Commentary: Making sense of royalty structures and rates

Royalties in the mining industry look pretty straightforward, but dig a little deeper and the complexities are soon apparent.

Let’s start with what exactly a royalty is, the different ways it can be structured and used, and its history in Canadian mining.

By definition, a royalty is the right to receive a percent of the revenue generated from the sale of mineral products mined from a property. The legal nature of this right depends on whether the royalty is a mere contractual right or a direct interest in the property.

If a royalty is determined to be a mere contractual right, the holder may lose the right on the sale of the property. However, if the right is an interest in land, the holder may be liable as an owner under environmental legislation.

Royalties are most commonly used in acquiring mineral properties. They benefit the purchaser because they calculate the full purchase price. If and when royalties start payment, the purchase price is amortized over an extended period of time. 

Exploration and development risks are also lessened because payments under the royalty are generally not due until production begins. The benefit to the holder is that he is able to share in any future exploration and development of the property.

Royalties are commonly used in joint-venture agreements, which often provide that a party’s interest can be converted into a royalty as a result of unpaid contributions.

Royalties are also used to compensate employees, acquire technology and incentivize shareholders in connection with a merger and acquisition, an example of which is the acquisition of Roughrider Uranium by Hathor Exploration in 2006.

The development of royalty structures and rates has been influenced by changes in the type of deposit and technological
advances.

Many early royalty arrangements in Canada are related to native gold or silver deposits at or near the surface, many of which were accidently discovered while building railways, including the Cobalt silver camp discovered while building the northern Ontario Railway.

These deposits required little infrastructure or expensive treatment facilities and lent themselves to a simple royalty structure with a relatively high rate. Accordingly, net smelter return (NSR) royalties in amounts averaging 5% were common in some Ontario camps in the early 1900s.

As native deposits became more scarce and as technological advances permitted the development of extensive underground mines and treatment of complex ores, the costs and risks associated with mining and treatment increased. In response, the concept of a net profits interest (NPI) royalty was developed with rates of up to 20%.

The effect of an NPI royalty is to make the holder a partner in the enterprise by withholding payments to him until the operator has been reimbursed for his expenses, and then sharing the profits. The NPI royalty structure is prone to manipulation and has acquired the reputation as the “no payment intended” royalty.

The most widely used royalty structure is the NSR royalty, which is a percent of the gross revenues from the sale of mineral product from a property by the mine operator to a treatment plant, with minimal deductions for transportation costs, sampling and assaying costs, smelter penalties and insurance.

The advantages to this structure are that it is widely understood, easily calculated and verified, not subject to manipulation and, of particular interest to the holder, provides for cash flows early in the project’s operation.

The principal disadvantage of this structure is that if the rate is set too high, the operator may be discouraged from developing the property.

An NPI royalty is a percent of the profits from the operations carried out in respect of a property after all exploration, development and capital costs have been recouped, and all operating expenses are paid together with the accrued interest. The effect of this is to delay the payment of royalty payments for an extended period of time after production begins.

NPI royalties are prone to abuse and the calculation of costs that can be deducted from revenues is often complex. In addition, the payment of an NPI royalty is dependent on non-market factors, including the financial capabilities, efficiency and operating decisions of the operator.

The difficulties with this structure are illustrated by Callinan Royalties’ ongoing litigation with HudBay Minerals concerning the payment of an NPI royalty from HudBay’s 777 zinc-copper-gold-silver mine in Manitoba.

Care should always be given to the negotiation and drafting of royalty agreements, because there is no such thing as a standard royalty. This is especially important with NPI royalties where deductions are extensive, often with unintended consequences, and where attention should be had to provisions concerning revenue sources and audit rights.

A fixed rate – or product tonnage royalty – is a royalty based on a set payment per tonne of ore processed. It acts as a fixed cost and does not take into account fluctuations in mineral prices or operating costs.

This structure is now generally used for quarry operations with low values and predictable operating costs. A variation of the fixed rate royalty is the gross overriding royalty, which allows for limited cost deduction and is most suited to mines that produce a product that can be sold without altering its basic character, for example: diamonds.

– Based in Vancouver and called to the bar in B.C. and New York State, the author is an associate
at Vector Corporate Finance Lawyers, and practices exclusively in the areas of corporate finance, securities, and mergers and acquisitions. Vector’s areas of practice include natural resource law, corporate finance and securities law, and company law. For more information, visit www.vectorlaw.com.