that allows for a lot of flexibility between the investor and the band. It provides a band with capital that is needed to hire a good public relationship firm, purchase advertisements, hire the right producers and properly exploit its music and merchandise, all without the constraints and the bureaucracy of the label system. If handled properly, such an investment structure may be the model for the “new” music industry.
*Josh Kaplan often acts as a left-brain guide to right brain thinkers. Josh is a business lawyer at Stahl Cowen who focuses on music, entertainment and intellectual property law. Josh regularly works with musicians, producers, djs, artists, filmmakers, writers and designers to protect their work product through entity formation, contract negotiations, license agreements, and copyright and trademark registration. Josh has negotiated on behalf of his clients to place their music in movies, television shows, video games, commercials, webcasts and compilations with other artists. In addition, Josh has extensive experience assisting filmmakers and musicians in their quest for private funding for their film and music projects. Josh regularly negotiates and drafts private placement offerings and all corresponding documents including operating agreements and subscription agreements. Lawyer4musicians.com is Josh’s outlet for his views on the music and film industry.
[FN1] Casey Johnston, US Digital Music Sales to Eclipse CDs by 2010, http://arstechnica.com/media/news/2009/08/global-digital-music-sales-to-overtake-physical-by-2016.ars.