There is big money to be made in backing artists even at a time when conventional models of music business have been hit by the downloading revolution. But watch out for pitfalls.

The huge – at least for now – popularity of music contests like the X-Factor has highlighted how there is big money to be made in backing artists even at a time when conventional models of music business have been hit by the downloading revolution and the assaults on traditional forms of intellectual property. And banks such as Investec and Coutts have even set up client segments to cater to people working and making a living in these areas. Here, Ben Gisbey, a senior entertainment and music industry lawyer at Bray and Krais Solicitors, explains the benefits and the challenges of this field.

The music industry is vibrant and generates billions each year. Figures for 2011 currently show worldwide music industry revenues of $67.6 billion, which is just under $7 billion more than five years ago. The industry has undergone many changes in recent years, but there is still money to be made and opportunities for savvy investors. However, music industry corporate deals have a number of potential obstacles which need to be overcome as part of the negotiation and due diligence for the investor to reap the benefits from the venture.

Music industry corporate deals include equity and debt investments; joint ventures in both start-ups and established businesses, such as record labels, publishing businesses, live events and festivals, rights management businesses; share sales and business sales; and so called “DIY artist deals” to name but a few. Each of these presents their own challenges, but there are a number of reoccurring themes:

Control vs flexibility

An investor will often want - and be used to - various controls in a joint venture. This will not always be possible to the same extent as it might in a non-music industry joint venture, as artists, managers and entrepreneurs will request more creative flexibility. A key question here is to what extent the investor should retain control over the use of funding. Due to the difficult balance of control and flexibility, an investor ultimately needs to be happy that the right management team is in place.

DIY artist deals

The balancing act referred to above is most stark when it comes to “DIY artist deals”, where artists decide to retain their rights, self-release their own albums and promote their own live events etc, and then seek funding in order to do so. Part of the perceived attraction of DIY artist deals (typically operated through a corporate joint venture structure) is that, in addition to retaining their rights, the artist can make decisions about their career to a greater extent than they might previously have been able to. What the investor brings to the table is the ability to reduce the personal financial risk to the artist of going it alone. Although an investor will of course need controls (particularly over the use of funds), if these controls are too onerous so that the artist and manager do not have the creative freedoms that they seek, the attractions of doing a DIY deal are significantly reduced. This is particularly the case for established or legacy acts that could otherwise just fund the album or venture themselves, or sign a traditional deal.

Securing the relevant rights

It is important to identify what assets and/or rights are needed, for example, recording, publishing, merchandising, sponsorship, or live rights, and make sure that these are held in the entity that is being invested into or, if this is not possible, that the investment vehicle is the beneficiary of the relevant revenue streams relating to those rights. This point may sound obvious, but rights may often be held in a mixture of different companies, partnerships or in the hands of individuals, and there may be restrictions in the relevant agreements on assigning these which require consents to be obtained from third parties. Due diligence is essential to ensure that the investor is actually investing in what they think they are investing in and to ensure that there is sufficient time to obtain any required consents or transfers to the joint venture vehicle or security over the relevant revenue streams. A third party with no direct involvement in the venture, but whose consent is needed or whose rights are to be transferred, may not have the same urgency as the parties to the venture. Recognising these potential stumbling blocks early on is essential.

Creative vs business approaches

Investors may not have the same comfort they might do in entering into
deals outside of the creative industries.  For example, there may not be
the same documentation an investor might be used to, in terms of
business plans and management accounts etc and company books may be out
of date or non-existent and filings incomplete. This is particularly
the case where a company may have been used as a “lifestyle” company. However, this is one of the reasons where an investor can add value and
make a business even more profitable.

Imposing a record deal structure on a corporate deal

Often music industry individuals will bring their experience of record, publishing or other music industry deals to bear when negotiating a corporate deal and this may lead to confusion. For example, where the individual is also investing in the business, a frequent question is, “How will I recoup the money paid for the shares?”, as if the price paid should be treated as an advance to be first reimbursed from business profits, without realising that the payment is for the shares themselves and that their “recoupment” will happen when the company makes profits or they sell their shares.

Manipulating the share structure

Individuals not accustomed to corporate transactions will sometimes suggest structures which, although not impossible from a corporate perspective, may cause more issues than they might have anticipated. Such issues often include adverse tax consequences and unnecessary complexity and so it is important to understand exactly what is intended to be achieved in order to find the most appropriate solution. Whilst it may not be the investor that is suggesting these structures, investors need to be aware of these potential hurdles. For example:

-- Shares for free: Individuals will often ask for shares for free or at nominal value, either on entry into the venture or upon certain milestones being reached during the venture.  This can have significant income tax implications for the individual where the company has an existing value and/or where the issue of shares is related to employment,where there may also be a tax implication for the company.

-- Return of shares: Individuals may suggest during a negotiation that they "want their shares back" on specified events, for example at the end of a side deal connected to the joint venture, such as a distribution deal; or at some other point in the future, such as upon repayment of a loan made by the investor, which may require putting in place option or buy-back arrangements.  This will most likely involve a payment by the individual to reacquire the shares at market value,which the individual may not have anticipated; or if shares are to be reacquired at nominal value, for example because the shareholding was connected to a commercial arrangement that has come to an end, then this will give rise to tax and legal issues that need to be mitigated.

-- Additional shares: Individuals may say that if certain milestones are reached, they want their shareholding to increase.  Whilst this is possible from a corporate perspective, through the use of ratchets or reverse/conditional vesting of shares, it will depend on the level of investment in the deal as to whether the transaction warrants this level of complexity and the consequent professional fees necessary to put the structure in place.

Tax reliefs

As always, it is important for the investor to take tax advice in relation to both structuringand exit from the venture, as this may allow significant tax savings through the use of reliefs such as entrepreneur's relief and EIS relief.

Exit: Depending on the nature of the business, the individuals involved may not have considered when and how the investor will exit the venture, whereas this will be high on the investor’s list of priorities.  Where the deal relates to a specific event or is otherwise limited to a set period, this will not be such an issue.  However, where the investment is in an on-going business, the counterparty will be keen to ensure that they have pre-emption rights over any share sale by the investor or commonly an option to buy out the investor at a pre-agreed future date.  This is particularly relevant where the business relates to an individual, such as a DIY artist deal, as the individual will not want their rights being owned by a third party.  Therefore, an investor cannot always expect to have complete freedom of sale or the benefit of drag-along rights as they might do in other business investments.

If done correctly, the pitfalls of doing music industry deals can be negotiated and the risks reduced.  Whilst the music industry may be in a constant state of change, this presents opportunities which, along with the potential financial rewards, make overcoming the challenges worthwhile.