Royalty financing

Royalty financing provides companies with an additional potential source of funds for exploration, project development and other financing needs. The basic concept of royalty finance is that a company funds its activities today by exchanging, for cash, a portion of its future revenue stream on a particular project or projects. It can be employed as an alternative to, or in conjunction with, conventional debt and equity financing vehicles.

A variety of royalty structures are employed in the natural resource sector. Common variants in royalty structure are gross and net smelter returns, net profits interest, and unit royalties. Some are more commonly employed in specific segments of the sector, such as unit royalties in coal mining, or sand, gravel and aggregate operations. Others, such as net smelter return royalties and net profits interests, are common to metal mining operations.

— Gross smelter and net smelter return royalties — Gross smelter return is a percentage of gross revenues received by the mine operator from the smelter or refiner of concentrates or dor shipped from the mine. Net smelter return is a percentage of gross revenues, but adjusted for transport, refining and insurance costs. These royalty structures are common in metal mining, and Royal Gold has found them preferable, because there is no need for the royalty holder to become strongly involved with the operator in auditing mining and processing costs.

— Net profits interest — In this structure, a percentage of the net profits of the mining operation, with net profits determined by deducting all cash costs of the operation from revenue, is paid out as a royalty. This royalty structure is also common in metal mining but may position the royalty-holder to be concerned with the efficiency of the operation or the operator.

— Net value royalty — The net value royalty is a royalty structure intermediate to net profits and net smelter return royalties. Certain agreed-upon costs, but not all, are deducted from revenues to determine the value subject to the royalty percentage.

— Dollar-per-ton royalty — This is a fixed-rate royalty whereby the royalty-holder receives payment on each ton (or tonne) mined, or each ton (tonne) processed. This type of royalty offers the royalty-holder exposure only to production rates, with payments totally independent of commodity or metal price.

— Dollar-per-ounce royalty — In this fixed-rate royalty structure, the royalty-holder receives payment on a per-ounce-produced basis. Payments are independent of metal price.

Although the most common structure for any of the above royalties is as a fixed percentage or dollar amount, certain of the royalty types (especially net or gross smelter return royalties) may be structured with a sliding scale of percentages that increase with increasing metal prices. The sliding-scale net (gross) smelter return royalty structure provides superior leverage to the royalty-holder with increasing metal prices, while offering protection to the operator via lower royalty rates in low metal price environments.

Royalty financing

Royalty financing can be employed in a variety of situations, including the following:

— Early-stage exploration projects.

— Late-stage exploration projects seeking financing for prefeasibility and feasibility studies.

— Mine development and construction financing.

— Mine or plant expansion projects.

— Reclamation bonding.

— Project or company acquisition financing.

— Financing to restructure debt and balance sheets of projects and companies.

Comparing equity, debt and royalty financing

In comparison with debt and equity financing vehicles, the ancillary costs of royalty financing are typically much smaller. The cost of money in conventional debt and bond issues and equity financings is commonly much higher than realized when all fees and costs are included.

Royalty financing may also be kinder to the company’s balance sheet: in its simplest form, royalty financing repayment is treated as an operating cost, and is not an obligation, as in debt or bond financing. Royalty financing also preserves debt capacity for future or additional opportunities. Royalty financing carries fewer restrictive covenants than conventional debt or bond agreements. Most notably, royalty financing does not typically impose a hedging requirement on the company or the operation, as is more standard with debt financing vehicles.

A further advantage is that royalty financing does not necessarily require extra-project collateralization; it applies only to the project (or projects) of interest. Debt financing may require that a security interest be extended to other assets of the company; bonds extend a claim to all assets of the company; and equity financing, by definition, provides an ownership interest to new shareholders and sponsors in all assets of the company, current and future. Therefore, for shareholders, royalty financing does not result in direct dilution as in a substantial equity financing.

The royalty financing concept stretches payments over the life of the reserve or mine, whereas conventional debt front-loads the project with interest, principal payments and fees. Analyzed from a financial viewpoint, this characteristic of royalty financing enables an operator to enjoy higher cash flows in the near term — as a result, the net present value of cash flows in a royalty-financed project may exceed those of a debt-financed operation.

Royalty financing also reduces risk by transferring the payment and repayment obligations of conventional debt and bonds (in dollars or other currency) to product-denominated payments. Thus it eliminates price risk and production and operational risk relative to more rigid debt service structures. The provider of royalty finance, therefore, assumes a share of the various risks involved in the operation; it is equally rewarded with the operator or owner for positive developments, and suffers with the operator in down markets or with negative developments.

Royalty financing is not permanent. If the projects subject to the royalty financing cease operation, the royalty payment also ceases. Equity financing permanently alters the ownership of the company, and applies to all assets, present and future, even if the project financed by the equity financing concludes operations. Debt and bond financing may remain corporate obligations regardless of the operational status of mining operations.

There are no hard formulas employed to calculate the royalty percentage for a certain financing amount. Each project requires consideration of the stage of development, and the risks associated with that project (technical, political, social, managerial, permitting and environmental). For a project in production, or with all permits in place, and with reasonable other risks, Royal Gold would typically value a royalty stream using a competitive discount rate on pro forma production from the proven and probable reserves. The application of the royalty beyond the life of proven and probable reserves is attractive to the party providing the royalty financing — and such significant upside potential may lead to a lower rate financing structure.

Royalty financing provides the opportunity to an operator to enjoy greater cash flow in the early years of an operation, to denominate the royalty payments in product, and to share the metal price and production risks with the provider of royalty financing. In this manner, the interests of the operator and the financing party are much more strongly aligned than in most conventional financing vehicles.

— The author is vice-president corporate development for Royal Gold Inc., based in Denver, Colo. Royal Gold is a precious metals royalty company with two primary business objectives: the purchase of existing royalty positions on precious metal mines and projects, and development of royalty interests through financing activities. The company is listed on the Nasdaq (RGLD) and TSE (RGL), has a web site at www.royalgold.com, and can be contacted at 303-573-1660.