Everyone loves the story of the film, produced for $750,000 by a handful of private investors (entrepreneurs, doctors and small business owners) with most of them contributing $10,000 to $20,000, that grossed $5,000,000 at the box office.
Anyone who has produced an independent film will tell you the most difficult task is raising money to pay for the production (although the rest is not easy either). If you’ve never produced an independent film, it is almost impossible to raise the money for it outside of a friends/family round or by being fortunate enough to obtain intellectual property with a following (i.e., book rights, life story rights, etc.).
One way “not” to raise money for an independent film, is to run around your town with a script and attachment letters and start taking money from people. Worse yet, take out newspaper ads for investors. This physically can be done, but the potential downside is jail. Read that twice. The penalties for violating securities laws when raising money for a movie can be criminal in nature, as well as civil. Accordingly, as fun as it is exciting as it may be to treat movie money like the wild west, it is not advisable. You can find money for a film in a million different ways and places. But lawyers can only participate in film financing situations that are in compliance with state and federal laws. Complicating the scene are the credit crunch and the precarious state of foreign pre-sales. The world’s film buyers are pickier than ever, and their offers are lower — and banks aren’t able to gap the shortfall. So, the pressure is on equity investors to foot the majority of a pic’s budget.
Raising money is the key to any independent film, regardless of your position, experience, and past credits, and there are only a few ways to actually accomplish that. Being that a film finance closing can last anywhere from 4–12 weeks, this can be a relatively clean, straightforward experience, or three months of hell. Simply put, a finance plan is the best indicator of a producer’s financial I.Q. We need to know that you know how much money you really need and where you’re going to get it from.
The new and first-time producer usually has to go the private equity route. The other financing methods usually depend on relationships and track records the producer has, which, if you’re a first-time filmmaker, you may not have. With larger budgets, equity usually covers 25%-60%. For lower budget projects under $5,000,000, equity usually covers 80%-100% of the budget. As an investor, you would be much happier giving a filmmaker a dollar knowing they can at least guarantee you 50 cents back from tax incentives and foreign sales and without carving out debt positions. Generally, for the lower budget indie film, producer is unlikely to get pre-sales, mainly due to the inability to attract pre-sellable cast at lower budgets. Therefore, if your budget is $500,000 and you have pre-sales in your finance plan, it’s a dead giveaway to the savvy investor that you do not know what you’re doing.
Movies that are getting made have a substantial slug of equity in there. Certain equity partners would rather own the whole film than pay expensive debt costs. Unlike other industries, there are two discrete types of equity sales in the motion picture industry. The first is sale of securities in the film company. By selling stock in a corporation or membership interests in the LLC, the company raises funds by increasing the amount of equity owned by people other than the filmmaker. The manager-managed LLC or the limited partnerships are the more common investment vehicles for such project financing. The second form of equity financing involves selling the film’s distribution rights, which we will discuss later.
Many independent filmmakers – including successful directors such as Spike Lee and Francis Coppolla – have used their personal funds to finance all or part of their films. There are no legal limits or restrictions on this practice. Despite the adage that a filmmaker should only spend other people’s money, personal funds are invariably part of the film financing mix. While there are many ways to structure these types of deals with many different ways for the investors to re-coup their investments and turn a profit, they all revolve around the same questions that must be answered: (i) How much ownership does the investor receive for the investment? (ii) How will the investor re-coup their investment? (iii) How will the investor’s see a profit? (iv) How much equity is the filmmaker putting in?
Background checks of publicly available records will certainly help identify convicted felons and anyone cast out of the fully regulated sectors of the financial community. But are such willful miscreants really the source of most film litigations? The complexity inherent in film funding — typified by smoke-and-mirror accounting and “waterfall” recoupment schedules that seem to punish those taking the greatest risks — means cinema is always prone to borderline behavior and bare-knuckle negotiating tactics from all quarters. Therefore, it is imperative that you spend the money to consult with an attorney on any equity structure.
Investors have been known to act against their better judgments, of course. In his chapter for the book, “Film And Risk”, prominent Los Angeles-based entertainment lawyer Bill Grantham recalls coming across projects that were so obviously flawed he begged clients not to get involved with them, sometimes providing detailed written explanations of exactly how they were going to lose all their money. They did it anyway — evidence of a psychological component to film investing that stretches beyond steely business calculation.
Even the most coldly detached investor still needs to guard against common pitfalls. A film might be a roaring success, but because some investors chose to invest in the overhead and development costs of the production company in a “first-in, last-out” position, they may have lost out on windfall profits. Alternatively, investors may find themselves too far down the revenue sharing waterfall in a film whose budget over-runs have led its producers to stack new senior financing tranches on top of investors’ equity claims.
Do You Need a Private Placement Memorandum (PPM)?
The most common source of seed capital when starting a business is friends or family. However, in general, the amount that can be raised from friends or family is no more than $100,000. As such, a PPM is generally not required to raise capital from family members and close friends.
A private placement (also known as unregistered offering) is a securities offering exempt from registration with the SEC. Production companies and film funds, will engage in private placements to raise equity or debt financing from a small group of select investors instead of the public, usually from institutional investors and high net worth individuals. In general, investing in private placements is risky: private placement offerings are not registered with the SEC; most private placement securities are restricted securities and can tie up your investment for a year or more; and most private placements do not have the same investor protections as registered offerings, such as the comprehensive disclosure requirements that apply to publicly traded companies.
While there is some overlap, a PPM is not the same thing as a business plan. The detailed “description of the securities” and the “risks factors” are perhaps the most important difference between the PPM and a business plan. Unlike a business plan, the PPM focuses on the structure and terms of the deal, and the attendant risks of the investment, whether they be equity securities or debt securities. The PPM should be a descriptive document. It should allow readers to reach their own conclusions regarding the merits of the deal. A major downside of seeking money from non-accredited investors is the much greater disclosure requirements. On the other hand, in general, the legal disclosure burdens are dramatically reduced (subject to the antifraud provisions of the securities laws), when only accredited investors (earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or (2) has a net worth over $1 million, excluding primary residence) are involved. In which case, you may avoid using a PPM to raise funds.
A Term Sheet is typically used for a negotiated transaction with a small number of investors. On the other hand, a PPM normally sets fixed terms the company wants, and which can be circulated to a relatively larger group of potential investors. Unlike the Business Plan, both the PPM and Term Sheet describe the deal. Both the Term Sheet and PPM define exactly what the investor is getting, who else is in on the deal and what percentages of the company is owned by them. However, unlike the PPM, a Term sheets does not have adequate warning about the risks of the investment. Risks factors in a Term Sheet would be a mere formality, since experienced accredited investors perform their own due diligence and risks assessment before they invest.
If you want Hollywood to invest in your movie, don’t send them a PPM. Studios will usually finance a movie idea if it’s a proven concept or appeals to the biggest demographic. No amount of fancy disclosures about the market and sales predictions will make a difference. You don’t need a PPM to pitch your project to Hollywood or to obtain studio financing. Angel Investors and high-net individuals typically like to negotiate the terms of the deal with a term sheet. Once the deal is fully negotiated, the term sheet goes back to the company’s attorneys who use it to draft a subscription agreement or stock purchase agreement, LLC operating agreement, or other document establishing the rights and preferences of the investor.
A PPM is not required for every capital raise. Rule 504 of Reg D provides an exemption from registration for securities offerings of less than $5 million within a 12-month period. A company may offer and sell these securities to an unlimited number of accredited and non-accredited investors. Under Rule 506(b), a company can raise an unlimited amount of money from an unlimited number of accredited investors, but from no more than 35 non-accredited investors. Both Rule 506 of Reg D and the antifraud provisions of the federal securities laws mandate that issuers disclose truthful and accurate information to investors, there is no requirement to provide any specific information or disclosures to accredited investors.
There are two general approaches to raising capital via private placement: (1) an offering with fixed terms to a relatively large group of potential investors, and (2) a negotiated transaction with a lead investor or smaller number of potential investors. For an offering to a small number of sophisticated (experienced) investors, usually only a term sheet will be necessary. However, for a larger group of investors, a PPM may be required or prudent. In any event, for offerings of more than $5 million to non-accredited investors, you must prepare, draft and deliver a lengthy PPM.
In order to help you determine which approach to take, you need to know how much money you need to raise, how you intend to use the capital, how much creative control you want to negotiate to retain, the stage or round of funding, who your prospective investors are, what your potential investors’ past behavior (as investors) is like (such as expectations of potential investors regarding PPMs), the Blue Sky law of each state in which your potential investors reside, and who is selling your securities for you if not yourself (such as a broker-dealer).
The decision of whether you need to use a PPM to raise money is rarely simple. But regardless of whether you use a PPM or not, you should prepare detailed disclosure documents in order to avoid liability for misstatements or securities fraud, especially if the nature and operations of your business and/or the terms of the investment offering are very complex.
Whether or not a PPM is used, each transaction and offering of securities should be carefully reviewed by legal counsel to determine the minimum level of disclosure that must be provided to prospective investors under applicable federal and state securities laws, and to catch and correct any compliance issues.
The most common lender transactions in the film industry do not quite fall into any of the categories described above. They typically are not supported by hard assets, so to speak, rather by distributor contracts. Those transactions may take the form of worldwide negative pickups, domestic and international split rights deals or foreign pre-sales. If the film producer can obtain a distribution agreement and guarantee from a credit-worthy distributor, the producer may be able to use that agreement or those agreements as effective collateral for the loan. Unfortunately, this form of lender financing of feature films is not available for most of the films sought to be produced by independent film producers. While it is common to see the financing plans for projects with budgets $3 million and up consisting of foreign pre-sales, it is not so common below $3 million.
Pre-sales agreements are pre-arranged and executed contracts made with distributors before the ﬁlm is produced, and are based on the perceived strength of the project as assessed by each distributor after reviewing numerous factors, including the script, the attached talent, and the marketing strategy. Once you enter the pre-sales agreements, there are two ways to go: (i) you can take out a bank loan using the pre-sales as collateral; or (ii) receive a direct payment at a discount from the distributors themselves.
This financing strategies requires the filmmaker to either repay the loan based on the pre-sales or a direct payment from the distributors before profiting on the film, and the filmmaker will likely have to personally guarantee the loan or advance payment in the event the film cannot be completed. Nonetheless, since pre-sell agreements allow the filmmaker to finance a project without personal funds at stake, they remain very attractive to the filmmaker. The pre-sell and distribution deals vary significantly. There are costs involved in putting such deals together. Packagers can take anywhere from 5%-15% of every sale. Sales agents’ fees vary between 10%-25% for obtaining distribution contracts only — and as much as 30%-35% should they secure a cash advance or bank contract.
Those that are lucky might be able to use a negative pickup as a type of film financing arrangement. A negative pickup is a contract entered into by an independent producer and a movie studio wherein the studio agrees to purchase the movie from the producer at a given date and for a fixed sum. Depending on whether the studio pays part or all of the cost of the film, the studio will receive the domestic, international, DVD, Blu-ray and/or TV rights to the film, with net profits split between the producer and the studio. By combining a negative pickup, other deals collateral to the production and pre-selling territories not covered in the negative pickup, a producer will usually cover all his costs and make a small profit before production has begun. But financing of the production up to its completion date is the responsibility of the producer—if the film goes over budget, the producer must pay the difference himself or go back to the studio and renegotiate the deal. Most negative pickup contracts, either from motion picture studios or television networks, are bankable at pretty much dollar for dollar (less fees); if one holds a negative pickup contract, one essentially holds a cheque from the studio for the cost of the film, post-dated to the day one delivers the film to them. So, while the studio technically does not pay the producer until the film negative is officially delivered (thus “negative pickup”), the producer can nonetheless get a bank loan against a negative pickup contract, which helps the producer to pay for production of the film.
The studios and distributors will contain this risk by offering the negative pickup contract only to a production that has financiers, a script, and key creative personnel, particularly the director and stars, already attached. Thus the conundrum: unless a film has U.S. distribution, a lot of investors and foreign buyers will not pre-buy a film, and unless the film is already financed, the studios do not want to guarantee distribution. This catch-22 is often resolved by attaching a major actor to the film; the mere appearance of an American movie star’s name on a film’s poster is often enough to drive box office to cover distribution in many foreign markets. Because of the complexity of these pre-sales deals, it is wise to consult with counsel before entering into one.
Loans/Gap or Bridge Financing
Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations. The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions. These latter two considerations only apply to corporations. Manager-managed LLC and limited partnerships do not require the meetings and investor approval on most issues.
Many filmmakers obtain loans for their films, although loans are usually only given once other financing is in place. Usually, filmmakers only use loans to fill in the “gap” or as “bridge” financing between what they have raised and the total cost of the film. With gap financing, banks provide a loan of between 10%-30% of a film’s budget against the value of all the distribution markets that remain unsold. As the pre-sales market continued to soften, the gap has widened further. So-called “super-gap” financing has recently emerged, essentially a riskier form of mezzanine-style financing in which more (up to 35%) of a film’s budget is borrowed against future revenue projections. In return for financing more of the budget, super-gap lenders demand higher interest rates.
What happens when your combination of presold minimum guarantees, gap financing, and soft money is still insufficient to cover the financing of a particular project? The answer has been to turn to some kind of private financing. Be careful about debt disguised as equity. Again, debt is usually the last piece of financing you bring in.
The game is finding a way of getting your money out soon. It’s a strange psychological thing. What I have discovered in this business is that if you simply call something, ‘debt’, then pretty much everybody says, ‘Yeah, well, you obviously come out ahead of the equity.’ Even if it’s just really basically a piece of hidden equity. Most filmmakers switch that around and look for debt first because it’s easy, but debt financing can’t actually close until all the rest of the financing is present and spoken for. Don’t allow filmmakers to claim they already have the debt piece figured out when they don’t have any financing in place or a pre-sellable movie with estimates.
Every company who engages in debt financing is different, but most will want to recoup their loan in first position before equity investors which can be a deal breaker right off the bat depending on what kind of deal you made with your principle financiers. Debt companies also charge interest and fees commensurate with the amount but also the experience of the filmmaking team and who is financing. Their opportunity cost is always deploying funds to the most ‘sure thing’ possible so they take vetting seriously.
For this reason, it’s often easier to work with private lenders rather than companies when covering your debt piece since the requirements might be easier to surmount for smaller films and companies. Of course, you have to find these private lenders first but since you’re offering a pretty solid deal backed by a state or country tax certificate, their risk is much lower than if they were making an equity investment. Their potential upside is also lower since they’re only earning interest on the loan and not back end participation, but it’s a great way for someone to diversify into a low risk deal.
The bottom line is this – debt is not for everyone and not available to most who think it is. You really have to come at it from the last piece of the puzzle after everything else is in place and you can serve as proof of value and collateral of the loan, the film package must demonstrate to the lender the value of the project. Since filming has not yet begun, the collateral includes tax rebate certificate (that hasn’t been collateralized yet by someone else), the screenplay and story rights; legally binding commitments by the key personnel to participate in the film; the production budget – including a draw-down schedule for the use of the proceeds as they are paid to the filmmaker throughout production; and most importantly, legally binding guarantees for the territory sales, negative pick-up, or other financing arrangement. These contracts must specify the guaranteed minimum the filmmaker will be paid, and that amount can be used as collateral to be pledged against the value of the loan.
The challenge with this late-stage private financing is two-fold. The producer is lumbered with high transaction fees, on top of all the bank charges, agency commissions, pre-paid interest, deferrals, and other contingencies that have already taken a bite out of the budget. The investor is also buying into a movie in which all the saleable foreign markets have been disposed of already. The only real asset that remains is the 20% tier of the foreign contracts and subsidy contracts which is not covered by the bank loan. This is also the riskiest tier. If the producer manages to bring the movie in on budget, some of that equity investment can be paid back from the contingency funds released by the completion bond company. Beyond that, the investor must hope that the unsold American rights will find a distribution home. If the film does not earn sufficient return to repay this loan, the filmmaker will be on the hook for the total unpaid loan amount. Another area to make sure that you are protected.
Most states (and several countries around the world) provide government aid for the development, pre-production, production, post-production and distribution of film, documentary, television series, commercials, video games and other audiovisual works. Such “soft money” sources include tax credits, tax deductions and tax shelters, cash rebates and grants, film funds and co-production funding. A Tax Shelter is a government-approved tax incentive program whereby a production company can raise production financing from a country’s taxpayers. Producers who qualify for these incentives are offered an average subsidy of 25 cents for every dollar of allowable production expense, a figure that has risen to more than 40 cents on the dollar for shoots in Alaska and Michigan.
In addition to state incentives there are also federal tax benefits available as well. If the film is made in the United States, producers may further educate potential investors on how to utilize the tax code Section 181 to reduce their tax burden and hence reduce their risk in financing the project.
Like bridge loans, tax credits can be helpful in filling in the gap between the money a filmmaker raises and the budget of the film. Individual states and countries allow film producers to subsidize the money spent on production through tax benefits. Typically, this requires the filmmaker to film a significant portion of the production in a local area, hire a certain number of local crew employees, rent from local vendors, and run payroll through local services. Tax credits are based on a lengthy application process and are often difficult to procure (Ex. NY is 16 to 18 month waiting period on a tax rebate). So, as investors that’s something that you need to account for in terms of recoupment. But, depending on the state or country, the benefits can be significant. For example, a $1 million movie can end up actually costing $750,000. This means that the filmmaker only needs to raise 75% of the film’s budget. In some cases, states allow for tax credits to be traded at a discount to rich people or entities looking to offset their own profits, in which case a percentage of the money is available to the production upfront. Whatever the system is, the attraction of such incentives is obvious: the more that soft money is able to reduce the budget, the quicker the film becomes profitable and the sooner equity holders get to share in that profit stream. “Anyone who makes a film in the US without a tax rebate is a de facto idiot,” proclaimed “Boyhood” producer John Sloss. As with the other forms of financing, due to the complexity of these transactions, its important for a filmmaker to know the rights regarding tax credits.
If your production will qualify for tax credits, many equity investors would prefer that the tax credits not be used as part of the finance plan to cash flow production. Therefore, if you’re able to qualify for Government subsidies, that doesn’t necessarily mean you have to increase your budget incrementally. You may use the tax credits or rebates to pay back your investors, rather than scaling up the budget because of it. Therefore, up to 80% of your investor’s investment can be secured by subsidies. These government subsidies can act as a partial safety net for the investor, if and when the movie flops at the box office and VOD.
How Do I Get Paid?
Most investors almost always skip to this. From the onset, it is important to note that there are multiple exit strategies for film investors looking to get back their equity capital. Some don’t even involve waiting until a film is released in theaters or watched on a small screen. Every year, at least one major film festival can point to an independent feature film whose distribution rights are sold on the spot for a multiple of its production budget. This immediate return of capital eliminates the investor’s exposure to performance risk — the ideal outcome for an investor, unless they are keen to play the long game and participate in the upside alongside the distributor.
It is very important that a good business plan set out exactly how a potential investor is going to get their money back and make a profit, how much time it’ll take and the order in which investor will recoup its investment. More often than not, a film has to start generating an income stream from its distribution before investors begin to see meaningful returns. For example, in a typical sales cycles, it may take 18-24 months after completion of the film before you can start positive cash flow.
Most filmmakers in the independent film world likely have to defer their producer fees and, if other talent will agree to defer their fees, then that much less money has to be raised to make the film. The problem with this method is that the “risk takers” are working for free and relying on the film’s success for payment. Certainly a gamble especially since all deferred fees will likely be paid only after the loans and investors have recouped.
Whether a first time or experienced filmmaker/producer, you will probably have to use a combination of the above financing options to make a film. Under any of the above options, the key is to present as complete a package as possible with all relevant, legally airtight attachments, a fleshed out budget and, at least, one experienced person to lend gravitas to the film. You might give financiers some assurance that the film will be made if all of these requirements are met.
So, what is a revenue waterfall? This is the contractual order in which financial contributors to a film’s production are repaid. From the total income to producer from worldwide sales and government incentives:
1. Any tax obligations and bank loan are repaid first
2. The costs associated with arranging distribution, including, sales agent’s fee and expenses, are paid
3. Equity investor’s first share (up to 120% of their investment)
4. The completion guarantor is repaid
5. Payment of any deferments to talent
6. Finally, you deduct investor’s share of profits (50%). Typically, any third-party talent participants (residuals/participation share) are paid from the producer’s share of profits, except for those participations that are deducted “off-the-top”, that is, before any division between producer and investor.
This is a simplified picture. As with all industry-specific corporate financing, there are many structures which can significantly increase the complexity of the returns waterfall. This is why a well-structured business plan is so important, balancing the competing claims on any film in a hopefully fair and equitable manner. While investors tend to concern themselves with limiting their downside exposure, going so far as to insist on significant fees within the film’s budget to help hedge their risk, it’s often the allocation of the upside that can cause greater problems. Even if it can obtain a relatively favorable recoupment position (e.g., ahead of deferrals) and a premium, a lot of money is paid out ahead of the investor. Another key consideration is timing. One of the reasons why investors like to keep budgets low is that this accelerates the break-even point and improves the internal rate of return on that investment. Too big a budget, especially in these times of diminishing pre-sales, and your capital is stuck.
There is no structure or mechanism to increase liquidity of film investments, either through clear exit strategies, or secondary capital markets. The dirty secret of film investment is that it is a long recoupment cycle with little planning for an exit strategy. Without a way to get out, fewer people choose to get in. It takes a particular investor to want to lock up an investment for four years. It’s important you work with a seasoned film financing consulting companies and/or law firm prior to moving forward with any film project as a financier.
The markets begin 2019 with a “stealth recovery” as all of the major indicators recorded positive increases. What’s driving the advance over the past three to four weeks? It doesn’t seem to be corporate earnings, which have been mixed for the companies that have reported so far. Projected earnings gains for the coming year are expected to show a growth rate of mid to high single-digits, compared with average gains last year of over 20%.
The gains have also come in the face of the longest government shutdown in our history. The shutdown was eating into 1Q GDP growth at the rate of 0.1% each week, according to some analysts. My guess is that the markets are finally coming to realize that they front-loaded the benefits of the 2017 tax bill, which are now beginning to fade. Those gains will pretty much be exhausted by 2020. Averaging the results for 2018 and 2019 might be the best way to handle the situation.
The wall! The government shutdown! Trump! Pelosi! McConnell! So many things to think about and to worry about. Do they have an impact on the U. S. economy or don’t they? It’s becoming more obvious that they do matter and that the general dysfunction in Washington, DC, is starting to infect the rest of the country. Quite a few years back, I heard Bill Seidman, an economist and then head of the FDIC, wittily introduce himself at a banking conference. He said, “I’m Bill Seidman, and I’m from Washington, DC. That’s 37 square miles surrounded by reality!” Everyone chuckled, but it’s becoming more obvious each day that he was on to something.
The government shutdown was a harsh reality for the 800,000 or so federal workers who didn’t received a paycheck and became more of a problem for millions of others whose jobs are interconnected with the U.S. government in some way or another.
Analysts are scrambling to figure out what the impact will be on the nation’s GDP for the first quarter of 2019. Some have predicted that each week of the shutdown will subtract a tenth of a percentage point from the nation’s overall output. A few extremists have even projected a flat or negative GDP for the quarter if the shutdown continues for another couple of months.
The economic impact of the shutdown obviously has to be weighing on the minds of the Federal Reserve and its FOMC Committee. My guess is that they will push back any short-term interest rate increases until at least late 2019, in order to offset the damage done to the economy from the shutdown. If the Fed doesn’t raise rates in 2019 it will likely give a boost to stock prices, and even bond prices as well.
How will the shutdown impact the monthly jobs numbers and the nation’s unemployment rate? No one knows for sure, and even some of the government agencies responsible for the data have been shut down. As economists are entering into relatively uncharted territory.
The headline on the front page of Saturday’s Wall Street Journal said it all, “Stocks Cap Worst Week Since 2008.” All three of the major indicators tumbled badly for the week and are likely to remain in negative territory for the year. The S&P 500 finally broke the lows set in February and March. Now it’s about 18% off the recent peak. U.S. small cap stocks and international stocks already went into a bear market (>20% off peak). Of the eight big asset classes — everything from bonds to U.S. and international stocks to commodities, not a single one of them is on track to post a return this year of more than 5%, a phenomenon last observed in 1972. So, you are looking like at another historically tough year. Nothing’s working, not large or small-cap stocks in the U.S., not international or emerging equities, not Treasuries, investment-grade bonds, commodities or real estate. Most of them are down, and the ones that are up are doing so by percentages in the low single-digits. That’s all but unique in history. Normally when something falls, something else gains. Amid the financial catastrophe of 2008, Treasuries rallied. In 1974, commodities were a bright spot. In 2002, it was REITs. In 2018, there’s nowhere to run.
As I noted in last month’s newsletter, there are a host of economic and political issues worrying the markets: interest rates, trade and tariffs, slowing growth in China, and “Brexit”. As of midnight Friday, you can add the partial federal government shutdown to that weighty list. The Trump Administration and Congress couldn’t agree on a funding plan even for the next couple of months. Presumably, the main sticking point was the President’s insistence on funding for a wall on the U.S. southern border. I doubt that the shutdown will have much impact on the economy so long as it is relatively short-lived. The markets were also disappointed in what they heard from Fed Chair Jerome Powell last Wednesday as the Fed’s FOMC Committee increased short-term interest rates by a quarter of one percent. The Committee evidently feels that two additional increases may be justified in 2019, even though they lowered their growth projection, and there is virtually no evidence of inflation in the economy.
The yield “spread” between short and long-term rates narrowed, putting additional pressure on the shares of banks and other financial institutions. The yield curve continued to flatten, worrying some analysts that it might become inverted, with short-term rates higher than long-term rates. Mortgage rates were virtually unchanged, though the housing sector continues to be weak. There’s a wide difference of opinion about where the U.S. economy is headed in the year ahead. Many economists and analysts believe that we’ll continue the strong performance we’ve had in 2018. They expect strong job growth to continue, wages to rise, and inflation to remain low. Others are less optimistic, worried that growth will not only slow, but that there’s a good chance of a recession just over the horizon. Which camp you’re in, if either, will color your reaction to last week’s announcement by the Federal Reserve that they would be increasing short-term interest rates, continuing on a path to “normalize” rates over the next year or two.
Travel hacking is a virtually no-brainer for consumers with higher income and strong credit. Travel hacking has obvious benefits. What are the limited downside considerations? Time and learning. Credit score is only slightly impacted and can expect to maintain your score 800+ with proper credit oversight.
In my opinion travel hacking includes the following buckets: Churning credit cards, manufactured spending, booking award travel efficiently and travel hacking without a credit card. Let’s break down these buckets in greater detail to help you plan your first travel hacking experience.
1) Churning Credit Cards
What is churning credit cards? Credit card churning is the act of repeatedly opening credit cards solely for the welcome bonus. The welcome bonus is usually the crux of receiving a large lump sum of airline miles or rewards points. For example, I recently opened the Chase Ink Preferred Card for the 100,000 Ultimate Rewards points after hitting the minimum spend. This is worth nearly $1,250 of travel rewards. I think I could find a destination for that.
2) Manufactured Spending
Manufactured spending is a loophole for generating more points using ‘artificial spending’ to turn credit card spending into cash. This cash, in turn, is used to pay off your credit card leading to $0 in net spend. You do manufactured spending for two primary reasons:
1) Meet the minimum spending requirements to meet the signup bonus without buying extra items.
2) Generate significant rewards points without actually buying anything.
How do you do manufactured spending? There are plenty of ways to do it and it is ever-changing, so stay nimble. However, there are some commonly known ways to participate in manufactured spending:
1) Funding bank accounts is the easiest manufactured spending method out available. It is fast and safe. You can only do this so often so choose your spots wisely. Doctor of Credit has a pretty comprehensive list of bank accounts (https://www.doctorofcredit.com/does-funding-a-bank-account-with-a-credit-card-count-as-a-purchase-or-cash-advance/) that can be funded with a credit card, including the limits and which credit cards have been reported to treat these as a cash advance.
2) Using your rewards card for all of your purchases and bills is another way to increase your spending on the card. With services like Plastiq, you can even pay your mortgage, rent and other major expenses with a credit card. The payment times lag, so you need to plan accordingly.
3) Purchase virtual gift cards and convert them into money orders.
This popular manufactured spending method of buying Visa, Mastercard or Amex gift cards has two steps: find a place to buy a gift card, then find a way to liquidate it. While most gift cards have activation fees, these can be offset by buying them at a store that qualifies for a category bonus on your credit card (e.g. such as a location offering the Chase Freedom 5% cash back categories). One-time promotions can make the deal even better. Often times, around Christmas, Simon Mall offers discounts on gift cards. Even if your credit card does not have any category bonus, some places sell gift cards with low activation fees that should easily be offset by whatever rewards you’ll get from the transaction. Simon malls are a popular example as most of them sell $500 Visa gift cards with a $3.95 activation fee. That equates to less than 1%, so if you are getting 3x points or even 2% cash back you are instantly coming out ahead.
Here are a few popular ways to liquidate gift cards with a PIN:
Buy money orders. Some grocery stores will allow you to buy a money order using a debit card (in your case, a Visa gift card) for a nominal fee, which you can then deposit in your bank account. Not all grocery stores will allow this and you need to do research or find data points reflecting what grocery stores will work. Not all grocery stores will allow this and you’ll need to do some online research then field testing to find one that will work. Please not that some banks do not like frequent money order deposits. Do not deposit money orders in to your personal bank account; set up a separate account.
Load your gift cards onto reloadable prepaid cards such as Amex Serve (https://www.serve.com/). If you receive a money order or check from manufactured spending, you can cash the check instantly.
3) Booking Award Travel Efficiently
An underrated component of travel hacking is booking your award travel efficiently. Travel hacking is solely a numbers game. Once you have amassed a large fortune of awards points, you need to deploy them in an efficient manner similar to how you would with spending or investing.
Some important definitions to consider include the following:
1) Cents per point – To calculate, you take the cost of the flight or hotel stay divided by the points redemption. For example, if you could pay $2,000 for a flight or redeem for 60,000 miles, your cents per point would equate to 3.33x. That is a very good redemption. Try to target anything above 1.5x. These are great ways to book award travel.
2) Transferability – The crown jewel rewards programs are typically the programs that offer the most flexibility with the rewards points. Rewards programs such as Chase Ultimate Rewards or American Express Membership Rewards offer maximum transferability. These programs have partnerships with virtually every airline imaginable, so you can transfer your point dollar for dollar to other airline programs for maximum redemption value. Additionally, they even offer flexible options to redeem for gift cards at your favorite stores. I would advise against this, however, since the redemption value is lower than travel. Organization is key here. Track all of your rewards programs in a simple document.
4) Travel Hacking Without a Credit Card
There is always a consideration to be made with travel hacking beyond credit cards. Far too many people believe that travel hacking only means opening a significant amount of credit cards. There is so much more that you can do other than solely just credit card reward bonuses.
Things that help with travel hacking without credit cards include:
1) Be cognizant of where you stay relative to the location – Staying in an American branded hotel in a foreign country (even it if it considered a 3-star hotel in America) may be viewed as a luxury hotel in a different country.
2) Find those hidden deal – Oftentimes, traveling via train/bus in foreign countries have opportunities for amazing deals. Hidden deals are hidden for a reason, so you must do your own research in certain cities. 3) Make sure you are earning rewards for anything that you do while traveling (especially work travel).
3) Oh, keep an eye out for bonuses too – Oftentimes these rewards programs offer bonuses like a free night for staying 2 nights over the course of a few months. Try creating a dummy email account where you can scrap the benefits for these various bonus options and avoid a bunch of promotional emails. However, if you can get on all these email lists, you will likely get targeted for special promotions.
In order to travel hack without a credit card, you need to travel and act like a pro. Are you going to be staying in a big city that you will spend most of your time outside exploring all of the landmarks? Well, why should you spend all your money on a luxurious hotel? There is a learning curve. This may be stressful for a rookie, so taking things very slowly will help you understand how the game works, and lets you get your feet wet. Also, it’s very important to always have a backup plan. Opening a number of different travel rewards programs takes some time and monitoring. It’s not easy. However, there are limited downside risks to travel hacking. It just takes some time and organization. I don’t know about you, but generating free money and rewards is highly attractive to me.
Many couples will end up paying for childcare in one form or another. This is especially true for households where both spouses are working and almost certainly true for dual attorney households. At attorney levels of income, especially for partners, most people avoid the second income trap (producing low net income after taxes, child care, maid, transportation, etc) and especially in duel attorneys’ homes it usually makes financial sense for both parents to work. Aside from being a stay-at-home parent or having relatives watch your child, the two most popular childcare choices are enrolling your child in a daycare center or hiring a nanny to watch your child in your home. Here are some tips and tricks to consider if you currently have a nanny or are considering one:
Follow the IRS Rules
Many attorneys pay their nanny in cash. This is a bad idea and clearly not consistent with IRS rules. Having a nanny means you are an employer. You should keep your nanny “on the books” and then pay taxes on your nanny’s salary. You can also take advantage of tax breaks via the Child Care Tax Credit and/or dependent care flexible spending accounts.
If you pay a domestic employee more than $2100 a year the IRS says you need to treat them like an employee, not a contractor. You will need an Employer Identification Number (easy to get from the IRS) and a way to calculate payroll. You’ll need to produce an I9 form proving that the nanny is eligible to work in the United States. You will be responsible for employer taxes and unemployment insurance. You will need to file a Schedule H with the IRS. None of this is particularly complicated but it all needs to be done and there can be consequences for those who ignore these rules. There are online services like HomeWork Solutions figures this all out, cuts your nanny a paycheck with a paystub and retains all of the tax information.
I know it’s easy to just cut a check and Venmo payment and it’s definitely the better route for the nanny looking to maximize their take-home pay. It’s just not legal after certain thresholds. Plus, the cash arrangements are bad for the nanny if they are trying to build employment history, get injured on the job, file for unemployment assistance, or want to collect a nice Social Security check in retirement.
Seek Help for Finding Nannies
Many sites like Care.com and SitterCity can perform background checks on the nannies they list for a low cost. In some cities, there are nanny placement services although these can be fairly expensive. There also exist some higher-end websites and placement agencies. The nannies coming through these services are the type who are going to perform full-service house management and have a gourmet dinner on the table when you get home in addition to having Junior in a clean romper. Expect to pay a significant premium if you enter these waters but for some very high-income attorneys, this may be money well spent.
Establish Clear Expectations and Have a Contract
Want your nanny to do dishes and household laundry? What about dog walking and grocery shopping? Will he or she be willing to work when your toddler is puking her brains out? These are all things to decide before the first day on the job. When hiring a nanny, you should discuss sick time and vacation days and create an agreement or a nanny contract. Also, as the employer, you should give your nanny feedback and have open conversations about her work. Simple nanny contracts are available online and you can edit these to suit your needs. Review by an attorney doesn’t seem to be necessary but would likely be relatively inexpensive. Be clear and straightforward, be as specific as possible. “Nanny will perform 3-5 household errands a week as requested” is far better than “Nanny to help as needed.” “Dishes done and countertops clean each day” is superior to “Light housekeeping expected.” Expect some negotiation especially if you are hiring an experienced nanny. It is better to that before work starts than to try to change gears in the middle of the race.
Use Technology for Ease and Convenience
Do your scheduling through a shared google calendar with hours sketched out well in advance. This allows you to track hours and our nanny to plan her life. Have your nanny carry a credit card for household purchases rather than petty cash. You can immediately reimburse them electronically for any expenses. All of the financials are online as well; your nanny experience is paperless and seamless. While there are surely many lovely people out there who do great child-care and are still using flip phones and pocket calendars, enjoy the added convenience of a smartphone system.
Weighing the Pros and Cons of Daycares
Daycare helps build social skills that can help your child in school and throughout life. Day care centers must follow state regulations around safety, staffing, sanitation, and space issues. Ask about the center’s most recent state license and if they have been accredited by the National Association for the Education of Young Children (NAEYC). The price of daycare tends to be more affordable than a nanny since you are sharing the cost with other families. The price varies based on location and type of facility. An in-home daycare center, also known as family care, is usually less expensive than a traditional daycare.
While there are many daycare pros, every pro comes with some sort of con. Daycare centers run on specific hours so if you are late picking up your child, it is probable that you will be subject to an extra charge. If you have a job where you cannot leave at a specific time each day, you may need more flexibility than daycare can offer. Daycare centers have strict sick policies so if your kid falls into their “sick” category, you have to take off from work or find other childcare arrangements when your child has an illness. Further, if your kid gets sick at daycare, you will have to pick them up and keep them home until they are free of the illness.
The right nanny makes your life work. There is nothing quite like getting home from a tough deposition and seeing your baby giggling with delight as a caring, professional nanny sings and plays with her. When choosing a childcare situation for your family, sit down and make a list of what is most important to your family. Be honest with yourself about your needs and wants and think about things that may upset or frustrate you. Remember that no decision is permanent and you can always change your situation based on your needs or your child’s needs.
This is the first year-end season when employees with stock compensation must consider the tax changes introduced in 2018 by the Tax Cuts & Jobs Act (TCJA). Fortunately, the new tax law doesn’t make any huge changes in the usual year-end steps that you and your financial advisor should consider when you have stock options, restricted stock/RSUs and company stock holdings.
“Tax reform” is the blanket term often applied to the TCJA, which made two major types of changes in the tax laws for individuals. In some areas, the TCJA made straight-up tax cuts. In others, it restructured or eliminated tax provisions. Each of those two categories affects your year-end strategies differently, as explained below.
The TCJA modified the income tax rate and income ranges of each tax bracket, including the reduction of the top income tax rate from 39.6% to 37%. However, we still have the same number of tax brackets (lucky seven), and the capital gains tax and the Medicare surtaxes remain unchanged.
What this means: Whenever you consider exercising stock options or selling shares at year-end (or recognize any extra income), you need to know your tax bracket. Even with the lower tax rates that took effect in 2018, you still want to consider the income thresholds that would trigger a higher tax rate and the Medicare surtax on investment income.
In general, you want to do the following multi-year planning, just as you did before the TCJA.
1) Keep your yearly income under the thresholds for higher tax rates and know the additional room you have for more income in your 2018 and 2019 tax brackets.
2) Recognize income at times when your yearly income and tax rates may, according to your projections, be lower.
The flat withholding rates for supplemental wages, including stock compensation, are tied to the seven income tax brackets, so those changed too. For income up to $1 million in a calendar year, the withholding rate is now 22%. For amounts of income in excess of $1 million during a calendar year, the withholding rate is 37%.
What this means: The 22% rate of withholding may not cover all of the taxes you will owe on income from an exercise of nonqualified stock options (NQSOs) or a vesting of restricted stock or restricted stock units. You must therefore know the tax bracket for your total income and assess the need to (1) put money aside to pay the additional taxes with your tax return, (2) increase the withholding on your salary, or (3) pay estimated taxes.
The checklist below summarizes what you need for comprehensive year-end planning with stock compensation.
– Exercises, vestings, and ESPP purchases in current year
– Holdings of NQSOs, ISOs, restricted stock/RSUs, and company shares
– Scheduled vestings in the year ahead, including the end of the cycle for a performance share grant and when payout occurs
– Salary contributions allocated for ESPP purchases
– Deadlines for option or SAR exercises and the expiration dates of option grants
– Expected new grants in year ahead and ESPP enrollment/change dates
– Trading windows and blackouts, company ownership guidelines, and any post-vest holding-period requirements
– Your ability to spread the recognition of income from certain sources over 2018 and 2019
– Your new marginal tax rate after tax reform and whether the flat rate for federal supplemental withholding covers it
– Your situation, including short-term cash needs that may prompt you to sell company stock and/or exercise options
– Whether your decisions should be entirely tax-driven
– Your outlook for both your company’s stock price and your job
– How comfortable you are with your concentration in company stock and whether you should diversify
– Multi-year projections for your income and taxes
– Donations in company shares instead of in cash
Company and brokerage firm statements, whether online or in print. You will need them for tax-return reporting.
Attorneys need to be vigilant with their Universal Life (UL) policies and get a second opinion from a fee-only fiduciary. Because UL policies contractually allow insurers to adjust insurance costs up to a maximum rate (sometimes an increase into the double and triple digits on a percentage basis) based on certain factors.
Time after time, I encounter investors who were unaware that fees and expenses in a universal life or variable universal life policy can skyrocket. With universal life, that means understanding that a contract could go “sideways” if insurers credit the minimum interest rate to a policy and impose the highest contractual cost of insurance.
Two years from now, California voters may have a chance to touch the third rail of state politics…proposition 13. A coalition of good-government groups, social justice organizations, affordable housing advocates and teachers unions held press conferences across the state today announcing they had submitted signatures for a measure that would significantly increase property taxes on California businesses and generates tens of billions in revenue for local and state governments.
Opportunity zone funds are the hottest topic in commercial real estate. Last month, the first round of regulations was officially released, answering many of the questions investors have about the funds—but not all of them. There are still a set of unknowns, most of which should be answered in a second round of regulation announcements at the end of the year.
Personally, I don’t see a lot of focus on what the capital base looks like and who the right investors are for these projects. Is it going to be high net worth individuals that have capital gains, or is it going to be unaccredited investors that have capital gains?
If you’re trying to find ways to deduct those losses against your attorney income or restructure your investments this is a great episode to pick up some tips.
Tax reform made a lot of good changes in the tax law for the small-business owner. But the changes to the net operating loss (NOL) deduction rules are not in the good-changes category. They are designed to hurt you and put money in the IRS’s pocket.
Now, if you have a bad year in your business, the new NOL rules are designed to stop you from using your business loss to find some immediate cash. The new (let’s call them bad-for-you) rules certainly differ from the prior beneficial rules.
Don’t worry. We’re here to help. We’ll give you five strategies you can use to get an immediate tax benefit from your business loss. And the good news is that you’ll likely end up better off with our strategies than with your options before tax reform.
As I’ve mentioned before, the stock market was lifted to record highs by just a few stocks that have disproportionate weightings. We are talking about Apple, Facebook, Amazon, Netflix, Google and Microsoft, although there were others that helped along the way. Since those stocks are in nearly every technology index fund and major ETF, they can either be very helpful in a rally, or very heavy in a sell-off. We are experiencing the latter and its impossible to say when investor sentiment will turn back in their favor. The sector rotation out of growth and technology stocks and into value has been happening since August. It may get worse as we approach the end of the year since there are very few catalysts to change perceptions.
After two-consecutive winning weeks on Wall Street, which included a nice rally at the start of November, the bears took back control of trading last week. Most of the damage was done early in the week, including a notable selloff last Monday, which saw the Dow Jones Industrial Average fall more than 600 points. Last week started with three straight losing days for the U.S. equity market before the bargain hunters returned over the final two trading days to pare the weekly losses. For the week, the Dow Jones Industrial Average, the NASDAQ, and the broader S&P 500 Index finished 2.2%, 2.1%, and 1.6% lower, respectively.
There are many variables in play for Wall Street right now, and we think some of the uncertainty arising has played a big hand in the spike in volatility this fall. Last week, the market was unnerved by a few events, most notably the signs that amicable Brexit deal stills appears far off. That has brought a good deal of uncertainty for the United Kingdom and the European Union. There were also continued worries about the health of Italy’s financial system; the ongoing global trade disputes and the effect it will have on the global economy; rising U.S. bond yields, and the impact such has on emerging market yields; and the recent slowing pace of GDP growth in China. The concerns about China’s economy, and the impact it will have on oil consumption has pushed crude oil prices into bear market territory, which is defined of a retreat of more than 20% from its most recent high. Not surprisingly, against this backdrop, it is easy to see why there has been a spike in equity market volatility. The CBOE Volatility Index (or VIX) rose more than 3% last week.
The sell-off we have been experiencing, while painful, is not historically bad, by any means. The numbers are large, because, well… the numbers are large. We’ve had multiple market records over the past two years, so a 10 percent decline looks bad, smells bad and feels bad.
Around two-thirds of the stocks in the S&P 500 are in a correction, and about one-third are in a bear market today. The index itself is flat for the year, which is a function of the performance of a select few stocks that outperformed in the first half of the year.
But the declines are comparable to other pullbacks, as we will demonstrate in our chart of the day, below:
The BMO Investment Strategy Group ran the numbers from the last correction back in February and showed that even fewer stocks entered bear market territory, although more stocks were in a correction. Every correction going back to 1990 was far worse, except for November 2012, June 2012, August 2004 and April 1997. This is not to say that this selloff won’t get worse and turn into a full blown correction or bear market. We can’t predict that one way or the other. It’s just important to keep this perspective when we have days like today and last week when all we see is red.