SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
Form 10-K
Annual Report Pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 1999 Commission File No. 0-11576
HARRIS & HARRIS GROUP, INC.
- -----------------------------------------------------------------------------
(Exact Name of Registrant Specified in Its Charter)
New York 13-3119827
- ---------------------------------------- -----------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
- ---------------------------------------------------------------- --------
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (212) 332-3600
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock $ .01 par value
- -----------------------------------------------------------------------------
(Title of class)
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. [ X ]
The aggregate market value of the Common Stock held by non-affiliates of
Registrant as of February 29, 2000 was $173,717,623 based on the last sale
price as quoted by NASDAQ National Market on such date (only officers and
directors are considered affiliates for this calculation).
As of February 29, 2000, the registrant had 9,240,831 shares of common
stock, par value $.01 per share, outstanding.
Portions of the registrant's definitive Proxy Statement for the Annual
Meeting of Shareholders to be held on April 26, 2000 are incorporated by
reference into Part III of this report.
TABLE OF CONTENTS
Page
PART I
Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . 11
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . 11
Item 4. Submission of Matters to a Vote of Security Holders . . 11
PART II
Item 5. Market for Company's Common Equity and Related
Stockholder Matters . . . . . . . . . . . . . . . . . . 12
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . 14
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . . . . . . . . 15
Item 7a. Quantitative and Qualitative Disclosures About Market
Risk. . . . . . . . . . . . . . . . . . . . . . . . . 27
Item 8. Consolidated Financial Statements
and Supplementary Data. . . . . . . . . . . . . . . . 28
Item 9. Disagreements on Accounting and Financial Disclosure. . 53
PART III
Item 10. Directors and Executive Officers of the Company . . . . 53
Item 11. Executive Compensation. . . . . . . . . . . . . . . . . 53
Item 12. Security Ownership of Certain Beneficial Owners
and Management. . . . . . . . . . . . . . . . . . . . 53
Item 13. Certain Relationships and Related Transactions. . . . . 53
PART IV
Item 14. Exhibits, Consolidated Financial Statements,
Schedules and Reports on Form 8-K . . . . . . . . . . 54
Signatures. . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Exhibit Index . . . . . . . . . . . . . . . . . . . . . . . . . . 58
PART I
Item 1. Business
Harris & Harris Group, Inc. (the "Registrant" or "Company") is a venture
capital investment company, operating as a Business Development Company
("BDC") under the Investment Company Act of 1940 (the "1940 Act"). The
Company's objective is to achieve long-term capital appreciation, rather
than current income, from its investments. The Company has invested a
substantial portion of its assets in private development stage or start-up
companies and in the development of new technologies in a broad range of
industry segments. These private businesses tend to be thinly capitalized,
unproven, small companies based on risky technologies that lack management
depth and have not attained profitability or have no history of operations.
The Company may also invest, to the extent permitted under the 1940 Act, in
publicly traded securities, including high risk securities as well as
investment grade securities. The Company may participate in expansion
financing and leveraged buyout financing of more mature operating companies
as well as other investments. As a venture capital company, the Company
invests in and provides managerial assistance to its private investees which,
in its opinion, have significant potential for growth. There is no assurance
that the Company's investment objective will be achieved.
The Company was incorporated under the laws of the State of New York in
August 1981. Prior to September 30, 1992, the Company had a class of
securities registered, and filed under the reporting requirements, of the
Securities Exchange Act of 1934 (the "1934 Act") as an operating company.
On that date the Company commenced operations as a closed-end, non-
diversified investment company under the 1940 Act. On July 26, 1995, the
Company elected to become a BDC subject to the provisions of Sections 55
through 65 of the 1940 Act. As a BDC, the Company operates as an internally
managed investment company whereby its officers and employees, under the
general supervision of its Board of Directors, conduct its operations.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a Regulated Investment
Company ("RIC") under Sub-Chapter M of the Internal Revenue Code (the
"Code"). At that time, the Company was taxable under Sub-Chapter C of the
Code (a "C Corporation"). On April 8, 1998, the Company announced that it
had received a certification from the Securities and Exchange Commission
("SEC") for 1997 relating to the Company's status under section 851(e) of
the Code. That certification was necessary for the Company to qualify as a
RIC for 1998 and subsequent taxable years.
Pursuant to the Company's receipt of the section 851(e) certification
and its intention to qualify as a RIC , in 1998 the Company's Board of
Directors declared and paid a one-time cash dividend of $0.75 per share,
for a total of $8,019,728, to meet one of the Company's requirements for
qualification for Sub-Chapter M tax treatment. On February 17, 1999, the
Company received rulings from the Internal Revenue Service (the "IRS")
regarding other issues relevant to the Company's tax status as a RIC.
(See "Note 6 of Notes to Consolidated Financial Statements" contained in
1
"Item 8. Consolidated Financial Statements and Supplementary Data" and
"Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Recent Developments - Sub-Chapter M Status.")
The qualification of the Company as a RIC under Sub-Chapter M of the
Code depends on it satisfying certain technical requirements regarding its
income, investment portfolio and distributions. The Company was unable to
satisfy these requirements for the 1998 tax year owing to the nature of the
Company's ownership interest in one of its investee companies, and therefore
it did not elect Sub-Chapter M status for 1998. In addition, because the
Company realized taxable losses in 1998, it was not strategically
advantageous for the Company to elect Sub-Chapter M tax status for 1998.
Moreover, the Company received a tax opinion in 1998 that the Company
interprets to mean that its tax-loss carryforward at December 31, 1998 of
approximately $7.0 million (resulting in a tax credit of approximately
$2.5 million) would be applicable as a qualifying RIC to its unrealized gains
as of December 31, 1998. That opinion was confirmed in one of the rulings
received from the IRS in February 1999.
The Company changed the nature of its ownership interest in the non-
qualifying investee company effective January 1, 1999 in order to meet the
Sub-Chapter M requirements. In 1999, because of changes in its investment
portfolio, the Company requested recertification from the SEC relating to
the Company's status under section 851(e) of the Code. On February 24, 2000,
the Company received the certification, and the Company plans to elect Sub-
Chapter M tax treatment for 1999. However, there can be no assurance that
the Company will qualify for Sub-Chapter M treatment in subsequent years.
In addition, under certain circumstances, even if the Company qualified for
Sub-Chapter M treatment in a given year and elected Sub-Chapter M treatment
for that year, the Company might take action in a subsequent year to ensure
that it would be taxed in that subsequent year as a C Corporation,rather
than as a RIC.
Venture Capital Investments
The Company has invested a substantial portion of its assets in private
development stage or start-up companies. The Company may initially own 100
percent of the securities of a start-up investee company for a period of
time and may control such company for a substantial period. In connection
with its venture capital investments, the Company may be involved in
recruiting management, formulating operating strategies, product development,
marketing and advertising, assisting in financial plans, as well as providing
management in the initial start-up stages and establishing corporate goals.
The Company may assist in raising additional capital for such companies from
other potential investors and may subordinate its own investment to that of
other investors. The Company may introduce such companies to potential
joint-venture partners, suppliers and customers. In addition, the Company
may assist in establishing relationships with investment bankers and other
professionals. The Company may also assist with mergers and acquisitions.
The Company may also find it necessary or appropriate to provide additional
capital of its own. The Company may derive income from such companies for
the performance of any of the above services. Because of the speculative
2
nature of these investments and the lack of any market for such securities,
there is significantly greater risk of loss than is the case with traditional
investment securities. The Company expects that some of its venture capital
investments will be a complete loss or will be unprofitable and that some
will appear likely to become successful, but never realize their potential.
The Company has in the past sought, and will continue in the future to seek,
investments that offer the potential for significantly higher returns but
that involve a significantly greater degree of risk than other investments.
The Company may control an investee company for which it has provided
venture capital, or it may be represented on the company's board of directors
by one or more of its officers or directors, who may also serve as officers
of such company. Particularly during the early stages of an investment, the
Company may in effect be conducting the operations of the investee company.
As a venture company emerges from the developmental stage with greater
management depth and experience, the Company expects that its role in the
company's operations will diminish. The Company seeks to assist each
investee company in establishing its own independent capitalization,
management and board of directors. The Company expects to be able to reduce
its active involvement in the management of its investment in those start-up
companies that become successful by a liquidity event, such as a public
offering or sale of a company.
The Company has invested a substantial portion of its assets in
securities that do not pay interest or dividends and that are subject to
legal or contractual restrictions on resale that may adversely affect the
liquidity and marketability of such securities.
In addition to the information discussed above, please see "Item 8.
Consolidated Financial Statements and Supplementary Data."
Intellectual Property
The Company believes there is a role for organizations like itself that
can assist in technology transfer. Scientists and institutions that develop
and patent intellectual property increasingly seek the rewards of
entrepreneurial commercialization of their inventions, particularly as
governmental, philanthropic and industrial funding for research has become
harder to obtain. The Company believes that several factors combine to give
it a high value-added role to play in the commercialization of technology:
its experience in organizing and developing successful new companies; its
willingness to invest its own capital at the highest risk- seed stage; its
access to high-grade institutional sources of intellectual property; its
experience in mergers, acquisitions and divestitures; its access to and
knowledge of the capital markets; and its willingness to do as much of the
early work as it is qualified and has time to do.
The Company invests principally but not exclusively in securities
issued by companies involved in: 1) research and development of a technology
and/or obtaining licensing rights to intellectual property or patents; 2)
outright acquisition of intellectual property or patents; and 3) formation
3
and funding of companies or joint ventures to commercialize intellectual
property. Income from the Company's investments in intellectual property
or its development may take the form of participation in licensing or
royalty income or some other form of remuneration. At some point during
the commercialization of a technology, the Company's investment may be
transformed into ownership of securities of a development stage or start-up
company as discussed above. Investing in intellectual property is highly
risky.
Illiquidity of Investments
Many of the Company's investments consist of securities acquired
directly from the issuer in private transactions. These investments may be
subject to restrictions on resale or otherwise be illiquid. The Company
does not anticipate that there will be any established trading market for
such securities. Additionally, many of the securities that the Company may
invest in will not be eligible for sale to the public without registration
under the Securities Act of 1933, as amended, which could prevent or delay
any sale by the Company of such investments or reduce the amount of proceeds
that might otherwise be realized therefrom. Restricted securities generally
sell at a price lower than similar securities not subject to restrictions on
resale. Further, even if a portfolio company registers its securities and
becomes a reporting company under the 1934 Act, the Company may be
considered an insider by virtue of its board representation or otherwise
and would be restricted in sales of such company's securities.
Managerial Assistance
The Company generally is required by the 1940 Act to make significant
managerial assistance available with respect to investee companies that the
Company treats as qualifying assets for purposes of the 70 percent test (see
"Regulation"). "Making available significant managerial assistance" as
defined in the 1940 Act with respect to a BDC such as the Company means (a)
any arrangement whereby a BDC, through its directors, officers, employees or
general partners, offers to provide, and if accepted, does so provide,
significant guidance and counsel concerning the management, operations, or
business objectives and policies of a portfolio company; or (b) the exercise
by a BDC of a controlling influence over the management or policies of a
portfolio company by a BDC acting individually or as a part of a group
acting together which controls such portfolio company. The Company believes
that providing managerial assistance to its investees is critical to its
business development activities. The nature, timing and amount of managerial
assistance provided by the Company vary depending upon the particular
requirements of each investee company.
The Company may be involved with its investees in recruiting management,
product planning, marketing and advertising and the development of financial
plans, operating strategies and corporate goals. In this connection, the
Company may assist clients in developing and utilizing accounting procedures
to efficiently and accurately record transactions in books of account, which
will facilitate asset and cost control and the ready determination of results
4
of operations. The Company also seeks capital for its investees from other
potential investors and occasionally subordinates its own investment to
those of other investors. The Company may introduce its investees to
potential suppliers, customers and joint venture partners and assists its
investees in establishing relationships with commercial and investment
bankers and other professionals, including management consultants,
recruiters, legal counsel and independent accountants. The Company also
assists with joint ventures, acquisitions and mergers.
In connection with its managerial assistance, the Company may be
represented by one or more of its officers or directors on the board of
directors of an investee. As an investment matures and the investee
develops management depth and experience, the Company's role ordinarily will
become progressively less active. However, when the Company owns or acquires
a substantial proportion of a more mature investee company's equity, the
Company may remain active in and may initiate planning of major transactions
by the investee. The Company typically seeks to assist each investee company
in establishing its own independent and effective board of directors and
management.
Need for Follow-On Investments
Following its initial investment in investees, the Company has made and
anticipates that it will continue to make additional investments in such
investees as "follow-on" investments, in order to increase its investment
in an investee, and may exercise warrants, options or convertible securities
that were acquired in the original financing. Such follow-on investments may
be made for a variety of reasons including:
1) to increase the Company's exposure to an investee,
2) to acquire securities issued as a result of exercising convertible
securities that were purchased in the original financing,
3) to preserve the Company's proportionate ownership in a subsequent
financing, or
4) to attempt to preserve or enhance the value of the Company's
investment.
There can be no assurance that the Company will make follow-on investments
or have sufficient funds to make such investments; the Company has the
discretion to make any follow-on investments as it determines, subject to
the availability of capital resources. The failure to make such follow-on
investments may, in certain circumstances, jeopardize the continued viability
of an investee and the Company's initial investment, or may result in a
missed opportunity for the Company to increase its participation in a
successful operation. Even if the Company has sufficient capital to make a
desired follow-on investment, the Company may, under certain circumstances
be inhibited from doing so if such an investment would result in non-
compliance with BDC or RIC regulations.
5
Competition
Numerous companies and individuals are engaged in the venture capital
business and such business is intensely competitive. Many of the competitors
have significantly greater resources and managerial capabilities than the
Company and are therefore in a better position than the Company to obtain
access to attractive venture capital investments.
Regulation
The Small Business Investment Incentive Act of 1980 added the provisions
of the 1940 Act applicable to BDC's, which are a special type of closed-end
investment company. After filing its election to be treated as a BDC, a
company may not withdraw its election without first obtaining the approval
of holders of a majority of its outstanding voting securities. The following
is a brief description of the 1940 Act provisions applicable to BDC's, and
is qualified in its entirety by reference to the full text of the 1940 Act
and the rules issued thereunder by the SEC.
Generally, to be eligible to elect BDC status, a company must primarily
engage in the business of furnishing capital and managerial expertise to
companies which do not have ready access to capital through conventional
financial channels. Such portfolio companies are termed "eligible portfolio
companies." In general, in order to qualify as a BDC, a company must (i) be
a domestic company; (ii) have registered a class of its securities pursuant
to Section 12 of the 1934 Act; (iii) operate for the purpose of investing in
the securities of certain types of portfolio companies, namely, immature or
emerging companies and businesses suffering or just recovering from financial
distress (see following paragraph); (iv) make available significant
managerial assistance to such portfolio companies; (v) have a majority of
"disinterested" directors (as defined in the 1940 Act); and (vi) file a
proper notice of election with the SEC.
An eligible portfolio company generally is a domestic company that is
not an investment company and that (i) does not have a class of equity
securities on which "margin" credit can be extended or (ii) is controlled
by a BDC (control under the 1940 Act is presumed to exist where a BDC owns
at least 25 percent of the outstanding voting securities of the investee).
The 1940 Act prohibits or restricts companies subject to the 1940 Act
from investing in certain types of companies, such as brokerage firms,
insurance companies, investment banking firms and investment companies.
Moreover, the 1940 Act requires that at least 70 percent of the value of
the Company's assets consist of qualifying assets. Qualifying assets
include: (i) securities of companies that were eligible portfolio companies
at the time the Company acquired their securities; (ii) securities of
bankrupt or insolvent companies that were eligible at the time of the
Company's initial investment in those companies; (iii) securities received
in exchange for or distributed in or with respect to any of the foregoing;
and (iv) cash items, government securities and high quality short-term
debt. The 1940 Act also places restrictions on the nature of the
transactions in which, and the persons from whom, securities can be
purchased in order for the securities to be considered qualifying assets.
6
The Company is permitted by the 1940 Act, under specified conditions, to
issue multiple classes of senior debt and a single class of preferred stock
if its asset coverage, as defined in the 1940 Act, is at least 200 percent
after the issuance of the debt or the preferred stock (i.e., such senior
securities may not be in excess of its net assets).
The Company may sell its securities at a price that is below the
prevailing net asset value per share only after a majority of its
disinterested directors has determined that such sale would be in the best
interest of the Company and its stockholders and upon the approval by the
holders of a majority of its outstanding voting securities, including a
majority of the voting securities held by non-affiliated persons. If the
offering of the securities is underwritten, a majority of the disinterested
directors must determine in good faith that the price of the securities
being sold is not less than a price which closely approximates market value
of the securities, less any distribution discount or commission. As defined
by the 1940 Act, the term "majority of the Company's outstanding voting
securities" means the vote of (i) 67 percent or more of the Company's Common
Stock present at the meeting, if the holders of more than 50 percent of the
outstanding Common Stock are present or represented by proxy or (ii) more
than 50 percent of the Company's outstanding Common Stock, whichever is less.
Certain transactions involving certain closely related persons of the
Company, including its directors, officers and employees, may require the
prior approval of the SEC. However, the 1940 Act ordinarily does not restrict
transactions between the Company and investee companies.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. The Company was unable to satisfy the requirements for Sub-
Chapter M for the 1998 tax year. (See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Recent
Developments -- Sub-Chapter M Status.") The Company plans to elect Sub-
Chapter M tax treatment for 1999. There can be no assurance that the
Company will qualify for Sub-Chapter M tax treatment in subsequent years.
In addition, under certain circumstances, even if the Company qualified for
Sub-Chapter M tax treatment in a given year and elected Sub-Chapter M
tax treatment for that year, the Company might take action in a subsequent
year to ensure that it would be taxed in that subsequent year as a C
Corporation, rather than as a RIC.
Employees
The Company currently employs directly four full-time employees and
one part-time employee and, in addition, employs two full-time employees
in a wholly owned subsidiary.
7
Risk Factors
Investing in the Company's Stock is Highly Speculative and You Could Lose
Some or All of the Amount You Invest
The value of the Company's common stock may decline and may be affected
by numerous market conditions, which could result in the loss of some or all
of your investment in the Company's shares. The securities markets
frequently experience extreme price and volume fluctuation which affect
market prices for securities of companies generally, and technology
companies in particular. Because of the Company's focus on the technology
sector, its stock price is likely to be impacted by these market conditions.
General economic conditions, and general conditions in the Internet and
information technology and life sciences and other high technology
industries, will also affect the Company's stock price.
Investing in the Company's Shares May be Inappropriate for Your Risk Tolerance
Investing in the Company's shares may be inappropriate for your risk
tolerance. The Company's investments in accordance with its investment
objective and principal strategies may result in an above average amount of
risk and volatility or loss of principal. The Company's investments in
portfolio companies are highly speculative and aggressive and, therefore,
an investment in its shares may not be suitable for you.
The Market for Venture Capital Investments is Highly Competitive. In Some
Cases, the Company's Status as a Regulated Business Development Company May
Hinder its Ability to Participate in Investment Opportunities.
The Company faces substantial competition in its investing activities
from private venture capital funds, investment affiliates of large
industrial, technology, service and financial companies, small business
investment companies, wealthy individuals and foreign investors. As a
regulated business development company, the Company is required to disclose
quarterly the name and business description of portfolio companies and value
of any portfolio securities. Most of the Company's competitors are not
subject to this disclosure requirement. The Company's obligation to
disclose this information could hinder its ability to invest in certain
portfolio companies. Additionally, other regulations, current and future,
may make the Company less attractive as a potential investor to a given
portfolio company than a private venture capital fund not subject to the same
regulations.
Regulatory Risks
Securities and tax laws and regulations governing the Company's
activities may change in ways negative to the Company's and its shareholders'
interests and interpretations of such laws and regulations may change with
unpredictable consequences.
8
The Company is Dependent Upon Key Management Personnel for Future Success
The Company is dependent for the selection, structuring, closing and
monitoring of its investments on the diligence and skill of its senior
management and other management members. The future success of the Company
depends to a significant extent on the continued service and coordination of
its senior management team, particularly the Chairman and Chief Executive
Officer. The departure of any of the executive officers or key employees
could materially adversely affect the Company's ability to implement its
business strategy. The Company does not maintain key man life insurance
on any of its officers or employees.
Investment in Small, Private Companies
There are significant risks inherent in the Company's venture capital
business. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies with risky
technologies that lack management depth and have not attained profitability
or have no history of operations. Because of the speculative nature and the
lack of a public market for these investments, there is significantly greater
risk of loss than is the case with traditional investment securities. The
Company expects that some of its venture capital investments will be a
complete loss or will be unprofitable and that some will appear to be likely
to become successful but never realize their potential. The Company has been
risk seeking rather than risk averse in its approach to venture capital and
other investments. Neither the Company's investments nor an investment in
the Company is intended to constitute a balanced investment program. The
Company has in the past relied, and continues to rely to a large extent,
upon proceeds from sales of investments rather than investment income to
defray a significant portion of its operating expenses.
Illiquidity of Portfolio Investments
Most of the investments of the Company are or will be equity securities
acquired directly from small companies. The Company's portfolio of equity
securities are and will usually be subject to restrictions on resale or
otherwise have no established trading market. The illiquidity of most of
the Company's portfolio of equity securities may adversely affect the
ability of the company to dispose of such securities at times when it may be
advantageous for the Company to liquidate such investments.
The Inability of the Company's Portfolio Companies to Successfully Market
Their Products Would Have a Negative Impact on its Investment Returns
Even if the Company's portfolio companies are able to develop
commercially viable products, the market for new products and services is
highly competitive and rapidly changing. Commercial success is difficult to
predict and the marketing efforts of the Company's portfolio companies may
not be successful.
9
Valuation of Portfolio Investments
There is typically no public market of equity securities of the small
private companies in which the Company invests. As a result, the valuation
of the equity securities in the Company's portfolio is subject to the good
faith estimate of the Company's Board of Directors. (See "Asset Valuation
Policy Guidelines" in "Footnote to Consolidated Schedule of Investments.")
In the absence of a readily ascertainable market value, the estimated value
of the Company's portfolio of equity securities may differ significantly
from the values that would be placed on the portfolio if a ready market for
the equity securities existed. Any changes in estimated net asset value are
recorded in the Company's statement of operations as "Change in unrealized
appreciation on investments." (See "Management's Discussion and Analysis
of Financial Condition and Results of Operations.")
Fluctuations of Quarterly Results
The Company's quarterly operating results could fluctuate as a result of
a number of factors. These include, among others, variations in and the
timing of the recognition of realized and unrealized gains or losses, the
degree to which the Company encounters competition in its markets and
general economic conditions. As a result of these factors, results for any
one quarter should not be relied upon as being indicative of performance in
future quarters. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Risk of Loss of Pass Through Tax Treatment
If the Company meets certain diversification and distribution
requirements under the Code, it may qualify as a RIC under the Code for
pass-through tax treatment. The Company would cease to qualify for pass-
through tax treatment if it were unable to comply with these requirements,
or if it ceased to qualify as a BDC under the 1940 Act. The Company also
could be subject to a four percent excise tax (and, in certain cases,
corporate level income tax) if it failed to make certain distributions.
(See "Management's Discussion and Analysis of Financial Condition -- Recent
Developments -- Sub-Chapter M Status.") The lack of Sub-Chapter M tax
treatment could have a material adverse effect on the total return, if any,
obtainable from an investment in the Company. If the Company fails to
qualify as a RIC, the Company would become subject to federal income tax as
if it were an ordinary C Corporation, which would result in a substantial
reduction in the Company's net assets and the amount of income available for
distribution to the Company's stockholders.
Because the Company Must Distribute Income, the Company Will Continue to Need
Additional Capital
The Company will continue to need capital to fund investments and to
pay for operating expenses. The Company must distribute at least 90 percent
of its net operating income other than net realized long-term capital gains
to its stockholders to maintain its RIC status. As a result such earnings
will not be available to fund investments. If the Company fails to generate
10
net realized long-term capital gains or to obtain funds from outside sources,
it could have a material adverse effect on the Company's financial condition
and results. The Company does not normally establish reserves for taxes on
unrealized capital gains. To the extent that the Company retains capital
gains, either as a C corporation or as a Sub-Chapter M corporation, it will
have to make provisions for federal taxes and possibly state and local taxes.
In addition, as a BDC, the Company is generally required to maintain a ratio
of at least 200 percent of total assets to total borrowings, which may
restrict its ability to borrow in certain circumstances.
Reserves for Taxes
As a Sub-Chapter M corporation, the Company does not have to pay
federal income taxes on realized capital gains to the extent that such
gains are distributed to shareholders. Accordingly, it does not
establish reserves for taxes on its unrealized capital gains. If the
Company were not to qualify or were to elect not to qualify for Sub-
Chapter M tax status, it would have to establish such reserves for taxes,
which would reduce its net asset value, net of a reduction in the reserve
for employee profit sharing, accordingly. To the extent that the Company
as a Sub-Chapter M corporation were to make a deemed distribution of net
realized capital gains and were to retain such net realized capital gains,
it would have to establish appropriate reserves for taxes upon making such
a decision.
Year 2000 Problem
The "Year 2000 problem" refers to the inability of many computers,
computer-based systems and related software, and other electronics to
process dates accurately during the Year 2000 and beyond. As of March 20,
2000, the Company has not experienced any business disruption as a result
of the Year 2000 problem. Although Year 2000 problems may not become
evident until long after January 1, 2000, the Company does not expect
significant Year 2000 related business disruptions in the future.
Item 2. Properties
The Company maintains its offices at One Rockefeller Plaza, New York,
New York 10020, where it leases approximately 4,700 square feet of office
space pursuant to a lease agreement expiring in 2003. A portion of this
space was sublet in 1997 and 1998 to an early-stage company in which the
Company then had an equity interest. In 1999, the same space was sublet
to an unaffiliated party. See "Note 7 of Notes to Consolidated Financial
Statements and Schedules" contained in "Item 8. Consolidated Financial
Statements and Supplementary Data."
Item 3. Legal Proceedings
None.
Item 4. Submission of Matters to a Vote of Security Holders
The Company did not submit any matters to a vote of its shareholders
during the fourth quarter of the 1999 fiscal year.
11
PART II
Item 5. Market for Company's Common Equity and Related Stockholder Matters
Stock Transfer Agent
The Bank of New York, 101 Barclay Street, Suite 12W, New York, New York
10286 (Telephone 800-524-4458, Attention: Ms. Diane Ajjan) serves as transfer
agent for the Company's common stock. Certificates to be transferred should be
mailed directly to the transfer agent, preferably by registered mail.
Market Prices
The Company's common stock is traded on the Nasdaq National Market
under the symbol "HHGP." The following table sets forth the range of the
high and low selling price of the Company's shares during each quarter of
the last two years, as reported by the National Association of Securities
Dealers, Inc. The quarterly stock prices quoted represent interdealer
quotations and do not include markups, markdowns or commissions.
1999 Quarter Ending Low High
March 31 $1.3125 $2.1250
June 30 $1.625 $2.00
September 30 $1.71875 $3.125
December 31 $2.9375 $14.250
1998 Quarter Ending Low High
March 31 $2.1875 $3.4375
June 30 $2.2500 $3.6875
September 30 $1.125 $2.3750
December 31 $1.25 $1.5938
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. To initially qualify as a RIC, the Company had, among other
things, to pay a dividend to shareholders equal to the Company's cumulative
realized earnings and profits ("E&P") from its pre-RIC taxable years. The
Company paid a $0.75 dividend per share (approximately $8.0 million) on May
12, 1998 to shareholders of record on April 27, 1998.
On February 23, 1999, the Company announced that subsequent to the
acquisition of NBX Corporation by 3Com Corporation, the Board of Directors
of the Company declared a cash dividend of $0.35 per share (approximately
$3.7 million) to shareholders of record on March 19, 1999, payable on March
25, 1999. (See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Recent Developments -- Sub-Chapter M
Status" and "Note 6 of Notes to Consolidated Financial Statements" contained
in "Item 8. Consolidated Financial Statements and Supplementary Data.")
Prior to 1998, the Company had not paid dividends since 1991.
12
Recent Sales of Unregistered Securities
The Company did not sell unregistered shares in the years ended December
31, 1999 and 1998 other than the restricted common stock shares sold to
Directors as part of their compensation program. In 1997, the Board of
Directors voted that, effective January 1, 1998, 50 percent of all directors'
fees be used to purchase Company common stock directly from the Company.
During 1998, the Directors purchased a total of 24,491 shares. (See "Note
4 of Notes to Consolidated Financial Statements" contained in "Item 8.
Consolidated Financial Statements and Supplementary Data.") On March 1,
1999, the Directors voted to purchase their shares in the open market rather
than directly from the Company. In 1999, the Directors purchased a total of
29,305 shares, 5,816 shares directly from the Company, prior to March 1,
1999, and 23,489 shares in the open market.
Shareholders
As of February 29, 2000, there were approximately 150 holders of record
of the Company's common stock which, the Company has been informed, hold the
Company's common stock for approximately 8,500 beneficial owners.
13
Item 6. Selected Financial Data
The following tables should be read in conjunction with the Consolidated
Financial Statements and Supplementary Data included in Item 8 of this
Form 10-K.
BALANCE SHEET DATA
Financial Position as of December 31:
1999 1998 1997 1996 1995
Total assets $65,320,768 $25,358,859 $39,273,784 $38,555,290 $37,524,555
Total
liabilities $11,685,963 $ 2,802,150 $ 5,618,850 $ 2,622,687 $ 962,646
Net asset
value $53,634,805 $22,556,709 $33,654,934 $35,932,603 $36,561,909
Net asset
value per
share $ 5.80 $ 2.13 $ 3.15 $ 3.44 $ 3.54
Dividends paid $ 0.35 $ 0.75 $ 0.0 $ 0.0 $ 0.0
Shares
outstanding 9,240,831 10,591,232 10,692,971 10,442,682 10,333,902
Operating Data for year ended December 31:
1999 1998 1997 1996 1995
Investment
income $ 287,684 $ 585,486 $ 561,546 $ 1,013,417 $ 1,109,517
Net operating
loss (9,636,336) (2,815,112) (1,550,641) (1,291,065) (1,099,409)
Net realized
gain (loss)
on investments 8,615,670 (1,718,528) (2,027,177) (2,465,175) 1,371,349
Net realized
(loss) income (1,020,666) (4,533,640) (3,577,818) (3,756,240) 271,940
Net increase in
unrealized
appreciation
on investments 38,102,047 1,655,830 969,243 2,967,248 158,219
Net increase
(decrease) in
net assets
resulting
from operations 37,081,381 (2,877,810) (2,608,575) (788,992) 430,159
Increase (decrease)
in net
assets
resulting from
operations per
outstanding
share $ 4.01 $ (0.27) $ (0.24) $ (0.08) $ 0.04
Certain reclassifications have been made to the December 31, 1997 and
December 31, 1998 financial statements to conform to the December 31, 1999
presentation.
14
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The information contained in this section should be read in conjunction
with Company's 1999 Consolidated Financial Statements and notes thereto.
Forward-Looking Statements
The information contained herein contains certain forward-looking
statements. These statements include the plans and objectives of management
for future operations and financial objectives, portfolio growth and
availability of funds. These forward-looking statements are subject to the
inherent uncertainties in predicting future results and conditions. Certain
factors that could cause actual results and conditions to differ materially
from those projected in these forward-looking statements are set forth herein.
Other factors that could cause actual results to differ materially include
the uncertainties of economic, competitive and market conditions, and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company.
Although the Company believes that the assumptions underlying the forward-
looking statements included herein are reasonable, any of the assumptions
could be inaccurate and therefore there can be no assurance that the forward-
looking statements included or incorporated by reference herein will prove to
be accurate. Therefore, the inclusion of such information should not be
regarded as a representation by the Company or any other person that the
objectives and plans of the Company will be achieved.
Statement of Operations
The Company accounts for its operations under Generally Accepted
Accounting Principles for investment companies. On this basis, the
principal measure of its financial performance is captioned "Net increase
(decrease) in net assets resulting from operations," which is the sum of
three elements. The first element is "Net operating loss," which is the
difference between the Company's income from interest, dividends, fees and
other income and its operating expenses, net of applicable income tax
benefit (provision). The second element is "Net realized gain (loss) on
investments," which is the difference between the proceeds received from
dispositions of portfolio securities and their stated cost, net of applicable
income tax benefit (provision). These two elements are combined in the
Company's financial statements and reported as "Net realized loss." The
third element, "Net increase in unrealized appreciation on investments,"
is the net change in the fair value of the Company's investment portfolio,
net of increase (decrease) in deferred income taxes that would become
payable if the unrealized appreciation were realized through the sale or
other disposition of the investment portfolio.
"Net realized gain (loss) on investments" and "Net increase (decrease)
in unrealized appreciation on investments" are directly related. When a
security is sold to realize a gain (loss), net unrealized appreciation
decreases (increases) and net realized gain increases (decreases).
15
Financial Condition
The Company's total assets were $65,320,768 and its net assets were
$53,634,805 at December 31, 1999, versus $25,358,859 and $22,556,709 at
December 31, 1998.
Net asset value per share ("NAV") was $5.80 at December 31, 1999, versus
$2.13 at December 31, 1998. NAV was reduced by $0.35 in 1999 and by $0.75
in 1998 by the cash dividends paid by the Company.
Among the significant changes that affected total assets, net assets and
NAV during 1999 were: (1) the acquisition of NBX Corporation by 3Com
Corporation, which increased the value of the Company's holdings by
approximately $5,868,568; (2) an increase in the value of the Company's
holding in SciQuest.com, Inc. of $31,981,750 as a result of a successful IPO
and subsequent increase in market value; (3) an increase in the market value
of the Company's holding in Alliance Pharmaceutical Corp. of $3,839,000;
(4) the acquisition of InSite Marketing Technology, Inc. by Silknet Software,
Inc. and subsequent increase in the market value of the Company's holding in
Silknet totaling $4,899,062; (5) an increase in the market value of the
Company's holding in Nanophase Technologies Corporation of $1,935,016;
(6) the payment of a cash dividend of $0.35 per share, which reduced assets
by approximately $3,647,017; (7) the addition to a deferred income tax
liability, which reduced assets by $586,710; (8) the purchase of 275,648
treasury shares in the open market for $540,720 and the successful tender
offer for 1,080,569 shares for a total of $1,832,831, which repurchases
reduced assets by a total of $2,373,551 while increasing NAV at December 31,
1999 by $0.59; and (9) the operating loss that reduced assets by $9,636,336.
(See "Consolidated Statements of Operations" contained in "Item 8.
Consolidated Financial Statements and Supplementary Data.")
The Company's shares outstanding as of December 31, 1999 were 9,240,831,
versus 10,591,232 at December 31, 1998. The Company's outstanding shares were
reduced as a result of its purchases in the open market of 243,523 shares in
the first quarter and 32,125 shares in the second quarter as well as the
tender offer for 1,080,569 shares completed in the third quarter. However,
during 1999, the treasury shares were decreased by purchases of a total of
5,816 shares of treasury shares by directors. (See "Note 4 of Notes to
Consolidated Financial Statements" contained in "Item 8. Consolidated
Financial Statements and Supplementary Data.")
The Company's financial condition is dependent on the success of its
investments. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack
management depth, are dependent on new, commercially unproven technologies
and have no history of operations. At December 31, 1999, $41,556,607 or
63.6 percent of the Company's total assets consisted of investments at fair
value in publicly traded securities (that were private businesses at the
time the Company made the investments), of which net unrealized appreciation
was $38,864,873; $18,892,731 or 29.0 percent of the Company's total assets
consisted of non-publicly traded securities at fair value in private
businesses and publicly traded companies, of which net unrealized
appreciation was $8,553,549. See "Recent Development -- Portfolio
16
Companies." At December 31, 1998, $1,570,642 or 6.2 percent of the
Company's total assets consisted of investments at fair value in publicly
traded securities, of which net unrealized appreciation was $156,440;
$19,562,386 or 77.1 percent of the Company's total assets consisted of
investments at fair value in private businesses, of which net unrealized
appreciation was $10,250,204. The increase in the value of publicly
traded securities from $1,570,642 in 1998 to $41,556,607 in 1999 is
primarily owing to the Company's investments in then-privately held InSite
Marketing Technology, Inc., and SciQuest.com, Inc., which subsequently
became publicly traded securities, through an acquisition by a publicly
traded company and an IPO, respectively.
A summary of the Company's investment portfolio is as follows:
December 31, 1999 December 31, 1998
Investments, at cost $16,653,130 $14,124,643
Unrealized appreciation 46,882,521 10,407,548
----------- -----------
Investments, at fair value $63,535,651 $24,532,191
=========== ===========
__________________
The accumulated unrealized appreciation on investments net of deferred taxes
is $45,098,711 at December 31, 1999, versus $6,996,664 at December 31, 1998.
Following an initial investment in a private company, the Company may
make additional investments in such investee in order to: (1) increase its
ownership percentage; (2) exercise warrants or options that were acquired in
a prior financing; (3) preserve the Company's proportionate ownership in a
subsequent financing; or (4) attempt to preserve or enhance the value of the
Company's investment. Such additional investments are referred to as
"follow-on" investments. There can be no assurance that the Company will
make follow-on investments or have sufficient funds to make additional
investments. The failure to make such follow-on investments could jeopardize
the viability of the investee company and the Company's investment or could
result in a missed opportunity for the Company to participate to a greater
extent in an investee's successful operations. The Company attempts to
maintain adequate liquid capital to make follow-on investments in its
private investee portfolio companies. The Company may elect not to make a
follow-on investment either because it does not want to increase its
concentration of risk, because it prefers other opportunities, or
because it is inhibited by compliance with BDC or RIC requirements, even
though the follow-on investment opportunity appears attractive.
The following table is a summary of the cash investments and loans made
by the Company in its private placement portfolio during the year ended
December 31, 1999:
New Investments: Amount
Adaptive Web Technologies, Inc. $1,000,000
Alliance Pharmaceutical Corp. 1,202,000
Kriton Medical, Inc. 1,000,001
Sundial Marketplace Corporation 500,000
----------
Sub-Total $3,702,001
17
Loans:
Sundial Marketplace Corporation $ 250,000
Exercise of Warrants Held:
Questech Corporation $ 50,000
SciQuest.com, Inc. $ 75,000
----------
$ 125,000
----------
Total $4,077,001
==========
Results of Operations
Investment Income and Expenses:
The Company had a net operating loss of $9,636,336 in 1999, $2,815,112
in 1998 and $1,550,641 in 1997. These net operating losses reflect accruals
for employee profit-sharing in those years of $8,110,908, $899,751 and
$423,808, respectively. If the unrealized appreciation as of December 31,
1999 subsequently decreases or if the gains are not realized, the profit-
sharing accrual will be decreased accordingly, resulting in a credit to
expenses, thereby reducing expenses for such subsequent year by that amount.
The Company's investment objective is to achieve long-term capital
appreciation rather than current income from its investments. Therefore, a
significant portion of the investment portfolio is structured to attempt to
enhance the potential for capital appreciation and provides little or no
current yield in the form of dividends or interest. The Company does earn
interest income from fixed-income securities, including U.S. Government
obligations. The amount of interest income earned varies based upon the
average balance of the Company's fixed-income portfolio and the average yield
on this portfolio. The Company also received or accrued net after-tax
distributions from its investment in PHZ Capital Partners, L.P. in 1999 of
$490,950, in 1998 of $50,000 and in 1997 of $52,500. The Company does not
regard distributions from PHZ as predictable.
The Company had total investment income of $287,684 in 1999, $585,486
in 1998 and $561,546 in 1997. The Company had interest income from fixed-
income securities of $234,347 in 1999, $355,591 in 1998 and $490,807 in 1997.
The decrease from 1998 to 1999 of $121,244 or 34.1 percent and the decrease
from 1997 to 1998 of $135,216 or 27.5 percent were the result primarily of
declines in the balances of the Company's fixed-income portfolio during 1999
and 1998 as a result of the payment of the dividends, additional investments
and operating expenses. The Company received consulting and administrative
fees which totaled $29,870 in 1997. The Company did not receive any
consulting or administrative fees in 1998 or 1999.
The Company had interest income from affiliated companies of $48,526
in 1999, $124,877 in 1998 and $40,000 in 1997. The decrease from 1998 to
1999 of $76,351 or 61.1 percent is owing to a decrease in loans outstanding.
The increase from 1997 to 1998 of $84,877 or 212.2 percent is owing to the
receipt of interest income (either in funds or in additional shares) on
loans to investee companies.
18
The Company had other income of $3,911 in 1999, $102,468 in 1998 and
$869 in 1997, some of which reflected income from an affiliated company,
BioSupplyNet, to reimburse the Company for consulting fees previously paid
and expensed by the Company on behalf of BioSupplyNet. Other income also
includes rental income.
Operating expenses were $9,924,020 in 1999, $3,634,786 in 1998 and
$3,045,290 in 1997. The increase from 1998 to 1999 of $6,289,234 or 173.0
percent is primarily owing to an increase in the accrual for the Company's
profit-sharing plan of $8,110,908 or an 801.5 percent increase over the
prior year as a result of the net increase in unrealized appreciation of
the Company's investments of approximately $40,709,767. (See "Note 3 of
Notes to Consolidated Financial Statements" contained in "Item 8.
Consolidated Financial Statements and Supplementary Data.") Approximately
$8,295,916 of the accrued profit-sharing plan balance will not be paid out
until such time as the gains are actually realized. If the unrealized
appreciation as of December 31, 1999 decreases or if the gains are not
realized, the profit-sharing accrual will be decreased accordingly,
resulting in a credit to expenses, thereby reducing expenses for such year
by that amount. A total of $1,024,696 or 90 percent of the profit-sharing
on the 1999 net realized gains was paid in March 2000, and $113,855, or the
remaining 10 percent, will be paid when the Company files its tax return for
the year 1999. (See "Note 3 of Notes to Consolidated Financial Statements"
contained in "Item 8. Consolidated Financial Statements and Supplementary
Data.")
Other than the increase in the profit-sharing accrual and a decrease in
professional fees, which decreased by $79,591 or 19.3 percent as a result of
lower legal fees, expenses remained stable. Salaries and benefits increased
from 1998 to 1999 by $3,579 or less than one percent; administration and
operations decreased from 1998 to 1999 by $11,712 or 3.5 percent;
depreciation decreased from 1998 to 1999 by $12,481 or 26.0 percent as a
result of assets that were fully depreciated as of the end of 1998; rent
increased from 1998 to 1999 by $3,472 or 2.2 percent; directors' fees and
expenses decreased from 1998 to 1999 by $8,925 or 6.9 percent because the
Company had one fewer director in 1999 than in 1998.
During 1999, the Company had no interest expense and no outstanding debt.
The increase in operating expenses from 1997 to 1998 of $589,496 or 19.4
percent is primarily owing to: an increase in the accrual for the Company's
profit-sharing plan of $899,751 or 112.3 percent over the prior year (See
"Note 3 of Notes to Consolidated Financial Statements" contained in "Item 8.
Consolidated Financial Statements and Supplementary Data"); the final payment
on the Harris & Harris Group Senior Professorship pledge to the Massachusetts
Institute of Technology of $728,862; mitigated by a decrease in salaries and
benefits of $676,136, or 44.9 percent.
The Company has in the past relied, and continues to rely to a large
extent, on proceeds from sales of investments, rather than on investment
income, to defray a significant portion of its operating expenses. Because
such sales are unpredictable, the Company attempts to maintain adequate
working capital to provide for fiscal periods when there are no such sales.
19
Realized Gains and Losses on Sales of Portfolio Securities:
During the three years ended December 31, 1999, 1998 and 1997, the
Company sold various investments and received distributions, realizing net
gains (losses) of $10,976,714, ($1,718,528) and ($3,147,002), respectively.
During 1999, the Company realized a gain of approximately $10,584,630
on the acquisition of NBX Corporation by 3Com Corporation; a gain of
approximately $160,918 on its sale of Princeton Video Image, Inc. stock;
and received a cash distribution from PHZ Capital Partners, L.P. of
approximately $612,170. The Company also incurred losses of approximately
$381,004 on the sale of various publicly traded investments.
During 1998, the Company realized losses on the sales of its: privately
held investment in MultiTarget, Inc. of $209,999; publicly held investments
that were once privately held, including (1) CORDEX Petroleums, Inc. in the
amount of $357,736; (2) Princeton Video Image, Inc., $288,369; and (3) Voice
Control Systems, Inc. (which purchased the Company's investee company,
PureSpeech, Inc.), $724,826. The Company also had a realized net loss of
$187,598 in various publicly traded securities. During 1998, the Company
received a cash distribution of $50,000 from PHZ Capital Partners, L.P.
Net losses of $1,171,496 had been recognized in prior years and realized in
1998. Realizing losses and gains from prior years increases (for losses)
or decreases (for gains) the Unrealized Appreciation on Investments.
During 1997, the Company realized losses on the sales of its investments
in: nFX Corporation of $2,631,720; Harber Brothers Productions, Inc.,
$1,205,000; Gel Sciences, Inc., $633,028; Dynecology, Inc., $99,900; and
Micracor Corporation, $66,444. These losses were offset by gains on the
sales of: Highline Capital Management LLC, $750,000; various publicly traded
securities, $686,590; and accrued a distribution of $52,500 from PHZ Capital
Partners, L.P.
Unrealized Appreciation and Depreciation of Portfolio Securities:
The Board of Directors values the portfolio securities on a quarterly
basis pursuant to the Company's Asset Valuation guidelines in accordance
with the 1940 Act. (See "Footnote to Consolidated Schedule of Investments"
contained in "Item 8. Consolidated Financial Statements and Supplementary
Data.")
Net unrealized appreciation on investments increased by $36,474,973 or
350.5 percent during the year ended December 31, 1999, from $10,407,548 to
$46,882,521. The most significant increases in valuation during 1999 were
in: SciQuest.com, Inc., $31,981,750; Silknet Software, Inc. (which acquired
InSite Marketing Technology, Inc.), $4,899,062; Alliance Pharmaceutical
Corp., $3,839,000; and Nanophase Technologies Corporation, $1,935,016.
(See "Consolidated Schedule of Investments" contained in "Item 8.
Consolidated Financial Statements and Supplementary Data" and "Recent
Developments -- Portfolio Companies.") The increase in valuations was
offset by the reclassification of the Company's gain in NBX Corporation of
$4,716,062 from unrealized to realized.
20
Net unrealized appreciation on investments increased by $2,248,816 or
27.6 percent during the year ended December 31, 1998, from $8,158,732 to
$10,407,548. The most significant increases in valuations during 1998 were
in: NBX Corporation, $1,865,766; NeuroMetrix, Inc., $4,400,125; and PHZ
Capital Partners, L.P., $443,432. The most significant decrease during
1998 was in Nanophase Technologies Corporation, $5,508,466. Other changes
included an increased valuation of Genomica Corporation, offset primarily
by decreased valuations in MedLogic Global Corporation and Princeton Video
Image, Inc.
Net unrealized appreciation on investments increased by $1,491,143 or
22.4 percent during the year ended December 31, 1997, from $6,667,589 to
$8,158,732. The most significant increases in valuations during 1997 were
in Nanophase Technologies Corporation, $3,775,701; NBX Corporation,
$2,850,296; and PHZ Capital Partners, L.P., $405,622. The most significant
decreases were in Princeton Video Image, Inc., $1,563,605 and PureSpeech,
Inc., $1,243,977 (which was subsequently acquired by Voice Control Systems,
Inc.).
Liquidity and Capital Resources
The Company's primary sources of liquidity are cash, receivables and
freely marketable securities. The Company's secondary sources of liquidity
are restricted securities of companies that are publicly traded. At
December 31, 1999, December 31, 1998 and December 31, 1997, respectively,
the Company's total primary liquidity was $6,622,216, $5,547,984 and
$13,060,370. On the corresponding dates, the Company's total secondary
liquidity was $38,230,812, $0 and $8,075,978. The Company's tertiary source
of liquidity is its holding in PHZ Capital Partners,L.P., from which the
Company received or accrued net after-tax distributions in 1999, 1998 and
1997 of approximately $490,950, $50,000 and $52,500, respectively.
The increase in cash, receivables and marketable securities from
December 31, 1998 to December 31, 1999 is primarily owing to an increase
in the value of marketable securities (which, with the exception of
Nanophase Technologies Corporation, are restricted), including increases in
the value of: SciQuest.com, Inc., $31,981,750; Nanophase Technologies
Corporation, $1,935,016; Silknet Software, Inc. (which acquired InSite
Marketing Technology, Inc.), $4,899,062; Alliance Pharmaceutical Corp.,
$3,839,000; and to the receipt of total proceeds of $12,432,940 in cash and
in funds in escrow ($1,475,276, against which the Company recorded a 10
percent reserve from the sale of NBX Corporation). These increases
were offset by the (1) payment of a dividend of $0.35 per share or
$3,647,017; (2) the investments of $1,000,001 in Kriton Medical, Inc.;
$1,202,000 in Alliance Pharmaceutical Corp.; $750,000 in Sundial Marketplace
Corporation; and $1,000,000 in Adaptive Web Technologies, Inc.; and (3) the
purchase of treasury shares in the open market for a total of $540,720 and
the purchase of 1,080,569 shares tendered in the Company's tender offer for
a total of $1,832,831 including approximately $71,500 of related fees; and
(4) the use of funds in the amount of $1,777,657 for 1999 cash operating
expenses.
At December 31, 1999, the Company valued its holdings in SciQuest.com,
Inc., Silknet Software, Inc. and Alliance Pharmaceutical Corp. at
$32,831,750, $5,399,062 and $5,041,000, respectively. These holdings were
21
subject to trading restrictions and were valued at discounts from market
value, for both the trading restrictions and a "blockage" or illiquidity
factor in the calculation of the values of SciQuest.com and Alliance
Pharmaceutical and for the trading restrictions and a 10 percent escrow in
the case of Silknet Software. (See "Consolidated Schedule of Investments"
contained in "Item 8. Consolidated Financial Statements and Supplemental
Data.")
On January 27, 2000, the Company placed privately, with an unaffiliated
investor, for $3 million in cash, a one-year, 12 percent note ("Note") with
one-year warrants to purchase 25,263 shares of the Company's common stock at
$11.8750 per share. The Note may be prepaid at any time. Unless the Note
is prepaid, six months after its issuance, the investor will receive
additional one-year warrants to purchase an additional $300,000 worth of the
Company's common stock at the then-current market price. On February 28,
2000, the Company announced its intent to pre-pay the Note with proceeds of
its sale of 43,400 shares of SciQuest.com, Inc. common stock at approximately
$77.2264 per share on February 25, 2000. The Company continues to hold
417,639 shares of SciQuest.com common stock. Because the Company intends to
use most of the proceeds of the SciQuest.com sale to pre-pay the Note,
most or all of the realized long-term capital gains from this sale,
approximately $3.3 million, will be retained by the Company and will not be
distributed to shareholders as a cash dividend.
From 1998 to 1999, the amounts receivable from brokers decreased by
$380,707 or 100 percent. Funds in escrow increased by $1,327,748 or 100
percent, owing to the escrowed funds net of a reserve of $147,528 received
by the Company on the sale of NBX Corporation. The Company received the
entirety of the escrowed funds plus accrued interest for a total of
$1,541,136 on March 6, 2000. The Company's liabilities for accrued profit
sharing and deferred income tax liability increased significantly during
1999. Accrued profit sharing increased by $8,110,908 or 612.8 percent to
$9,434,467 as a result of the gain on the sale of NBX Corporation and
the increase in the unrealized appreciation on investments. Ninety percent
of the profit-sharing amount attributable to 1999 net realized income or
approximately $1,024,696 was paid out in March 2000. The remaining 10
percent or approximately $113,855 will be paid out after the Company has
filed its federal tax return for the year. There was no profit sharing paid
out during 1999 or previous years.
The deferred income tax liability increased by $586,710 or 63.0 percent
to $1,517,774. The deferred tax liability reflects utilization of
approximately $6.3 million of the Company's net operating and capital loss
carryforward to offset the long-term capital gain realized when the Company
sold its interest in NBX Corporation. As a result of the utilization of the
net operating and capital loss carryforwards, the Company had to accrue
additional tax reserves against the remaining built-in gains as of
December 31, 1998.
The Company's primary sources of liquidity, including cash, receivables
and freely marketable securities, are more than adequate to cover the
Company's gross cash operating expenses over the next 12 months. Such gross
cash operating expenses totaled $1,777,657, $2,687,099 and $2,572,514 in
1999, 1998 and 1997, respectively. The Company's secondary sources of
liquidity are the restricted securities of companies, all of which are
scheduled to become freely tradable at various times in the year 2000.
22
The Company cannot predict the amount, if any, of net after-tax distributions
that it might receive from its holding in PHZ in the year 2000.
In the future, to the extent that the Company decides to buy back shares
or make new investments and follow-on investments, the Company would either
have to raise capital externally and thereby incur interest or dividend
expenses and/or issue new shares of its stock or raise capital internally
by selling appreciated securities in its portfolio. To the extent that the
Company chooses to sell appreciated securities, if it wishes to retain all
or part of the gains instead of distributing them as cash dividends to
shareholders as a RIC, it would have to declare a deemed distribution. In
the event that the Company declares a deemed distribution or in the event
that the Company is taxed as a "C" Corporation, it would owe a federal tax
of 35 percent, and might owe state and local taxes, on any net realized
gains, and the Company's asset value would decline by the amount of the tax
accrual. To the extent that the Company distributes net realized gains to
its shareholders in the form of cash dividends, such cash dividends would also
reduce the Company's asset value accordingly.
Recent Developments Portfolio Companies
On January 5, 2000, the Company announced that it had purchased for
$1,000,000 approximately a 15 percent equity interest in MyPersonalAdvocate.com,
Inc., a business-to-business e-commerce and e-services trust-based marketing
start-up.
On January 13, 2000 the Company announced that it would discontinue the
operations of, and liquidate, Adaptive Web Technologies, Inc. Adaptive was
founded in late 1999, with $1,000,000 in funding from the Company. Because
Adaptive was able to determine early in the process of research and analysis
not to proceed with the development and commercialization effort, the Company
anticipates that the amount of money expended to date by Adaptive is unlikely
to prove to be material and that it will recapture most of its $1,000,000
investment in Adaptive.
On January 20, 2000, the Company invested $500,000 in iPacer
Corporation, an Internet technology startup, in the form of a six percent
Convertible Promissory Note due March 31, 2000.
On February 7, 2000, the Company announced that Kana Communications,
Inc. and Silknet Software, Inc. had signed a merger agreement, whereby each
of the Company's Silknet shares would be exchanged tax free for 0.83 Kana
Communications shares. There can be no assurance that the merger will be
consummated.
On February 9, 2000, the Company announced that it had exercised a
warrant to purchase 200,000 common shares of Alliance Pharmaceutical Corp.
for $490,000. The exercise price was $2.45 per share, and the warrant had
an expiration date of May 20, 2004. The Company also converted its
$1,200,000 note due May 20, 2002 into 600,000 shares of Alliance
23
Pharmaceutical. The conversion price was $2.00 per share. The Company now
owns 800,000 common shares of Alliance Pharmaceutical. These shares are
currently restricted under Rule 144.
On February 28, 2000, the Company announced its sale of 43,400 shares of
SciQuest.com, Inc. common stock (NASDAQ: SQST) at approximately $77.2264 per
share on February 25, 2000. The Company continues to hold 417,639 shares of
SciQuest.com common stock.
On March 8, 2000, the Company increased its investment in Sundial
Marketplace Corporation by purchasing from Sundial a $150,000 note with
equity features under certain circumstances. Thus, the Company has now
invested a total of $900,000 in Sundial.
On March 14, 2000, the Company announced that it had invested an
additional $500,000 in Genomica Corporation as part of a $15,000,000 private
placement of Genomica's Series C convertible preferred stock. Including this
new investment, the Company owns approximately a 3.4 percent fully diluted
interest in Genomica. On March 15, 2000, the Company noted that Genomica
had filed an S-1 registration statement with the Securities and Exchange
Commission.
Recent Developments -- Sub-Chapter M Status
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. In order to qualify as a RIC, the Company must, in general (1)
annually derive at least 90 percent of its gross income from dividends,
interest and gains from the sale of securities; (2) quarterly meet certain
investment diversification requirements; and (3) annually distribute at
least 90 percent of its investment company taxable income as a dividend.
In addition to the requirement that the Company must annually distribute at
least 90 percent of its investment company taxable income, the Company may
either distribute or retain its taxable net capital gains from investments,
but any net capital gains not distributed could be subject to corporate level
tax. Further, the Company could be subject to a four percent excise tax if
it fails to distribute 98 percent of its annual taxable income and would be
subject to income tax if it fails to distribute 100 percent of its taxable
income.
Because of the specialized nature of its investment portfolio, the
Company could satisfy the diversification requirements under Sub-Chapter M
of the Code only if it received a certification from the SEC that it is
"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 April 8, 1998, the Company announced
that it had received such a certification from the SEC for 1997.
Pursuant to the Company's receipt of the certification, the Company's
Board of Directors declared and paid a one-time cash dividend of $0.75 per
share to meet one of the Company's requirements for qualification for Sub-
Chapter M tax treatment.
24
The qualification of the Company as a RIC under Sub-Chapter M of the
Code depends on it satisfying certain technical requirements regarding its
income, investment portfolio and distributions. The Company was unable to
satisfy these requirements for the 1998 tax year owing to the nature of the
Company's ownership interest in one of its investee companies. In addition,
because it realized taxable losses in 1998, it was not strategically
advantageous for the Company to elect Sub-Chapter M tax status for 1998.
The Company changed the nature of its ownership interest in the non-
qualifying investee company effective January 1, 1999 in order to meet the
Sub-Chapter M requirements.
In 1999, because of changes in its investment portfolio, the Company
requested recertification from the SEC relating to the Company's status under
section 851(e) of the Code. On February 24, 2000, the Company received the
certification, and the Company intends to elect Sub-Chapter M tax treatment
for 1999. Although the SEC certification for 1999 was issued, there can be
no assurance that the Company will receive such certification for 2000 or
subsequent years (to the extent it needs additional certification as a
result of changes in its portfolio) or that it will qualify as a RIC in
2000 or that, if it does qualify in 2000, it will continue to qualify in
subsequent years. The Company plans to elect Sub-Chapter M tax treatment
for 1999. In addition, under certain circumstances, even if the Company
were qualified for Sub-Chapter M treatment in 2000 and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than as a RIC.
The Company incurred ordinary and capital losses during its C
Corporation taxable years that remain available for use and may be carried
forward to its 2000 and subsequent taxable years. A C Corporation that
elects to qualify as a RIC and that makes an appropriate election continues
to be taxable as a C Corporation on any gains realized within 10 years of
its qualification as a RIC from sales of assets that were held by the
corporation on the effective date of the election ("C Corporation Assets")
to the extent of any gain built into the assets on such date ("Built-In
Gain").
On February 17, 1999, the Company received rulings from the IRS
regarding issues relevant to the Company's tax status as a RIC, including a
ruling from the IRS concluding that the Company can carry forward its C
Corporation losses to offset any Built-In Gains resulting from sales of its
C Corporation Assets. That ruling may enable the Company to retain some or
all of the proceeds from such sales without disqualifying itself as a RIC or
incurring corporate level income tax, depending on whether the Company's
sale of C Corporation Assets with Built-In Gains will generate C Corporation
E&P. In general, a RIC is not permitted to have, as of the close of any RIC
taxable year, E&P accumulated during any C Corporation taxable year. However,
because the realization of Built-In Gains will occur while the Company is a
RIC, a strong argument exists that, under current law and IRS pronouncements,
the sale of C Corporation Assets with Built-In Gains during RIC taxable
years will not generate C Corporation E&P. In 1999, the Company used the
$6.3 million loss carryforward (which resulted in a tax credit of
approximately $2.2 million) to reduce the taxes resulting from Built-In
Gains. The December 31, 1999 NAV includes the utilization of the ordinary
and capital loss carryforwards against Built-in Gains of approximately $0.03
per share. (See "Note 6 of Notes to Consolidated Financial Statements"
25
contained in "Item 8. Consolidated Financial Statements and Supplementary
Data.")
If necessary for liquidity purposes or to fund investment opportunities,
in lieu of distributing its taxable net capital gains, the Company may
retain such net capital gains and elect to be deemed to have made a
distribution of the gains, or part thereof, to the shareholders under the
"designated undistributed capital gain" rules of section 852(b)(3) of the
Code. In such a case, the Company would have to pay a 35 percent corporate-
level income tax on such "designated undistributed capital gain," but it
would not have to distribute the excess of the retained "designated
undistributed capital gain" over the amount of tax thereon in order to
maintain its RIC status.
Tax Consequences of Net Capital Gains
The following simplified examples illustrate the tax treatment under Sub-
Chapter M of the Code for the Company and its shareholders with regard to
three possible alternatives, assuming a net long-term capital gain of $1.00
per share, consisting entirely of sales of non-real property assets held for
more than 12 months.
Under Alternative A: 100 percent of net capital gain declared as a
dividend and distributed to shareholders:
1. No federal taxation at the Company level.
2. Taxable shareholders receive a $1.00 per share dividend and pay
a maximum federal tax of 20 percent* or $.20 per share, retaining $.80 per
share.
Under Alternative B: 100 percent of net capital gain retained by the
Company and designated as "undistributed capital gain" or deemed dividend:
1. The Company pays a corporate-level federal income tax of 35
percent on the undistributed gain or $.35 per share and retains 65 percent
of the gain or $.65 per share.
2. Taxable shareholders increase their cost basis in their stock by
$.65 per share. They pay a 20 percent* federal capital gains tax on 100
percent of the undistributed gain of $1.00 per share or $.20 per share in
tax. Offsetting this tax, shareholders receive a tax credit equal to 35
percent of the undistributed gain or $.35 per share.
Under Alternative C: 100 percent of net capital gain retained by the
Company, with no designated undistributed capital gain or deemed dividend:
*Assumes all capital gains qualify for long-term rates of 20 percent.
26
1. The Company pays a corporate-level federal income tax of 35
percent on the retained gain or $.35 per share plus an excise tax of four
percent of $.98 per share, or about $.04 per share.
2. There is no tax consequence at the shareholder level.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
The Company's business activities contain elements of risk. The Company
considers a principal type of market risk to be valuation risk. Investments
are stated at "fair value" as defined in the 1940 Act and in the applicable
regulations of the Securities and Exchange Commission. All assets are valued
at fair value as determined in good faith by, or under the direction of, the
Board of Directors. See the Asset Valuation Policy Guidelines in the Footnote
to Consolidated Schedule of Investments.
Neither the Company's investments nor an investment in the Company is
intended to constitute a balanced investment program. The Company has
exposure to public-market price fluctuations to the extent of its publicly
traded portfolio.
The Company has invested a substantial portion of its assets in private
development stage or start-up companies. These private businesses tend to be
thinly capitalized, unproven, small companies that lack management depth and
have not attained profitability or have no history of operations. Because of
the speculative nature and the lack of public market for these investments,
there is significantly greater risk of loss than is the case with traditional
investment securities. The Company expects that some of its venture capital
investments will be a complete loss or will be unprofitable and that some
will appear to be likely to become successful but never realize their
potential.
Because there is typically no public market for the equity interests of
the small companies in which the Company invests, the valuation of the equity
interests in the Company's portfolio is subject to the estimate of the
Company's Board of Directors in accordance with the Company's Asset Valuation
Policy Guidelines. In the absence of a readily ascertainable market value,
the estimated value of the Company's portfolio of equity interests may differ
significantly from the values that would be placed on the portfolio if a
ready market for the equity interests existed. Any changes in valuation are
recorded in the Company's consolidated statements of operations as "Net
increase (decrease) in unrealized appreciation on investments."
27
Item 8. Consolidated Financial Statements and Supplementary Data
HARRIS & HARRIS GROUP, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
The following reports and consolidated financial schedules of Harris
& Harris Group, Inc. are filed herewith and included in response to Item 8.
Documents Page
Report of Independent Public Accountants. . . . . . . . . . . 29
Consolidated Financial Statements
Consolidated Statements of Assets and Liabilities
as of December 31, 1999 and 1998 . . . . . . . . . . . . 30
Consolidated Statements of Operations for the
years ended December 31, 1999, 1998 and 1997 . . . . . . 31
Consolidated Statements of Cash Flows for the
years ended December 31, 1999, 1998 and 1997. . . . . . . 32
Consolidated Statements of Changes in Net Assets for the
years ended December 31, 1999, 1998 and 1997. . . . . . . 33
Consolidated Schedule of Investments as of
December 31, 1999 . . . . . . . . . . . . . . . . . . . . 34-38
Footnote to Consolidated Schedule of Investments. . . . . . . 39-41
Notes to Consolidated Financial Statements. . . . . . . . . . 42-51
Selected Per Share Data and Ratios for the
years ended December 31, 1999, 1998, 1997, 1996
and 1995. . . . . . . . . . . . . . . . . . . . . . . . . 52
Schedules other than those listed above have been omitted because
they are not applicable or the required information is presented in the
consolidated financial statements and/or related notes.
28
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Harris & Harris Group, Inc.:
We have audited the accompanying consolidated statements of assets and
liabilities of Harris & Harris Group, Inc. (a New York corporation) as of
December 31, 1999 and 1998, including the consolidated schedule of
investments as of December 31, 1999, and the related consolidated statements
of operations, cash flows and changes in net assets for the three years ended
December 31, 1999, and the selected per share data and ratios for each of the
five years ended December 31, 1999. These consolidated financial statements
and selected per share data and ratios are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and selected per share data and ratios
based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the
consolidated financial statements and selected per share data and ratios are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
Our procedures included confirmation of securities owned as of December 31,
1999 and 1998, by correspondence with the custodian and brokers. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable
basis for our opinion.
As explained in Note 2, the consolidated financial statements include
securities valued at $18,892,731 (35.22 percent of net assets), whose values
have been estimated by the Board of Directors in the absence of readily
ascertainable market values. However, because of the inherent uncertainty
of valuation, those estimated values may differ significantly from the values
that would have been used had a ready market for the securities existed, and
the differences could be material.
In our opinion, the consolidated financial statements and selected per
share data and ratios referred to above present fairly, in all material
respects, the financial position of Harris & Harris Group, Inc. as of
December 31, 1999 and 1998, the results of its consolidated operations,
its consolidated cash flows and the consolidated changes in its net assets
for the three years ended December 31, 1999, and the selected per share data
and ratios for each of the five years ended December 31, 1999 in conformity
with accounting principles generally accepted in the United States.
/s/ Arthur Andersen LLP
------------------------
New York, New York
March 20, 2000
29
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
December 31, 1999 December 31, 1998
Investments, at value (See
accompanying consolidated schedule
of investments and notes). . . . . . $ 63,535,651 $ 24,532,191
Cash and cash equivalents . . . . . . . 133,256 164,143
Funds in escrow (Note 7). . . . . . . . 1,327,748 0
Receivable from brokers . . . . . . . . 0 380,707
Interest receivable . . . . . . . . . . 44,189 666
Prepaid expenses. . . . . . . . . . . . 74,328 90,649
Note receivable . . . . . . . . . . . . 32,663 32,663
Other assets. . . . . . . . . . . . . . 172,933 157,840
--------------- ----------------
Total assets. . . . . . . . . . . . . . $ 65,320,768 $ 25,358,859
=============== ================
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities. . . . . . . . . . . . . $ 700,566 $ 505,118
Accrued profit sharing (Note 3) . . . . 9,434,467 1,323,559
Deferred rent . . . . . . . . . . . . . 33,156 42,409
Deferred income tax liability (Note 6). 1,517,774 931,064
--------------- -----------------
Total liabilities . . . . . . . . . . . 11,685,963 2,802,150
--------------- -----------------
Commitments and contingencies
(Notes 7 and 8)
Net assets. . . . . . . . . . . . . . . $ 53,634,805 $ 22,556,709
=============== ================
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,
25,000,000 shares authorized;
10,692,971 issued at 12/31/99
and at 12/31/98. . . . . . . . . . . 106,930 106,930
Additional paid in capital. . . . . . . 16,159,504 16,158,381
Accumulated net realized loss . . . . . (5,192,860) (525,177)
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $1,783,810 at 12/31/99
and $3,410,884 at 12/31/98 . . . . . 45,098,711 6,996,664
Treasury stock, at cost (1,452,140
shares at 12/31/99 and 101,739
at 12/31/98) . . . . . . . . . . . . (2,537,480) (180,089)
-------------- -----------------
Net assets. . . . . . . . . . . . . . . $ 53,634,805 $ 22,556,709
============== =================
Shares outstanding. . . . . . . . . . . 9,240,831 10,591,232
============== =================
Net asset value per outstanding share . $ 5.80 $ 2.13
============== =================
The accompanying notes are an integral part of these consolidated
financial statements.
30
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended Year Ended Year Ended
Dec. 31, 1999 Dec. 31, 1998 Dec. 31, 1997
Investment income:
Interest from:
Fixed-income securities. . $ 234,347 $ 355,591 $ 490,807
Affiliated companies . . . 48,526 124,877 40,000
Dividend income--
unaffiliated companies. . 900 2,550 0
Consulting and
administrative fees . . . 0 0 29,870
Other income . . . . . . . . 3,911 102,468 869
----------- ----------- -----------
Total investment income. . 287,684 585,486 561,546
Expenses:
Profit-sharing accrual
(Note 3). . . . . . . . . 8,110,908 899,751 423,808
Salaries and benefits. . . . 834,700 831,121 1,507,257
Professional fees. . . . . . 331,889 411,480 327,038
Administration and
operations. . . . . . . . 319,167 330,879 392,114
Rent . . . . . . . . . . . . 162,987 159,515 130,092
Directors' fees and
expenses. . . . . . . . . 120,328 129,253 100,496
Depreciation . . . . . . . . 35,455 47,936 48,968
Custodian fees . . . . . . . 8,586 10,513 15,517
Restructuring charges. . . . 0 0 100,000
Other expense (Note 7) . . . 0 728,862 0
Interest expense . . . . . . 0 85,476 0
------------ ------------ ------------
Total expenses . . . . . . 9,924,020 3,634,786 3,045,290
------------ ------------ ------------
Operating loss before
income taxes. . . . . . . (9,636,336) (3,049,300) (2,483,744)
Income tax benefit (Note 6). 0 234,188 933,103
------------ ------------ ------------
Net operating loss . . . . . . (9,636,336) (2,815,112) (1,550,641)
Net realized gain (loss)
on investments:
Realized gain (loss) on
sale of investments . . . 10,976,714 (1,718,528) (3,147,002)
------------ ------------ ------------
Total realized gain (loss) 10,976,714 (1,718,528) (3,147,002)
Income tax (expense)
benefit (Note 6). . . . . (2,361,044) 0 1,119,825
------------ ------------ ------------
Net realized gain (loss) on
investments . . . . . . . 8,615,670 (1,718,528) (2,027,177)
------------ ------------ ------------
Net realized loss. . . . . . . (1,020,666) (4,533,640) (3,577,818)
Net increase in unrealized
appreciation on investments:
Increase as a result of
investment sales. . . . . 704,801 2,135,176 93,999
Decrease as a result of
investment sales. . . . . (4,939,595) (963,680) (2,892,408)
Increase on investments
held. . . . . . . . . . . 43,186,960 9,766,320 7,297,164
Decrease on investments
held. . . . . . . . . . . (2,477,193) (8,689,000) (3,007,612)
------------ ------------- ------------
Change in unrealized
appreciation on
investments . . . . . . 36,474,973 2,248,816 1,491,143
Income tax benefit
(provision) (Note 6). . . 1,627,074 (592,986) (521,900)
------------ ------------ ------------
Net increase in unrealized
appreciation on
investments . . . . . . . 38,102,047 1,655,830 969,243
------------ ------------ ------------
Net increase (decrease) in net
assets resulting from operations:
Total. . . . . . . . . . . . $ 37,081,381 $ (2,877,810) $ (2,608,575)
============ ============ ============
Per outstanding share. . . . $ 4.01 $ (0.27) $ (0.24)
============ ============ ============
The accompanying notes are an integral part of these consolidated
financial statements.
31
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended Year Ended Year Ended
Dec. 31, 1999 Dec. 31, 1998 Dec. 31, 1997
Cash flows (used in)
provided by operating activities:
Net increase (decrease) in net assets
resulting from operations . $37,081,381 $ (2,877,810) $ (2,608,575)
Adjustments to reconcile net
decrease in net assets
resulting from operations
to net cash (used in) provided
by operating activities:
Net realized and unrealized (gain) loss
on investments . . . . . . . (47,451,687) (480,288) 1,708,359
Deferred income taxes . . . . 586,710 263,367 (1,442,094)
Depreciation. . . . . . . . . 35,455 47,936 48,968
Other . . . . . . . . . . . . 0 (2,927) 0
Changes in assets and liabilities:
Funds in escrow . . . . . . . (1,327,748) 0 0
Receivable from brokers . . . 380,707 (380,707) 0
Prepaid expenses. . . . . . . 16,321 (5,523) (3,625)
Interest receivable . . . . . (43,523) 110,440 87,236
Taxes receivable. . . . . . . 0 0 2,119,492
Notes receivable. . . . . . . 0 (32,663) 0
Other assets. . . . . . . . . (41,281) 86,312 40,296
Accounts payable
and accrued liabilities . . 195,448 81,235 49,555
Accrued profit sharing (Note 3) 8,110,908 899,751 423,808
Deferred rent . . . . . . . . (9,253) (9,253) (9,252)
Collection on notes receivable 10,000 800,000 0
Purchase of fixed assets. . . (9,261) (16,426) (10,169)
----------- ----------- ---------
Net cash (used in) provided
by operating activities (2,465,823) (1,516,556) 403,999
Cash provided by (used in)
investing activities:
Net sale (purchase) of
short-term investments
and marketable securities . . 12,515,222 14,715,834 (155,667)
Investment in private
placements and loans . . . . (4,077,001) (960,308) (4,511,434)
----------- ----------- -----------
Net cash provided by (used in)
investing activities 8,438,221 13,755,526 (4,667,101)
Cash flows (used in)
provided by financing activities:
Payment of dividend. . . . . (3,647,017) (8,019,728) 0
Purchase of
treasury stock (Note 4). . (2,373,551) (254,786) 0
Proceeds from exercise
of stock options (Note 3). 0 0 253,250
Proceeds (payment of)
from note payable (Note 7) 0 (4,000,000) 4,000,000
Proceeds from sale
of stock (Note 4). . . . . 17,283 54,099 0
----------- ------------ ----------
Net cash (used in) provided
by financing activities (6,003,285) (12,220,415) 4,253,250
----------- ------------ ----------
Net (decrease) increase
in cash and cash equivalents:
Cash and cash equivalents
at beginning of the year 164,143 145,588 155,440
Cash and cash equivalents
at end of the year 133,256 164,143 145,588
----------- ----------- ----------
Net (decrease) increase in
cash and cash equivalents. . $ (30,887) $ 18,555 $ (9,852)
=========== =========== ==========
Supplemental disclosures
of cash flow information:
Income taxes paid . . . . . . $ 122,560 $ 372 $ 5,909
Interest paid . . . . . . . . $ 0 $ 85,476 $ 0
The accompanying notes are an integral part of these consolidated
financial statements.
32
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended Year Ended
Dec. 31, 1999 Dec. 31, 1998 Dec. 31, 1997
Changes in net assets from operations:
Net operating loss . . . . . $ (9,636,336) $ (2,815,112) $ (1,550,641)
Net realized gain
(loss) on investments. . . 8,615,670 (1,718,528) (2,027,177)
Net (decrease) increase in unrealized
appreciation on investments
as a result of sales . . . (4,234,794) 1,171,496 (1,818,966)
Net increase in unrealized
appreciation on
investments held . . . . . 42,336,841 484,334 2,788,209
------------- ------------ -------------
Net increase (decrease)
in net assets resulting
from operations. . . . . . . 37,081,381 (2,877,810) (2,608,575)
Changes in net assets from
capital stock transactions:
Payment of dividend. . . . . (3,647,017) (8,019,728) 0
Purchase of treasury stock . (2,373,551) (254,786) 0
Proceeds from exercise of stock
options and warrants . . . 0 0 253,250
Proceeds from sale of stock 17,283 54,099 0
Tax benefit of restricted
stock award and common
stock transactions . . . . 0 0 77,656
----------- ----------- ----------
Net (decrease) increase in
net assets resulting from
capital stock transactions . (6,003,285) (8,220,415) 330,906
------------ ------------ -----------
Net increase (decrease)
in net assets . . . . . . . . 31,078,096 (11,098,225) (2,277,669)
Net assets:
Beginning of the year. . . . 22,556,709 33,654,934 35,932,603
------------- ------------- -------------
End of the year . . . . . . $ 53,634,805 $ 22,556,709 $ 33,654,934
============= ============= =============
The accompanying notes are an integral part of these consolidated statements.
33
CONSOLIDATED SCHEDULE OF INVESTMENTS DECEMBER 31, 1999
Method of Shares/
Valuation (3) Principal Value
Investments in
Unaffiliated Companies (14)(15)(16) -- 71.8% of total investments
Publicly Traded Portfolio (Common stock
unless noted otherwise) -- 60.2% of total investments
Silknet Software, Inc. (1)(2)(8) --
Provides customer-centric e-business
applications and systems -- 0.24% of
fully diluted equity . . . . . . . . (C) 40,864 $ 5,399,062
SciQuest.com, Inc. (1)(2)(9) -- Internet
e-commerce source for scientific products
-- 1.25% of fully diluted equity . . (C) 461,039 32,831,750
------------
Total Publicly Traded Portfolio (cost: $1,350,000) . . . . $ 38,230,812
Private Placement Portfolio (Illiquid) -- 11.6% of total investments
Alliance Pharmaceutical Corp. (2)(4)(10) --
Research and development of pharmaceutical
products $1,200,000 subordinated 6% notes
due 5/20/02 convertible into 600,000 common
shares @ $2.00 per share . . . . . . (C) $ 1,200,000
Warrants convertible into 200,000 common shares
@ $2.45 expiring 5/20/04. . . . . . .(C) 200,000 $ 5,041,000
Exponential Business Development Company
(1)(2)(5) -- Venture capital partnership
focused on early stage companies
Limited partnership interest . . . .(A) -- 25,000
Genomica Corporation (1)(2)(6)(11) --
Develops software that enables the
study of complex genetic diseases --
4.47% of fully diluted equity
Common Stock . . . . . . . . . . . (B) 199,800
Series A Voting
Convertible Preferred Stock . . . . (B) 1,660,200 1,209,730
Kriton Medical, Inc. (1)(2)(4)(6) --
Research and development of medical
devices -- 1.88% of fully diluted equity
Series B
Convertible Preferred Stock. . . . .(A) 476,191 1,000,001
MedLogic Global Corporation (1)(2)(6)
-- Medical cyanoacrylate adhesive
-- 0.37% of fully diluted equity
Series B
Convertible Preferred Stock . . . .(D) 54,287
Common Stock . . . . . . . . . . .(D) 25,798 101,876
-----------
Total Private Placement Portfolio
(cost: $4,261,080) . . . . . . . . . . . . . . . . . . . $ 7,377,607
-----------
Total Investments in
Unaffiliated Companies (cost: $5,611,080) . . . . . . . $ 45,608,419
The accompanying notes are an integral part of this consolidated schedule.
34
CONSOLIDATED SCHEDULE OF INVESTMENTS DECEMBER 31, 1999
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled
Affiliates (14)(16) -- 21.7% of total investments
Publicly Traded Portfolio - 5.2% of total investments
Nanophase Technologies Corporation (1)(7)
Manufactures and markets
inorganic crystals of nanometric
dimensions -- 5.16% of
fully diluted equity. . . . . . . (C) 758,016 $ 3,325,795
-----------
Total Publicly Traded Portfolio (cost $1,341,734). . . . . . . $ 3,325,795
-----------
Private Placement Portfolio (Illiquid) (14)(16) -- 16.5% of total investments
NeuroMetrix, Inc. (1)(2)(6) --
Developing devices for detection
of neuromuscular disorders --
16.19% of fully diluted equity
Series A
Convertible Preferred Stock . . . . (B) 175,000
Series B
Convertible Preferred Stock . . . . (B) 125,000
Series C-2
Convertible Preferred Stock . . . . (B) 229,620 $ 5,958,225
PHZ Capital Partners Limited
Partnership (2)(12) -- Organizes
and manages investment partnerships
-- 20.0% of fully diluted equity
Limited partnership interest . . . . (D) -- 1,770,802
Questech Corporation (1)(2)(6) --
Manufactures and markets proprietary
decorative tiles and signs -- 12.30% of
fully diluted equity
Common Stock . . . . . . . . . . . . (D) 580,037 2,035,930
Warrants at
$5.00 expiring 11/15/09. . . . . . . (A) 1,965
Warrants at
$4.00 expiring 11/28/01. . . . . . . (A) 152,422 167
Sundial Marketplace Corporation
(1)(2)(4)(6) -- Business-to-
business e-commerce company
providing retail wireless
communications services --
20% of fully diluted equity
Series A
Convertible Preferred Stock. . . . . (A) 2,000,000 500,000
12% Convertible Note . . . . . . . . (A) $ 250,000 250,000
-----------
Total Private
Placement Portfolio (cost: $5,614,538). . .. . . . . . . . . $10,515,124
-----------
Total Investments
in Non-Controlled Affiliates (cost: $6,956,272). . . . . . . $13,840,919
The accompanying notes are an integral part of this consolidated schedule.
35
CONSOLIDATED SCHEDULE OF INVESTMENTS DECEMBER 31, 1999
Method of Shares/
Valuation (3) Principal Value
Private Placement Portfolio
in Controlled Affiliates
(14)(16) (Illiquid) --
1.6% of total investments
Adaptive Web Technologies
Inc.(1)(2)(4)(6)(13) --
100.0% of fully diluted
equity
Series A Convertible
Preferred Stock . . . . . . . (A) 1,000,000 $ 1,000,000
------------
Total Private Placement Portfolio
in Controlled Affiliates (cost: $1,000,000). . . . . . . . . $ 1,000,000
U.S. Government Obligations -- 4.9% of total investments
U.S. Treasury Bill dated
07/15/99 due date
01/13/00 -- 3.9% yield . . . . (K) $ 1,200,000 $ 1,198,308
U.S. Treasury Bill dated
07/29/99 due date
01/27/00 -- 4.2% yield . . . . (K) $ 1,500,000 1,495,245
U.S. Treasury Bill dated
11/04/99 due date
05/04/00 -- 5.3% yield . . . . (K) $ 400,000 392,760
-----------
Total Investments in U.S. Government Obligations
(cost: $3,085,778). . . . . . . . . . . . . . . . . . . . . . . $ 3,086,313
-----------
Total Investments -- 100% (cost: $16,653,130). . . . . . . . . . $63,535,651
===========
The accompanying notes are an integral part of this consolidated schedule.
36
CONSOLIDATED SCHEDULE OF INVESTMENTS DECEMBER 31, 1999
Notes to Consolidated Schedule of Investments
(1) 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.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Consolidated Schedule of Investments for a
description of the Method of Valuation A to L.
(4) These investments were made during 1999.
(5) No changes in valuation occurred in these investments during the year
ended December 31, 1999.
(6) These investments are in 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 has
not yet commenced its planned principal operations or has commenced
such operations but has not realized significant revenue from them.
(7) As of December 31, 1999, the market price per share of Nanophase
Technologies Corporation ("NANX") was $4.875. The Company's holding
in Nanophase Technologies Corporation before a discount for
illiquidity was valued at $3,695,328. During January and February
2000, the Company sold 85,100 shares of Nanophase Technologies
Corporation stock in the open market for a total of $420,555 or
$4.94 per share. On March 20, 2000, the market price per share of
Nanophase Technologies Corporation was $13.1875.
(8) On October 5, 1999, Silknet Software, Inc. ("SILK") acquired InSite
Marketing Technology, Inc. The Company is subject to a lock-up
agreement on the Silknet Software stock that expires on October 5,
2000. On December 31, 1999, the market price per share of Silknet
Software, Inc. was $165.75. The Company's holding in Silknet
Software before a discount for trading restrictions and a 10
percent escrow was valued at $6,773,208. On February 7, 2000,
Kana Communications, Inc. and Silknet Software, Inc. announced a
merger agreement, in which the Silknet Software shares will be
exchanged tax free for 0.83 Kana Communications (pre two-for-one
stock split) shares. See Note 8 of Notes to Consolidated Financial
Statements. On March 20, 2000, the market prices per share of
Silknet Software and Kana Communications were $165.375 and
$103.00 (post two-for-one stock split), respectively.
(9) The Company is subject to a lock-up agreement on the stock which
expires on May 18, 2000. On December 31, 1999, the market price per
share of SciQuest.com, Inc. ("SQST") was $79.50. The Company's
holding in SciQuest.com before a discount for trading restrictions
was valued at $36,652,600. On February 25, 2000, the Company sold
43,400 shares of SciQuest.com at $77.23 per share. On March 20,
2000, the market price per share of SciQuest.com, Inc. was $38.25.
The accompanying notes are an integral part of this consolidated schedule.
37
(10) As of December 31, 1999, the market price per share of Alliance
Pharmaceutical Corp. ("ALLP") was $7.375. The Company's holding in
Alliance Pharmaceutical, before a discount for delays in converting
the note and warrants to registered shares, was valued at $5,410,000,
including valuing the warrants at their in the money common stock
value. On February 9, 2000, the Company exercised the warrant to
purchase 200,000 common shares of Alliance Pharmaceutical Corp.
and converted its $1,200,000 note due May 20, 2002 into 600,000
shares of common stock. These shares are currently restricted under
Rule 144. On March 20, 2000, the market price per share of Alliance
Pharmaceutical Corp. was $13.1875.
(11) In 1996, Genomica Corporation was cofounded by the Company, Cold
Spring Harbor Laboratory ("CSHL"), a not-for-profit institution, and
Falcon Technology Partners, LP. Mr. G. Morgan Browne serves on the
Board of Directors of the Company and is Administrative Director of
CSHL. In late 1998, Charles E. Harris, Chairman and CEO of Harris &
Harris Group, became a trustee of CSHL. (See "Note 8 of Notes to
Consolidated Financial Statements.")
(12) Harris Partners I L.P. owns a 20 percent limited partnership interest
in PHZ Capital Partners L.P. 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. is a 100 percent owned subsidiary of Harris &
Harris Group, Inc.
(13) On January 13, 2000, the Company announced its decision not to
proceed with the development and commercialization of, and to
liquidate, Adaptive Web Technologies, Inc. (See "Note 8 of Notes
to Consolidated Financial Statements.")
(14) Investments in unaffiliated companies consist of investments in which
Harris & Harris Group, Inc. (the "Company") owns less than 5 percent
of the investee company. Investments in non-controlled affiliated
companies consist of investments in which the Company owns more than
5 percent but less than 25 percent of the investee company.
Investments in controlled affiliated companies consist of investments
in which the Company owns more than 25 percent of the investee company.
(15) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $5,611,080. The gross unrealized
appreciation based on tax cost for these securities is $40,929,238.
The gross unrealized depreciation on the cost for these securities
is $931,899.
(16) The percentage ownership of each investee disclosed in the
Consolidated Schedule of Investments expresses the potential common
equity interest in each such investee. The calculated percentage
represents the amount of issuer's common stock the Company owns or
can acquire as a percentage of the issuer's total outstanding common
stock plus common shares reserved for issued and outstanding
warrants, convertible securities and stock options.
The accompanying notes are an integral part of this consolidated schedule.
38
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
The Company's investments can be classified into five broad categories for
valuation purposes:
1) EQUITY-RELATED SECURITIES
2) INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND
DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
3) LONG-TERM FIXED-INCOME SECURITIES
4) SHORT-TERM FIXED-INCOME INVESTMENTS
5) ALL OTHER INVESTMENTS
The Investment Company Act of 1940 (the "1940 Act") requires periodic
valuation of each investment in the Company's portfolio to determine 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 Company's Board of Directors is responsible for 1) determining overall
valuation guidelines and 2) ensuring the valuation of investments within the
prescribed guidelines.
The Company's Investment and Valuation Committee, comprised of at least
three or more 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.
Fair value is generally defined as the amount that an investment could
be sold for in an orderly disposition over a reasonable time. Generally, to
increase objectivity in valuing the assets of the Company, external measures
of value, such as public markets or third-party transactions, are utilized
whenever possible. Valuation is not based on long-term work-out value, nor
immediate liquidation value, nor incremental value for potential changes
that may take place in the future.
Valuation assumes that, in the ordinary course of its business, the
Company will eventually sell its investment.
The Company's valuation policy with respect to the five broad investment
categories is as follows:
EQUITY-RELATED SECURITIES
Equity-related securities are carried at fair value using one or more of
the following basic methods of valuation:
A. Cost: The cost method is based on the original cost to the Company.
This method is generally used in the early stages of a company's development
until significant positive or negative events occur subsequent to the date of
the original investment that dictate a change to another valuation method.
39
Some examples of such events are: (1) a major recapitalization; (2) a major
refinancing; (3) a significant third-party transaction; (4) the development
of a meaningful public market for the company's common stock; (5) significant
positive or negative changes in the company's business.
B. Private Market: The private market method uses actual third-party
transactions in the company's securities as a basis for valuation, using
actual, executed, historical transactions in the company's securities by
responsible third parties. The private market method may also use, where
applicable, unconditional firm offers by responsible third parties as a
basis for valuation.
C. Public Market: The public market method is used when there is an
established public market for the class of the company's securities held by
the Company. The Company discounts market value for securities that are
subject to significant legal, contractual or practical restrictions,
including large blocks in relation to trading volume. Other securities,
for which market quotations are readily available, are carried at market
value as of the time of valuation.
Market value for securities traded on securities exchanges or on the
Nasdaq National Market is the last reported sales price on the day of
valuation. For other securities traded in the over-the-counter market and
listed securities for which no sale was reported on that day, market value
is the mean of the closing bid price and asked price on that day.
This method is the preferred method of valuation when there is an
established public market for a company's securities, as that market provides
the most objective basis for valuation.
D. Analytical Method: The analytical method is generally used to value
an investment position when there is no established public or private market
in the company's securities or when the factual information available to the
Company dictates that an investment should no longer be valued under either
the cost or private market method. This valuation method is inherently
imprecise and ultimately the result of reconciling the judgments of the
Company's Investment and Valuation Committee members, based on the data
available to them. The resulting valuation, although stated as a precise
number, is necessarily within a range of values that vary depending upon the
significance attributed to the various factors being considered. Some of the
factors considered may include the financial condition and operating results
of the company, the long-term potential of the business of the company, the
values of similar securities issued by companies in similar businesses, the
proportion of the company's securities owned by the Company and the nature
of any rights to require the company to register restricted securities under
applicable securities laws.
INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND DEVELOPMENT
IN TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the following basic
methods of valuation:
E. Cost: The cost method is based on the original cost to the Company.
Such method is generally used in the early stages of commercializing or
developing intellectual property or patents or research and development in
technology or product development until significant positive or adverse
events occur subsequent to the date of the original investment that dictate
a change to another valuation method.
40
F. Private Market: The private market method uses actual third-party
investments in intellectual property or patents or research and development
in technology or product development as a basis for valuation, using actual
executed historical transactions by responsible third parties. The private
market method may also use, where applicable, unconditional firm offers by
responsible third parties as a basis for valuation.
G. Analytical Method: The analytical method is used to value an
investment after analysis of the best available outside information where
the factual information available to the Company dictates that an investment
should no longer be valued under either the cost or private market method.
This valuation method is inherently imprecise and ultimately the result of
reconciling the judgments of the Company's Investment and Valuation
Committee members. The resulting valuation, although stated as a precise
number, is necessarily within a range of values that vary depending upon
the significance attributed to the various factors being considered. Some
of the factors considered may include the results of research and
development, product development progress, commercial prospects, term of
patent and projected markets.
LONG-TERM FIXED-INCOME SECURITIES
H. Fixed-Income Securities for which market quotations are readily
available are carried at market value as of the time of valuation using the
most recent bid quotations when available.
Securities for which market quotations are not readily available are
carried at fair value using one or more of the following basic methods of
valuation:
I. Fixed-Income Securities are valued by independent pricing services
that provide market quotations based primarily on quotations from dealers
and brokers, market transactions, and other sources.
J. Other Fixed-Income Securities that are not readily marketable are
valued at fair value by the Investment and Valuation Committee.
SHORT-TERM FIXED-INCOME INVESTMENTS
K. Short-Term Fixed-Income Investments are valued at market value at
the time of valuation. Short-term debt with remaining maturity of 60 days
or less is valued at amortized cost.
ALL OTHER INVESTMENTS
L. All Other Investments are reported at fair value as determined in
good faith by the Investment and Valuation Committee.
The reported values of securities for which market quotations are not
readily available and for other assets reflect the Investment and Valuation
Committee's judgment of fair values as of the valuation date using the
outlined basic methods of valuation. They do not necessarily represent an
amount of money that would be realized if the securities had to be sold in
an immediate liquidation. The Company makes many of its portfolio
investments with the view of holding them for a number of years, and the
reported value of such investments may be considered in terms of disposition
over a period of time. Thus valuations as of any particular date are not
necessarily indicative of amounts that may ultimately be realized as a
result of future sales or other dispositions of investments held.
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. THE COMPANY
Harris & Harris Group, Inc. (the "Company") is a venture capital
investment company operating as a business development company ("BDC")
under the Investment Company Act of 1940 ("1940 Act"). A BDC is a
specialized type of investment company under the 1940 Act. The Company
operates as an internally managed investment company whereby its officers
and employees, under the general supervision of its Board of Directors,
conduct its operations.
The Company elected to become a BDC on July 26, 1995, after receiving
the necessary approvals. From September 30, 1992 until the election of BDC
status, the Company operated as a closed-end, non-diversified, investment
company under the 1940 Act. Upon commencement of operations as an
investment company, the Company revalued all of its assets and liabilities
at fair value as defined in the 1940 Act. Prior to such time, the Company
was registered and filed under the reporting requirements of the Securities
and Exchange Act of 1934 as an operating company and, while an operating
company, operated directly and through subsidiaries.
Harris & Harris Enterprises, Inc. ("Enterprises") is a 100 percent wholly
owned subsidiary of the Company. Enterprises holds the lease for the office
space, which it subleases to the Company and an unaffiliated party; owns a
financial relations and consulting firm; is a partner in Harris Partners I,
L.P. and is taxed as a C corporation. Harris Partners I L.P. is a limited
partnership and owns a 20 percent limited partnership interest in PHZ Capital
Partners, L.P. The partners of Harris Partners I L.P. are Harris & Harris
Enterprises, Inc. (sole general partner) and Harris & Harris Group, Inc.
(sole limited partner).
The Company intends for 1999 to elect treatment as a Regulated Investment
Company ("RIC") under Sub-Chapter M of the Internal Revenue Code. As a RIC,
the Company must, among other things, distribute at least 90 percent of its
taxable net income and may either distribute or retain its taxable net
realized capital gains on investments. (See "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Recent
Developments Sub Chapter M Status.") There can be no assurance that the
Company will qualify as a RIC or that if it does qualify, it will continue
to qualify. In addition, even if the Company were to qualify as a RIC, and
elected Sub-Chapter M treatment for that year, the Company might take action
in a subsequent year to ensure that it would be taxed in that subsequent year
as a C Corporation, rather than a RIC.
NOTE 2. 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 Generally Accepted Accounting
Principles for investment companies and include the accounts of the Company
and its wholly owned subsidiary. All significant intercompany accounts and
transactions have ben eliminated in consolidation.
Cash and Cash Equivalents. Cash and cash equivalents include money
market instruments with maturities of less than three months.
42
Portfolio Investment Valuations. Investments are stated at "fair value"
as defined in the 1940 Act and in the applicable regulations of the
Securities and Exchange Commission. All assets are valued at fair value as
determined in good faith by, or under the direction of, the Board of
Directors. See the Asset Valuation Policy Guidelines in the Footnote to
Consolidated Schedule of Investments.
Securities Transactions. Securities transactions are accounted for on
the date the securities are purchased or sold (trade date); dividend income
is recorded on the ex-dividend date; and interest income is accrued as
earned. Realized gains and losses on investment transactions are determined
on specific identification for financial reporting and tax reporting.
Income Taxes. Prior to January 1, 1999, the Company recorded income
taxes using the liability method in accordance with the provision of
Statement of Financial Accounting Standards No. 109. Accordingly, deferred
tax liabilities had been established to reflect temporary differences
between the recognition of income and expenses for financial reporting and
tax purposes, the most significant difference of which relates to the
Company's unrealized appreciation on investments.
The December 31, 1999 consolidated financial statements include a
provision for deferred taxes on the remaining net built-in gains as of
December 31, 1998, net of the unutilized operating and capital loss
carryforwards incurred by the Company through December 31, 1998.
The Company pays federal, state and local income taxes on behalf of its
wholly owned subsidiary, Harris & Harris Enterprises, which is a C
corporation. (See Note 6. Income Taxes.)
Reclassifications. Certain reclassifications have been made to the
December 31, 1997 and December 31, 1998 financial statements to conform to
the December 31, 1999 presentation.
Estimates by Management. The preparation of the consolidated financial
statements in conformity with Generally Accepted Accounting Principles
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities as of December 31,1999 and 1998,
and the reported amounts of revenues and expenses for the three years ended
December 31, 1999. Actual results could differ from these estimates.
NOTE 3. STOCK OPTION PLAN, WARRANTS OUTSTANDING AND EMPLOYEE PROFIT-
SHARING PLAN
On August 3, 1989, the shareholders of the Company approved the 1988
Long Term Incentive Compensation Plan. On June 30, 1994, the shareholders
of the Company approved various amendments to the 1988 Long Term Incentive
Compensation Plan: 1) to conform to the provisions of the BDC regulations
under the 1940 Act, which allow for the issuance of stock options to
qualified participants; 2) to increase the reserved shares under the amended
plan; 3) to call the plan the 1988 Stock Option Plan, as Amended and Restated
(the "1988 Plan"); and 4) to make various other amendments. On October 20,
1995, the shareholders of the Company approved an amendment to the 1988
Plan authorizing automatic 20,000 share grants of non-qualified stock options
to newly elected non-employee directors of the Company. The Company's 1988
Plan was cancelled as of December 31, 1997, canceling all outstanding stock
options and eliminating all potential stock option grants. As a substitution
for the 1988 Stock Option Plan, the Company adopted an employee profit-
sharing plan.
43
The Company accounted for the 1988 Plan under APB Opinion No. 25, under
which no compensation cost has been recognized. Had compensation cost for
the 1988 Plan been determined consistent with the fair value method required
by FASB Statement No. 123 ("FASB No. 123"), the Company's net realized loss
and net asset value per share would have been reduced to the following pro-
forma amounts:
1999 1998 1997
Net Realized Loss:
As Reported N/A N/A $(3,577,818)
Pro Forma N/A N/A $(3,921,583)
Net Asset Value per share:
As Reported N/A N/A $ 3.15
Pro Forma N/A N/A $ 3.12
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted average
assumptions:
1999 1998 1997
Stock volatility N/A N/A 0.60
Risk-free interest rate N/A N/A 6.3%
Option term in years N/A N/A 7
Stock dividend yield N/A N/A - -
A summary of the status of the Company's 1988 Plan at December 31, 1997
changes during the year then ended is presented in the table and narrative
below:
December 31, 1997
-----------------
Shares Weighted
Average
------- --------
Exercise Price
--------------
Outstanding at beginning of year 1,080,000 $4.584
Granted 300,000 $3.875
Exercised 158,000 $1.603
Forfeited 397,000 $5.267
Expired - - - -
Canceled 825,000 $4.569
Outstanding at end of year 0 0
Exercisable at end of year 0 0
Weighted average fair
value of options granted $2.50 - -
During 1997, the Chairman of the Company exercised a warrant to purchase
237,605 shares of common stock at a price of $2.0641.
44
As of January 1, 1998, the Company began implementing the Harris &
Harris Group, Inc. Employee Profit Sharing Plan (the "1998 Plan") that
provides for profit sharing equal to 20 percent of the net realized income
of the Company as reflected on the Consolidated Statement of Operations of
the Company for such year, less the nonqualifying gain, if any. Under the
1998 Plan, net realized income of the Company includes investment income,
realized gains and losses, and operating expenses (including taxes paid or
payable by the Company), but it will be calculated without regard to
dividends paid or distributions made to shareholders, payments under the
1998 Plan, unrealized gains and losses, and loss carry-overs from other
years ("Qualifying Income"). The portion of net after-tax realized gains
attributable to asset values as of September 30, 1997 will be considered
nonqualifying gain, which will reduce "Qualifying Income."
As soon as practicable following year end, the Board of Directors will
determine whether, and if so, how much "Qualifying Income" exists for a
plan year, and 90 percent of the Qualifying Income will be paid out to 1998
Plan participants pursuant to the distribution percentages set forth in the
1998 Plan. The remaining 10 percent will be paid out after the Company has
filed its federal tax return for that year in which "Qualifying Income"
exists. The distribution amounts for each officer and employee is as
follows: Charles E. Harris, 13.790 percent; Mel P. Melsheimer, 4.233
percent; Rachel M. Pernia, 1.524 percent; and Jacqueline M. Matthews, 0.453
percent. If a participant leaves the Company for other than cause, the
amount earned will be accrued and paid to such participant, and the
remaining amount allocable under the 1998 Plan will be redistributed by the
Compensation Committee and paid to the other participants.
Notwithstanding any provisions of the 1998 Plan, in no event may the
aggregate amount of all awards payable for any 1998 Plan year during which
the Company remains a "business development company" within the meaning of
the Investment Company Act of 1940, as amended (the "1940 Act"), be greater
than 20 percent of the Company's "net income after taxes" within the meaning
of Section 57(n)(1)(B) of the 1940 Act. In the event the awards exceed such
amount, the awards will be reduced pro rata.
The 1998 Plan may be modified, amended or terminated by the Company's
Board of Directors at any time; provided however, no such modification,
amendment or termination may adversely affect any participant that has not
consented to such modification, amendment or termination.
The Company calculates the 1998 Plan accrual at each quarter end based
on the unrealized gains at that date, net of operating expenses for the
year. Any adjustments to the 1998 Plan accrual are then reflected in the
Consolidated Statement of Operations for the quarter. The 1998 Plan accrual
is not paid out until the gains are realized. During 1999, the Company
accrued profit-sharing expense of $8,110,908, of which $8,295,916 represents
a profit sharing accrual on unrealized gains and will not be paid out until
the gains are realized, bringing the cumulative accrual under the 1998 Plan
to $9,434,467 at December 31, 1999.
The 1998 Plan was terminated as of December 31, 1999 subject to the
payment of any amounts owed under the 1998 Plan. As of January 1, 2000, the
Company adopted the Harris & Harris Group Employee Profit-Sharing Plan
(the "2000 Plan") with substantially the same terms as the 1998 Plan, except
for a limitation on the amount of an award that may be paid out to any one
participant during any one year if the shareholders do not approve the
performance goals of the 2000 Plan. The Shareholders are being asked to
approve the performance
45
goals under the 2000 Plan in accordance with Section 162(m) of the Internal
Revenue Code at the Annual Meeting of Shareholders to be held on April 26,
2000. If the Shareholders do not approve the performance goals, the Company
could implement the 2000 Plan in its current form, or modify or terminate
the 2000 Plan. At present, the Company has no plans to take any particular
action in the event of a negative shareholder vote.
In March 2000, the Company paid out under the 1998 Plan 90 percent of
the profit sharing on the 1999 realized gains of approximately $1,024,696;
the remaining 10 percent or approximately $113,855 will be paid out on the
completion and filing of the Company's 1999 federal tax return.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that effective January 1,
1998, 50 percent of all directors' fees be used to purchase Company common
stock from the Company. However, effective on March 1, 1999, the directors
may purchase the Company's common stock in the market, rather than from the
Company. During 1998, the directors bought a total of 24,491 shares.
On April 15, 1998, the Company announced that the Board of Directors
had approved the purchase of up to 700,000 shares of Company stock in the
open market. As of December 31, 1998, the Company had purchased a total of
126,230 shares for a total of $254,786 or an average of $2.02 per share.
However, the treasury shares purchased were decreased by the directors'
purchases of a total of 24,491 shares of Company stock.
In the first six months of 1999, the Company purchased a total of
275,648 shares of treasury shares in the open market for a total of $540,720
or $1.96 per share.
On July 14, 1999, the Company announced an offer to purchase up to
1,100,000 shares of its common stock for cash at a price equal to $1.63 per
share. A total of 1,080,569 shares were tendered for a total cost,
including related expenses of approximately $71,500, of $1,832,831. Of
these shares, 1,075,269 were tendered by one shareholder, which tendered all
of its holdings.
Since 1998, as a result of the shares purchased in the open market and
through the tender offer in 1999, the Company has purchased a total of
1,482,447 shares for a total of $2,628,337, including commissions and
expenses, at an average price of $1.77 per share.
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment Agreement
with the Company (disclosed in a Form 8-K filed on October 27, 1999) ("The
Employment Agreement"), which superseded an employment agreement that was
about to expire on December 31, 1999. The Employment Agreement expires on
December 31, 2004 ("Term"); on January 1, 2000 and on each day thereafter,
the Term extends automatically by one day unless at any time the Company or
Mr. Harris, by written notice, decides not to extend the Term, in which case
the Term will expire five years from the date of the written notice.
During the period of employment, Mr. Harris shall serve as the Chairman
and Chief Executive Officer of the Company; be responsible for the general
management of the affairs of the Company and all its subsidiaries, reporting
directly to the Board of Directors of the Company; serve as a member of the
46
Board for the period of which he is and shall from time to time be elected or
reelected; and serve, if elected, as President of the Company and as an officer
and director of any subsidiary or affiliate of the Company.
Mr. Harris is to receive compensation under his Employment Agreement in
the form of base salary of $202,980, with automatic yearly adjustments to
reflect inflation. In addition, the Board may increase such salary, and
consequently decrease it, but not below the level provided for by the
automatic adjustments described above. Mr. Harris is also entitled to
participate in the Company's Profit-Sharing Plan as well as in all
compensation or employee benefit plans or programs, and to receive all
benefits, perquisites, and emoluments for which salaried employees are
eligible. Under the Employment Agreement, the Company is to furnish Mr.
Harris with certain perquisites which include a company car, membership in
certain clubs and up to a $5,000 annual reimbursement for personal,
financial or tax advice.
The Employment Agreement provides Mr. Harris with life insurance for the
benefit of his designated beneficiaries in the amount of $2,000,000; provides
reimbursement for uninsured medical expenses, not to exceed $10,000 per annum,
adjusted for inflation, over the period of the contract; provides Mr. Harris
and spouse with long-term care insurance; and disability insurance in the
amount of 100 percent of his base salary. These benefits are for the term of
the contract.
The Employment Agreement provides for the Company to adopt a supplemental
executive retirement plan (the "SERP") for the benefit of Mr. Harris. Under
the SERP, the Company will cause an amount equal to one-twelfth of the Mr.
Harris's current base salary to be credited each month (a "Monthly Credit") to
a special account maintained for this purpose on the books of the Company for
the benefit of Mr. Harris (the "SERP Account"). The amounts credited to the
SERP Account will be deemed invested or reinvested in such mutual funds or U.S.
Government securities as determined by Mr. Harris. The SERP Account will be
credited and debited to reflect the deemed investment returns, losses and
expenses attributed to such deemed investments and reinvestments. Mr. Harris's
benefit under the SERP will equal the balance in the SERP Account and such
benefit will always be 100 percent vested (i.e., not forfeitable). Mr. Harris
will determine the form and timing of the distribution of the balance in the
SERP Account; provided, however, in the event of the termination, the balance
in the SERP Account will be distributed to Mr. Harris or his beneficiary, as
the case may be, in a lump-sum payment within 30 days of such termination. The
Company will establish a rabbi trust for the purpose of accumulating funds to
satisfy the obligations incurred by the Company under the SERP. During 1999,
the Company accrued $41,442 in accordance with this provision of the SERP. Mr.
Harris's rights to benefits pursuant to this SERP will be no greater than those
of a general creditor of the Company.
The Employment Agreement provides severance pay in the event of
termination without cause or by constructive discharge and also provides for
certain death benefits payable to the surviving spouse equal to the
executive's base salary for a period of two years.
In addition, Mr. Harris is entitled to receive severance pay pursuant to
the severance compensation agreement that he entered into with the Company,
effective August 15, 1990. The severance compensation agreement provides that
if, following a change in control of the Company, as defined in the agreement,
such individual's employment is terminated by the Company without cause or by
the executive within one year of such change in control, the individual shall
be entitled to receive compensation in a lump sum payment equal to 2.99 times
the individual's average annualized compensation and payment of other welfare
benefits. If Mr. Harris's termination is without cause or is a constructive
47
discharge, the amount payable under the Employment Agreement will be reduced
by the amounts paid pursuant to the severance compensation agreement.
As of January 1, 1989, the Company adopted an employee benefits program
covering substantially all employees of the Company under a 401(k) Plan and
Trust Agreement. As of January 1, 1999, the Company adopted the Harris &
Harris Pension Plan and Trust, a money purchase plan which would allow the
Company to stay compliant with the 401(k) top-heavy regulations and deduction
limitation regulations. Contributions to the plan are at the discretion of
the Company. During 1999, contributions to both plans that have been charged
to salaries and benefits totaled approximately $37,000.
On June 30, 1994, the Company adopted a plan to provide medical and
health insurance for retirees, their spouses and dependents who, at the time
of their retirement, have ten years of service with the Company and have
attained 50 years of age or have attained 45 years of age and have 15 years of
service with the Company. On February 10, 1997, the Company amended this plan
to include employees who "have seven full years of service and have attained
58 years of age." The coverage is secondary to any government provided or
subsequent employer provided health insurance plans. Based upon actuarial
estimates, the Company provided an original reserve of $176,520 that was
charged to operations for the period ending June 30, 1994. As of December
31, 1999 the Company had a reserve of $317,600 for the plan.
NOTE 6. INCOME TAXES
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification as a RIC under Sub-Chapter M of the Code. As
a RIC, the Company annually must distribute at least 90 percent of its
investment company taxable income as a dividend and may either distribute or
retain its taxable net capital gains from investments. To initially qualify
as a RIC, among other requirements, the Company had to pay a dividend to
shareholders equal to the Company's cumulative realized earnings and profits
("E&P"). On April 9, 1998, the Company declared a one-time cash dividend of
$0.75 per share to meet this requirement (for a total of $8,019,728). The
cash dividend was paid on May 12, 1998.
The Company intends to elect Sub-Chapter M status for the year ended
December 31, 1999. Accordingly, on February 23, 1999, the Company declared a
cash dividend of $0.35 per share (for a total of $3,647,017) as a result of
the long-term capital gain generated in 1999 by the acquisition of NBX
Corporation by 3Com Corporation. The Company utilized its net operating loss
and capital loss carryforwards of approximately $6.3 million in order to
retain most of the remaining long-term capital gain to invest in new
opportunities. Approximately $300,000 of the long-term capital gain was not
distributed during 1999. Therefore, the Company incurred approximately
$26,044 in excise taxes.
The Company had incurred net ordinary and capital losses for a total of
approximately $7.0 million (which results in a tax credit of approximately
$2.5 million) during its C Corporation taxable years of which $0.8 million
still remains available for use. A corporation that elects to qualify as a
RIC continues to be taxable as a C Corporation on any gains realized within 10
years of its qualification as a RIC from sales of assets that were held by the
corporation on the effective date of the election ("C Corporation Assets") to
the extent of any gain built into the assets on such date ("Built-In Gain").
On February 17, 1999, the Company received a ruling from the IRS concluding
that the Company can carry forward its C Corporation losses to offset any
Built-In Gains resulting from sales of its C Corporation Assets. That ruling
48
may enable the Company to retain some or all of the proceeds from such sales
without disqualifying itself as a RIC or incurring corporate level income tax,
depending on whether the Company's sale of C Corporation Assets with Built-In
Gains will generate C Corporation E&P. In general, a RIC is not permitted to
have, as of the close of any RIC taxable year, E&P accumulated during any C
Corporation taxable year. However, because the realization of Built-In Gains
will occur while the Company is a RIC, a strong argument exists that, under
current law and IRS pronouncements, the sale of C Corporation Assets with
Built-In Gains during RIC taxable years will not generate C Corporation E&P.
The Company intends to use the remaining $0.8 million loss carryforward (which
results in a tax credit of approximately $0.3 million) to reduce its taxes
which are the result of Built-In Gains.
Continued qualification as a RIC requires the Company to satisfy certain
portfolio diversification requirements in future years. The Company's ability
to satisfy those requirements may not be controllable by the Company. (See
"Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operation - Recent Developments - Sub-Chapter M Status.")
There can be no assurance that the Company will qualify as a RIC for 2000
or subsequent years or that, if it does qualify, it will continue to elect RIC
status.
For the years ended December 31, 1999, 1998 and 1997, the Company's
income tax (benefit) provision was allocated as follows:
1999 1998 1997
Investment operations $ 0 $ (234,188) $ (933,103)
Realized gain (loss) on investments 2,361,044 0 (1,119,825)
Increase in unrealized
appreciation on investments (1,627,074) 592,986 521,900
------------ ----------- ------------
Total income tax (benefit) provision $ 733,970 $ 358,798 $(1,531,028)
============ =========== ============
The above tax (benefit) provision consists of the following:
1999 1998 1997
Current -- Federal $ 2,361,044 $ 95,430 $ 0
Deferred -- Federal (1,627,074) 263,368 (1,531,028)
------------ ---------- -------------
Total income tax (benefit) provision $ 733,970 $ 358,798 $ (1,531,028)
============ ========== ==============
The Company's net deferred tax liability at December 31, 1999 and 1998
consists of the following:
1999 1998
Unrealized appreciation on investments $1,783,810 $ 3,410,884
Net operating and capital loss carryforward (266,036) (2,479,820)
----------- ------------
Net deferred income tax liability $1,517,774 $ 931,064
=========== ============
49
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a 10-year lease with sublet provisions
for office space. In 1995, this lease was amended to include additional
office space. Rent expense under this lease for the year ended December 31,
1999, was $162,987. Future minimum lease payments in each of the following
years are: 2000 $178,561; 2001 -- $178,561; 2002 -- $178,561; 2003 --
$101,946.
In December 1997, the Company signed a Demand Promissory Note for a
$4,000,000 line of credit with J.P. Morgan collateralized by the Company's
U.S. Treasury obligations. In March 1998, the line of credit was increased
to $6,000,000. As of December 31, 1997, the Company had borrowed $4,000,000
against the line of credit. From December 31, 1997 to January 2, 1998, the
rate on the line of credit was prime (8.5 percent). From January 2, 1998 to
April 2, 1998, the interest rate on the line of credit was LIBOR plus 1.5
percent (7.3125 percent). In March 1998, the Company paid down $2,500,000;
in April 1998, the Company paid the remaining balance and did not draw
against the line for the remainder of the year. This Demand Promissory Note
for a line of credit is no longer available to the Company.
The Company had a total of $1,475,276 of funds in escrow as a result of
the acquisition of NBX Corporation by 3Com Corporation. The funds were in a
one-year interest-bearing escrow account for the benefit of the Company,
subject to any 3Com Corporation warranty claims associated with its
acquisition of NBX Corporation. The Company set up a reserve of 10 percent
for any potential claims, therefore the funds in escrow account reflected
$1,327,748 net of the reserve of $147,528. The Company received the full
escrow monies including interest for a total of $1,541,136 on March 6, 2000.
NOTE 8 SUBSEQUENT EVENTS
On January 5, 2000, the Company announced that it had purchased for
$1,000,000 approximately a 15 percent equity interest in MyPersonalAdvocate.com,
Inc., a business-to-business e-commerce and e-services trust-based marketing
start-up.
On January 13, 2000 the Company announced that it would discontinue the
operations of, and liquidate, Adaptive Web Technologies, Inc. Adaptive was
founded in late 1999, with $1,000,000 in funding from the Company. Because
Adaptive was able to determine early in the process of research and analysis
not to proceed with the development and commercialization effort, the Company
anticipates that the amount of money expended to date by Adaptive is unlikely to
prove to be material and that it will recapture most of its $1,000,000
investment in Adaptive.
On January 20, 2000, the Company invested $500,000 in iPacer Corporation,
an Internet technology startup, in the form of a six percent Convertible
Promissory Note, maturing on March 31, 2000.
On January 27, 2000, the Company announced that it had placed privately,
with an unaffiliated investor, for $3 million in cash, a one-year 12 percent
note with one-year warrants to purchase 25,263 shares of the Company's common
stock at $11.8750 per share. The note may be prepaid at any time. Unless
the note is prepaid, six months after its issuance, the investor will receive
additional one-year warrants to purchase an additional $300,000 worth of the
Company's common stock at the then-current market price. On February 28,
2000, the Company announced its intent to pre-pay the Note from the proceeds
50
of its sale of 43,400 shares of SciQuest.com, Inc. common stock (NASDAQ:
SQST) at $77.2264 per share on February 25, 2000. The Company continues to
hold 417,639 shares of SciQuest.com common stock. Because the Company
intends to use most of the proceeds of the SciQuest.com sale to pre-pay
indebtedness, most or all of the realized long-term capital gains from this
sale, approximately $3.3 million, will be retained by the Company and will
not be distributed to shareholders as a cash dividend.
On February 7, 2000, the Company announced that Kana Communications, Inc.
and Silknet Software, Inc. had signed a merger agreement, whereby each of the
Company's Silknet shares would be exchanged tax free for 0.83 Kana
Communications shares. There can be no assurance that the merger will be
consummated.
On February 9, 2000, the Company announced that it had exercised a
warrant to purchase 200,000 common shares of Alliance Pharmaceutical Corp.
for $490,000. The exercise price was $2.45 per share, and the warrant had
an expiration date of May 20, 2004. The Company also converted its
$1,200,000 note due May 20, 2002 into 600,000 shares of Alliance
Pharmaceutical. The conversion price was $2.00 per share. The Company now
owns 800,000 common shares of Alliance Pharmaceutical. These shares are
currently restricted under Rule 144.
On March 8, 2000, the Company increased its investment in Sundial
Marketplace Corporation by purchasing from Sundial a $150,000 note with
equity features under certain circumstances. Thus, the Company has now
invested a total of $900,000 in Sundial.
On March 14, 2000, the Company announced that it had invested an
additional $500,000 in Genomica Corporation as part of a $15,000,000 private
placement of Genomica's Series C convertible preferred stock. Including
this new investment, the Company owns approximately a 3.4 percent fully
diluted interest in Genomica. On March 15, 2000, Genomica filed an S-1
registration statement with the Securities and Exchange Commission.
51
SELECTED PER SHARE DATA AND RATIOS
Per share operating performance:
Year Ended Year Ended Year Ended Year Ended Year Ended
Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31,
1999 1998 1997 1996 1995
Net asset value,
beginning of
period $ 2.13 $ 3.15 $ 3.44 $ 3.54 $ 3.43
Net operating
loss (1.04) (0.26) (0.14) (0.12) (0.11)
Net realized
(loss) gain
on investments 0.93 (0.16) (0.19) (0.24) 0.14
Net (decrease)
increase in
unrealized
appreciation as
a result of sales (0.46) 0.11 (0.17) 0.16 (0.01)
Net increase in
unrealized
appreciation on
investments held 4.58 0.05 0.26 0.13 0.03
Net decrease as a
result of dividend (0.35) (0.75) 0.0 0.0 0.0
Net increase
(decrease) from
capital stock
transactions 0.01 (0.01) (0.05) (0.03) 0.06
---------- ----------- ---------- ---------- ----------
Net asset value,
end of period* $ 5.80 $ 2.13 $ 3.15 $ 3.44 $ 3.54
========= ========== ========== ========== ==========
Dividends paid
per share $ 0.35 $ 0.75 $ 0.00 $ 0.00 $ 0.00
Market value per
share, end of
period $ 11.50 $ 1.50 $ 3.50 $ 3.75 $ 7.875
Deferred income
tax per share $ 0.16 $ 0.09 $ 0.06 $ 0.21 $ 0.050
Ratio of expenses
to average net
assets 34.08% 10.9% 9.1% 8.1% 8.3%
Ratio of net
operating loss to
average net assets (3.50)% (10.4)% (4.5)% (3.5)% (3.2)%
Investment return based on:
Stock price 666.7% (45.5)% (6.7)% (52.4)% 23.5%
Net asset value 188.7% (8.3)% (8.4)% (2.8)% 3.2%
Portfolio turnover 53.54% 19.71% 77.2% 51.3% 51.2%
Net assets, end
of period $53,634,805 $22,556,709 $33,654,934 $35,932,603 $36,561,909
Number of shares
outstanding 9,240,831 10,591,232 10,692,971 10,442,682 10,333,902
*The net asset value as of December 31, 1999 reflects the decline in net
asset value as a result of the $0.35 dividend paid in 1999 and $0.75
dividend paid in 1998.
The accompanying notes are an integral part of this schedule.
52
Item 9. Disagreements on Accounting and Financial Disclosure
None.
PART III
Item 10. Directors and Executive Officers of the Company
The information set forth under the captions "Election of Directors"
on page 2, "Executive Officers" on page 8 and "Section 16(a) Beneficial
Ownership Reporting Compliance" on page 15 in the Company's Proxy Statement
for Annual Meeting of Shareholders to be held April 26, 2000, filed pursuant
to Regulation 14A under the Securities Exchange Act of 1934 on or about
March 24, 2000 (the "2000 Proxy Statement") is herein incorporated by
reference.
Item 11. Executive Compensation
The information set forth under the captions "Summary Compensation
Table" on pages 9 and 10 and "Compensation of Directors" on page 14 in the
2000 Proxy Statement is herein incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information set forth under the caption "Security Ownership of
Directors and Executive Officers and other principal holders of the
Company's voting securities" on page 7 in the 2000 Proxy Statement is
herein incorporated by reference.
Item 13. Certain Relationships and Related Transactions
There were no relationships or transactions within the meaning of
this item during the year ended December 31, 1999.
53
PART IV
Item 14. Exhibits, Consolidated Financial Statements, Schedules and
Reports on Form 8-K
(a) The following documents are filed as a part of this report:
(1) The following Consolidated Financial Statements of the Company
are set forth under Item 8:
Consolidated Statements of Assets and Liabilities as of
December 31, 1999 and 1998
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997
Consolidated Statements of Changes in Net Assets for the years
ended December 31, 1999, 1998 and 1997
Consolidated Schedule of Investments as of December 31, 1999
Footnote to Consolidated Schedule of Investments
Notes to Consolidated Financial Statements
Selected Per Share Data and Ratios for the years ended
December 31, 1999, 1998, 1997, 1996 and 1995
(2) Report of Independent Public Accountants.
(3) The following exhibits are filed with this report or are
incorporated herein by reference to a prior filing, in accordance
with Rule 12b-32 under the Securities Exchange Act of 1934.
(Asterisk denotes exhibits filed with this report.)
3.1(a) Restated Certificate of Incorporation of the Company, as
amended, incorporated by reference to Exhibit 3.1 (a) to
the Company's Form 10-K for the year ended December 31, 1995.
3.1(b) Restated By-laws of the Company, incorporated by reference
to Exhibit 3.1(b) to the Company's Form 10-K for the year
ended December 31, 1995 and the Company's Form 10-Q for
the quarter ended September 30, 1998.
4.1 Specimen certificate of common stock certificate,
incorporated by reference to Exhibit 4 to Company's
Registration Statement on Form N-2 filed October 29, 1992.
9.1 Harris & Harris Group, Inc. Custodian Agreement with JP
Morgan, incorporated by reference to Exhibit 9.1 to the
Company's Form 10-K for the year ended December 31, 1995.
10.1 Amended and Restated Employment Agreement between Harris &
Harris Group, Inc. and Charles E. Harris dated January
1, 1998.
10.5 Severance Compensation Agreement by and between the
Company and Charles E. Harris dated August 15, 1990,
incorporated by reference to exhibit 10 (s) to the
Company's Annual Report on Form 10-K for the year ended
December 31, 1990.
54
10.13 Stock Purchase Agreement, Standstill Agreement and
Termination and Release by and among Harris & Harris Group,
Inc. and American Bankers Life Assurance Company of Florida
dated May 18, 1995, incorporated by reference to Exhibit
10.13 to the Company's Form 10-K for the year ended
December 31, 1995.
10.14 Form of Indemnification Agreement which has been
established with all directors and executive officers of
the Company, incorporated by reference to Exhibit 10.14 to
the Company's Form 10-K for the year ended December 31,
1995.
10.16 Demand Promissory Note, Corporate Certificate-Borrowing,
Statement of Purpose for an Extension of Credit Secured by
Margin Stock by and among Harris & Harris Group, Inc. and
J.P. Morgan.
10.17 Harris & Harris Group, Inc. Employee Profit Sharing Plan,
incorporated by reference as Exhibit (c) to the Company's
Form 8-K filed June 15, 1998.
10.18 Employment Agreement Between Harris & Harris Group, Inc.
and Charles E. Harris, dated October 19, 1999, incorporated
by reference as Exhibit (C) to the Company's Form 8-K filed
on October 27, 1999.
10.19* Deferred Compensation Agreement Between Harris & Harris
Group, Inc. and Charles E. Harris.
10.20* Trust Under Harris & Harris Group, Inc. Deferred
Compensation Agreement.
10.21* Note due January 26, 2001; Form of Warrant to Purchase
25,263 Shares of Harris & Harris Group, Inc. common stock.
10.22* Harris & Harris Group, Inc. Employee Profit-Sharing Plan.
11.0* Computation of Per Share Earnings is set forth under Item 8.
23* Consent of Arthur Andersen LLP.
27.0* Financial Data Schedule.
(b) Reports on Form 8-K. On October 27, 1999, the Company filed a
Form 8-K to disclose the Employment Agreement between Charles E. Harris,
Chief Executive Officer of Harris & Harris Group, Inc. and Harris & Harris
Group, Inc.
*Exhibits attached.
55
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
HARRIS & HARRIS GROUP, INC.
Date: March 21, 2000 By: /s/ Charles E. Harris
----------------------
Charles E. Harris
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Company and in the capacities and on the dates indicated.
Signatures Title Date
/s/ Charles E. Harris Chairman of the Board, March 21, 2000
- --------------------- Chief Compliance Officer and
Charles E. Harris Chief Executive Officer
/s/ Mel P. Melsheimer President, Chief Operating March 21, 2000
- --------------------- Officer and Chief Financial Officer
Mel P. Melsheimer
/s/ Rachel M. Pernia Vice President, Controller, March 21, 2000
- ---------------------- Treasurer and Principal
Rachel M. Pernia Accounting Officer
56
/s/ C. Wayne Bardin Director March 20, 2000
- --------------------
C. Wayne Bardin
/s/ Phillip A. Bauman Director March 18, 2000
- ---------------------
Phillip A. Bauman
/s/ G. Morgan Browne Director March 17, 2000
- ---------------------
G. Morgan Browne
/s/ Harry E. Ekblom Director March 18, 2000
- ---------------------
Harry E. Ekblom
/s/ Dugald A. Fletcher Director March 17, 2000
- ----------------------
Dugald A. Fletcher
/s/ Glenn E. Mayer Director March 17, 2000
- -----------------------
Glenn E. Mayer
/s/ James E. Roberts Director March 17, 2000
- -----------------------
James E. Roberts
57
EXHIBIT INDEX
The following exhibits are filed with this report in accordance with
Rule 12b-32 under the Securities Exchange Act of 1934.
Exhibit No. Description
10.19 Deferred Compensation Agreement Between Harris & Harris Group,
Inc. and Charles E. Harris.
10.20 Trust Under Harris & Harris Group, Inc. Deferred Compensation
Agreement.
10.21 Note due January 26, 2001; Form of Warrant to Purchase 25,263
Shares of Harris & Harris Group, Inc. common stock.
10.22 Harris & Harris Group, Inc. Employee Profit-Sharing Plan.
11.0 Computation of Per Share Earnings is set forth under Item 8.
23 Consent of Arthur Andersen LLP.
27.0 Financial Data Schedule.