UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

Form 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to _____________
 
Commission file number: 0-11576

HARRIS & HARRIS GROUP, INC.
(Exact Name of Registrant as Specified in Its Charter)

New York
13-3119827
(State or Other Jurisdiction of
(I.R.S. Employer Identification No.)
  Incorporation or Organization)
  

111 West 57th Street, New York, New York
10019
(Address of Principal Executive Offices)
(Zip Code)

(212) 582-0900
 (Registrant's Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes     x  No     o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes  o  No  x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

 
Outstanding at August 7, 2008
Common Stock, $0.01 par value per share
  
25,859,573 shares   


Harris & Harris Group, Inc.
Form 10-Q, June 30, 2008
 
 
Page Number
PART I. FINANCIAL INFORMATION
  
   
Item 1. Consolidated Financial Statements
1
   
Consolidated Statements of Assets and Liabilities
2
   
Consolidated Statements of Operations
3
   
Consolidated Statements of Cash Flows
4
   
Consolidated Statements of Changes in Net Assets
5
   
Consolidated Schedule of Investments
6
   
Notes to Consolidated Financial Statements
21
   
Financial Highlights
32
   
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
33
   
Background and Overview
33
   
Results of Operations
37
   
Financial Condition
41
   
Liquidity
42
   
Capital Resources
43
   
Critical Accounting Policies
43
   
Recent Developments – Portfolio Companies
45
   
Forward-Looking Statements
46
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk
46
   
Item 4. Controls and Procedures
47
   
PART II. OTHER INFORMATION
  
   
Item 1A. Risk Factors
49
   
Item 4. Submission of Matters to a Vote of Security Holders
50
   
Item 6. Exhibits
51
   
Signatures
52
   
Exhibit Index
53

2

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

The information furnished in the accompanying consolidated financial statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim period presented.

Harris & Harris Group, Inc.® (the "Company," "us," "our" and "we"), is an internally managed venture capital company that has elected to operate as a business development company under the Investment Company Act of 1940 (the "1940 Act"). Certain information and disclosures normally included in the consolidated financial statements in accordance with Generally Accepted Accounting Principles have been condensed or omitted as permitted by Regulation S-X and Regulation S-K. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2007, contained in our Annual Report on Form 10-K for the year ended December 31, 2007.

On September 25, 1997, our Board of Directors approved a proposal to seek qualification as a regulated investment company ("RIC") under Subchapter M of the Internal Revenue Code (the "Code"). At that time, we were taxable under Subchapter C of the Code (a "C Corporation"). We filed for the 1999 tax year to elect treatment as a RIC. In order to qualify as a RIC, we must, in general, (1) annually, derive at least 90 percent of our gross income from dividends, interest, gains from the sale of securities and similar sources; (2) quarterly, meet certain investment diversification requirements; and (3) annually, distribute at least 90 percent of our investment company taxable income as a dividend. In addition to the requirement that we must annually distribute at least 90 percent of our investment company taxable income, we may either distribute or retain our taxable net capital gains from investments, but any net capital gains not distributed could be subject to corporate level tax. Further, we could be subject to a four percent excise tax to the extent we fail to distribute at least 98 percent of our annual investment company taxable income and would be subject to income tax to the extent we fail to distribute 100 percent of our investment company taxable income.

Because of the specialized nature of our investment portfolio, we generally can satisfy the diversification requirements under Subchapter M of the Code if we receive a certification from the Securities and Exchange Commission (“SEC”) that we are "principally engaged in the furnishing of capital to other corporations which are principally engaged in the development or exploitation of inventions, technological improvements, new processes, or products not previously generally available."
 
On May 30, 2008, we received SEC certification for 2007, permitting us to qualify for RIC treatment for 2007 (as we had for the years 1999 through 2006) pursuant to Section 851(e) of the Code. Although the SEC certification for 2007 was issued, there can be no assurance that we will qualify for or receive such certification for subsequent years (to the extent we need additional certification as a result of changes in our portfolio) or that we will actually qualify for Subchapter M treatment in subsequent years. In 2007, we qualified for RIC treatment even without certification. In addition, under certain circumstances, even if we qualified for Subchapter M treatment in a given year, we might take action in a subsequent year to ensure that we would be taxed in that subsequent year as a C Corporation, rather than as a RIC. Because Subchapter M does not permit deduction of operating expenses against long-term capital gains, it is not clear that the Company and its shareholders have paid less taxes since 1999 than they would have paid had the Company remained a C Corporation.

1
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
 
   
June 30, 2008
 
December 31, 2007
 
 
 
(Unaudited)
 
 
  
           
ASSETS
              
               
Investments, in portfolio securities at value
(cost: $88,459,760 and $82,677,528, respectively)
  
$
92,335,524
  
$
78,110,384
  
Investments, in U.S. Treasury obligations at value
(cost: $60,984,874 and $59,552,933, respectively)
    
61,425,025
    
60,193,593
  
Cash and cash equivalents
    
688,119
    
330,009
  
Restricted funds (Note 9)
    
53,871
    
2,667,020
  
Receivable from portfolio company
    
21,500
    
524
  
Interest receivable
    
573,686
    
647,337
  
Prepaid expenses
    
263,363
    
488,667
  
Other assets
    
425,895
    
455,798
  
Total assets
  
$
155,786,983
  
$
142,893,332
  
               
               
LIABILITIES & NET ASSETS
              
               
               
Accounts payable and accrued liabilities (Note 9)
  
$
1,996,853
  
$
4,515,463
  
Deferred rent
    
11,290
    
14,525
  
Total liabilities
    
2,008,143
    
4,529,988
  
               
Net assets
  
$
153,778,840
  
$
138,363,344
  
               
Net assets are comprised of: Preferred stock, $0.10 par value, 2,000,000 shares authorized; none issued
  
$
0
  
$
0
  
Common stock, $0.01 par value, 45,000,000 shares authorized at 6/30/08 and 12/31/07; 27,688,313 issued at 6/30/08 and 25,143,313 issued at 12/31/07
    
276,884
    
251,434
  
Additional paid in capital (Note 7)
    
178,252,063
    
160,927,691
  
Accumulated net realized loss
    
(25,660,491
)
  
(15,483,766
)
Accumulated unrealized appreciation (depreciation) of investments
    
4,315,915
    
(3,926,484
)
Treasury stock, at cost (1,828,740 shares at 6/30/08 and 12/31/07)
    
(3,405,531
)
  
(3,405,531
)
               
Net assets
  
$
153,778,840
  
$
138,363,344
  
               
Shares outstanding
    
25,859,573
    
23,314,573
  
               
Net asset value per outstanding share
  
$
5.95
  
$
5.93
  

The accompanying notes are an integral part of these consolidated financial statements.

2
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
   
Three Months Ended June 30,
  
Six Months Ended June 30,
  
   
2008
  
2007
  
2008
  
2007
  
                   
Investment income:
                          
Interest from:
                          
Fixed-income securities
  
$
464,456
  
$
637,701
  
$
1,040,758
  
$
1,290,199
  
Miscellaneous income
    
3,169
    
0
    
3,169
    
0
  
Total investment income
    
467,625
    
637,701
    
1,043,927
    
1,290,199
  
                           
Expenses:
                          
Salaries, benefits and stock-based compensation (Note 5)
    
2,461,802
    
2,644,284
    
4,895,097
    
5,179,050
  
Administration and operations
    
283,361
    
357,178
    
585,216
    
738,043
  
Professional fees
    
201,866
    
335,067
    
340,098
    
517,262
  
Rent
    
59,748
    
58,813
    
117,602
    
118,320
  
Directors’ fees and expenses
    
79,169
    
112,157
    
184,315
    
253,353
  
Depreciation
    
13,819
    
15,908
    
27,804
    
31,221
  
Custodian fees
    
6,143
    
5,961
    
12,696
    
11,735
  
Total expenses
    
3,105,908
    
3,529,368
    
6,162,828
    
6,848,984
  
                           
Net operating loss
    
(2,638,283
)
  
(2,891,667
)
  
(5,118,901
)
  
(5,558,785
)
                           
Net realized gain (loss) from investments:
                          
Realized gain (loss) from investments
    
3,912
    
(8,213
)
  
(5,010,958
)
  
(8,887
)
Income tax expense (Note 6)
    
668
    
0
    
46,866
    
84,905
  
Net realized gain (loss) from investments
    
3,244
    
(8,213
)
  
(5,057,824
)
  
(93,792
)
                           
Net decrease (increase) in unrealized depreciation on investments:
                          
Change as a result of investment sales
    
0
    
0
    
5,014,653
    
0
  
Change on investments held
    
3, 989,748
    
(1,193,764
)
  
3,227,746
    
(4,831,227
)
Net decrease (increase) in unrealized
                          
depreciation on investments
    
3, 989,748
    
(1,193,764
)
  
8,242,399
    
(4,831,227
)
                           
Net increase (decrease) in net assets resulting from operations
  
$
1,354,709
  
$
(4,093,644
)
$
(1,934,326
)
$
(10,483,804
)
                           
Per average basic and diluted outstanding share
  
$
0.06
  
$
(0.19
)
$
(0.08
)
$
(0.49
)
                           
Average outstanding shares
    
23,622,210
    
21,721,591
    
23,468,392
    
21,500,810
  

The accompanying notes are an integral part of these consolidated financial statements.

3
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
   
Six Months Ended
  
Six Months Ended
  
   
June 30, 2008
  
June 30, 2007
  
   
 
      
Cash flows used in operating activities:
              
Net decrease in net assets resulting from operations
  
$
(1,934,326
)
$
(10,483,804
)
Adjustments to reconcile net decrease in net assets resulting from operations
to net cash used in operating activities:
              
Net realized and unrealized (gain) loss on investments
    
(3,231,441
)
  
4,840,114
  
Depreciation of fixed assets and amortization of premium
              
or discount on U.S. government securities
    
82,877
    
89,891
  
Stock-based compensation expense
    
2,966,325
    
3,422,637
  
               
Changes in assets and liabilities:
              
Restricted funds
    
2,613,149
    
(175,533
)
Receivable from portfolio company
    
(20,976
)
  
0
  
Receivable from broker
    
0
    
668,340
  
Interest receivable
    
73,651
    
40,216
  
Prepaid expenses
    
225,304
    
(294,798
)
Other assets
    
3,894
    
20,647
  
Accounts payable and accrued liabilities
    
(2,518,610
)
  
228,888
  
Accrued profit sharing
    
0
    
(261,661
)
Deferred rent
    
(3,235
)
  
(3,401
)
               
Net cash used in operating activities
    
(1,743,388
)
  
(1,908,464
)
               
Cash flows from investing activities:
              
Purchase of short and long-term investments and marketable securities
    
(66,940,804
)
  
(27,600,155
)
Sale of short and long-term investments and
              
marketable securities
    
65,395,679
    
18,353,983
  
Investment in private placements and loans
    
(10,847,095
)
  
(10,043,027
)
Proceeds from sale of investments
    
112,234
    
0
  
Purchase of fixed assets
    
(2,013
)
  
(13,804
)
 
              
Net cash provided by (used in) investing activities
    
(12,281,999
)
  
(19,303,003
)
               
Cash flows from financing activities:
              
Proceeds from stock option exercises (Note 5)
    
0
    
8,360,029
  
Proceeds from stock offering (Note 7)
    
14,383,497
    
12,993,168
  
               
Net cash provided by financing activities
    
14,383,497
    
21,353,197
  
               
Net increase (decrease) in cash and cash equivalents:
              
Cash and cash equivalents at beginning of the period
    
330,009
    
2,071,788
  
Cash and cash equivalents at end of the period
    
688,119
    
2,213,518
  
               
Net increase (decrease) in cash and cash equivalents
  
$
358,110
  
$
141,730
  
               
Supplemental disclosures of cash flow information:
              
Income taxes paid
  
$
46,325
  
$
84,706
  

The accompanying notes are an integral part of these consolidated financial statements.

4
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
 
   
Six Months Ended
  
Year Ended
  
   
June 30, 2008
  
December 31, 2007
  
   
(Unaudited)
      
           
Changes in net assets from operations:
              
               
Net operating loss
  
$
(5,118,901
)
$
(11,827,543
)
Net realized (loss) gain on investments
    
(5,057,824
)
  
30,162
  
Net decrease in unrealized depreciation on investments sold
    
5,014,653
    
0
  
Net decrease in unrealized depreciation on investments held
    
3,227,746
    
5,080,936
  
 
              
               
Net decrease in net assets resulting from operations
    
(1,934,326
)
  
(6,716,445
)
               
Changes in net assets from capital stock transactions:
              
               
Issuance of common stock upon the exercise of stock options
    
0
    
9,996
  
Issuance of common stock on offering
    
25,450
    
13,000
  
Additional paid-in capital on common stock issued
    
14,358,047
    
23,075,683
  
Stock-based compensation expense
    
2,966,325
    
8,050,807
  
               
Net increase in net assets resulting from capital stock transactions
    
17,349,822
    
31,149,486
  
               
Net increase in net assets
    
15,415,496
    
24,433,041
  
               
Net assets:
              
               
Beginning of the period
    
138,363,344
    
113,930,303
  
 
              
End of the period
  
$
153,778,840
  
$
138,363,344
  

The accompanying notes are an integral part of these consolidated financial statements.

5
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)

   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
Investments in Unaffiliated Companies (2)(3) – 13.18% of net assets at value
                    
                     
Private Placement Portfolio (Illiquid) – 13.18% of net assets at value
                    
                     
                     
BioVex Group, Inc. (4)(5)(6)(7) — Developing novel biologics for treatment of cancer and infectious disease
                   
Series E Convertible Preferred Stock
    
(M)
 
  
2,799,552
  
$
2,500,000
  
                     
Exponential Business Development Company (4)(5) — Venture capital partnership focused on early stage companies
                    
Limited Partnership Interest
    
(M)
 
  
1
    
2,219
  
                     
Molecular Imprints, Inc. (4)(5) — Manufacturing nanoimprint lithography capital equipment
                   
Series B Convertible Preferred Stock
    
(M)
 
  
1,333,333
    
2,173,333
  
Series C Convertible Preferred Stock
    
(M)
 
  
1,250,000
    
2,037,500
  
Warrants at $2.00 expiring 12/31/11
    
( I )
 
  
125,000
    
117,250
  
                 
4,328,083
  
                     
Nanosys, Inc. (4)(5)(6) — Developing zero and one-dimensional inorganic nanometer-scale materials and devices
                   
Series C Convertible Preferred Stock
    
(M)
 
  
803,428
    
2,370,113
  
Series D Convertible Preferred Stock
    
(M)
 
  
1,016,950
    
3,000,003
  
                 
5,370,116
  
                     
Nantero, Inc. (4)(5)(6) — Developing a high-density, nonvolatile, random access memory chip, enabled by carbon nanotubes
                    
Series A Convertible Preferred Stock
    
(M)
 
  
345,070
    
1,046,908
  
Series B Convertible Preferred Stock
    
(M)
 
  
207,051
    
628,172
  
Series C Convertible Preferred Stock
    
(M)
 
  
188,315
    
571,329
  
                 
2,246,409
  

The accompanying notes are an integral part of these consolidated financial statements.

6
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
 
Principal
  
Value
  
               
Investments in Unaffiliated Companies (2) (3) – 13.18% of net assets at value (cont.)
                   
                     
Private Placement Portfolio (Illiquid) – 13.18% of net assets at value (cont.)
                   
                     
                     
NeoPhotonics Corporation (4)(5) — Developing and manufacturing optical devices and components
                    
Common Stock
    
(M)
   
716,195
  
$
93,106
  
Series 1 Convertible Preferred Stock
    
(M)
   
1,831,256
    
919,989
  
Series 2 Convertible Preferred Stock
    
(M)
   
741,898
    
456,710
  
Series 3 Convertible Preferred Stock
    
(M)
   
2,750,000
    
2,750,000
  
Series X Convertible Preferred Stock
    
(M)
   
2,000
    
400,000
  
Warrants at $0.15 expiring 01/26/10
    
( I )
   
16,364
    
785
  
Warrants at $0.15 expiring 12/05/10
    
( I )
   
14,063
    
675
  
                 
4,621,265
  
                     
Polatis, Inc. (4)(5)(6)(8) — Developing MEMS-based optical networking components
                    
Series A-1 Convertible Preferred Stock
    
(M)
   
16,775
    
0
  
Series A-2 Convertible Preferred Stock
    
(M)
   
71,611
    
132,653
  
Series A-4 Convertible Preferred Stock
    
(M)
   
4,774
    
8,768
  
Series A-5 Convertible Preferred Stock
    
(M)
   
16,438
    
135,105
  
                 
276,526
  
                     
PolyRemedy, Inc. (4)(5)(6)(9) —Developing a robotic manufacturing platform for wound treatment patches
                    
Series B-1 Convertible Preferred Stock
    
(M)
   
287,647
    
244,500
  
                     
                     
                     
Starfire Systems, Inc. (4)(5)(6) — Producing ceramic-forming polymers
                   
Common Stock
    
(M)
   
375,000
    
90,000
  
Series A-1 Convertible Preferred Stock
    
(M)
   
600,000
    
600,000
  
                 
690,000
  
                     
Total Unaffiliated Private Placement Portfolio (cost: $21,879,892)
             
$
20,279,118
  
 
                    
Total Investments in Unaffiliated Companies (cost: $21,879,892)
             
$
20,279,118
  
 
The accompanying notes are an integral part of these consolidated financial statements.

7
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
 
Principal
  
Value
  
               
Investments in Non-Controlled Affiliated Companies (2) (10) – 42.69% of net assets at value
                    
                     
Private Placement Portfolio (Illiquid) – 42.69% of net assets at value
                    
                     
Adesto Technologies Corporation (4)(5)(6) — Developing semiconductor-related products enabled at the nanoscale
                    
Series A Convertible Preferred Stock
    
(M)
   
6,547,619
  
$
2,200,000
  
                     
Ancora Pharmaceuticals, Inc. (4)(5)(6) — Developing synthetic carbohydrates for pharmaceutical applications
                    
Series B Convertible Preferred Stock
    
(M)
   
1,663,808
    
1,600,000
  
                     
BridgeLux, Inc. (4)(5)(11) — Manufacturing high-power light emitting diodes
                    
Series B Convertible Preferred Stock
    
(M)
   
1,861,504
    
2,792,256
  
Series C Convertible Preferred Stock
    
(M)
   
2,130,699
    
3,196,050
  
Series D Convertible Preferred Stock
    
(M)
   
666,667
    
1,000,001
  
Warrants at $0.7136 expiring 02/02/17
    
( I )
   
98,340
    
137,774
  
Warrants at $0.7136 expiring 04/26/17
    
( I )
   
65,560
    
92,177
  
                 
7,218,258
  
                     
Cambrios Technologies Corporation (4)(5)(6) — Developing nanowire-enabled electronic materials for the display industry
                    
Series B Convertible Preferred Stock
    
(M)
   
1,294,025
    
1,294,025
  
Series C Convertible Preferred Stock
    
(M)
   
1,300,000
    
1,300,000
  
                 
2,594,025
  
                     
CFX Battery, Inc. (4)(5)(6)(12) — Developing batteries using nanostructured materials
                    
Series A Convertible Preferred Stock
    
(M)
   
1,208,262
    
946,528
  
 
The accompanying notes are an integral part of these consolidated financial statements.

8
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
Investments in Non-Controlled Affiliated Companies (2)(10) – 42.69% of net assets at value (cont.)
                    
                     
Private Placement Portfolio (Illiquid) – 42.69% of net assets at value (cont.)
                    
                     
Crystal IS, Inc. (4)(5)(6) — Developing single-crystal aluminum nitride substrates for optoelectronic devices
                  
Series A Convertible Preferred Stock
    
(M)
 
  
391,571
  
$
305,425
  
Series A-1 Convertible Preferred Stock
    
(M)
 
  
1,300,376
    
1,014,294
  
Warrants at $0.78 expiring 05/05/13
    
(I)
 
  
15,231
    
9,276
  
Warrants at $0.78 expiring 05/12/13
    
(I)
 
  
2,350
    
1,431
  
Warrants at $0.78 expiring 08/08/13
    
(I)
 
  
4,396
    
2,717
  
                 
1,333,143
  
                     
CSwitch Corporation (4)(5)(6)(13) — Developing next-generation, system-on-a-chip solutions for communications-based platforms
                    
Series A-1 Convertible Preferred Stock
    
(M)
 
  
6,863,118
    
3,431,559
  
Unsecured Convertible Bridge Note (including interest)
    
(M)
 
$
1,516,673
    
1,550,619
  
                 
4,982,178
  
                     
D-Wave Systems, Inc. (4)(5)(6)(14) — Developing high- performance quantum computing systems
                    
Series B Convertible Preferred Stock
    
(M)
 
  
2,000,000
    
2,179,676
  
Series C Convertible Preferred Stock
    
(M)
 
  
678,264
    
739,198
  
                 
2,918,874
  
                     
Ensemble Discovery Corporation (4)(5)(6) — Developing DNA Programmed Chemistry for the discovery of new classes of therapeutics and bioassays
                    
Series B Convertible Preferred Stock
    
(M)
 
  
1,449,275
    
2,000,000
  
                     
Innovalight, Inc. (4)(5)(6) — Developing solar power products enabled by silicon-based nanomaterials
                    
Series B Convertible Preferred Stock
    
(M)
 
  
16,666,666
    
5,718,216
  
Series C Convertible Preferred Stock
    
(M)
 
  
5,810,577
    
1,993,568
  
               
7,711,784
  
 
The accompanying notes are an integral part of these consolidated financial statements.

9
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
Investments in Non-Controlled Affiliated Companies (2)(10) – 42.69% of net assets at value (cont.)
                    
                     
Private Placement Portfolio (Illiquid) – 42.69% of net assets at value (cont.)
                    
                     
Kereos, Inc. (4)(5)(6) — Developing emulsion-based imaging agents and targeted therapeutics to image and treat cancer and cardiovascular disease
                    
Series B Convertible Preferred Stock
    
(M)
 
  
545,456
  
$
90,371
  
                     
Kovio, Inc. (4)(5)(6) — Developing semiconductor products using printed electronics and thin-film technologies
                    
Series C Convertible Preferred Stock
    
(M)
 
  
2,500,000
    
3,125,000
  
Series D Convertible Preferred Stock
    
(M)
 
  
800,000
    
1,000,000
  
                 
4,125,000
  
                     
Mersana Therapeutics, Inc. (4)(5)(6)(15) — Developing advanced polymers for drug delivery
                    
Series A Convertible Preferred Stock
    
(M)
 
  
68,451
    
136,902
  
Series B Convertible Preferred Stock
    
(M)
 
  
866,500
    
1,733,000
  
Warrants at $2.00 expiring 10/21/10
    
(I)
 
  
91,625
    
109,309
  
                 
1,979,211
  
                     
Metabolon, Inc. (4)(5)(6) — Discovering biomarkers through the use of metabolomics
                    
Series B Convertible Preferred Stock
    
(M)
 
  
2,173,913
    
1,765,535
  
Series B-1 Convertible Preferred Stock
    
(M)
 
  
869,565
    
706,214
  
Warrants at $1.15 expiring 3/25/15
    
(I)
 
  
434,783
    
291,739
  
                 
2,763,488
  
                     
NanoGram Corporation (4)(5)(6) — Developing a broad suite of intellectual property utilizing nanoscale materials
                    
Series I Convertible Preferred Stock
    
(M)
 
  
63,210
    
124,524
  
Series II Convertible Preferred Stock
    
(M)
 
  
1,250,904
    
2,464,281
  
Series III Convertible Preferred Stock
    
(M)
 
  
1,242,144
    
2,447,024
  
Series IV Convertible Preferred Stock
    
(M)
 
  
432,179
    
851,393
  
                 
5,887,222
  

The accompanying notes are an integral part of these consolidated financial statements.

10
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
Investments in Non-Controlled Affiliated Companies (2)(10) – 42.69% of net assets at value (cont.)
                    
                     
Private Placement Portfolio (Illiquid) – 42.69% of net assets at value (cont.)
                    
                     
Nanomix, Inc. (4)(5)(6) — Producing nanoelectronic sensors that integrate carbon nanotube electronics with silicon microstructures
                    
Series C Convertible Preferred Stock
    
(M)
 
  
977,917
  
$
235,683
  
Series D Convertible Preferred Stock
    
(M)
 
  
6,802,397
    
485,457
  
     
 
          
721,140
  
                     
Nextreme Thermal Solutions, Inc. (4)(5)(6) — Developing thin-film thermoelectric devices for cooling and energy conversion
                    
Series A Convertible Preferred Stock
    
(M)
 
  
1,750,000
    
1,750,000
  
Unsecured Convertible Bridge Note (including interest)
    
(M)
 
$
777,580
    
783,928
  
                 
2,533,928
  
                     
Questech Corporation (4)(5) — Manufacturing and marketing proprietary metal and stone decorative tiles
                    
Common Stock
    
(M)
 
  
655,454
    
139,208
  
Warrants at $1.50 expiring 11/19/08
    
(I)
 
  
5,000
    
0
  
Warrants at $1.50 expiring 11/19/09
    
(I)
 
  
5,000
    
70
  
                 
139,278
  
                     
Siluria Technologies, Inc. (4)(5)(6) — Developing next-generation nanomaterials
                    
Series S-2 Convertible Preferred Stock
    
(M)
 
  
482,218
    
160,723
  
                     
Solazyme, Inc. (4)(5)(6) — Developing algal biodiesel, industrial chemicals and special ingredients based on synthetic biology
                    
Series A Convertible Preferred Stock
    
(M)
 
  
988,204
    
4,994,383
  
Series B Convertible Preferred Stock
    
(M)
 
  
495,246
    
2,502,973
  
Unsecured Convertible Bridge Note (including interest)
    
(M)
 
$
2,000,000
    
2,245,685
  
                 
9,743,041
  
 
The accompanying notes are an integral part of these consolidated financial statements.

11
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
Investments in Non-Controlled Affiliated Companies (2)(10) – 42.69% of net assets at value (cont.)
                    
                     
Private Placement Portfolio (Illiquid) – 42.69% of net assets at value (cont.)
                    
                     
Xradia, Inc. (4)(5) — Designing, manufacturing and selling ultra-high resolution 3D x-ray microscopes and fluorescence imaging systems
                    
Series D Convertible Preferred Stock
    
(M)
 
  
3,121,099
  
$
4,000,000
  
                     
Zia Laser, Inc. (4)(5)(16) — Developed quantum dot semiconductor lasers
                    
Series C Convertible Preferred Stock
    
(M)
 
  
1,500,000
    
0
  
                     
Total Non-Controlled Private Placement Portfolio (cost: $57,591,270)
              
$
65,648,192
  
                     
Total Investments in Non-Controlled Affiliated Companies (cost: $57,591,270)
              
$
65,648,192
  
 
The accompanying notes are an integral part of these consolidated financial statements.

12
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
Investments in Controlled Affiliated Companies (2)(17) – 4.17% of net assets at value
                    
                     
Private Placement Portfolio (Illiquid) – 4.17% of net assets at value
                    
                     
Evolved Nanomaterial Sciences, Inc. (4)(5)(18) — Developed nanoscale-enhanced approaches for the resolution of chiral molecules
                    
Series A Convertible Preferred Stock
    
(M)
 
  
5,870,021
  
$
0
  
                     
Laser Light Engines, Inc. (4)(5)(6)(9) — Manufacturing solid-state light sources for digital cinema and large venue projection displays
                    
Series A Convertible Preferred Stock
    
(M)
 
  
7,499,062
    
2,000,000
  
                     
Phoenix Molecular Corporation (4)(5)(6) — Developing technology to enable the separation of difficult-to-separate materials
                    
Common Stock
    
(M)
 
  
1,000
    
10
  
Unsecured Convertible Bridge Note (including interest)
    
(M)
 
$
100,000
    
103,588
  
     
 
          
103,598
  
                     
SiOnyx, Inc. (4)(5)(6) — Developing silicon-based optoelectronic products enabled by its proprietary "Black Silicon"
                    
Series A Convertible Preferred Stock
    
(M)
 
  
233,499
    
135,686
  
Series A-1 Convertible Preferred Stock
    
(M)
 
  
2,966,667
    
1,723,930
  
Series A-2 Convertible Preferred Stock
    
(M)
 
  
4,207,537
    
2,445,000
  
                 
4,304,616
  
                     
Total Controlled Private Placement Portfolio (cost: $8,988,598)
              
$
6,408,214
  
                     
Total Investments in Controlled Affiliated Companies (cost: $8,988,598)
              
$
6,408,214
  
                     
Total Private Placement Portfolio (cost: $88,459,760)
              
$
92,335,524
  

The accompanying notes are an integral part of these consolidated financial statements.

13
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
   
Method of
  
Shares/
      
   
Valuation (1)
  
Principal
  
Value
  
               
U.S. Government and Agency Securities (19) - 39.95% of net assets at value
                    
                     
U.S. Treasury Bill — due date 07/24/08
    
(M)
 
$
7,100,000
  
$
7,093,184
  
U.S. Treasury Notes — due date 09/15/08, coupon 3.125%
    
(M)
 
  
4,775,000
    
4,787,702
  
U.S. Treasury Notes — due date 01/15/09, coupon 3.25%
    
(M)
 
  
3,000,000
    
3,019,920
  
U.S. Treasury Notes — due date 02/15/09, coupon 4.50%
    
(M)
 
  
5,100,000
    
5,169,309
  
U.S. Treasury Notes — due date 04/15/09, coupon 3.125%
    
(M)
 
  
3,000,000
    
3,018,060
  
U.S. Treasury Notes — due date 07/15/09, coupon 3.625%
    
(M)
 
  
3,000,000
    
3,040,080
  
U.S. Treasury Notes — due date 10/15/09, coupon 3.375%
    
(M)
 
  
3,000,000
    
3,040,560
  
U.S. Treasury Notes — due date 01/15/10, coupon 3.625%
    
(M)
 
  
3,000,000
    
3,056,730
  
U.S. Treasury Notes — due date 04/15/10, coupon 4.00%
    
(M)
 
  
3,000,000
    
3,076,410
  
U.S. Treasury Notes — due date 06/30/10, coupon 2.875%
    
(M)
 
  
1,250,000
    
1,256,150
  
U.S. Treasury Notes — due date 07/15/10, coupon 3.875%
    
(M)
 
  
3,000,000
    
3,075,480
  
U.S. Treasury Notes — due date 09/15/10, coupon 3.875%
    
(M)
 
  
2,000,000
    
2,051,880
  
U.S. Treasury Notes — due date 10/15/10, coupon 4.25%
    
(M)
 
  
2,000,000
    
2,070,780
  
U.S. Treasury Notes — due date 12/15/10, coupon 4.375%
    
(M)
 
  
2,000,000
    
2,077,040
  
U.S. Treasury Notes — due date 03/31/11, coupon 4.750%
    
(M)
 
  
2,000,000
    
2,098,600
  
U.S. Treasury Notes — due date 06/30/11, coupon 5.125%
    
(M)
 
  
2,000,000
    
2,125,620
  
U.S. Treasury Notes — due date 09/30/11, coupon 4.500%
    
(M)
 
  
2,000,000
    
2,090,320
  
U.S. Treasury Notes — due date 12/31/11, coupon 4.625%
    
(M)
 
  
2,000,000
    
2,101,260
  
U.S. Treasury Notes — due date 10/31/12, coupon 3.875%
    
(M)
 
  
2,000,000
    
2,050,940
  
U.S. Treasury Notes — due date 02/15/13, coupon 3.875%
    
(M)
 
  
5,000,000
    
5,125,000
  
                     
Total Investments in U.S. Government and Agency Securities (cost: $60,984,874)
              
$
61,425,025
  
                     
Total Investments (cost: $149,444,634)
              
$
153,760,549
  
 
The accompanying notes are an integral part of these consolidated financial statements.

14
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
Notes to Consolidated Schedule of Investments

(1)
See Footnote to Consolidated Schedule of Investments on page 17 for a description of the Valuation Procedures.

(2)
Investments in unaffiliated companies consist of investments in which we own less than five percent of the voting shares of the portfolio company. Investments in non-controlled affiliated companies consist of investments in which we own five percent or more, but less than 25 percent, of the voting shares of the portfolio company, or where we hold one or more seats on the portfolio company’s Board of Directors but do not control the company. Investments in controlled affiliated companies consist of investments in which we own 25 percent or more of the voting shares of the portfolio company or otherwise control the company.

(3)
The aggregate cost for federal income tax purposes of investments in unaffiliated companies is $21,879,892. The gross unrealized appreciation based on the tax cost for these securities is $1,732,194. The gross unrealized depreciation based on the tax cost for these securities is $3,332,968.

(4)
Legal restrictions on sale of investment.

(5)
Represents a non-income producing security. Equity investments that have not paid dividends within the last 12 months are considered to be non-income producing.

(6)
These investments are development stage companies. A development stage company is defined as a company that is devoting substantially all of its efforts to establishing a new business, and either it has not yet commenced its planned principal operations, or it has commenced such operations but has not realized significant revenue from them.

(7)
With our purchase of Series E Convertible Preferred Stock of BioVex, we received a warrant to purchase a number of shares of common stock of BioVex as determined by dividing 624,999.99 by the price per share at which the common stock is offered and sold to the public in connection with the initial public offering.  The ability to exercise this warrant is therefore contingent on BioVex completing successfully an initial public offering before the expiration date of the warrant on September 27, 2012. The exercise price of this warrant shall be 110 percent of the initial public offering price.

(8)
Continuum Photonics, Inc., merged with Polatis, Ltd., to form Polatis, Inc.

(9)
Initial investment was made during 2008.
 
The accompanying notes are an integral part of this consolidated schedule.

15
 
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2008
(Unaudited)
 
 (10)
The aggregate cost for federal income tax purposes of investments in non-controlled affiliated companies is $57,591,270. The gross unrealized appreciation based on the tax cost for these securities is $17,069,201. The gross unrealized depreciation based on the tax cost for these securities is $9,012,279.

(11)
BridgeLux, Inc., was previously named eLite Optoelectronics, Inc.

(12)
On February 28, 2008, Lifco, Inc., merged with CFX Battery, Inc. The surviving entity is CFX Battery, Inc. 

(13)
With our investments in secured convertible bridge notes issued by CSwitch, we received two warrants to purchase a number of shares of the class of stock sold in the next financing of CSwitch equal to $529,322 and $985,835, respectively, the principal of the notes, divided by the lowest price per share of the class of stock sold in the next financing of CSwitch.  The ability to exercise these warrants is, therefore, contingent on CSwitch completing successfully a subsequent round of financing.  The warrants will expire five years from the date of the close of the next round of financing.  The cost basis of these warrants is $529 and $986, respectively.

(14)
D-Wave Systems, Inc., is located and is doing business primarily in Canada. We invested in D-Wave Systems, Inc., through D-Wave USA, a Delaware company. Our investment is denominated in Canadian dollars and is subject to foreign currency translation. See "Note 3. Summary of Significant Accounting Policies."

(15)
Mersana Therapeutics, Inc., was previously named Nanopharma Corp.

(16)
On November 30, 2006, the assets of Zia Laser, Inc., were acquired by Innolume Inc., in exchange for shares of Innolume, Inc. On July 1, 2008, Innolume repurchased these shares for $122,000. The Company received its pro rata portion of this amount, which was $21,500.

(17)
The aggregate cost for federal income tax purposes of investments in controlled affiliated companies is $8,988,598. The gross unrealized appreciation based on the tax cost for these securities is $219,616. The gross unrealized depreciation based on the tax cost for these securities is $2,800,000.

(18)
On September 30, 2007, Evolved Nanomaterial Sciences, Inc., filed for Chapter 7 bankruptcy. On July 9, 2008, the bankruptcy trustee sold the intellectual property assets of Evolved Nanomaterial Sciences, Inc., for a sum that was substantially less than the liabilities of the company. Harris & Harris Group, therefore, does not expect to receive any cash from the proceeds of this sale.

(19)
The aggregate cost for federal income tax purposes of our U.S. government securities is $60,984,874. The gross unrealized appreciation on the tax cost for these securities is $657,153. The gross unrealized depreciation on the tax cost of these securities is $217,002.
 
The accompanying notes are an integral part of this consolidated schedule.

16
 
HARRIS & HARRIS GROUP, INC.
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
 
VALUATION PROCEDURES

I. Determination of Net Asset Value

The 1940 Act requires periodic valuation of each investment in the portfolio of the Company to determine its net asset value. Under the 1940 Act, unrestricted securities with readily available market quotations are to be valued at the current market value; all other assets must be valued at fair value as determined in good faith by or under the direction of the Board of Directors.

The Board of Directors is responsible for (1) determining overall valuation guidelines and (2) ensuring that the investments of the Company are valued within the prescribed guidelines.

The Valuation Committee, comprised of all of the independent Board members, is responsible for reviewing and approving the valuation of the Company’s assets within the guidelines established by the Board of Directors. The Valuation Committee receives information and recommendations from management.

The values assigned to these investments are based on available information and do not necessarily represent amounts that might ultimately be realized, as such amounts depend on future circumstances and cannot reasonably be determined until the individual investments are actually liquidated or become readily marketable.
 
II. Approaches to Determining Fair Value

Statement of Financial Accounting Standards No. 157, "Fair Value Measurements," ("SFAS No. 157") defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). In effect, SFAS No. 157 applies fair value terminology to all valuations, whereas the 1940 Act applies market value terminology to readily marketable assets and fair value terminology to other assets.

The main approaches to measuring fair value utilized are the market approach and the income approach.

 
·
Market Approach (M): The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. For example, the market approach often uses market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range each appropriate multiple falls requires judgment considering factors specific to the measurement (qualitative and quantitative).

17
 
 
·
Income Approach (I): The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present value amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model), which incorporate present value techniques; and the multi-period excess earnings method, which is used to measure the fair value of certain assets.

SFAS No. 157 classifies the inputs used to measure fair value by these approaches into the following hierarchy:

 
·
Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities.
 
 
·
Level 2: Quoted prices in active markets for similar assets or liabilities, or quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
 
·
Level 3: Unobservable inputs for the asset or liability.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
 
III. Investment Categories

The Company’s investments can be classified into five broad categories for valuation purposes:

 
·
Equity-related securities;
 
·
Long-term fixed-income securities;
 
·
Short-term fixed-income securities;
 
·
All other securities; and
 
·
Investments in intellectual property, patents, research and development in technology or product development.
 
The Company applies the methods for determining fair value discussed above to the valuation of investments in each of these five broad categories as follows:
 
A. EQUITY-RELATED SECURITIES

Equity-related securities, including warrants, are fair valued using the market or income approaches. The following factors may be considered when the market approach is used to fair value these types of securities:

18
 
 
·
Readily available public market quotations;

 
·
The cost of the Company’s investment;

 
·
Transactions in a company's securities or unconditional firm offers by responsible parties as a factor in determining valuation;

 
·
The financial condition and operating results of the company;

 
·
The long-term potential of the business and technology of the company;

 
·
The values of similar securities issued by companies in similar businesses;

 
·
Multiples to revenue, net income or EBITDA that similar securities issued by companies in similar businesses receive;

 
·
The proportion of the company's securities we own and the nature of any rights to require the company to register restricted securities under applicable securities laws; and

 
·
The rights and preferences of the class of securities we own as compared with other classes of securities the portfolio company has issued.
 
When the income approach is used to value warrants, the Company uses the Black-Scholes-Merton formula.

B. LONG-TERM FIXED-INCOME SECURITIES

1. Readily Marketable: Long-term fixed-income securities for which market quotations are readily available are valued using the most recent bid quotations when available.

2. Not Readily Marketable: Long-term fixed-income securities for which market quotations are not readily available are fair valued using the market approach. The factors that may be considered when valuing these types of securities by the market approach include:

 
·
Credit quality;
 
·
Interest rate analysis;
 
·
Quotations from broker-dealers;
 
·
Prices from independent pricing services that the Board believes are reasonably reliable; and
 
·
Reasonable price discovery procedures and data from other sources.

19

C. SHORT-TERM FIXED-INCOME SECURITIES

Short-term fixed-income securities are valued using the market approach in the same manner as long-term fixed-income securities until the remaining maturity is 60 days or less, after which time such securities may be valued at amortized cost if there is no concern over payment at maturity.

D. ALL OTHER SECURITIES

All other securities are reported at fair value as determined in good faith by the Valuation Committee using the approaches for determining valuation as described above.

For all other securities, the reported values shall reflect the Valuation Committee's judgment of fair values as of the valuation date using the outlined basic approaches of valuation discussed in Section II. They do not necessarily represent an amount of money that would be realized if we had to sell such assets in an immediate liquidation. Thus, valuations as of any particular date are not necessarily indicative of amounts that we may ultimately realize as a result of future sales or other dispositions of investments we hold.

E. INVESTMENTS IN INTELLECTUAL PROPERTY, PATENTS, RESEARCH AND DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT

Such investments are fair valued using the market approach. The Company may consider factors specific to these types of investments when using the market approach including:

 
·
The cost of the Company’s investment;
 
·
Investments in the same or substantially similar intellectual property or patents or research and development in technology or product development or offers by responsible third parties;
 
·
The results of research and development;
 
·
Product development progress;
 
·
Commercial prospects;
 
·
Term of patent;
 
·
Projected markets; and
 
·
Other subjective factors.

20
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 1. THE COMPANY

Harris & Harris Group, Inc. (the "Company," "us," "our" and "we"), is a venture capital company operating as a business development company ("BDC") under the Investment Company Act of 1940 ("1940 Act"). We operate as an internally managed company whereby our officers and employees, under the general supervision of our Board of Directors, conduct our operations.

We elected to become a BDC on July 26, 1995, after receiving the necessary shareholder approvals. From September 30, 1992, until the election of BDC status, we operated as a closed-end, non-diversified investment company under the 1940 Act. Upon commencement of operations as an investment company, we revalued all of our assets and liabilities in accordance with the 1940 Act. Prior to September 30, 1992, we were registered and filed under the reporting requirements of the Securities Exchange Act of 1934 (the "1934 Act") as an operating company and, while an operating company, operated directly and through subsidiaries.

Harris & Harris Enterprises, Inc.,SM is a 100 percent wholly owned subsidiary of the Company. Harris & Harris Enterprises, Inc., is a partner in Harris Partners I, L.P.,SM and is taxed under Subchapter C of the Code (a “C Corporation”). Harris Partners I, L.P, is a limited partnership and is used to hold certain interests in portfolio companies. The partners of Harris Partners I, L.P., are Harris & Harris Enterprises, Inc., (sole general partner) and Harris & Harris Group, Inc., (sole limited partner). Harris & Harris Enterprises, Inc., pays taxes on any non-passive investment income generated by Harris Partners I, L.P. For the period ended June 30, 2008, there was no non-passive investment income. The Company consolidates the results of its subsidiaries for financial reporting purposes.

NOTE 2. INTERIM FINANCIAL STATEMENTS

Our interim financial statements have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X and in conformity with generally accepted accounting principles applicable to interim financial information. Accordingly, they do not include all information and disclosures necessary for a presentation of our financial position, results of operations and cash flows in conformity with generally accepted accounting principles in the United States of America. In the opinion of management, these financial statements reflect all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of our financial position, results of operations and cash flows for such periods. The results of operations for any interim period are not necessarily indicative of the results for the full year. These financial statements should be read in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

21

NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The following is a summary of significant accounting policies followed in the preparation of the consolidated financial statements:

Principles of Consolidation. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for investment companies and include the accounts of the Company and its wholly owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.

Use of Estimates. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities as of June 30, 2008, and December 31, 2007, and the reported amounts of revenues and expenses for the three months and six months ended June 30, 2008, and 2007. Actual results could differ from these estimates, and the differences could be material. The most significant estimates relate to the fair valuations of certain of our investments.
 
Cash and Cash Equivalents. Cash and cash equivalents includes demand deposits and money market instruments with maturities of less than three months. Cash and cash equivalents are carried at cost which approximates value.

Portfolio Investment Valuations. Investments are stated at "value" as defined in the 1940 Act and in the applicable regulations of the SEC. Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) the fair value as determined in good faith by, or under the direction of, the Board of Directors for all other assets. (See "Valuation Procedures" in the "Footnote to Consolidated Schedule of Investments.") At June 30, 2008, our financial statements include private venture capital investments valued at $92,335,524, the fair values of which were determined in good faith by, or under the direction, of the Board of Directors. Upon sale of investments, the values that are ultimately realized may be different from what is presently estimated. The difference could be material. Effective January 1, 2008, the Company adopted SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The Company would resolve any inconsistencies between Section 2(a)(41) of the 1940 Act and SFAS No. 157 in accordance with the requirements of Section 2(a)(41). The adoption of SFAS No. 157 did not have a material impact on the fair value measurements of the Company's investments.

Foreign Currency Translation. The accounting records of the Company are maintained in U.S. dollars. All assets and liabilities denominated in foreign currencies are translated into U.S. dollars based on the rate of exchange of such currencies against U.S. dollars on the date of valuation. For the six months ended June 30, 2008, included in the net decrease in unrealized depreciation on investments was a $57,229 loss resulting from foreign currency translation.

Securities Transactions. Securities transactions are accounted for on the date the transaction for the purchase or sale of the securities is entered into by the Company (i.e., trade date).

22

Interest Income Recognition. Interest income, adjusted for amortization of premium and accretion of discount, is recorded on accrual basis. The Company ceases accruing interest when securities are determined to be non-income producing and writes off any previously accrued interest.

Realized Gain or Loss and Unrealized Appreciation or Depreciation of Portfolio Investments. Realized gain or loss is recognized when an investment is disposed of and is computed as the difference between the Company’s cost basis in the investment at the disposition date and the net proceeds received from such disposition. Realized gains and losses on investment transactions are determined by specific identification. Unrealized appreciation or depreciation is computed as the difference between the fair value of the investment and the cost basis of such investment.

Stock-Based Compensation. The Company has a stock-based employee compensation plan. The Company accounts for the plan in accordance with the provisions of Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment," ("SFAS No. 123(R)"). See “Note 5. Stock-Based Compensation” for further discussion.

Income Taxes. As we intend to qualify as a RIC under Subchapter M of the Internal Revenue Code, the Company does not provide for income taxes. Our taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," and FIN 48, "Accounting for Uncertainty in Income Taxes." The Company recognizes interest and penalties in income tax expense.

We pay federal, state and local income taxes on behalf of our wholly owned subsidiary, Harris & Harris Enterprises, Inc., which is a C corporation. See "Note 6. Income Taxes."

Restricted Funds. The Company maintains a rabbi trust for the purposes of accumulating funds to satisfy the obligations incurred by us for the Supplemental Executive Retirement Plan ("SERP") under the employment agreement with Charles E. Harris.
 
Property and Equipment. Property and equipment are included in "Other Assets" and are carried at cost, less accumulated depreciation of $364,152. Depreciation is provided using the straight-line method over the estimated useful lives of the premises and equipment.

Concentration of Credit Risk. The Company places its cash and cash equivalents with financial institutions and, at times, cash held in checking accounts may exceed the Federal Deposit Insurance Corporation insured limit. 

NOTE 4. FAIR VALUE MEASUREMENTS

At June 30, 2008, our financial assets were categorized as follows in the fair value hierarchy for SFAS No. 157 purposes:

23


       
Fair Value Measurement at Reporting Date Using:
 
                   
Description
  
June 30, 2008
  
Quoted Prices in 
Active Markets for
Identical Assets (Level 1)
  
Significant Other
Observable Inputs 
(Level 2)
  
Significant 
Unobservable 
Inputs (Level 3)
  
U.S. Government Securities
 
$
61,425,025
  
$
0
  
$
61,425,025
  
$
0
  
                           
Portfolio Companies
  
$
92,335,524
  
$
0
  
$
0
  
$
92,335,524
  
                           
Total
  
$
153,760,549
  
$
0
  
$
61,425,025
  
$
92,335,524
  

The following chart shows the components of change in the financial assets categorized as Level 3, for the three months ended June 30, 2008.

   
Fair Value Measurements 
Using Significant
  
   
Unobservable Inputs (Level 3)
  
       
   
Portfolio Companies
  
       
Beginning Balance, April 1, 2008
  
$
83,097,863
  
         
Total realized losses included in changes in net assets
    
0
  
Total unrealized gains included in changes in net assets
    
4,791,705
  
Purchases and interest on bridge notes
    
4,467,456
  
Disposals
    
(21,500
)
Ending Balance, June 30, 2008
 
$
92,335,524
  
         
The amount of total gains for the period included in changes in net assets attributable to the change in unrealized gains or losses relating to assets still held at the reporting date
  
$
4,791,705
  

The following chart shows the components of change in the financial assets categorized as Level 3, for the six months ended June 30, 2008.

24

   
Fair Value Measurements 
Using Significant
  
   
Unobservable Inputs (Level 3)
  
       
   
Portfolio Companies
  
       
Beginning Balance, January 1, 2008
 
$
78,110,384
  
         
Total realized losses included in changes in net assets
    
(5,014,653
)
Total unrealized gains included in changes in net assets
    
8,442,908
  
Purchases and interest on bridge notes
    
10,924,099
  
Disposals
    
(127,214
)
Ending Balance, June 30, 2008
 
$
92,335,524
  
         
The amount of total gains for the period included in changes in net assets attributable to the change in unrealized gains or losses relating to assets still held at the reporting date
  
$
3,428,255
  

NOTE 5. STOCK-BASED COMPENSATION

On March 23, 2006, the Board of Directors of the Company voted to terminate the Employee Profit-Sharing Plan and to establish the Harris & Harris Group, Inc. 2006 Equity Incentive Plan (the "Stock Plan"), subject to shareholder approval. This proposal was approved at the May 4, 2006, Annual Meeting of Shareholders. The Stock Plan provides for the grant of equity-based awards of stock options to our officers, employees and directors (subject to receipt of an exemptive order described below) and restricted stock (subject to receipt of an exemptive order described below) to our officers and employees who are selected by our Compensation Committee for participation in the plan and subject to compliance with the 1940 Act.

On July 11, 2006, the Company filed an application with the SEC regarding certain provisions of the Stock Plan, and on June 29, 2007, the Company responded to comments from the SEC on the application. In the event that the SEC provides the exemptive relief requested by the application, and we receive any additional stockholder approval required by the SEC, the Compensation Committee may, in the future, authorize awards of stock options under the Stock Plan to non-employee directors of the Company and authorize grants of restricted stock to employees.

A maximum of 20 percent of our total shares of our common stock issued and outstanding are available for awards under the Stock Plan. Under the Stock Plan, no more than 25 percent of the shares of stock reserved for the grant of the awards under the Stock Plan may be restricted stock awards at any time during the term of the Stock Plan. If any shares of restricted stock are awarded, such awards will reduce on a percentage basis the total number of shares of stock for which options may be awarded. If the Company does not receive exemptive relief from the SEC to issue restricted stock, all shares granted under the Stock Plan may be subject to stock options. No more than 1,000,000 shares of our common stock may be made subject to awards under the Stock Plan to any individual in any year.

25

On March 19, 2008, the Compensation Committee of the Board of Directors and the full Board of Directors of the Company approved a grant of individual Non-Qualified Stock Option ("NQSO") awards for certain officers and employees of the Company. The terms and conditions of the stock options granted were set forth in award agreements between the Company and each award recipient entered into on that date. Options to purchase a total of 348,032 shares of stock were granted with vesting periods ranging from March 2009 to March 2012 and with an exercise price of $6.18, which was the closing volume weighted average price of our shares of common stock on March 19, 2008. Upon exercise, the shares would be issued from our previously authorized but unissued shares.

The Company accounts for the Stock Plan in accordance with the provisions of SFAS No. 123(R), which requires that we determine the fair value of all share-based payments to employees, including the fair value of grants of employee stock options, and record these amounts as an expense in the Statement of Operations over the vesting period with a corresponding increase to our additional paid-in capital. At June 30, 2008 and December 31, 2007, the increase to our operating expenses was offset by the increase to our additional paid-in capital, resulting in no net impact to our net asset value. Additionally, the Company does not record the tax benefits associated with the expensing of stock options, because the Company currently intends to qualify as a RIC under Subchapter M of the Code.

An option's expected term is the estimated period between the grant date and the exercise date of the option. As the expected term period increases, the fair value of the option and the non-cash compensation cost will also increase. The expected term assumption is generally calculated using historical stock option exercise data. The Company does not have historical exercise data to develop such an assumption. In cases where companies do not have historical data and where the options meet certain criteria, SEC Staff Accounting Bulletin 107 ("SAB 107") provides the use of a simplified expected term calculation. Accordingly, the Company calculated the expected terms using the SAB 107 simplified method.
 
Expected volatility is the measure of how the stock's price is expected to fluctuate over a period of time. An increase in the expected volatility assumption yields a higher fair value of the stock option. Expected volatility factors for the stock options were based on the historical fluctuations in the Company’s stock price over a period commensurate with the expected term of the option, adjusted for stock splits and dividends.

The expected dividend yield assumption is traditionally calculated based on a company's historical dividend yield. An increase to the expected dividend yield results in a decrease in the fair value of option and resulting compensation cost. Although the Company has declared deemed dividends in previous years, most recently in 2005, the amounts and timing of any future dividends cannot be reasonably estimated. Therefore, for purposes of calculating fair value, the Company has assumed an expected dividend yield of zero percent.

The risk-free interest rate assumptions are based on the annual yield on the measurement date of a zero-coupon U.S. Treasury bond the maturity of which equals the option’s expected term. Higher assumed interest rates yield higher fair values.

26

The amount of non-cash, stock-based compensation expense recognized in the Consolidated Statements of Operations is based on the fair value of the awards the Company expects to vest, recognized over the vesting period on a straight-line basis for each award, and adjusted for actual options vested and pre-vesting forfeitures. The forfeiture rate is estimated at the time of grant and revised, if necessary, in subsequent periods if the actual forfeiture rate differs from the estimated rate and is accounted for in the current period and prospectively.

The fair value of each stock option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model as permitted by SFAS No. 123(R). The assumptions used in the calculation of fair value of the stock options granted on March 19, 2008, using the Black-Scholes-Merton model for the contract term was as follows:

                           
Weighted
  
                           
Average
  
       
Number
  
Expected
  
Expected
  
Expected