What is a royalty? In virtually all cases, it is a right to be paid money. Whether or not a royalty-holder will ever actually receive any payments may be open to question and will depend upon a number of things, including the size and grade of the orebody and the type of royalty held. A royalty is based in some way upon a mine’s production or the returns from production. The four most common types of royalties are: net smelter return (nsr); net profit royalty or interest (npi); net proceeds royalty; and product payment royalty. In some exceptional cases a royalty may be a right to receive a quantity of material — ususally a precious metal. This type of royalty has its own problems and considerations and is not dealt with here.
Let’s look at each of the four common types of royalties. Net Profit
The npi is the most complex of the royalty types and is the one most commonly used in Canada. If it is managed properly it is probably the fairest of the royalties because the operator receives back its investment with a reasonable return; operating costs are deducted along with some specified reserves such as working capital and reclamation costs, and then the operator and royalty-holder share in the “profits.” It is, however, open to abuse by a disreputable operator. The royalty requires detailed accounts to be kept with respect to both capital and operating costs and the prudent royalty holder will want his own accountant to at least “spot check” the operator’s accounts.
In most instances the royalty provisions will require that the royalty calculation be carried out in accordance with gaap (Generally Accepted Accounting Principles) so that it will probably be necessary to involve an accountant with these calculations as well as with respect to a general review of the operator’s books. This will be an expense to the holder. As with any agreement, the parties should basically trust each other before they enter into a contractual arrangement. However, no agreement is that “airtight” and if the parties to it are feuding, adding accountants for both the holder and the operator will do nothing to ease a tense situation]
As said above, the npi royalty is a fair type of royalty. The operator is the party that is going to take the risks of developing the orebody and therefore should be entitled to recoup its investment with a reasonable return. The royalty-holder is taking no risk whatsoever, other than the possibility of receiving no money. After recoupment has been accomplished and operating costs (both current and past) are paid out, we are left with a “profit.” At this point the npi royalty-holder enters and is looking for some money. He has sat back until this point and expects to reap some benefits — after all he brought the property to the operator. It is this reasoning that gives rise to high percentages for npi (in properties where “risk” was considered by the operator to be relatively small because of the apparent “sure” orebody, the rate can be set very high indeed, even to 50%). Obviously the npi rate must be set at the time that the initial agreement is entered into and will be based on the prospects of the property. If it is a Hemlo then 50% may be reasonable, but if it’s “moose pasture” then the rate will have to be negotiated and will probably be between 7% and 25% (a wide range, yes, but geologists, like lawyers, tend to have their own opinions on matters).
There are many things to bear in mind when considering an npi royalty (or, for that matter, any royalty), including the following:
*As a holder, do you want to press for an early cash flow in the form of an advance or minimum royalty? The actual rate of the royalty will no doubt suffer if you are successful, but you will stand to see cash promptly. If an advance or minimum royalty is granted, it is reasonable for its commencement to be delayed for at least a couple of years so that the operator is given a chance to do some meaningful work before assuming this burden.
*Payment of the royalty should be considered. The holder will want payments as frequently as possible whereas the operator will want to delay payments so that it may use the funds. A fair compromise is to require quarterly or semi-annual payments but to provide that the operator pays only, say, 80% of the estimated payment due with an annual adjustment based on the operator’s audited financial statements. This protects the operator from adverse financial or operational developments but, at the same time, gives the holder reasonably prompt payments.
*It is possible that ores from several properties owned by different parties may be blended for treatment in the facility on the property to which the royalty is applicable. Obviously, as the details of the blending are not known when the agreement is drafted, the possibility cannot be dealt with precisely. At best, concepts can be provided for and “pious hope clauses” set forth. All you can hope to do is to guide a judge or arbitrator to think along the “right,” or at least reasonable, lines.
*A procedure should be provided to deal with the possibility that the operator may dispose of product on a non-arm’s-length basis. Some method of establishing a fair value for the purpose of royalty determination should be set forth. Arbitration of disputes in this area may offer a good solution. Net Smelter Return
The nsr royalty is quite straightforward and requires a minimum of “policing” by the holder. In all likelihood the holder will be able to check necessary records himself. The royalty is based on gross revenues received by the operator from the sale of product produced (whether direct shipping ores, concentrates or whatever) less certain limited but specified deductions such as transportation to the purchaser, sampling and assay costs, and so on. Sometimes confusion arises with this royalty because the purchaser of product will usually not be a smelter — it is best to think of the “smelter” merely as a buyer.
The NSR royalty can be disastrous for an operator. It is based on gross revenues received from the sale of product and therefore is payable regardless of profitability. In some cases an operator can be operating at a loss but still have to add to the loss by paying a required nsr royalty. For this reason the royalty is unpopular with operators. On the other hand it is equally popular with holders because cash flow comes early. Royalty rates are quite small, usually in the order of 1%-5%. An operator should be careful to exclude product produced from a pilot operation from the royalty, although the holder will, with some justification, want to be protected from the possibility that his entire orebody may disappear as a result of pilot operations.
Traditionally, an nsr royalty is defined to include as a permitted deduction penalties and charges made by the smelter. As the “smelter” is really any buyer and as the royalty is based on gross revenues received by the operator, this deduction is not logical unless it is intended to permit these deductions where product is custom-smelted and the resulting product then sold. If this latter is intended, then it should be specifically provided for; the traditional wording may not accomplish the desired effect if there is a dispute.
Many of the considerations applicable to the npi royalty are equally applicable to the nsr royalty. Net Proceeds Royalty
The net proceeds royalty is a relative newcomer to the royalty family. It is one to be very careful about as it does not have a clearly understood meaning within the mining industry. The plain meaning of its name would lead one to think that is a royalty based on net operating profit (i.e. no recoupment of pre-production expenses) as opposed to net profit. In fact the net proceeds royalty is usually defined in terms that are the same as, or very close to, the npi royalty. The best advice that can be offered if a royalty called a “net proceeds royalty” is involved in proposed arrangements is for all parties thereto to know exactly what type of royalty is being considered. Do not rely on what you think is being d
iscussed. Product Payment Royalty
This is the most straightforward type of royalty. The holder receives a fixed amount for each ton (or tonne) of ore mined and processed through a mill whether or not the mill is owned by the operator. This latter concept of processing is essential; otherwise future problems could develop if, say, waste were crushed and sold. In these circumstances, if the royalty is based only on ore mined, it may be argued that, because the waste has become a commercially salable product, it has become “ore” and therefore the royalty is payable with respect to it as well as the true ore. As a result of its nature, the product payment royalty is usually found only where relatively small precious metals deposits are expected. If a major orebody is discovered, this type of royalty may present a problem to the operator.
The royalty may be “dressed up” in many ways, such as introducing an inflation multiple or tying the quantum of the royalty to escalation of metal prices and so on. However, such refinements complicate the determination of the royalty and sometimes result in what may, in practical terms, be an impossible determination. If during negotiations the parties try to become too sophisticated in the determination of a product payment royalty, they may well be better to switch to some other form of royalty that will more closely meet their respective requirements.
When considering or dealing with royalites, make certain that everyone knows what they are talking about and that they are all talking about the same thing. Karl Harries is a partner with the Toronto law firm Fasken & Calvin. The information in this article is summary and general in nature and is not intended to be taken or acted upon as legal advice.
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