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13 January 2020

Royalty Financing: A New Source of Capital in Mining, Tech and Beyond

Royalty financing is a type of alternative finance where the financier, often called the royalty holder, advances a one-off up-front fixed cash amount to a company, a royalty payor, which in return promises to pay a percentage of its future revenues or profits to the royalty holder. This type of financing is used to develop an asset or a business when traditional debt or equity financing options are limited. It is a true alternative to traditional debt finance, since there is no fixed repayment plan and payments depend on the performance of the underlying business or asset. Also, unlike equity financing, the ownership and control in the royalty payor is not diluted, since it is not giving away its equity stake.

Royalty financing has become increasingly popular in the mining industry in the past decade, as junior or medium-size exploration companies needed to fund their capital expenditure needs. Low commodity prices and continued global economic uncertainty have turned the tap dry for financing through traditional equity offerings. On the other hand, traditional lenders like banks typically are not prepared to finance projects in the exploration phase that only include costs and no revenues and often a great deal of uncertainty about whether commercial exploitation is even feasible. So, from the banks' perspective, the loans are too risky and remote, since revenues may only start to flow five to ten years and tens millions of dollars down the line, if at all.

This global trend has also found its way to Serbia. This is no surprise given that there are over 30 exploration projects in the country, targeted mainly at copper, gold, boron and jadarite, a lithium-bearing mineral with a composite similar to the fictional Kryptonite. While mining heavyweights like Rio Tinto or Freeport-McMoRan, which hold interest in some of the projects, have their sources of capital, smaller players face universal financing issues and may need to grant royalties to fund the (pre)feasibility studies, equipment purchases, construction or other capital expenditures required in various exploration phases. Royalties in mining typically include a percentage of revenues or profits from the mineral production (once it starts) over the lifespan of the mine, without guaranteed minimum payments but also without caps on the upside.

In North America, royalty financing is gaining popularity across industries, especially in tech and life sciences start-ups, but also in the entertainment industry. According to some sources, around USD 100bln of royalties are being paid out each year globally. These ventures all need seed capital and all offer promising but uncertain returns, making them unattractive borrowers for banks. On the other hand, owners often are reluctant to share equity and control with investors. These are universal challenges that all entrepreneurs also face in Southeast Europe. Therefore, royalties may be just the right fit in the capital structure of a tech start-up thanks to several attractive features for both the royalty payors and investors.

For royalty payors these are: (i) no fixed payment obligations or repayment terms, thus less risk of default; (ii) covenant-lite documents, which are much shorter and simpler compared to standard debt finance packages; (iii) negotiable security package, but no recourse to owners and recourse strictly limited to the financed asset; (iv) tax-deductible royalty payments; and (v) no dilution or pressure to sell the business. The royalties are attractive to investors because: (i) they receive equity-like returns, although they are senior ranked to equity; (ii) returns come faster compared to equity investments in the early stages of the business's lifespan; (iii) there is lower risk of default due to the flexible payment terms of royalty payors; and (iv) depending on jurisdiction, royalty holders may acquire an actual interest in the core assets of the royalty payors (e.g. mineral rights, IP, etc.).

But all that glitters is not gold! For payors, the main drawback of royalties is that they are more expensive than bank debt. They also do not work well together with traditional debt. Lenders are not comfortable that royalty holders receive a guaranteed percentage of revenues and effectively rank senior to them. A possible solution is to negotiate intercreditor provisions with royalty holders together with the royalty agreement. Also, a royalty combined with (senior) bank debt increases the risk of default considerably, since there may not be enough free cash flow for everyone.

Unlike banks, investors need to do their diligence in what they invest. They will not have control, covenants or acceleration rights to rely on, so they need to be sure they have assessed all the risks and expected value of the underlying business linked to the royalties. The laws of Southeast European countries generally do not recognise royalties, so they run the risk of being mischaracterised by the courts. Therefore, legal advice should be sought to determine if they may be considered as hidden repayment of equity (contravening often mandatory capital maintenance rules) or as aleatory contracts that can be subject to equitable adjustment or struck down by the court; or if they cause regulatory issues, for instance under currency control rules in case of cross-border payments. All these legal issues can be overcome by identifying them ahead of time and structuring the product around them.

Given the speculative nature of investment and the conservative approach of traditional lenders, this region may be fertile soil for royalties to grow. With numerous mining projects, time will tell if royalty financing will spill over to other industries.

authors: Luka Lopičić and Jelena Arsić