The definition of vertical integration is as follows: “The combination in one company of two or more stages of production normally operated by separate companies.”
Many of us are familiar with “vertical integration” and see it on a regular basis – most recognizably in the areas of communications and technology. For example, phone companies (such as Apple and Verizon) virtually perform every function of the supply chain, e.g. research and development, manufacturing of the product, purchasing of the phone towers, ownership of the retail stores, customer service, maintenance and monthly subscriptions, and processing – as well as offering additional communications services, such as internet and cable. Today, companies find growth and efficiency in being immersed across the supply chain.
Vertical Integration in Entertainment
While the world of entertainment – and especially its impact on profit participations – is less obvious than the examples above, its proliferation in the industry is just as poignant. Like other industries, consolidation within the entertainment industry continues for economies of scale and efficiency reasons. In terms of vertical integration structures, each studio appears to have a similar structure, such as 20th Century Fox, which produces and distributes its own television series and movies and licenses them on its affiliated network, and Fox Broadcasting Channel and its numerous basic cable channels: FX, FXM and FXX, as well as online platforms Fox.com, FX.com, etc.
Viacom owns Paramount and several well-known television stations such as BET, CMT, MTV, Nickelodeon and VH1. Time Warner owns Warner Brothers as well as HBO, Turner and The CW. Recent vertical integration examples include Lionsgate’s acquisition of Starz and Universal’s acquisition of Dreamworks Animation.
Other forms of vertical integration can be seen via Epix and Hulu, both of which are partially owned by several major studios, which often license them their own film and television properties. Also, related party “Internet/Online” and “On-Demand” exploitation may oftentimes create potential issues, as the agreements are sometimes unclear as to how such secondary rights and revenue streams should be accounted for, if at all.
Arguably the largest vertical integrator is the Walt Disney Company, which owns the companies that create and produce film and television properties, and are then marketed and distributed by Disney throughout the world, who therein broadcast on affiliated networks, such as ABC and other channels and platforms like ABC.com. The home videos are manufactured by Buena Vista Home Video, which is owned by Disney, and oftentimes shipped to Disney retail stores, along with significant forms of other consumer products such as toys, games, etc. and sold directly to the customers. Many of the products are found in Disney’s hotel, restaurants and theme parks.
Vertical Integration and Profit Participations
How does the trend toward consolidation and vertical integration impact the profit participants? What can we do to ensure “fair and reasonable” reporting of revenues and expenses between vertically integrated affiliated or related parties?
Our main concern is that the vertically integrated relationships could potentially either understate the revenues or overstate the deductions on the participation statement. When the payment effectively goes from “one pocket to the other,” there is an inherent risk of entering into business transactions which are not at “arm’s length.” When evaluating the underlying transaction, you should ask: “Had the studio licensed the same property in the same manner to an unrelated party, could it have earned more revenue?”
The most telling evidence of the significant impact vertical integration has on a profit participant was seen in the court’s decision to force Disney to pay Celador $319M in relation to the Who Wants To Be A Millionaire litigation. According to a Bloomberg article, “Buena Vista and ABC ‘through a complex web of self-dealing transactions’ allowed ABC to keep the advertising revenue and pay Buena Vista only a licensing fee equal to the cost of producing the show. That kept Buena Vista from earning a profit from ‘Millionaire’ that it would have had to share.”
While the participation agreements, which dictate the terms and conditions, may require the studio to be “fair and reasonable[…]when dealing with affiliates” and “consistent with unrelated third parties,” such may not be properly adhered to, as the terms are ambiguous and extremely difficult to prove or disprove.
In the agreement negotiation phase, you should consider requiring approval of significant related party deals, specifying what documents are acceptable to confirm compliance with the related party “fair dealing” provisions or perhaps require that distribution fees be reduced or removed in connection with related party deals, if applicable.
Furthermore, you may wish to exercise your audit rights to review the details supporting related party transactions.
We hope the above was informative and helpful. Please let us know if you have any questions or we can assist in anyway.