Gladly… I live for this ;)
The Setup
Pretend there's a mining project that is going to operate for 1 year and in that year it'll produce a certain amount of copper. Let's say it will cost $60 million to bring those rocks with copper in them to surface and to process them. When you sell that copper you can get $100 million for it. So in this example (for simplicity we'll ignore taxes) you have made $40 million in profit for the year.
Scenario #1: A "Normal" Joint-Venture Agreement
Imagine there are 2 parties and one party owns 85% and the other party owns 15%. So at the start of the year, before they start mining, that "team" knows they need $60 million to dig these rocks up. The one guy puts up his 85% stake, which would be $51 million, and the other guy puts up his 15% stake, which would be the remaining $9 million. They dig the rocks up and process them, sell them for $100M, then the one guy gets his 85% of that, or $85 million, and the other guy gets his 15%, or $15 million.
When all is said and done, the 85% guy has made $34M [85% x ($100 - $60)] and the 15% guy has made $6M [15% x ($100 - $60)].
These two partners are effectively in the same structure, they just own a different proportion of the project. You’ll notice that the “bigger guy” has a 5.67x as big of a stake in the project, and thus makes 5.67x more profit (note: it’s a double-edged sword that goes both ways in the event the venture loses money).
Scenario #2: A Carried-Interest Joint-Venture Agreement
Imagine there are 2 parties and one party owns an 85% and the other party owns a 15% carried-interest. So at the start of the year, before they start mining, that "team" knows they need $60 million to dig these rocks up. The one guy puts up his 85% stake, which would be $51 million, and the other guy is just about to put up his 15% stake but then he remembers his interest is carried which mean that the other partners in the joint-venture must pay for his portion of costs. So rather than him putting up his 15%, which would be $9M, he tells that other guy to pay for it… so the 85% partner pays $60M and the 15% carried-interest pays zero. They dig the rocks up and process them, sell them for $100M, then the one guy gets his 85% of that, or $85 million, and the other guy gets his 15%, or $15 million.
When all is said and done, the 85% guy has made $25M ($85M Revenue - $60M Costs) and the 15% carried guy has made $15M ($15M Revenue – zero Costs].
These two partners are now in a different structure from one another… the one guy is carried and the other isn’t. You’ll now notice that the “bigger guy” still has a 5.67x bigger stake in the project, but due to the nature of the carried-interest he’s only making 1.67x more profit. Also note that the 15% carried-interest guy made $15M and the equivalent “normal interest” he would have needed to make that much money would be a 37.5% interest in the project ($40M total profit in project x 37.5% = $15M). So with this simple 1 year mine life example, a 15% carried-interest is equivalent to a 37.5% “normal” interest in the project.
A joint-venture structure with a carried-interest component is decently common in natural resource development. Especially in parts of the world like Northern Africa where a government would like to share in the profits of the development of a project inside its borders but it doesn’t want to be told periodically to cut multi-million dollar cheques for its proportionate interest in the project… so instead they ask for a smaller % interest and say, “You carry me”. Another advantage is they don’t have to share in the potential losses of a project if it’s the case the mine ends up being a really bad idea.
Usually with these sort of structures, there’s a clause where basically if that 85% partner is losing money, you’re not going to be allowed to “profit”... him carrying you is supposed to be about helping you both succeed, not create a situation where you are succeeding but he is failing. However, what you want to avoid is a situation where that 85% interest guy decides to hire say a management team for $40M for that year, they’re his friends, and when you add that cost onto your $60M rock moving cost it seems like the project “doesn’t make any money”. It’s for this reason why I’d suggest going for a deal structure where you get the greater of either the Scenario #2 metric or Scenario #3.
Scenario #3: A Royalty Agreement
Imagine there are 2 parties and one party owns 100% of the project, and the other party owns a 5% royalty that is on top of the project. So at the start of the year, before they start mining, that "team" knows they need $60 million to dig these rocks up. The one guy puts up his 100% stake, which would be $60 million, and the other guy puts up nothing because he’s got a royalty and only takes from the revenue while never helping with the cost. So, the 100% partner pays $60M, they dig the rocks up and process them, then sell them for $100M. Now, because you just sold $100 of your product, that royalty guy gets 5% of all of that money right off the top, so you gotta pay him $5M.
When all is said and done, the 100% guy has made $35M ($100M Revenue - $5M Royalty Payment - $60M Costs) and the 5% royalty guy has made $5M (from the royalty payment). So note that the 5% royalty guy made $5M and the equivalent “normal interest” he would have needed to make that much money would be a 12.5% interest in the project ($40M total profit in project x 12.5% = $5M). So with this simple 1 year mine life example, a 5% royalty is equivalent to a 12.5% “normal” interest in the project.
The advantage of a deal structure like this is you can do whatever accounting gymnastics you’d like to try and make it look like “you’re not making money”, but it isn’t going to matter because I’m entitled to take some right off the top whether you’re wildly profitable or narrowly evading bankruptcy.
Signed,
Your friendly neighborhood investment banker ;)