Prediscovery through development

— The following is an excerpt from Mining Explained, published by The Northern Miner.

Every mineral discovery requires not only money, but dedicated effort from many different sources. Many discoveries result from the efforts of prospectors who are financed by a grubstake. This is an informal business association between friends or associates who put up seed money to do some initial work with the intention of participating in the benefits. That is to say, a friend may finance the prospector’s work in exchange for an interest in whatever he or she may find.

Discovery

Let’s assume that a prospector, Morty, for example, has staked some ground and found a surface mineral showing. Most prospectors or grubstakers can only put together enough money for a limited amount of work on their ground — some sampling or trenching, maybe a few days work with a backhoe, or one of the less expensive geophysical ground surveys like magnetics or VLF-EM. Beyond this point, they have the choice of forming a company to do more work or finding an established company to take on the work — and the expense.

Under an option agreement, Morty offers an interest in the property to a company with enough funds to do further work. In exchange, the company commits to spending a specified amount on exploration — when it has done that, it has earned its interest. Often, the company taking the option will make a cash payment or issue some of its shares to the property holder.

The original holders may be left with a participating or working interest in the property, in which they fund part of the future work, or with a carried interest, which gives them a royalty on future production without the obligation to contribute to future expenses.

The other choice for Morty and his grubstakers is to form a limited liability company. Their company could then issue a definite number of shares to raise the capital it needs.

In the case of the incorporated company, consideration for the money and effort our grubstakers have put into the discovery will be returned to them in an agreed-upon number of shares in the new company — Morty Mines Corp. These shares are called vendor shares and the vendors will not be allowed to turn around and sell them in the market. Rather, they will be held in escrow, usually in the hands of a trust company acting under instruction, until a successful application may be made to the securities commission for their release, to be traded on the stock market. The reason for this will be apparent shortly.

Equity Financing

If, for instance, Morty Mines is capitalized at 5 million shares, and 1 million shares are pooled or placed in escrow for the vendors’ interest, the treasury will contain 4 million shares the company can sell to raise funds. A financial or brokerage firm is commissioned to sell the shares to its clients in what is called an initial underwriting.

The firm usually does this by buying the 4 million shares, then issuing a prospectus to its clients. This is a written document that includes all the financial and technical details of the company and its properties. The prospectus allows the company to apply for a listing on a public stock exchange, where the investors can trade their stock.

Small exploration companies generally get their first listings on exchanges that specialize in trading the shares of venture-capital companies, such as the TSX-Venture exchange in Canada, the NASDAQ in the United States, or the London Stock Exchange’s Alternative Investment Market. If they become successful, they will “graduate” to the major stock markets.

Now, if all of the vendor shares, or any substantial part of them, were to appear on the market without warning or control, the underwriter would be severely handicapped in his attempts to sell the shares, for which he has put badly needed funds into the Morty treasury. This is why the vendor shares are held in escrow — to protect the underwriter.

Development and Production

Let’s now suppose that our exploration program has found a major mine. Production is justified at a rate of 1,500 tonnes per day. Morty Mines may still have a million shares in the treasury, and perhaps a small cash balance. But it is now faced with the problem of raising something like $60 million for the construction of a major mine and mill.

Morty Mines is not as risky an investment anymore; it has ore in the ground and a good chance of making money. This gives the company more ways to finance the development of the mine.

In rare cases, it may be possible to raise a substantial part of the money the company needs by selling the million shares remaining in the Morty treasury. Market conditions and patterns of investor behavior at the time may be such that the sale of these shares, together with a bond or debenture issue, may fit the bill. There are other possibilities: for example, it may be possible to combine equity with debt financing.

Often, however, it will be necessary to create a large number of new shares. The simplest way to do this is to reorganize the company. In this case, a new company, New Morty Mines Corp., will be formed. It will have its own share capital structure and its own identity separate from that of its predecessor. The property and assets of Morty Mines will be transferred to New Morty Mines in exchange for some agreed upon portion of the New Morty shares, to be distributed among the equity holders of the older company. These shares, in turn, may also be pooled or placed in escrow in the same way and for the same reasons described above.

New Morty Mines then sets out to sell its shares through an underwriter. If our example is as good as we set out to make it, New Morty will be able to raise the necessary funds to bring its find into production.

Debt Financing

If conditions are right, Morty Mines may get debt financing, by issuing a bond or a debenture and selling units in it to the public. The bond or debenture is treated as a loan and must be repaid when the company starts to make money.

In some cases, the bond or debenture certificate may have a warrant or right attached to it. This is in order to give the investor an added inducement to purchase the bond.

A warrant usually gives the purchaser the right to purchase so many equity shares at a stated price if exercised by a stated time. The warrants or rights are themselves negotiable on the market, and their prices are listed on the stock exchange with the share prices of the issues they represent.

Banks are often willing to consider project loans to a mining company for a specific mine, or for an expansion. But the mining company must have a sure orebody and management with a proven track record.

One way to borrow money at low interest rates is to negotiate a gold loan. This is an option for companies with a potential gold mine in the works. In this case, a company borrows bullion from a financial institution in exchange for bullion from future mine production. The company sells the bullion at the prevailing market price and uses the cash to build the mine. Once in production, the company then pays back the loan with actual bullion produced from the mine.

If markets are weak, Morty Mines may decide to form a joint venture with a senior company to develop the mine. Typically, the major company will put up the capital required to build the mine in return for a direct ownership interest. This may range from 25% to 60% or more, depending on the project’s economics and the capital cost requirements.

In certain cases, the major company may make an offer to buy all the shares of Morty Mines, sometimes at a premium to the trading price. In this way, a patient shareholder can be rewarded by receiving a return many times his original investment.