This article originally appeared in the Fall 2014 issue of Canadian Mining Magazine.

In the last few years, while mining companies have been hit with hard times, large-cap royalty companies are thriving and smaller cap royalty companies have emerged, hoping to profit from the royalty model.

A royalty company acquires and earns revenues from royalties. In theory, investment in a royalty company offers greater diversification to investors. While a typical mining company only holds a few principal properties, a royalty company generally holds many royalties, so bets are hedged.

A royalty is a right to receive a payment from the proceeds from the sale of minerals produced from a property. Royalties are typically paid in cash, but may be taken in kind and paid in minerals. A royalty should not be confused with a streaming deal, although many royalty companies are also in the business of streaming deals. In a streaming deal, the royalty company pays cash to a preproduction resource company in exchange for the right to purchase minerals produced from the property later below market price. Streaming deals typically operate as an alternative form of financing to resource companies.

A royalty may also be sold as a source of financing, but can also be generated in several other ways. For example, a property owner may retain a royalty when it sells a property or a joint venture partner’s interest may be converted into a royalty once that interest is diluted down below a certain threshold.

There are several types of royalties. Two that are common are the net smelter returns royalty (NSR) and the net profit interest royalty (NPI). An NSR is a percentage of revenue from the sale of minerals less permitted deductions, such as refining, transportation and marketing costs, and taxes. An NPI is a percentage of profits realized from mining operations after all exploration and developments costs have been recuperated by the operator.

When investing in royalties or royalty companies, one must be careful. A royalty may not be as valuable as it appears at first glance. The royalty may have title defects or competing claims to title. The royalty may not cover the claims overlaying the deposit or cover the main mineral being extracted. There may be too many royalties burdening a property, making commercial extraction uneconomical to the property owner. The royalty may be subject to a buy-back clause whereby the property owner can repurchase all or part of the royalty at a discounted price. The royalty holder also needs to understand what costs may be deducted. The more costs that may be deducted, the less valuable the royalty becomes.

This is especially important for NPI holders. While payment on an NSR begins at commercial production, an NPI only begins to generate cash flow after all mining exploration and developments costs are deducted—which may be significant. It is not uncommon for NPIs to never generate a profit. Accounting disputes are common between the NPI holder and the operator of the property. One also needs to understand how long the royalty will generate cash flow. Does the royalty cover the life of the mine or will it expire after a certain amount of minerals are produced?

Finally, many royalties are acquired at the exploration stage. To truly understand the value of a royalty, one needs to understand the likelihood of the property ever reaching commercial production. Most mineral properties do not.

Companies considering an investment in a royalty should conduct careful due diligence and consider retaining specialized legal counsel.