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Analysts, newsletter writers, brokers, fund
managers, and savvy investors big and small all seem to love the prospect
generator business model for junior exploration companies. I am no exception
but my love is conditional and I don’t spread it around too much.
A prospect generator / joint venture company shares
its risk by partnering with other companies that invest their capital and
move exploration projects toward development and production.
Prospect generators are not a rare or endangered
species. There are many listed on the Toronto
and Venture Stock Exchanges. However, I follow only a few of these
companies. The reasons are always the same: They fail at least one of the
Mercenary Geologist litmus tests: Share structure, people, and projects.
Let’s examine what a prospect generator does,
how the model works, and set it within the context of industry practices,
standards, and terms.
A prospect generator generates new projects with
reconnaissance (also called grass roots, generative, or greenfields)
exploration programs. Costs are low for these companies because the work
involves basic geological research and compilation followed by field geology
consisting of sampling, prospecting, and mapping of targets. Successful
prospect generators rely heavily on talented and tough field geologists,
geotechnical crews, and support staffs.
To enhance the odds of success, exploration programs
are conducted in frontier geological terranes. A
frontier terrane is defined as one where geologists
have not explored extensively in the past or have developed a new exploration
concept.
In the current boom a frontier terrane
often is located in an “emerging market country” (Mercenary Musing, May 18, 2009);
that’s a politically correct way to say Third
World. Because these locales can be remote and inaccessible with
little infrastructure, difficult terrain, and challenging climates, the cost
of logistics, mobilization, and field support can be the largest budget
expense for a prospect generator.
Once a significant prospect is found and land
acquired, the prospect generator seeks another company to buy a portion of
its prospect for a negotiated price thru a joint venture agreement. To earn
its joint venture interest, the purchaser will pay cash, stock, or a
combination of both in staged payments and commit to spend a substantial sum
to explore the prospect over a period of time.
Although terms vary widely, the prospect generator
usually relinquishes ownership majority, ranging from 51% to 70%. Since it
has the requisite geological staff with expertise in the area of interest,
the prospect generator often is designated the “operator” during
the time that the purchaser is earning its interest. It is paid a management
fee of 10% of the exploration budget for providing these services.
Once the purchaser earns its initial interest, it
may have the option to earn another incremental interest by spending more on
exploration, feasibility, and/or development. At some point, perhaps at 70 or
80% earn-in, the prospect generator must fund its share of exploration and
development or be diluted to a royalty. The standard metal industry royalty
is termed a Net Smelter Return or “NSR”, which is
the gross proceeds from sale of the mineral product less transportation
charges to the refinery or point of sale. NSRs vary but 2% is a common
industry standard. There may be a set price buyout clause for the NSR or a
portion thereof.
Good prospect generators have a stable of prospects
in joint ventures and others in various stages of prospecting, exploration,
and development. For the companies, it is not only necessary to develop
quality early stage prospects but also generate a quantity of prospects.
This is because the chances of targeting and finding
a prospect, exploring a project, developing a deposit, and operating a
profitable mine are very low. It is best to have a cadre of prospects and
spread risk over many projects to ensure eventual success.
When applied correctly, the business model is
successful because it allows a junior resource company to continually
generate a number of prospects, entice other companies to spend money
exploring and developing on its behalf, maintain low administrative expense
and burn rate (i.e., no expensive drill programs), hoard equity capital, and
preserve a well-managed, tight share structure with a low number of shares
outstanding.
There are many variations to the simple
generator-joint venture model presented above.
Some companies function as project
generators. In this model the company acquires raw prospects, drill-ready
projects, and/or advance exploration projects and upgrades them by a round of
drilling before seeking a partner. Some project generators own drills and
employ or contract drillers and support staff.
The upside is the joint venture sale price is higher
for an advanced project and the generator can attract top tier juniors and
mining companies; the downside is that some projects will not be upgraded and
working capital is burned much faster with drilling. Since more equity raises
are required, it is more difficult to maintain a low number of tightly held
shares over a long period of time.
Others choose to develop strategic alliances
with mid-tier or major mining companies. In this model, the prospect
generator has previous experience and/or a reconnaissance database in a
particular country, region, district, or deposit type with strong exploration
potential. It sells an interest in the reconnaissance project for a private
placement investment by the mining company and a substantial commitment of
dollars for exploration over a period of time.
The mining company becomes an exploration partner
and holds a significant number of shares of the junior company. The junior
uses the miner’s money to fund its share of the exploration program. In
developing countries, world banking organizations (e.g., International
Finance Corporation) and/or sovereign wealth funds may take an equity stake
as a means of investing in the economy and business development of the host
country.
Other companies are development generators.
In this model, the generator acquires advanced exploration and/or development
projects, sometimes at contrarian times and low prices in the commodities
cycle. When markets improve, it spins them out as flagship development
projects to exploration juniors or to mining companies that have operations
acumen. The company may retain a small minority interest or a royalty. More
working capital is required for initial purchases than the early-stage
prospect or exploration project models but the proceeds from joint ventures
or sales are significantly higher, often in the tens of millions of dollars.
The prospect generator model will succeed only if
there is something to be found by modern exploration techniques within a
reasonable time frame and exploration cost. It is critical for the prospect
generator to choose a permissive geological terrane
and develop compelling prospects.
Examples of failure abound in our business because a
company did not choose wisely.
Some prospect generator juniors have the requisite
share structure, experienced people with positive track records, and a
treasury well-stocked with cash and equities but they picked wildcat
prospects in the wrong part of the world of geology.
Reasons for failure include: The selected terrane is mature as an exploration province, it has
little potential for ore grade outcrops or shallowly buried deposits, and/or
the targets require deep and expensive wildcat drilling (e.g., 600 meters of
gravel cover in Nevada).
Another common mistake is picking a country or a
region with unacceptable geopolitical risk. Venture capital will flow where
risk is perceived as lowest for the highest potential reward.
Choosing a country with a friendly, stable
government, honest business culture, rule of law, desire for foreign
investment, security of mineral tenure, support of the local people, and
acceptable environmental and permitting regulations is not easy but is
essential for a prospect generator.
The task is doubly difficult because geopolitical
risk is a wild card that cannot be accurately predicted. A good
risk/reward scenario today may become a very bad case tomorrow. There are
numerous examples of countries coming in and out of favor with venture
capital investors during the current commodities boom, now in its seventh
year, and undoubtedly that will continue.
As with all companies in our business, many prospect
generators fail due to incompetent management. I wrote about geologists and
their shortcomings as CEOs last year (Mercenary Musing, September 21,
2009).
The prospect generator model is flavor of the year,
largely because lots of analysts and newsletter writers (including yours
truly) have said so within the past year. So as more CEOs listen to the
message time and time again, more and more juniors will adopt the model as a
corporate philosophy and a greater percentage will fail.
Others go under because they pick the wrong
commodity or the wrong timing for that particular commodity. Acquiring
millions of hectares of moose pasture and muskeg in geological basins in the
far north of Canada
for uranium and attempting to joint venture these lands in 2007 was not a
viable business plan.
You, the lay investor, know that I love my career,
this business, and the educating and mentoring parts of it. However,
it’s always necessary for me to be candid with you. We must keep
in mind that 95% of juniors eventually will fail. My job and yours alike is
to pick companies for speculation with the right share structure, people, and
projects at a time they are undervalued.
The average life span of a junior resource company
is five to eight years before the company dilutes itself beyond viability,
drills and kills its projects, changes direction, rolls back, becomes a
shell, installs new management, reincarnates as a different entity, gets
delisted, and/or goes bankrupt.
The goal of the prospect generator is to preserve
capital and avoid share dilution by spending someone else’s money to
explore and develop its projects. If done effectively, the company increases
its life span and generates significant cash flow from its minority working
interests, royalties from mining projects, or the outright sale of a project
to a developer or miner.
A company successfully implementing this model can
grow old without becoming, in the words of Jerry Garcia, “Old and in
the Way”.
The well-run prospect generator resembles the
Energizer Bunny: It just keeps going and going and going. By monetizing its projects,
a prospect generator can achieve a zero sum balance between incoming cash and
tradable securities versus outlays for general, administrative, and
exploration expenses.
The prospect generator is built for the long haul.
Time is on its side and given time, success likely will come and shareholders
will be rewarded.
Folks, now you see why the pros in our microcap
junior resource business love prospect generators.
I presently cover a worldwide gold and copper
prospect generator and a uranium development generator in the western U.S.
Each has monetized significant assets in the past year. In the near future, a
venerable North American prospect generator will be added to my list of
sponsors.
Please stay tuned.
Perhaps you, the lay investor, will want do your own
due diligence and research the merits of prospect generators as speculative
investments.
For a list of companies I cover in my newsletter,
interviews, and speaking engagements, here’s the link: Mercenary Site Sponsors.
Ciao for now,
Mickey Fulp
The Mercenary Geologist
Miningcompanyreport.com
The Mercenary Geologist Michael S.
“Mickey” Fulp is a Certified
Professional Geologist with a B.Sc. Earth Sciences with honor from the
University of Tulsa, and M.Sc. Geology from the University of New Mexico.
Mickey has 30 years experience as an exploration
geologist searching for economic deposits of base and precious metals,
industrial minerals, coal, uranium, and water in North and South America and
China.
Mickey has worked for junior explorers, major mining companies, private
companies, and investors as a consulting economic geologist for the past 22
years, specializing in geological mapping and property evaluation. In
addition to Mickey’s professional credentials and experience, he is
high-altitude proficient and is bilingual in English and Spanish. From 2003
to 2006, Mickey made four outcrop ore discoveries in Peru, Nevada, Chile, and
British Columbia.
Mickey is well known throughout the mining and exploration community for his
ongoing work as an analyst for public and private companies, investment
funds, newsletter and website writers, private investors, and brokers.
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