Fred Wilson writes one of my favorite blogs.  He’s a venture capitalist based in New York, and his blog is always stimulating, honest, bracing, and provoking. 

A few weeks ago, he wrote a terrific post on venture fund economics, in which he described what is, in Hollywood terms, the search for a hit – a hit that showers everything with money, a hit that pays for all of the non-hits.

The term he used is “a deal that returns the fund.” 

Here’s what I wrote in response:

Great posts. Thanks, Fred...

I keep applying this to the Hollywood model, which I operate in, and it's not so different. Lots of at-bats, lots of sinkholes, some outright bombs, one or two strong runners, and then a hit that showers everything with money.

Peter Guber tells the story of his first meeting with his Sony bosses in Tokyo, after they installed him at what was then Columbia/Tri- Star, and he told them his business plan: make about 14 movies a year -- 6 will do okay, maybe break even; 2 or 3 will do a bit better, and have franchise possibilities; 2 will be hits; 1 will be a monster hit; and at least 3 will be total losses, total bombs. They listened respectfully, then one of the older guys asked (through an interpreter), "May I ask Guber-san why he bothers to make the bombs?"

I guess the real question is, what can you learn from the failures that might help move the successes along? In Hollywood, honestly, not much. There's a temptation to learn too much, if anything. Each failure suggests its own new rules, most of which aren't useful: No more westerns! No dark comedies! And that holds until someone makes a hit western, or dark comedy, and then the rules are rewritten again.

Personnel, I guess, is one area where you can learn a lot from a failure. There are people I've worked with on failed shows that I can't wait to work with again; actors and writers who are fantastic -- a failed show or movie really has a million reasons for going down. And there are people I'd never work with again, even though we worked on a successful project together.

I can think of times when I consciously went to "swing for the fence" and pitched a project that really was a little out there, and times when I made a more strategic decision and pitched an 8:30 show to a network that needed a 8:30 show. In a fear- based business (which Hollywood most definitely is) the trick is to convince the studio or network that's putting up the money that your project is a straight-down-the- middle double. And then when they greenlight the project, you start swinging for the fence!

I'm guessing that's where the venture model and the Hollywood model part company....

To which Fred replied:

Here's where early stage VC and Hollywood might be different. We get to start with a 250k wager, then see a flop that can last a year, then put up a 1mm additional bet, then see another flop that lasts another year, at that point we can go all in, or ask to see another flop.

Its risk mitigation with outs along the way that include selling the company early.

Can Holywood play the game that way?

And then I said:

Well, theoretically, of course, the major studios could figure out a way to do business like this. But it's awfully hard to change a culture, especially one that is still making a lot of people rich. It's sort of like the Ottoman Empire in 1850: a glorious history, lots of treasure, creeping decay.

Incremental investing of the kind you describe is hard to do when you have a closed- ended product. It's hard to invest in a movie in stages, because you really have no idea until you've seen the finished picture if it's any good or not. The truth is -- and this is why people in this business seem so anxious and crazy all the time -- is that a great script and a great cast and a great director really don't add up to a great movie, necessarily. Hits are lightning in a bottle. Hits are the worst possible thing: that thing that can't be reverse engineered.

So the studios do the smart thing: they try to spread the risk around, and raise capital from hedge funds and private equity funds, with hilariously lop-sided terms, to fund their conservative, highly hedged and promoted big releases, betting that even if they have to share the profits of, say, Iron Man, they've subsidized the development of a huge franchise that's going to last, maybe, 10 years (or more, look at "The Dark Knight") .

The problem for them is, they used to be the only game in town. Studios and media companies used to make all the movies, produce all the TV shows. Now they've moved sideways a bit along the chain, and they've bought distribution outfits like MySpace and TV networks and Last.fm. But they've shut down their development efforts, so the script and project pipeline is shorter and a lot tighter. My prediction is that they're going to essentially outsource the "new idea" business to the web, to people with funny blogs and short YouTube films, things like that. The media companies that used to be such great incubators of scripts and stories are finding it hard to afford that side of the business.

Which is great news, actually, if you're a young person who wants to break into Hollywood. And exciting if you're someone like me, who's been in it for a while and doesn't have a crushing mortgage. But if you're in the middle somewhere, these are tough times. Textbook times, actually: an old business getting squeezed by disruptive, cheaper innovations...

All of this can be found here, on my Disqus page.  (I’m trying my hardest to get Disqus up and running on this blog, too.  What a great product!)

The shorter, better way to put all of it was said by a brilliant writer and mathematician – and general polymath – Arthur Devany, who wrote the best book on Hollywood economics since… well, there haven’t been any others.

He puts it this way, roughly:  5% of the movies pay for the other 95%.  Trouble is, you have no way of knowing which movies are going to be in that 5%.