Royalty Financing: An Alternative Equity Financing Mechanism

This paper examines a case where $5 million is required for reserve development, drilling and feasibility work on a million-ounce discovery that ha - already reached the pre­ feasibility stage, and compare scenarios where the capital is raised via the 'sale of equity or the sale of a royalty'.

Selling a royalty causes less dilution than joint venturing, and preserves existing shareholders' interest. at the corporate level. Depending on the likely cost structure of the mine, the operator may seek to sell a net profits interest or a net smelter returns royalty. In down markets, the Net Profits Interest (NPI) offers more upside for the royalty financier and less risk for the operator and thus may be an attractive alternative to the conventional Net Smelter Returns (NSR) form of royalty.

The disadvantages of conventional mine finance become particularly pronounced in times of a down market. When equity markets are buoyant, the sale of equity can be an inexpensive S0Luce of finance; conversely, when the markets are in the doldrums, selling equity can seriously erode the existing shareholder base because low share prices force too much of the company to be sold. The most common alternative to selling equity is to the joint venture. While joint venturing presents an attractive variation, it still results in dilution to shareholders at the level of the property. It can also make life more complicated if the interests of the parb1ers start to differ. Debt financing may be an alternative for more advanced projects, but most smaller or earlier stage companies may find required debt covenants overly restrictive (the Company may be prevented from selling assets or restructuring existing contracts).

Selling a royalty interest to finance further development and a feasibility study can present an acceptable solution to raising capital while simultaneously avoiding dilution or new partners. In countries with accounting conventions similar to those in the United States, a royalty payment is a cost of sales and is accounted for as an expense. For a gold producer looking for annual ounces of gold production and reserve base, the Company books all of the gold production for its own account and subtracts the dollar amount of the royalty as a cash cost of production. The royalty burden does not reduce the number of ounces of gold that the operator can claim to produce, and the operator retains the full amount of gold reserves on its books, undiluted by the royalty burden.

The two most common forms of mineral royalty interest are the Net Smelter Returns and the Net Profits Interest.

NSR Royalties

An NSR royalty is calculated in percentage terms based upon the amount of proceeds paid by are finery or smelter for dare or concentrates. Depending on the commodity or product produced, an NS R can vary widely. An NSR royalty on a gold mine where the product is dare closely approximates a percentage of the gross value of gold produced; however, if the gold contained in concentrates, the smelting charges will exceed those incurred in refining dare, and the royalty will be commensurately less. Smelting charges for base metals constitute a large portion of the value of contained base metals, implying that an NSR on a base metal mine (even one with a precious metal credit) will be even smaller. For purposes of this paper, assume that an NSR royalty equates to a percentage interest in 99% of the revenue (1% being deducted for transportation, insurance, and refining). NS Rs are commonly used because of their relative case of calculation; however, because they are tied to revenue, with essentially no consideration for costs, SRs place most of the risk on the operator, who face paying the royalty whether commodity prices are high or low.

NPI Royalties

An NPI royalty is calculated in percentage terms, based upon the net profits of the operation. Therein lies its attractiveness: the NPI spreads the risk between the operator of the mine and the owner of the royalty. Both share in the profits, therefore, their interests tend to be more aligned. The mine operator knows that the NPI will diminish if profit margins are squeezed, but he/she must give up more of the upside when times are good. From the owner's perspective, there is much more of a between to understanding the complexity of mining and processing costs and having access to the operator 's production and sales information. Due to these latter considerations, it behoves the owner of an NPI to have considerable skill and capability at monitoring and auditing the operation.

Performance Comparison: NSR vs. the more leveraged NPI

NSR: Tied to mine revenue, offers higher pay-out in down markets, places the risk on the operator, no leverage. (A 17% increase in the gold price from $3 00/oz to $350/oz results in a 17% increase in the royalty).

NPI: Tied to profits, offers higher yield in up markets, operator and owner share risk, highly levered. (On the same 17 % increase in the gold price, an NPI offers a 50% increase in profits and pay-out).