Understanding and Using Royalty Based Financing
Michael R. Cartwright, CMA, ASA, RPG ((c) 1995)

Introduction: Funding for advanced exploration, feasibility studies, mine development and mine site capital improvements or production expansion is often a major problem for many small and mid-size mining companies. Traditional methods of financing these projects have been through personal loans from friends and relatives, bank loans, joint ventures and attempting to take the company public. Oftentimes, none of these financing methods are available or suitable for small and mid-size miners. Traditional financing methods may not be economically suitable because of drains on capital or operating income or problems associated with losing operating control or sacrificing the owner’s equity. Mineral product, lending and investment market conditions may also prevent miners from relying on typical capital funding methods at times when money is most needed. This article briefly describes royalty based financing techniques and some of the benefits which mining companies can obtain by using them.

Royalty based financing is a specialized technical and financial niche in the mining industry which provides custom tailored methods for mining companies to acquire mine development and production expansion capital. Royalty companies and investment groups can provide the miner with capital for improvement, expansion or purchase while also providing the necessary return on investment to both the miner and the royalty group. One of the main benefits of royalty based financing is that a production royalty allows the miner to maintain 100% ownership in the mine. For many mining operations, capital funding can be obtained without any payback obligation except the creation of a royalty based only on mineral production and sales.

Benefits: Creating a production based royalty on a mining property in order to secure capital funding has many advantages over conventional financing methods: (1) Royalty companies and investment groups are usually less restricted in geographical area, type of mineral or mining and processing method than more conventional funding sources; (2) Royalty companies can create a royalty financing package that is unique to the miner’s property and economic situation without undue reliance on more formal approaches and absolute debt coverage ratios; (3) Royalty based financing groups understand the geologic, mining, processing and marketing aspects of mine operation and do not require excess education efforts by the miner which usually allows for quicker decision making; (4) Production royalties do not dilute the equity position of existing owners or operators and normally royalty companies will not be directly involved in or control the miner’s operation; (5) Royalty financing groups have the financial flexibility to close transactions ranging from several hundred thousand to fifty million dollars; (6) Payback of royalty based financings is normally covered solely from mineral production and sales while conventional sources always require inflexible payback schedules, even if the mine encounters production difficulties or fails to go into production; (7) Royalty investors also provide a market for the sale of existing royalties held by individuals, for royalties generated by farmouts, and for royalties that are established through the dilution of interest of small miners that are joint ventured with large mining companies.

Royalty based financing can often be obtained for uses that would not meet the size or underwriting criteria of conventional sources. Royalty financing is a unique method for mining companies to obtain funding and is a useful technique for many operating and economic situations, including: (1) Partner or equity/debt holder buyout; (2) Completion of feasibility study; (3) Funding of mine development from feasibility through production; (4) Financing mine development in new areas; (5) Production or product line expansion; (6) Purchase of existing mine; (7) Establishment of completion guarantees, and; (8) Purchase of farmout royalties; (9) Purchase of existing royalties from individuals, partnerships and non-mining companies.

Buyout Financing: A miner may want to buy out joint venture partners, or other equity or debt interest holders, but lacks the required cash. An equity interest holder could also want a miner to buy them out, but the operator lacks sufficient funds and the equity holder does not want a long term payment schedule. A royalty could be created that allows the miner to purchase these types of interests, and end up with 100% of the equity. This transaction benefits the miner by leaving him with full operating control and ownership which may improve his mining operations and financial standing. The departing interest holders now have cash they can use for other purposes. The royalty creator has achieved a necessary return on investment of its capital without being involved in day-to-day mining operations. A royalty created for partner buyouts on a producing mine usually provides royalty holder payments based solely on mineral production and sales.

Completion of a Feasibility Study: Mining companies have run out of working capital after spending very large sums of money on exploration that resulted in a developable mineral resource. These miners may not have the necessary additional funds required to complete a feasibility study, which demonstrates the existence of proven and probable mineral reserves in sufficient detail to obtain conventional financing. A royalty can be created which would provide the miner with sufficient funding to complete a feasibility study. A royalty created at this stage of a potential mine often provides that the only return to which the royalty holder is entitled to, is payment of the royalty, if and when mineral production and sales occur. The mining operator may be able to acquire funds free from mandatory and inflexible repayment obligations, even if the mine encounters production difficulties or fails to go into production.

Funding Mine Development from Feasibility to Production: Mining operators can also find themselves with a completed feasibility study that clearly demonstrates the existence of proven and probable mineral reserves, but they are still unable to obtain conventional funding to go into production. Conventional funding sources may be reluctant to advance funds because of the property’s geographic location, the type of mineral, the mining and processing methods or the size of the financing. Another conventional method to fund mine development is for the operator to take in a joint venture partner. A miner may not want to dilute its equity position or sacrifice operational control of the mine, which would be required by having a joint venture partner. It is possible to create a royalty on the mining property which will provide the necessary capital to develop the mine, construct the processing facility and provide working capital through initial mineral product sales. A royalty created at this stage of a mining operation usually does not result in any mandatory or scheduled repayment obligation. The royalty holder will normally only receive payment from actual mineral production and sales.

Financing New Mine Development: Some miners could expand their production capacity by developing adjacent or nearby mineral property they control, but they cannot fund this work from existing cash flow. The miner is not generally willing to give up equity in the total mining operation to a joint venturer in order to develop an adjacent property and, a joint venturer may not be interested in participating in only the new operation. Just as in funding a totally new mining operation, a royalty may be created on the new property that will be sufficient to secure funding for the development work. If the new development area was unable to support an acceptable royalty on its own, an additional royalty could be created on the existing property that would allow both the miner and royalty company to proceed with funding. Alternatively a royalty could be created only on the existing mining property, leaving the new development area open for future royalty based funding. This type of royalty arrangement is not too common, but in the right situations, it is a funding method that is of value to both the operator and the royalty company. As in the other cases above, the royalty payments will only come from mineral production and sales.

Production or Product Line Expansion: This situation is analogous to development of an adjacent mineral property. A mineral property may be capable of a dramatically increased rate of production, or of producing another mineral commodity from the same mining operation, or its processing system could be modified to produce a higher value-added product, but the operator cannot finance this expansion from existing cash flow. It is not uncommon for different minerals from the same deposit to have a different royalty structure applied to them. Depending upon the cash flow that is capable of being generated and the risk profile associated with the existing and new production level, or the new mineral product line, an acceptable royalty could be created on the existing operation, the new operation or a combination of them. Again, royalty payments will normally come only from mineral production and sales.

Purchase of an Existing Mining Operation: A miner may have an opportunity to purchase a producing mining property or one at an advanced exploration or development stage. Growth through acquisition of additional mining properties is often more cost and time effective than grass roots exploration, but the funds required to purchase operating mines or proven mineral reserves are usually due at closing, and may currently be beyond the miner’s reach. This situation is another excellent candidate for using royalty financing since the royalty company will be working with an established mining operator. This situation also allows for creating more than one royalty if the size of the funding is beyond the level that could be supported by only the existing or the new mine. As is the usual case with royalty based financing, the royalty company only receive payments from mineral production and sales.

Establishment of Completion Guarantees: Conventional financing sources may require smaller or single-mine operators to take in a joint venture partner for up to 50% of a mining project in order to obtain sufficient financial guarantee strength. As an alternative to sacrificing a major portion of equity in a mine, the miner may arrange a completion guarantee from a royalty company which has sufficient financial strength to satisfy the lender. Conventional lenders are attracted to this method of financial guarantee because, in addition to the collateral provided by the mining property, they gain comfort from the financial strength and guarantee of the royalty company. The net effect of a production royalty would likely be much less than the equivalent percentage of equity that would have to be given up in order to attract a financially acceptable joint venturer. In addition, a production royalty does not dilute the owner’s equity interest and repayment would normally be accomplished only through mineral production and sales.

Purchase of Farmout Royalties: Smaller miners are often unable to complete exploration on a mineral property because of a weak financial condition or the necessity to spend existing funds on more advanced properties. It may be in the small company’s best interest to farm out a property to a larger, more financially secure operator, and structure the farmout agreement to include a production royalty. Depending upon the development stage of the farmed out property, it is possible to sell this royalty to a royalty company for a cash payment. This cash payment could allow the miner to proceed to development and production on a more advanced property. A royalty usually has greater value than the working or net profits interests that small miners usually end up with as their joint venture interest is whittled away as a result of continuing cash calls that are required to bring the property into production. As is normal for royalty funding, payments to the royalty buyer are usually received solely from mineral production and sales.

Purchase of Existing Royalties: Another important function that royalty buyers perform is providing a market in which non-mining company royalty owners can sell their existing mineral production royalties. Many times a mining property is owned by an individual, partnership or company that does not have a long term desire to stay involved in the mining industry and would rather have the present value of their periodic and fluctuating royalty payments in a lump sum cash payment. These royalty owners may have alternative uses for a single payment buyout of their royalty. Some royalty owners may not want to sell 100% of their royalty, but would rather sell only a portion of it, in order to have cash for some other use. Unfortunately, these mineral royalty owners have probably discovered that conventional or institutional sources of funds are not interested in purchasing all or a part of mineral production royalties. Royalty buyers understand the long term nature of the mining industry and the sometimes wildly fluctuating mineral prices, and can provide these royalty owners with an opportunity to sell their mineral royalty for a fair price.

Qualifying Minerals: Most royalty based financings and royalty purchases have involved precious metals properties, but the interests of royalty financing and buying companies are expanding into base metals, construction materials, industrial minerals, coal, uranium, and geothermal properties.

Conclusion: This article has provided a brief introduction to royalty based financing and purchasing by royalty creating and buying companies and groups. Perhaps the most important benefit to mining companies is that by using royalty financing they can retain, or even increase, their equity position in their mining operations. There are many methods available for royalty companies to work with miners, and their continuing needs for capital improvements, production expansions or new property development funding. In addition, these same royalty companies provide a market for individual and non-mining company royalty owners to find a willing buyer for a mineral royalty interest they would like to sell.

Discuss your mineral property appraisal, mining business valuation, or other mineral industry related concerns with Mineral Business Appraisal:
Michael R. Cartwright  michael@minval.com
Five Claret Court, Reno, NV  89512-4744
Tel/Fax: 775-322-9028

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