The Net Profits Puzzle
The use of "net profit" clauses in the movie business poses a problem. The standard perception is that Hollywood accounting results in successful films showing no net profits. If that is indeed so, then why have they survived for over four decades? This paper argues that a successful movie will fail to yield net profits only if a "gross participant" (a major star whose compensation is in part a function of the film's gross receipts) becomes associated with the film. Since the net participants typically are associated with a project first, the question becomes: why would net participants be willing to sacrifice some (or all) of their contingent compensation when a gross participant is added to the project. The answer is that the net participants are made better off, ex ante, both directly by increasing their expected earnings, and indirectly because the studio is willing to pay for the increased flexibility. Contingent compensation is endemic in the movie industry. Because the inputs for the commercial success of a movie are not all supplied simultaneously, the compensation schemes will be tailored to induce effort at the appropriate time. If the studio-distributor gives up too much of the back-end, it waters down its incentives to market the film effectively. At the same time, giving the net profit participants a share of the back-end sharpens their incentives, both before and after the completion of production. The net profits clause nicely balances these two effects.