Prospect Generators & Cost Of Capital
Incoherent Rambling
I've been stuck at home with covid and thought what a great excuse to write about the idea that prospect generators are really just cost of capital arbitrage. This way if anyone asks I can just say, "Oh that must have been the covid talking, I was so delirious, sorry about that."
The Typical Prospect Generator Path
I'm going to say at least 9 out of 10 prospect generators don't really understand their own business. What typically happens is a geologist wants to start his or her own company. They stake some ground and hit some outcrops with hammers, and maybe stake some more ground and hit some more outcrops with hammers.
Pretty soon they have a bunch of ground and still don't have any money to pay for more expensive exploration that might involve helicopter rental or a diamond drill or even things like summer interns that like to stick things in plastic bags. So they remember hearing about this prospect generator model they once heard about where you get other people to spend money you don't have to pay for your exploration.
So they call up their buddy they went to university with or tromped through some lower income country's jungle with that now works at a mining company that has money. They tell their buddy about the great rocks they have and their interpretation of how the strands of time surely have conspired to leave large amounts of valuable metal beneath their feet. Their buddy believes them because they went to the same university and/or tromped through the same jungles and thus they both think the same way about rocks.
So the buddy goes to his company and says hey, I'd like us to go drill these rocks. The company says, sure we have money for drilling rocks and you have a good history of understanding rocks, here have the money.
Then the buddy goes back to the first geologist, who is now called a prospect generator only out of necessity because he has land and is broke, and says "This law was handed down from on high to Moses the 11th commandment that the percentage of a project that shall be given for drilling rocks is 70%, never higher, never lower lest ye shall be excluded from drinking beers with fellow alumni at university reunions." This is by the way the only explanation I have ever seen for why option agreements almost always have a 70:30 split.
Then the prospect generator says, "how much did your company give you to drill my rocks", and the buddy says "$5 million" and the prospect generator says, "great, I'll put work commitments of $5 million for 70%." They shake hands, sign some papers, drink some beer.
Wait, That's Not A Business
The traditional thinking is if you have a great geologist then you'll have a great prospect generator. Because if you just follow the 70:30 split rule and your geologist is good then it doesn't take many projects to find metal. The traditional thinking also says that a prospect generator is like a junior explorer but more diversified. Instead of having 100% of a few projects they have 30% of a bunch of projects.
Pretty quickly it's easy to poke holes in this line of thinking. What if the prospect generator's university friends are now university professors instead of working at companies with budgets to drill rocks, does that make him a bad geologist? What if he found a world famous deposit at his last job but his first four prospects at his own company don't have much metal? What if he can convince a company to take an extra 5% of the project but pay for all of his costs forever? What if there is metal there but he can't fund exploration or convince partners to drill it? Being a great geologist that acquires projects with metal in the ground is a lot of the ballgame. But if I take two great geologists and give one of them twice as much ground, twice as many geophysics surveys, twice as many meters drilled, twice as much exploration funding I know which geologist I'm going to bet on.
If it's a publicly traded company surely there is a business?
Return On Capital
You can think of a business return as the return on capital minus the cost of capital. If I give a junior explorer $10m to drill and I do that enough times that we get a large sample and on average they hypothetically create $11m in value from drilling we would say they have a 10% return on capital. I don't actually have good data on junior miners return on capital of drill programs, but if its as high as 10% on average I'd be surprised. This is on average a terrible business. I'll use 10% return on capital below, but you can substitute your own numbers and the conclusions will be the same.
Cost Of Capital
I'm going to simplify and say there are two kinds of partners. Majors have very low cost of capital and juniors have very high cost of capital. As a prospect generator the approach for each should arbitrage that cost of capital.
Majors
Antofagasta has issued bonds that yield 2.375%. If you have a 10% return on capital 70% of that is still 7% return on capital. It's nice to have cheap money. When companies have low cost of capital it's best for the prospect generator to try to get them to spend more. Larger minimums, more upfront cash payments, excessive management fees. The major should carry more of the spending longer. The balance of benefit weighted spend shifts your way not from the greater benefit, but from the greater spend. Want an extra 5%; fund through feasibility study and construction decision. Pre-negotiate that they'll lend you your share of any construction costs at LIBOR+x where that is cheaper than they can borrow but since nobody would lend you a dime is way cheaper than your cost of capital. Live in this dream world where things are lean and hungry and efficient but the money falls from the sky like rain.
Prospect generators want strong protections that return a property to them with a major. Many majors will drop serious money and find some drill results that might still be a Tier 2 deposit and walk away. That money was cheap and that size doesn't move the needle. Flip that stuff on to a mid-tier or junior for another bite at the exploration apple. Home runs are nice, but it's also nice to just get some runs on base.
Juniors
Imagine you are a junior exploration company and have an arbitrarily chosen but realistic 20% cost of capital. You will do almost anything to avoid spending cash today. Some of it is rational, because your cost of capital is so high. Some of it is just because cash being so expensive makes you do irrational stupid things.
With Juniors prospect generators want to harvest their cost of capital by having them pay it to you. If they raise money they have to pay for promotion, pay finders fees, give discounts to market, dilute, often give out warrants that have Black-Scholes time value, etc. At a 20% discount rate money today is worth twice as much as money 4 years from now.
Let me play out two scenarios, you offer a 3% NSR royalty and a chance to earn in 100% of the project to a major and to a junior.
Major: "The average profit margin of our mines is 13.1%, 3/13.1 = 22.9%. So you are telling me you want 22.9% of the profit of any mine we find here and in return the 100% we get is 100% of the costs and you get 0% of the costs. Oh, here's the door, don't let it hit you on the way out. No no, don't get on your knees and beg. How about we spend $10m to earn in 70%, that's basically like giving you 30% of that $10m, $3m for just walking around with a pick and some baggies before we showed up. We'll even toss in a $250k signing payment so your company can afford to reimburse your lunches at the local sandwich shop and you won't have to pack a sack lunch anymore. Now, don't you worry about your 30% of two hundred million we plan to spend on infill drilling and late stage studies or your 30% of the billion dollar mine construction costs, I mean I'm sure you'll figure it out."
Junior: "If we find a mine it won't be built for at least 10 years. 20% cost of capital ten years, the net present value of that is only 10% of whatever it's worth then. Plus, we aren't going to build it anyway so it's someone else's problem. My shareholders don't seem to notice royalties, and we make sure they aren't anywhere on our presentation or website and as little as required in our 43-101 or JORC tech reports. Shareholders do like 100% owned projects. Plus 3% sounds like a small number, I've still got two fingers left on my hand and a whole second hand with all the fingers, yeah 3 is a very small number. Toes, why didn't I think of toes, why between fingers and toes I've got 17 left, 3 is a very small number. Why is that all the prospect generator wants, maybe I should give them some shares now to be safe and be sure to give them more shares every year of the earn in and more shares when we hit milestones. I thought shares outstanding meant Shares, Outstaning! Why is my shareprice always down? I have to remember to have the board re-price my options later this week, they are so underwater."
Summary
As a project generator if your partner is a major get them to pay for more of the cash costs for as long as possible. Arbitrage their low cost of capital to compete against other junior explorers with high costs of capital.
As a project generator if your partner is a junior get them to get them to pay you their cost of capital by getting paid in shares/warrants. Backend weight the value as well by taking a royalty whose cashflow is farther in the future and worth less in present value with a larger discount rate. That larger discount rate increases the value of your royalty as it gets closer to production. Arbitrage their high cost of capital by acting as their financier.