UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended September 30, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to _____________
Commission File Number: 0-11576
HARRIS & HARRIS GROUP, INC.
- -------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
New York 13-3119827
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(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
111 West 57th Street, New York, New York 10019
- -------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
(212) 582-0900
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements
for the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act).
Yes No X
----- -----
Indicate the number of shares outstanding of each of the
issuer's classes of common stock, as of the latest practicable
date.
Class Outstanding at November 12, 2004
- --------------------------------------------------------------------------------
Common Stock, $0.01 par value per share 17,248,845 shares
Harris & Harris Group, Inc.
Form 10-Q, September 30, 2004
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements..................... 1
Consolidated Statements of Assets and Liabilities.............. 2
Consolidated Statements of Operations.......................... 3
Consolidated Statements of Cash Flows.......................... 4
Consolidated Statements of Changes in Net Assets............... 5
Consolidated Schedule of Investments........................... 6
Notes to Consolidated Financial Statements..................... 14
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................ 23
Background and Overview ....................................... 23
Results of Operations.......................................... 25
Financial Condition............................................ 27
Liquidity and Capital Resources................................ 29
Risk Factors................................................... 30
Item 3. Quantitative and Qualitative Disclosures About
Market Risk.................................................... 38
Item 4. Controls and Procedures............................... 39
PART II OTHER INFORMATION
Item 1. Legal Proceedings...................................... 40
Item 2. Changes in Securities and Use of Proceeds.............. 40
Item 3. Defaults Upon Senior Securities........................ 40
Item 4. Submission of Matters to a Vote of Security Holders.... 40
Item 5. Other Information...................................... 40
Item 6. Exhibits and Reports on Form 8-K....................... 40
Signature...................................................... 41
Exhibit Index to Form 10-Q..................................... 42
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated
financial statements reflects all adjustments that are, in the
opinion of management, necessary for a fair statement of the
results for the interim period presented.
Harris & Harris Group, Inc. (the "Company," "us," "our" and
"we"), is an internally managed venture capital company that has
elected to be treated as a business development company under the
Investment Company Act of 1940. Certain information and
disclosures normally included in the consolidated financial
statements in accordance with Generally Accepted Accounting
Principles have been condensed or omitted as permitted by
Regulation S-X and Regulation S-K. It is suggested that the
accompanying consolidated financial statements be read in
conjunction with the audited consolidated financial statements and
notes thereto for the year ended December 31, 2003, contained in
our 2003 Annual Report.
On September 25, 1997, our Board of Directors approved a
proposal to seek out qualification as a Regulated Investment
Company ("RIC") under Subchapter M of the Internal Revenue Code
(the "Code"). At that time, we were taxable under Subchapter C of
the Code (a "C Corporation"). In order to qualify as a RIC, we
must, in general (1) annually derive at least 90% of our gross
income from dividends, interest, gains from the sale of securities
and similar sources; (2) quarterly meet certain investment
diversification requirements; and (3) annually distribute at least
90% of our investment company taxable income as a dividend. In
addition to the requirement that we must annually distribute at
least 90% of our investment company taxable income, we may either
distribute or retain our taxable net capital gains from
investments, but any net capital gains not distributed could be
subject to corporate level tax. Further, we could be subject to a
4% excise tax to the extent we fail to distribute at least 98% of
our annual investment company taxable income and would be subject
to income tax to the extent we fail to distribute 100% of our
investment company taxable income.
Because of the specialized nature of our investment portfolio
and the size of our Company, prior to our recent offerings of
additional shares, we were able to satisfy certain diversification
requirements under Subchapter M of the Code only if we received a
certification from the Securities and Exchange Commission ("SEC")
that we are "principally engaged in the furnishing of capital to
other corporations that are principally engaged in the development
or exploitation of inventions, technological improvements, new
processes, or products not previously generally available."
On June 15, 2004, we received SEC certification for 2003,
permitting us to qualify for RIC treatment for 2003 (as we had for
the years 1999 through 2002). Although the SEC certification for
2003 was issued, there can be no assurance that we will qualify for
or receive such certification for subsequent years (to the extent
we need certification for any subsequent year) or that we will
actually qualify for Subchapter M treatment in any subsequent year.
In addition, under certain circumstances, even if we qualified for
Subchapter M treatment in a given year, we might take action in a
subsequent year to ensure that we would be taxed in that subsequent
year as a C Corporation, rather than as a RIC.
1
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
September 30, 2004 December 31, 2003
(Unaudited)
Investments, at value
(Cost: $78,938,861 at 9/30/04,
$44,603,778 at 12/31/03)........... $78,613,954 $42,227,062
Cash and cash equivalents............ 290,641 425,574
Restricted funds (Note 5)............ 1,393,093 1,212,078
Interest receivable.................. 184,325 450
Income tax receivable................ 9,532 17,375
Prepaid expenses..................... 25,669 6,841
Other assets, net of reserve
of $255,486 at 9/30/04............. 240,422 225,748
----------- -----------
Total assets......................... $80,757,636 $44,115,128
=========== ===========
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities........................ $ 2,565,303 $ 2,723,398
Accrued profit sharing (Note 3)...... 336,820 0
Deferred rent........................ 34,922 39,648
Deferred income tax liability
(Note 6)........................... 1,315,579 669,344
----------- -----------
Total liabilities.................... 4,252,624 3,432,390
----------- -----------
Net assets........................... $76,505,012 $40,682,738
=========== ===========
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;
19,077,585 issued at 9/30/04
and 15,627,585 at 12/31/03......... 190,776 156,276
Additional paid in capital (Note 4).. 85,657,650 49,564,475
Accumulated net realized loss........ (4,121,822) (2,410,847)
Accumulated unrealized depreciation
of investments, including
deferred tax liability of
$1,491,153 at 9/30/04 and
$844,918 at 12/31/03............... (1,816,061) (3,221,635)
Treasury stock, at cost (1,828,740
shares at 9/30/04 and 12/31/03).... (3,405,531) (3,405,531)
----------- -----------
Net assets........................... $76,505,012 $40,682,738
=========== ===========
Shares outstanding................... 17,248,845 13,798,845
=========== ===========
Net asset value per outstanding
share...................................$ 4.44 $ 2.95
=========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Nine Months Ended
Sept. 30, 2004 Sept. 30, 2003 Sept. 30, 2004 Sept. 30, 2003
Investment income:
Interest from:
Fixed-income securities......................$ 235,778 $ 25,910 $ 365,842 $ 104,165
Portfolio companies.......................... 17,803 0 23,506 0
Other income................................... 0 4,702 0 41,687
-------------- -------------- -------------- --------------
Total investment income...................... 253,581 30,612 389,348 145,852
Expenses:
Profit-sharing (Note 3)........................ 336,820 0 336,820 0
Salaries and benefits.......................... 419,384 360,116 1,384,566 1,084,015
Administration and operations.................. 129,649 85,536 475,724 324,238
Professional fees.............................. 231,144 59,277 389,083 276,571
Rent........................................... 38,860 49,885 111,515 169,203
Directors' fees and expenses................... 63,188 31,250 156,811 121,295
Depreciation................................... 10,958 11,408 29,906 31,538
Bank custody fees.............................. 2,351 1,499 8,145 5,908
Interest expense............................... 0 3,987 0 16,879
-------------- -------------- -------------- --------------
Total expenses............................... 1,232,354 602,958 2,892,570 2,029,647
-------------- -------------- -------------- --------------
Operating loss before income taxes............. (978,773) (572,346) (2,503,222) (1,883,795)
-------------- -------------- -------------- --------------
Net operating loss............................. (978,773) (572,346) (2,503,222) (1,883,795)
Net realized (loss) gain on investments:
Realized (loss) gain on investments............ 2,704 (1,003,919) 798,673 (975,347)
-------------- -------------- -------------- --------------
Total realized (loss) gain................... 2,704 (1,003,919) 798,673 (975,347)
Income tax benefit (provision) (Note 6)........ 1,482 3,500 (6,426) (13,822)
-------------- -------------- -------------- --------------
Net realized (loss) gain on investments........ 4,186 (1,000,419) 792,247 (989,169)
-------------- -------------- -------------- --------------
Net realized loss................................ (974,587) (1,572,765) (1,710,975) (2,872,964)
Net increase (decrease) in unrealized
appreciation on investments:
Increase as a result of investment sales....... 0 1,000,001 915,118 1,000,001
Decrease as a result of investment sales....... 0 0 0 (18,031)
Increase on investments held................... 3,172,633 67,982 3,212,494 757,841
Decrease on investments held................... (440,690) (765,516) (2,075,803) (1,896,981)
-------------- -------------- -------------- --------------
Net change in unrealized appreciation
on investments............................... 2,731,943 302,467 2,051,809 (157,170)
Income tax (expense) benefit (Note 6).......... (646,235) 0 (646,235) 0
-------------- -------------- -------------- --------------
Net increase (decrease) in unrealized
appreciation on investments.................... 2,085,708 302,467 1,405,574 (157,170)
-------------- -------------- -------------- --------------
Net (decrease) increase in net assets
resulting from operations:
Total..........................................$ 1,111,121 $ (1,270,298) $ (305,401) $ (3,030,134)
============== ============== ============== ==============
Per outstanding share..........................$ .06 $ (.11) $ (.02) $ (.26)
============== ============== ============== ==============
The accompanying notes are an integral part of
these consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended Nine Months Ended
Sept. 30, 2004 Sept. 30, 2003
Cash flows from operating activities:
Net (decrease) in net assets
resulting from operations.............$ (305,401) $ (3,030,134)
Adjustments to reconcile net
decrease in net assets resulting
from operations to net cash used in
operating activities:
Realized and unrealized (loss)
gain on investments................. (2,850,482) 1,132,517
Depreciation.......................... 29,906 31,538
Deferred income taxes................. 646,235 0
Changes in assets and liabilities:
Restricted funds...................... (181,015) (342,107)
Receivable from portfolio company..... 0 786,492
Funds in escrow....................... 0 750,000
Interest receivable................... (183,875) (153)
Income tax receivable................. 7,843 (83,595)
Prepaid expenses...................... (18,828) 72,692
Other assets.......................... 5,514 (40,927)
Accounts payable and accrued
liabilities......................... (158,095) 394,485
Payable to broker for unsettled trade. 0 (5,696,725)
Accrued profit sharing................ 336,820 (15,233)
Current income tax liability.......... 0 (857,656)
Deferred rent......................... (4,726) 35,826
---------------- ------------
Net cash used in operating activities. (2,676,104) (6,862,980)
Cash flows from investing activities:
Net (purchase) sale of short-term
investments and marketable
securities.......................... (24,578,644) (2,975,719)
Proceeds from investments............. 2,515,386 26,791
Investment in private placements
and loans........................... (11,473,651) (3,331,118)
Purchase of fixed assets.............. (49,595) (195,725)
---------------- ------------
Net cash (used in) provided by
investing activities.................... (33,586,504) (6,475,771)
Cash flows from financing activities:
Proceeds from note payable............ 0 7,609,500
Proceeds from public offering, net.... 36,127,675 0
Collection on notes receivable........ 0 1,500
---------------- ------------
Net cash provided by financing
activities.......................... 36,127,675 7,611,000
---------------- ------------
Net increase (decrease) in cash and
cash equivalents:
Cash and cash equivalents at
beginning of the period............. 425,574 5,967,356
Cash and cash equivalents at
end of the period................... 290,641 239,605
---------------- ------------
Net decrease in cash and cash
equivalents.........................$ (134,933) $ (5,727,751)
================ ============
Supplemental disclosures of cash flow information:
Income taxes paid.....................$ 0 $ 575,100
Interest paid.........................$ 0 $ 15,441
The accompanying notes are an integral part of
these consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Nine Months Ended
Sept. 30, 2004 Sept. 30, 2003 Sept. 30, 2004 Sept. 30, 2003
Changes in net assets
from operations:
Net operating loss..... $ (978,773) $ (572,346) $ (2,503,222) $ (1,883,795)
Net realized gain
(loss) on
investments.......... 4,186 (1,000,419) 792,247 (989,169)
Net increase in
unrealized
appreciation on
investments as a
result of sales..... 0 1,000,001 915,118 981,970
Net increase
(decrease) in
unrealized
appreciation on
investments held..... 2,085,708 (697,534) 490,456 (1,139,140)
------------- -------------- ------------- --------------
Net increase
(decrease) in net
assets resulting
from operations...... 1,111,121 (1,270,298) (305,401) (3,030,134)
Changes in net assets
from capital stock
transactions:
Proceeds from sale
of common stock...... 34,500 0 34,500 0
Additional paid in
capital on common
stock issued......... 36,093,175 0 36,093,175 0
-------------- --------------- ------------- --------------
Net increase in
net assets
resulting from
capital stock
transactions......... 36,127,675 0 36,127,675 0
-------------- --------------- ------------- --------------
Net increase (decrease)
in net assets............ 37,238,796 (1,270,298) 35,822,274 (3,030,134)
Net assets:
Beginning of
the period............. 39,266,216 25,496,210 40,682,738 27,256,046
-------------- --------------- ------------- ---------------
End of the period...... $ 76,505,012 $ 24,225,912 $ 76,505,012 $ 24,225,912
============== =============== ============= ===============
The accompanying notes are an integral part of
these consolidated financial statements.
5
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2004
(UNAUDITED)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies
(8)(9)(10) -- 12.2% of total investments
Private Placement Portfolio (Illiquid) --
12.2% of total investments
AlphaSimplex Group, LLC (2)(5) --
Investment management company headed by
Dr. Andrew W. Lo, holder of the Harris &
Harris Group Chair at MIT
Limited Liability Company Interest................(C) -- $ 125,000
Continuum Photonics, Inc. (1)(2)(5)(6) --
Develops optical networking components by
merging cutting-edge materials, MEMS and
electronics technologies -- 4.23% of fully
diluted equity
Series B Convertible Preferred Stock..............(C) 2,000,000 776,119
Series C Convertible Preferred Stock..............(C) 2,689,103 839,000
-----------
1,615,119
Crystal IS, Inc. (1)(2)(4)(6) -- Develops
a technology to grow aluminum
nitride single-crystal boules --
1.81% of fully diluted equity
Series A Convertible Preferred Stock............. (A) 5,482 199,983
Exponential Business Development Company (1)(2) --
Venture capital partnership focused on
early stage companies
Limited Partnership Interest......................(B) -- 0
Heartware, Inc. (1)(2)(5)(6) -- Develops
ventricular assist devices -- 0% of
fully diluted equity
Series A-2 Non-Voting Preferred Stock.............(B) 47,620 0
Molecular Imprints, Inc. (1)(2)(4)(5) --
Develops nanoimprint lithography capital
equipment -- 2.09% of fully diluted equity
Series B Convertible Preferred Stock..............(A) 1,333,333 2,000,000
Nanosys, Inc. (1)(2)(5)(6) -- Develops
nanotechnology-enabled systems incorporating
novel and patent-protected zero and one-
dimensional nanometer-scale materials --
1.58% of fully diluted equity
Series C Convertible Preferred Stock..............(A) 803,428 1,500,000
Nantero, Inc. (1)(2)(5)(6) -- Develops a
high-density, nonvolatile, random access
memory chip, using nanotechnology -- 3.35%
of fully diluted equity
Series A Convertible Preferred Stock..............(C) 345,070 538,309
Series B Convertible Preferred Stock..............(C) 207,051 323,000
----------
861,309
NeoPhotonics Corporation (1)(2)(5)(6)(12) --
Develops and manufactures planar
optical devices and components using
nanomaterials -- deposition technology
-- 3.49% of fully diluted equity
Common Stock (C) 60,580 9,105
Series 1 Convertible Preferred Stock..............(A) 1,831,256 2,014,677
Warrants at $0.15 expiring 3/12/11................(C) 30,426 304
----------
2,024,086
The accompanying notes are an integral part of
these consolidated financial statements.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2004
(UNAUDITED)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies
(8)(9)(10) -- 12.2% of total investments (cont.)
Private Placement Portfolio (Illiquid) --
12.2% of total investments (cont.)
Optiva, Inc. (1)(2)(6) -- Develops and
commercializes nanomaterials for
advanced applications -- 1.74% of
fully diluted equity
Series C Convertible Preferred Stock................(B) 1,249,999 $ 625,000
Secured Convertible Bridge Note with
50% Preferred Stock Warrant coverage................(A) 401,536 408,752
-----------
1,033,752
Starfire Systems, Inc. (1)(2)(4)(5)(6) --
Develops and produces ceramic-forming
polymers -- 1.80% of fully diluted equity
Common Stock........................................(A) 125,000 50,000
Series A-1 Convertible Preferred Stock..............(A) 200,000 200,000
-----------
250,000
Total Unaffiliated Private Placement Portfolio (cost: $10,316,632)............$ 9,609,249
-----------
Total Investments in Unaffiliated Companies (cost: $10,316,632)...............$ 9,609,249
-----------
The accompanying notes are an integral part of
these consolidated financial statements.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2004
(UNAUDITED)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated
Companies (8)(9)(11) -- 22.2% of total
investments
Publicly Traded Portfolio -- 12.7% of total
investments
NeuroMetrix, Inc. (1)(2)(13) -- Develops and
sells medical devices for monitoring
neuromuscular disorders -- 8.65% of fully
diluted equity
Common Stock.......................................(D) 1,137,570 $9,998,103
----------
Total Publicly Traded Portfolio (cost: $4,411,373)............................$9,998,103
----------
Private Placement Portfolio (Illiquid) -- 9.5% of total investments
Agile Materials & Technologies, Inc. (1)(2)(6)
-- Develops and sells variable integrated
passive RF electronic equipment components --
8.15% of fully diluted equity
Series A Convertible Preferred Stock...............(B) 3,732,736 $ 110,700
Convertible Bridge Note with 20% warrants..........(B) $301,273 310,650
----------
421,350
Chlorogen, Inc. (1)(2)(5)(6) -- Develops
patented chloroplast technology to
produce plant-made proteins -- 9.74%
of fully diluted equity
Series A Convertible Preferred Stock...............(A) 4,478,038 785,000
CSwitch, Inc. (1)(2)(4)(5)(6) -- Develops
next-generation, system-on-a-chip
solutions for communications-based
platforms -- 5.66% of fully diluted equity
Series A Convertible Preferred Stock...............(A) 1,000,000 1,000,000
Experion Systems, Inc. (1)(2)(7) -- Develops
and sells software to credit unions -- 12.49%
of fully diluted equity
Series A Convertible Preferred Stock...............(B) 294,118 0
Series B Convertible Preferred Stock...............(B) 35,294 0
Series C Convertible Preferred Stock...............(B) 222,184 0
Series D Convertible Preferred Stock...............(B) 64,501 363,786
----------
363,786
NanoGram Corporation (1)(2)(5)(6) -- Develops a
broad suite of intellectual property utilizing
nanotechnology -- 7.29% of fully diluted equity
Series I Convertible Preferred Stock...............(A) 63,210 21,672
Series II Convertible Preferred Stock..............(A) 1,250,904 1,000,723
-----------
1,022,395
NanoOpto Corporation (1)(2)(6) -- Develops high
performance, integrated optical communications
sub-components on a chip by utilizing
patented nano-manufacturing technology -- 11.92%
of fully diluted equity
Series A-1 Convertible Preferred Stock.............(C) 267,857 47,567
Series B Convertible Preferred Stock...............(C) 3,819,935 1,625,000
----------
1,672,567
Nanopharma Corp. (1)(2)(6) -- Develops advanced
nanoscopic drug delivery vehicles and systems
-- 14.32% of fully diluted equity
Series A Convertible Preferred Stock...............(A) 684,516 700,000
Subordinated Convertible Bridge Note...............(A) $ 150,000 153,370
----------
853,370
Nanotechnologies, Inc. (1)(2)(5)(6) -- Develops
high-performance nanoscale materials for
industry -- 6.48% of fully diluted equity
Series B Convertible Preferred Stock...............(B) 1,538,837 553,982
Series C Convertible Preferred Stock...............(B) 235,720 84,859
----------
638,841
The accompanying notes are an integral part of
these consolidated financial statements.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2004
(UNAUDITED)
Method of Shares/
Valuation (3) Principal Value
Questech Corporation (1)(2)(5) -- Manufactures
and markets proprietary metal decorative
tiles -- 6.73% of fully diluted equity
Common Stock.......................................(C) 646,954 $ 724,588
Warrants at $5.00 expiring 10/25/04................(C) 1,966 0
Warrants at $1.50 expiring 11/16/05................(C) 1,250 0
Warrants at $1.50 expiring 08/03/06................(C) 8,500 0
Warrants at $1.50 expiring 11/21/07................(C) 3,750 0
Warrants at $1.50 expiring 11/19/08................(C) 5,000 0
-----------
724,588
-----------
Total Non-Controlled Private Placement Portfolio (cost: $12,510,313).........$ 7,481,897
-----------
Total Investments in Non-Controlled Affiliated Companies (cost: $16,921,686).$17,480,000
-----------
U.S. Government and Agency Obligations -- 65.5% of total investments
U.S. Treasury Bills -- due date 10/07/04...........(J) $2,500,000 $2,499,400
U.S. Treasury Bills -- due date 10/28/04...........(J) 2,700,000 2,697,057
U.S. Treasury Bills -- due date 01/06/05...........(J) 2,500,000 2,488,275
U.S. Treasury Notes -- due date 04/30/05,
coupon 1.625%....................................(H) 2,692,000 2,685,889
U.S. Treasury Notes -- due date 06/30/05,
coupon 1.125%....................................(H) 21,500,000 21,348,855
U.S. Treasury Notes -- due date 02/28/06,
coupon 1.625%....................................(H) 2,428,000 2,403,234
U.S. Treasury Notes -- due date 06/30/06,
coupon 2.75%.....................................(H) 10,000,000 10,041,400
U.S. Treasury Notes -- due date 02/15/07,
coupon 2.25%.....................................(H) 2,428,000 2,402,118
U.S. Treasury Notes -- due date 05/15/08,
coupon 2.625%...................................(H) 2,433,000 2,397,357
U.S. Treasury Notes -- due date 03/15/09,
coupon 2.625%...................................(H) 2,631,000 2,561,120
-----------
Total Investments in U.S. Government and Agency
Obligations (cost: $51,700,543)............................................$51,524,705
-----------
Total Investments -- 100% (cost: $78,938,861)................................$78,613,954
===========
The accompanying notes are an integral part of
these consolidated financial statements.
9
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2004
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 Schedule of Investments for a description of the
Asset Valuation Policy Guidelines.
(4) Initial investment was made during 2004.
(5) No changes in valuation occurred in these investments during the
three months ended September 30, 2004.
(6) These investments are development stage companies. A development
stage company is defined as a company that is devoting
substantially all of its efforts to establishing a new business,
and either it has not yet commenced its planned principal
operations, or it has commenced such operations but has not
realized significant revenue from them.
(7) Experion Systems, Inc. was previously named MyPersonalAdvocate.com,
Inc.
(8) Investments in unaffiliated companies consist of investments in
which we own less than 5% of the portfolio company Investments in
non-controlled affiliated companies consist of investments in which
we own more than 5% but less than 25% of the portfolio company.
Investments in controlled affiliated companies consist of
investments in which we own more than 25% of the portfolio company.
(9) The percentage ownership of each portfolio company disclosed in the
Consolidated Schedule of Investments expresses the potential equity
interest in each such portfolio company. The calculated percentage
represents the amount of the issuer's equity securities we own or
can acquire as a percentage of the issuer's total outstanding
equity securities plus equity securities reserved for issued and
outstanding warrants, convertible securities and all authorized
stock options, both granted and ungranted.
(10) The aggregate cost for federal income tax purposes of investments
in unaffiliated companies is $10,316,632. The gross unrealized
appreciation based on the tax cost for these securities is
$166,498. The gross unrealized depreciation based on the tax cost
for these securities is $873,881.
(11) The aggregate cost for federal income tax purposes of investments
in non-controlled affiliated companies is $16,921,686. The gross
unrealized appreciation based on the tax cost for these securities
is $5,586,730. The gross unrealized depreciation based on the tax
cost for these securities is $5,028,416.
(12) NeoPhotonics filed for bankruptcy on November 17, 2003. We sold
our investment in its Series D Preferred Stock in January 2004.
NeoPhotonics emerged from bankruptcy, as a newly reorganized
company, after obtaining financing from us and other investors.
(13) The Company's 1,137,570 share holding in NeuroMetrix, Inc.
(National Market Symbol: NURO), before a lock-up discount, at the
September 30, 2004, market price per share of $10.00, was
$11,375,700 The lock-up expires on January 18, 2005. On November
4, 2004, the market price per share of NeuroMetrix was $9.21.
The accompanying notes are an integral part of
these consolidated financial statements.
10
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
Our 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 our portfolio to determine
our 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.
Our Board of Directors is responsible for (1) determining
overall valuation guidelines and (2) ensuring that our investments
are valued within the prescribed guidelines.
Our Valuation Committee, comprised of at least three or more
independent Board members, is responsible for reviewing and
approving the valuation of our assets within the guidelines
established by the Board of Directors. The Valuation Committee
receives information and recommendations from management.
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 our
assets, 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.
The values assigned to these investments are based on
available information and do not necessarily represent amounts that
might ultimately be realized, as such amounts depend on future
circumstances and cannot reasonably be determined until the
individual investments are actually liquidated or become readily
marketable.
Our 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 our original cost.
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. Some examples of these events are:
11
(1) a major recapitalization; (2) a major refinancing; (3) a
significant third-party transaction; (4) the development of a
meaningful public market for a company's common stock; and
(5) significant positive or negative changes in a company's business.
B. 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 us 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 our 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 we own and the nature of any rights to require
the company to register restricted securities under applicable
securities laws.
C. Private Market: The private market method uses actual,
executed, historical transactions in a company's securities by
responsible third parties as a basis for valuation. The private
market method may also use, where applicable, unconditional firm
offers by responsible third parties as a basis for valuation.
D. Public Market: The public market method is used when
there is an established public market for the class of a company's
securities held by us or into which our securities are convertible.
We discount market value for securities that are subject to
significant legal or contractual transfer restrictions. Securities
for which market quotations are readily available and which are not
subject to substantial legal or contractual and transfer
restrictions, 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. If for any reason, the Valuation
Committee determines that market quotations are not reliable, such
securities shall be fair valued by the Valuation Committee in
accordance with these valuation procedures.
INVESTMENTS IN INTELLECTUAL PROPERTY, PATENTS, 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 our original cost. This
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.
F. 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 us 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
our 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,
projected markets, and other subjective factors.
12
G. Private Market: The private market method uses actual
third-party investments in the same or substantially similar
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.
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.
I. Long-Term Fixed-Income Securities for which market
quotations are not readily available are carried at fair value as
determined in good faith by the Valuation Committee on the basis of
available data, which may include credit quality, and interest rate
analysis as well as quotations from broker-dealers or, where such
quotations are not available, prices from independent pricing
services that the Board believes are reasonably reliable and based
on reasonable price discovery procedures and data from other
sources.
SHORT-TERM FIXED-INCOME INVESTMENTS
J. Short-Term Fixed-Income Investments are valued in the
same manner as long-term fixed income securities until the
remaining maturity is 60 days or less, after which time such
securities may be valued at amortized cost if there is no concern
over payment at maturity.
ALL OTHER INVESTMENTS
K. All Other Investments are reported at fair value as
determined in good faith by the Valuation Committee.
For all other investments, the reported values shall reflect
the Valuation Committee's judgment of fair values as of the
valuation date using the outlined basic methods of valuation or
any other method of valuation that the Valuation Committee
determines after review and analysis is more appropriate for the
particular kind of investment. They do not necessarily represent
an amount of money that would be realized if we had to sell such
assets in an immediate liquidation. Thus, valuations as of any
particular date are not necessarily indicative of amounts that we
may ultimately realize as a result of future sales or other
dispositions of investments we hold.
13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. THE COMPANY
Harris & Harris Group, Inc. (the "Company," "us," "our" and
"we"), is a venture capital company operating as a business
development company ("BDC") under the Investment Company Act of
1940 ("1940 Act"). We operate as an internally managed company
whereby our officers and employees, under the general supervision
of our Board of Directors, conduct our operations.
We elected to become a BDC on July 26, 1995, after receiving
the necessary approvals. From September 30, 1992, until the
election of BDC status, we operated as a closed-end, non-
diversified investment company under the 1940 Act. Upon
commencement of operations as an investment company, we revalued
all of our assets and liabilities at fair value as defined in the
1940 Act. Prior to September 30, 1992, we were 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%
wholly owned subsidiary of the Company. Enterprises held a lease
for office space until the lease expired on July 31, 2003, which
office space it sublet to the Company and an unaffiliated party; 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
owned, until December 31, 2002, a 20% limited partnership interest
in PHZ Capital Partners L.P. Currently, Harris Partners I, L.P.,
owns our interest in AlphaSimplex Group, LLC. The partners of
Harris Partners I, L.P., are Enterprises (sole general partner) and
Harris & Harris Group, Inc. (sole limited partner).
We filed for the 1999 tax year to elect treatment as a
Regulated Investment Company ("RIC") under Subchapter M of the
Internal Revenue Code of 1986 (the "Code") and qualified for the
same treatment for 2000-2003. There can be no assurance that we
will qualify as a RIC for 2004 and subsequent years or that if we
do qualify, we will continue to qualify for subsequent years. In
addition, under certain circumstances, even if we qualified for
Subchapter M treatment for a given year, we might take action in a
subsequent year to ensure that we would be taxed in that subsequent
year as a C Corporation, rather than as a RIC. As a RIC, we must,
among other factors, distribute at least 90% of our investment
company taxable income and may either distribute or retain our
realized net capital gains on investments.
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 accounting
principles generally accepted in the United States for investment
companies and include the accounts of the Company and its wholly
owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
Cash and Cash Equivalents. Cash and cash equivalents include
money market instruments with maturities of less than three months.
14
Portfolio Investment Valuations. Investments are stated at
"value" as defined in the 1940 Act and in the applicable
regulations of the Securities and Exchange Commission. Value, as
defined in Section 2(a)(41) of the 1940 Act, is (i) the market
price for those securities for which a market quotation is readily
available and (ii) for all other assets is as determined in good
faith by, or under the direction of, the Board of Directors. (See
"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 by specific
identification for financial reporting and tax reporting.
Income Taxes. Prior to January 1, 1999, we 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 such difference relates to our unrealized appreciation
on investments.
The September 30, 2004, 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 us through December 31,
1998.
We pay federal, state and local income taxes on behalf of our
wholly owned subsidiary, Harris & Harris Enterprises, which is a C
corporation. (See "Note 6. Income Taxes.")
Estimates by Management. The preparation of the consolidated
financial statements in conformity with accounting principles
generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of
assets and liabilities as of September 30, 2004, and December 31,
2003, and the reported amounts of revenues and expenses for the
three months ended September 30, 2004, and September 30, 2003. The
most significant estimates relate to the fair valuations of certain
of our investments. Actual results could differ from these
estimates.
NOTE 3. EMPLOYEE PROFIT SHARING PLAN
As of January 1, 2003, we implemented the Amended and Restated
Harris & Harris Group, Inc. Employee Profit-Sharing Plan, which we
refer to as the 2002 Plan.
The 2002 Plan (and its predecessor) provides for profit
sharing by our officers and employees equal to 20% of our
"qualifying income" for that plan year. For the purposes of the
2002 Plan, qualifying income is defined as net realized income as
reflected on our consolidated statements of operations for that
year, less nonqualifying gains, if any.
For purposes of the 2002 Plan, our net realized income
includes investment income, realized gains and losses, and
operating expenses (including taxes paid or payable by us), but is
calculated without including dividends paid or distributions made
to shareholders, payments under the Plan, unrealized gains and
losses, and loss carry-overs from other years. The proportion of
net after-tax realized gains attributable to asset values as of
September 30, 1997, is considered nonqualifying gain, which reduces
qualifying income.
On October 15, 2002, our shareholders approved the performance
goals under the 2002 Plan in accordance with Section 162(m) of the
Code, effective as of January 1, 2003. The Code generally provides
that a public company such as we may not deduct compensation paid
to its chief executive officer or to any of its four most highly
compensated officers to the extent that the compensation paid to
the officer/employee exceeds $1,000,000 in any tax year, unless
payment is made upon the attainment of objective performance goals
that are approved by our shareholders.
15
Under the 2002 Plan, our net realized income, which we refer
to as qualifying income, includes investment income, realized
qualifying gains and losses, and operating expenses (including
taxes paid or payable by us), but is calculated without including
dividends paid or loss carry-overs from other years. As soon as
practicable following the year-end audit, the Compensation
Committee will determine whether, and if so how much, qualifying
income exists for a plan year. Once determined, 90% of the
qualifying income will be paid out to 2002 Plan participants
pursuant to the distribution percentages set forth in the 2002
Plan. The remaining 10% will be paid out after we have filed our
federal tax return for that plan year.
Under the 2002 Plan, awards previously granted to four current
Participants (Messrs. Harris and Melsheimer and Ms. Shavin and Ms.
Matthews, herein referred to as the "grandfathered participants")
will be reduced by 10% with respect to "Non-Tiny Technology
Investments" (as defined in the 2002 Plan) and by 25% with respect
to "Tiny Technology Investments" (as defined in the 2002 Plan) and
will become permanent. These reduced awards are herein referred to
as "grandfathered participations." The amount by which the awards
are reduced will be allocable and reallocable each year by the
Compensation Committee among current and new participants as awards
under the 2002 Plan. The grandfathered participations will be
honored by us whether or not the grandfathered participant is still
employed by us or is still alive (in the event of death, the
grandfathered participations will be paid to the grandfathered
participant's estate), unless the grandfathered participant is
dismissed for cause, in which case all awards, including the
grandfathered participations, will be immediately cancelled and
forfeited. With regard to new investments and follow-on
investments made after the date on which the first new employee
begins participating in the 2002 Plan, both current and new
participants will be required to be employed by us at the end of a
plan year in order to participate in profit-sharing on our
investments with respect to that year.
Notwithstanding any provisions of the 2002 Plan, in no event
may the aggregate amount of all awards payable for any Plan Year
during which we remain a "business development company" within the
meaning of the 1940 Act be greater than 20% of our "net income
after taxes" within the meaning of Section 57(n)(1)(B) of the 1940
Act. In the event the awards as calculated exceed that amount, the
awards will be reduced pro rata.
The 2002 Plan may be modified, amended or terminated by the
Compensation Committee at any time. Notwithstanding the foregoing,
the grandfathered participations may not be further modified.
Nothing in the 2002 Plan will preclude the Compensation Committee
from naming additional participants in the 2002 Plan or, except for
grandfathered participations, changing the Award Percentage of any
Participant (subject to the overall percentage limitations
contained in the 2002 Plan). Currently, under the 2002 Plan, the
distribution amounts for non-grandfathered investments for each
officer and employee are: Charles E. Harris, 7.790%; Mel P.
Melsheimer, 3.733%; Douglas W. Jamison, 3.5%; Daniel V. Leff, 3.0%;
Helene B. Shavin, 1.524%; and Jacqueline M. Matthews, 0.453%, which
together equal 20%. In one case, for a former employee who left
other than due to termination for cause, any amount earned will be
accrued and may subsequently be paid to the participant.
The grandfathered participations are set forth below:
Grandfathered Participations
------------------------------------------------
Name of Officer/Employee Non-Tiny Technology (%) Tiny Technology (%)
- ------------------------ ----------------------- -------------------
Charles E. Harris 12.41100 10.34250
Mel P. Melsheimer 3.80970 3.17475
Helene B. Shavin 1.37160 1.14300
Jacqueline M. Matthews 0.40770 0.33975
TOTAL 18.00000 15.00000
16
Accordingly, an additional 2% of Qualifying Income with
respect to grandfathered Non-Tiny Technology Investments, 5% of
Qualifying Income with respect to grandfathered Tiny Technology
Investments and the full 20% of Qualifying Income with respect to
non-grandfathered investments are available for allocation and
reallocation from year to year. Currently, Douglas W. Jamison and
Daniel V. Leff are each allocated 0.80% of the Non-Tiny Technology
Grandfathered Participations and 2% of the Tiny Technology
Grandfathered Participations.
Each quarter, we perform a calculation to determine the
accrual for profit-sharing. We calculate 20% of Qualifying Income
pursuant to the terms of the plan and estimate the effect on
Qualifying Income of selling all the portfolio investments that are
valued above cost (i.e., are in an unrealized appreciation
position). While the accrual will fluctuate each quarter as a
result of changes in Qualifying Income and changes in unrealized
appreciation, payments are only made to the extent that Qualifying
Income exists. During 2003, we made no accrual for profit sharing.
At September 30, 2004, we have $336,820 accrued for profit
sharing.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that effective
January 1, 1998, 50% of all Directors' fees be used to purchase our
common stock from us. However, effective March 1, 1999, the Board
of Directors approved that Directors may purchase our common stock
in the open market, rather than from us.
Since 1998, we have repurchased a total of 1,859,047 of our
shares for a total of $3,496,388, including commissions and
expenses, at an average price of $1.88 per share. These treasury
shares were reduced by the purchases made by the Directors. On
July 23, 2002, because of our strategic decision to invest in tiny
technology, the Board of Directors reaffirmed its commitment not to
authorize the purchase of additional shares of stock in the
foreseeable future.
On August 1, 2002, we sold 2,954,743 shares of common stock
for net proceeds of $5,927,882; net proceeds of the offering, less
offering costs of $284,412, were $5,643,470. We have invested all
of the net proceeds raised from the offering in accordance with our
investment objectives and policies.
On December 30, 2003, we sold 2,300,000 shares of common stock
for net proceeds of $17,296,000; net proceeds of the offering, less
offering costs of $664,038, were $16,631,962. We intend to use the
net proceeds of the offering, less offering costs, to make new
investments in tiny technology as well as follow-on investments in
our existing venture capital investments, and for working capital.
For these purposes, from the completion of the offering through
September 30, 2004, we have used $14,408,046 of the $16,631,962.
In 2004, we registered with the Securities and Exchange
Commission for the sale of up to 7,000,000 shares of our common
stock from time to time. On July 7, 2004, we sold 3,450,000 common
shares for net proceeds of $36,501,000; net proceeds of the
offering, less offering costs of $373,325, were $36,127,675. We
intend to use the net proceeds of the offering, less offering
costs, to make new investments in tiny technology as well as
follow-on investments in our existing venture capital investments,
and for working capital. An additional 3,550,000 shares may be sold
at prices and on terms to be set forth in one or more supplements
to the prospectus from time to time.
17
As of December 31, 2003, there are no distributable earnings.
The difference between the book basis and tax basis components of
distributable earnings is primarily attributed to Built-In Gains
existing at the time of our qualification as a RIC (see Note 6.
"Income Taxes"), nondeductible deferred compensation and net
operating losses.
Beginning with the Consolidated Statements of Assets and
Liabilities at December 31, 2003, additional paid-in capital and
common stock warrants have been combined and are reported as
additional paid-in capital. There have been no common stock
warrants outstanding since March 2000.
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment
Agreement with us (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 shall terminate on December 31, 2004 ("Term")
subject to either an earlier termination or an extension in
accordance with the terms; on January 1, 2000 and on each day
thereafter, the Term extends automatically by one day unless at any
time we or Mr. Harris, by written notice, decide not to extend the
Term, in which case the Term will expire five years from the date
of the written notice. On October 14, 2004, Mr. Harris signed an
Amended and Restated Employment Agreement with us (disclosed on
Form 8-K filed on October 15, 2004) (the "Amended Employment
Agreement") for the purpose of changing the termination date to be
consistent with his retirement date under the Company's Executive
Mandatory Retirement Benefit Plan. According to the Amended
Employment Agreement, Mr. Harris's employment shall not be extended
beyond December 31, 2008, unless his employment is extended
pursuant to the Executive Mandatory Retirement Benefit Plan.
During the period of employment, Mr. Harris shall serve as our
Chairman and Chief Executive Officer; be responsible for the
general management of our affairs and all our subsidiaries,
reporting directly to our Board of Directors; serve as a member of
the Board for the period of which he is and shall from time to time
be elected or reelected; and serve, if elected, as our President
and as an officer and director of any subsidiary or affiliate of
us.
Mr. Harris is to receive compensation under his Employment
Agreement in the form of base salary of $208,315 for 2000 ($229,778
for 2004), 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 our 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, we will
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 his spouse
with long-term care insurance; and with disability insurance in the
amount of 100% of his base salary. These benefits are for the term
of the Employment Agreement.
The Employment Agreement provides for us to adopt a
supplemental executive retirement plan (the "SERP") for the benefit
of Mr. Harris. Under the SERP, we will cause an amount equal to
one-twelfth of Mr. Harris's current annual salary to be credited
each month (a "Monthly Credit") to a special account maintained for
this purpose on our books for the benefit of Mr. Harris (the "SERP
18
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%
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 of
his employment, 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. We will establish a
rabbi trust for the purpose of accumulating funds to satisfy the
obligations incurred by us under the SERP. The restricted funds
for the SERP Plan total $1,393,093 at September 30, 2004. Mr.
Harris's rights to benefits pursuant to this SERP will be no
greater than those of a general creditor of us.
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 us, effective August 15, 1990. The severance
compensation agreement provides that if, following a change in our
control, as defined in the agreement, such individual's employment
is terminated by us 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 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, we adopted an employee benefits program
covering substantially all of our employees under a 401(k) Plan and
Trust Agreement. As of January 1, 1999, we adopted the Harris &
Harris Pension Plan and Trust, a money purchase plan which would
allow us to stay compliant with the 401(k) top-heavy regulations
and deduction limitation regulations. In 2001, Congress enacted the
Economic Growth and Tax Relief Reconciliation Act of 2001 which has
increased the deduction limits for plans such as the 401(k) Plan.
This Act eliminates the need for us to maintain two separate plans.
Effective December 31, 2001, the Pension Plan merged into the
401(k) Plan, with the 401(k) Plan being the surviving plan. For
the year ended December 31, 2003, the Compensation Committee
approved a 100% match. Contributions to the plan are at the
discretion of the Compensation Committee.
On June 30, 1994, we adopted a plan to provide medical and
dental insurance for retirees, their spouses and dependents who, at
the time of their retirement, have ten years of service with us and
have attained 50 years of age or have attained 45 years of age and
have 15 years of service with us. On February 10, 1997, we 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. The annual premium cost to us
with respect to the entitled retiree shall not exceed $12,000,
subject to an index for inflation. Based upon actuarial estimates,
we provided an original reserve of $176,520 that was charged to
operations for the period ending June 30, 1994. As of September
30, 2004, we had a reserve of $602,801 for the plan. Recent
changes to the Medicare program may affect our costs under this
plan. In accordance with FASB Staff Position 106-1, our estimates
of the obligation under this standard do not reflect these changes.
Specific authoritative guidance regarding these changes is pending
and when issued, could require us to change previously reported
information.
We are making the following disclosures about our plan to
provide medical and dental insurance for retirees.
19
Reconciliation of Accumulated
Postretirement Benefit Obligations
----------------------------------
Projected accumulated postretirement
benefit obligation at January 1, 2004 $525,288
Service cost 47,964
Interest cost 23,544
--------
Projected accumulated postretirement
Benefit obligation at September 30, 2004 $596,796
========
On March 20, 2003, in order to begin planning for eventual
management succession, the Board of Directors voted to establish a
mandatory retirement plan for individuals who are employed by us in
a bona fide executive or high policy-making position. There are
currently two such individuals, the Chairman and CEO, and the
President and COO. Under this plan, mandatory retirement will take
place effective December 31 of the year in which the eligible
individuals attain the age of 65. On an annual basis beginning in
the year in which the designated individual attains the age of 65,
a committee of the Board consisting of non-interested directors may
determine to postpone the mandatory retirement date for that
individual for one additional year for our benefit.
Under applicable law prohibiting discrimination in employment
on the basis of age, we can impose a mandatory retirement age of 65
for our executives or employees in high policy-making positions
only if each employee subject to the mandatory retirement age is
entitled to an immediate retirement benefit at retirement age of at
least $44,000 per year. The benefits payable at retirement to
Charles E. Harris, our Chairman and Chief Executive Officer, and
Mel P. Melsheimer, our President, Chief Operating Officer and Chief
Financial Officer, under our existing retirement plans do not equal
this threshold. A new plan was established to provide them with
the difference between the benefit required under the age
discrimination laws and that provided under our existing plans.
For Mr. Harris, the expense to us of providing the benefit under
this new plan, which prior to October 14, 2004, had been waived by
Mr. Harris, is currently estimated to be $76,597 and is being
amortized over the fiscal periods through the year ended December
31, 2008. For Mr. Melsheimer, the expense to us of providing the
benefit under this new plan is currently estimated to be $247,516
and is being amortized over the fiscal periods through the year
ended December 31, 2004. This benefit will be unfunded.
NOTE 6. INCOME TAXES
Provided that a proper election is made, a corporation taxable
under Subchapter C of the Internal Revenue Code (a "C 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 (the "Inclusion Period") from sales of
assets that were held by the corporation on the effective date of
the RIC election ("C Corporation Assets"), to the extent of any
gain built into the assets on such date ("Built-In Gain"). (If the
corporation fails to make a proper election, it is taxable on its
Built-In Gain as of the effective date of its RIC election.) We
had Built-In Gains at the time of our qualification as a RIC and
made the election to be taxed on any Built-In Gain realized during
the Inclusion Period. Prior to 1999, we incurred ordinary and
capital losses from operations. After our election of RIC status,
those losses remained available to be carried forward to subsequent
taxable years. We have previously used loss carryforwards to
offset Built-In Gains. As of January 1, 2004, we had $501,640 of
pre-1999 loss carryforwards remaining and $4,663,457 of unrealized
Built-In Gains remaining.
Continued qualification as a RIC requires us to satisfy
certain investment asset diversification requirements in future
years. Our ability to satisfy those requirements may not be
controllable by us. There can be no assurance that we will qualify
as a RIC in subsequent years.
20
We pay federal, state and local taxes on behalf of our wholly
owned subsidiary, Harris & Harris Enterprises, Inc., which is taxed
as a C Corporation.
For the three and nine months ended September 30, 2004, and
2003, our income tax provision was allocated among various types of
realized and unrealized gain or loss as follows:
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
Sept. 30, 2004 Sept. 30, 2003 Sept. 30, 2004 Sept. 30,2003
Net operating loss......$ 0 $ 0 $ 0 $ 0
Net realized gain
(loss) on investments... 1,482 (3,500) 6,426 13,822
Net increase in
unrealized
appreciation on
investments............. 0 0 0 0
-------------- -------------- ------------- -------------
Total income tax
(benefit)
provision...............$ 1,482 $ (3,500) $ 6,426 $ 13,822
============= ============== ============= =============
The above tax (benefit) provision consists of the following:
Current ................$ 1,482 $ (3,500) $ 6,426 $ 13,822
Deferred -- Federal..... 0 0 0 0
------------- -------------- ------------- -------------
Total income tax
provision...............$ 1,482 $ (3,500) $ 6,426 $ 13,822
============= ============== ============= =============
The Company's net deferred tax liability at September 30, 2004,
and December 31, 2003, consists of the following:
Sept. 30, 2004 December 31, 2003
Tax on unrealized appreciation
on investments..........................$ 1,491,153 $ 844,918
Net operating loss and
capital carryforward.................... (175,574) (175,574)
-------------- -----------------
Net deferred income tax liability.......$ 1,315,579 $ 669,344
============== =================
NOTE 7. COMMITMENTS
During 1993, we signed a 10-year lease for office space, which
lease expired on July 31, 2003. On April 17, 2003, we signed a
seven-year sublease for office space at 111 West 57th Street in New
York City to replace the expired lease. Total rent expense was
$200,711 for 2003. Future minimum sublease payments in each of the
following years are: 2004 -- $134,816; 2005 -- $138,187; 2006 --
$141,641; 2007 -- $145,182; 2008 -- $148,811; and thereafter, for
the remaining term -- $203,571.
NOTE 8. ASSET ACCOUNT LINE OF CREDIT
On November 19, 2001, we established an asset account line of
credit. The asset account line of credit is secured by government
and government agency securities. Currently, under the asset
account line of credit, we may borrow up to $8,000,000. The asset
account line of credit may be increased to up to 95% of the
current value of the government and government agency securities
with which we secure the line. Our outstanding balance under the
asset account line of credit at September 30, 2004, and September
30, 2003, was $0 and $7,609,500, respectively. The asset account
line of credit bears interest at a rate of the Broker Call Rate
plus 50 basis points.
21
NOTE 9. SUBSEQUENT EVENTS
On October 5, 2004, we made a $400,000 follow-on investment in
a Senior Secured Convertible Bridge Note of a privately held
portfolio company.
On October 26, 2004, we made a $171,492 follow-on investment
in a privately held portfolio company.
On October 27, 2004, we made a $348,464 follow-on investment
in a Convertible Bridge Note of a privately held portfolio company.
On November 9, 2004, we made a $74,735 follow-on investment in
a Secured Convertible Bridge Note of a privately held portfolio
company and a $783,019 initial equity investment in a privately
held company.
NOTE 10. INTERIM FINANCIAL STATEMENTS
Our interim financial statements have been prepared in
accordance with the instructions to Form 10-Q and Article 10 of
Regulations S-X. Accordingly, they do not include all information
and disclosures necessary for a presentation of our financial
position, results of operations and cash flows in conformity with
generally accepted accounting principles in the United States of
America. In the opinion of management, these financial statements
reflect all adjustments, consisting only of normal recurring
accruals, necessary for a fair presentation of our financial
position, results of operations and cash flows for such periods.
The results of operations for any interim period are not
necessarily indicative of the results for the full year. These
financial statements should be read in conjunction with the
financial statements and notes thereto contained in our Annual
Report on Form 10-K for the fiscal year ended December 31, 2003.
22
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
The information contained in this section should be read in
conjunction with our September 30, 2004, Consolidated Financial
Statements, and our year-end 2003 Consolidated Financial Statements
and the Notes thereto.
Background and Overview
We incorporated under the laws of the state of New York in
August 1981. In 1983, we completed an initial public offering and
invested $406,936 in Otisville BioTech, Inc. ("Otisville"), which
also completed an initial public offering later that year. In
1984, Charles E. Harris purchased a controlling interest in us,
thereby also becoming the control person in Otisville. We then
divested our other assets and became a financial services company,
with the investment in Otisville as the initial focus of our
business activity. We hired new management for Otisville, and
Otisville acquired new technology targeting the development of a
human blood substitute.
By 1988, we operated two insurance brokerages and a trust
company as wholly-owned subsidiaries. In 1989, Otisville changed
its name to Alliance Pharmaceutical Corporation ("Alliance"), and
by 1990, we had completed selling our $406,936 investment in
Alliance for total proceeds of $3,923,559.
In 1992, we sold our insurance brokerage and trust company
subsidiaries to their respective managements and registered as an
investment company under the 1940 Act, commencing operations as a
closed-end, non-diversified investment company. In 1995, we elected
to become a business development company subject to the provisions
of Sections 55 through 65 of the 1940 Act. Throughout our corporate
history, we have made early-stage venture capital investments in a
variety of industries. In 1994, we made our first nanotechnology
investment. Since August 2001, we have made initial investments
exclusively in tiny technology, including our last 17 initial
investments.
Since our investment in Otisville in 1983, we have made a
total of 59 venture capital investments, including four private
investments in public equities. We have sold 38 of these 58
investments, realizing total proceeds of $108,159,142 on our
invested capital of $40,094,851. Seventeen of these 38 investments
were profitable. As measured from first dollar in to last dollar
out, the average and median holding periods for these 38
investments were 3.5 years and 3.2 years, respectively. As
measured by tranches of cash invested to tranches of cash received,
the average and median holding periods for the 122 separate
investment tranches were 2.8 years and 2.4 years, respectively. At
September 30, 2004, we valued the 21 venture capital investments
remaining in our portfolio at $27,089,249, or 35.4% of our net
assets, net of unrealized depreciation of $149,069. At September
30, 2004, from first dollar in, the average and median holding
periods for our 21 current venture capital investments are 3.0
years and 2.3 years, respectively.
We have invested a substantial portion of our assets in
private, development stage or start-up companies. These private
businesses tend to be thinly capitalized, unproven, small companies
that lack management depth, have little or no history of operations
and are developing unproven technologies. At September 30, 2004,
$17,091,146, or 22.3%, of our net assets, consisted of private
venture capital investments at fair value, net of unrealized
depreciation of $5,735,799. At December 31, 2003, $15,106,576, or
37.1% of our net assets, consisted of private venture capital
investments at fair value, of which net unrealized depreciation was
$2,375,303. At December 31, 2002, $12,036,077, or 44.2%, of our
net assets consisted of private venture capital investments at fair
value, of which net unrealized appreciation was $2,718,389.
23
At September 30, 2004, $9,998,103, or 13.1%, of our net
assets, consisted of common shares of NeuroMetrix, Inc., a now
publicly-traded venture capital investment, at fair value, of which
unrealized appreciation was $5,586,730. We had no publicly-traded
venture capital investments at December 31, 2003, and 2002.
We value our investments each quarter at fair value as
determined in good faith by our Valuation Committee pursuant to
Valuation Procedures established by our Board of Directors in
accordance with the 1940 Act. (See "Footnote to Consolidated
Schedule of Investments" contained in "Consolidated Financial
Statements.")
We have broad discretion in the investment of our capital.
However, we invest primarily in illiquid equity securities of
private companies. Generally, these investments take the form of
preferred stock, are subject to restrictions on resale and have no
established trading market. Our principal objective is to achieve
long-term capital appreciation. Therefore, a significant portion
of our investment portfolio provides little or no income in the
form of dividends or interest. We do earn interest income from
fixed-income securities, including U.S government and government
agency obligations. The amount of interest income we earn varies
with the average balance of our fixed-income portfolio and the
average yield on this portfolio and is usually not material to our
results of operations.
General business and capital markets conditions in 2003 were
adverse for the venture capital industry. There were few
opportunities to take venture capital-backed companies public or
sell them to established companies. During this period, it was
difficult to finance venture capital-backed companies privately and
in general, for venture capital funds themselves to raise capital.
General business and capital markets conditions in the first
quarter of 2004 improved for the venture capital industry from
those prevailing in 2003, then began deteriorating again in certain
respects through the date of this filing.
We present the financial results of our operations utilizing
accounting principles generally accepted in the United States for
investment companies. On this basis, the principal measure of our
financial performance during any period is the net
increase/(decrease) in our net assets resulting from our operating
activities, which is the sum of the following three elements:
(1) Net Operating Income / (Loss) -- the difference between
our income from interest, dividends, and fees and our
operating expenses.
(2) Net Realized Gain / (Loss) on Investments -- the
difference between the net proceeds of dispositions of
portfolio securities and their stated cost.
(3) Net Increase / (Decrease) in Unrealized Appreciation on
Investments -- the net change in the fair value of our
investment portfolio.
Because of the structure and objectives of our business, we
generally expect to experience net operating losses and seek to
generate increases in our net assets from operations through the
long term appreciation of our venture capital investments. We have
in the past relied, and continue to rely, on proceeds from sales of
investments, rather than on investment income, to defray a
significant portion of our operating expenses. Because such sales
are unpredictable, we attempt to maintain adequate working capital
to provide for fiscal periods when there are no such sales.
24
Results of Operations
Three months ended September 30, 2004, as compared with the three
months ended September 30, 2003
We had a net increase in net assets resulting from operations
of $1,111,121, compared with a net decrease in net assets resulting
from operations of $1,270,298. We had a net increase in net assets
resulting from capital stock transactions of $36,127,675, versus a
net increase in net assets resulting from capital transactions of
$0.
Investment Income and Expenses:
We had net operating losses of $978,773 and $572,346,
respectively. In the three months ended September 30, 2004, our
larger net operating loss reflected a net increase to expenses
primarily for an increase in provision for profit-sharing expense
and for professional fees, offset by an increase in income from
fixed-income securities.
Investment income increased by $222,969, or 728.4%, primarily
as a result of additional funds received following the sale of
3,450,000 shares of common stock on July 7, 2004, that were
invested in U.S. government and agency obligations.
Operating expenses were $1,232,354 and $602,958, respectively.
The profit-sharing provision increased by $336,820 or 100%. The
profit-sharing provision changes as a result of realized gains and
losses and increases and decreases in unrealized appreciation. The
increase in the profit-sharing provision is primarily a result of
the of the increase in the value of our investment in NeuroMetrix,
which completed its IPO on July 27, 2004. Professional fees
increased by $171,867, or 290%, and directors' fees and expenses
increased by $31,938, or 102.2%, primarily as a result of the
expenses associated with implementation of the Sarbanes-Oxley Act
of 2002 and Rule 38a-1 under the 1940 Act. Salaries and benefits
increased by $59,268, or 16.5%, primarily as a result of four
additional employees, offset partially by a decrease in mandatory
retirement plan pension expense, that is being amortized through
December 31, 2004, pursuant to revised actuarial calculations.
Realized Gains and Losses on Portfolio Securities:
We realized gains of $2,704 and losses of $1,003,919,
respectively. During the three months ended September 30, 2003, we
realized net losses of $1,003,919, consisting primarily of a loss
of $1,000,001 on the realized loss resulting from the bankruptcy of
Kriton Medical, Inc. from which we did not receive any direct
distribution.
Unrealized Appreciation and Depreciation of Portfolio Securities:
Net unrealized depreciation on investments decreased by
$2,731,943 or 840.8%, from $3,056,850 at September 30, 2003, to
$324,907 at September 30, 2004.
During the three months ended September 30, 2004, we recorded
a net decrease of $2,678,872 in unrealized depreciation of our
venture capital investments. This net decrease in unrealized
depreciation was primarily owing to an increase in the valuation of
our investment in NeuroMetrix, Inc., of $3,172,686, partially
offset by a decrease in the valuation of our investment in Experion
Systems, Inc., of $468,814.
25
Nine Months ended September 30, 2004, as compared with the nine
months ended September 30, 2003
We had net decreases in net assets resulting from operations
of $305,401 and $3,030,134, respectively.
Investment Income and Expenses:
We had net operating losses of $2,503,222 and $1,883,795,
respectively.
Operating expenses were $2,892,570 and $2,029,647,
respectively. Operating expenses changed primarily for the
following reasons:
o Operating expenses for the nine months ended September
30, 2004, included an expense for employee profit-sharing
of $336,820, as compared with no such expense for the
nine months ended September 30, 2003.
o Salaries and benefits increased by $300,551, or 27.7%,
primarily as a result of the addition of four employees,
partially offset by a decrease in mandatory retirement
plan pension expense, that is being amortized through
December 31, 2004, pursuant to revised actuarial
calculations.
0 Administration and operations increased by $151,486, or
46.7%, primarily as the result of additional expenses to
support four new employees.
0 Professional fees increased by $112,512, or 40.7%,
primarily owing to expenses associated with
implementation of the Sarbanes-Oxley Act of 2002 and Rule
38a-1 under the 1940 Act.
Realized Gains and Losses on Portfolio Securities:
During the nine months ended September 30, 2004, we realized
net gains of $798,673. During the nine months ended September 30,
2003, we realized net losses of $975,347.
During the nine months ended September 30, 2004, our realized
net gains of $798,673 consisted primarily of a realized gain of
$1,681,259, resulting from the sale of our investment in NanoGram
Devices Corporation, offset by a realized loss of $915,108
resulting from the sale of our shares of Series D Convertible
Preferred Stock in NeoPhotonics Corporation.
26
During the nine months ended September 30, 2003, we realized a
loss of $1,000,001 resulting from the bankruptcy of Kriton Medical,
Inc., from which bankruptcy we received no direct distribution.
Unrealized Appreciation and Depreciation of Portfolio Securities:
Net unrealized depreciation on investments decreased by
$2,051,809 during the nine months ended September 30, 2004, from
$2,376,716 at December 31, 2003, to $324,907 at September 30, 2004.
During the nine months ended September 30, 2004, we recorded a
net decrease of $2,226,234 in unrealized depreciation of our
venture capital investments. The net decrease in unrealized
depreciation during the nine months ended September 30, 2004, was
primarily owing to an increase in the valuation of our investment
in NeuroMetrix, Inc. of $3,172,686 and the realization of the loss
of $915,108 on the sale of our shares of Series D Convertible
Preferred stock in NeoPhotonics Corporation, as well as decreases
in the valuations of our investments in Experion Systems, Inc., of
$468,814, Nanotechnologies, Inc., of $638,840 and Optiva, Inc., of
$625,000.
Financial Condition
Nine Months ended September 30, 2004
Our total assets and net assets were $80,757,636 and
$76,505,012, respectively, at September 30, 2004, compared with
$44,115,128 and $40,682,738, respectively, at December 31, 2003.
Net asset value per share ("NAV") was $4.44 at September 30,
2004, versus $2.95 at December 31, 2003. Our shares outstanding
increased to 17,248,845 versus 13,798,845 at December 31, 2003.
During the nine months ended September 30, 2004, significant
financial developments included the receipt of net proceeds of
$36,501,000, less costs of $373,325, for a total of $36,127,675,
pursuant to the issuance of 3,450,000 new shares of our common
stock. In addition, the value of our venture capital investments
increased by $11,982,673 to $27,089,249, primarily owing to five
new venture capital investments and eight follow-on investments
totaling $11,450,144, the sale of NanoGram Devices and the net
increase in the valuation of our venture capital investments.
The net increase in the valuation of our venture capital
investments was primarily owing to an increase in the valuation of
our investment in NeuroMetrix, Inc. of $3,172,678, partially offset
by decreases in the valuation of our investments in Experion
Systems, Inc., Nanotechnologies, Inc., and Optiva, Inc. of
$468,814, $638,840 and $625,000, respectively.
On July 27, 2004, NeuroMetrix, Inc., closed its IPO. Our
preferred stock was converted into 1,137,570 shares of common stock
that are subject to a 180-day lock-up period expiring on January
18, 2005. The valuation of our investment in NeuroMetrix, Inc. at
September 30, 2004, reflects a 12.1% discount to the market price.
Upon the completion of the lock-up period, we expect to value
NeuroMetrix at its full, undiscounted, market price.
The increase in the value of our investment in U.S. government
and agency obligations, from $27,120,486 at December 31, 2003, to
$51,524,705 at September 30, 2004, resulted primarily from the
receipt of net proceeds of $36,127,675 pursuant to the issuance of
3,450,000 new shares of our common stock, partially offset by five
27
new venture capital investments and eight follow-on investments
totaling $11,450,144, as well as operating expenses..
The following table is a summary of additions to our portfolio
of venture capital investments during the nine months ended
September 30, 2004:
New Investment Amount
------------------------- -----------
Crystal IS, Inc. $ 199,983
CSwitch, Inc. $ 1,000,000
Molecular Imprints, Inc. $ 2,000,000
NeoPhotonics Corporation $ 1,937,092
Starfire Systems, Inc. $ 250,000
Follow-on Investment
------------------------------------
Agile Materials & Technologies, Inc. $ 301,272
Continuum Photonics, Inc. $ 839,000
Experion Systems, Inc. $ 121,262
NanoGram Corporation $ 1,000,000
NanoOpto Corporation $ 1,500,000
Nanopharma Corp. $ 150,000
NeuroMetrix, Inc. $ 1,749,999
Optiva $ 401,536
-----------
Total $11,450,144
===========
The following tables summarize the fair values of our
portfolios of venture capital investments and U.S. Government and
Agency Obligations, as compared with their cost, at September 30,
2004, December 31, 2003, and December 31, 2002:
September 30, December 31,
2004 2003 2002
------------- --------------------------
Venture capital
investments,at cost $27,238,318 $17,481,879 $14,754,466
Unrealized depreciation (1) 149,069 2,375,303 2,718,389
----------- ----------- -----------
Venture capital investments,
at fair value $27,089,249 $15,106,576 $12,036,077
=========== =========== ===========
September 30, December 31,
2004 2003 2002
------------- --------------------------
U.S. Government and Agency
Obligations, at cost $51,700,543 $27,121,899 $15,452,469
Unrealized depreciation (1) 175,838 1,413 1,724
------------ ----------- -----------
U.S. Government and Agency
Obligations, at fair value $51,524,705 $27,120,486 $15,450,745
=========== =========== ===========
(1) At September 30, 2004, December 31, 2003, and December 31,
2002, the accumulated unrealized depreciation on investments,
including deferred taxes, was $1,816,061, $3,221,635 and
$3,565,032, respectively.
28
The following table summarizes the fair value composition of
our venture capital investment portfolio at September 30, 2004,
December 31, 2003, and December 31, 2002:
September 30, December 31,
Category 2004 2003 2002
---------- ------------- --------------------------
Tiny Technology 61.3% 60.7% 49.0%
Other Venture Capital
Investments 38.7% 39.3% 51.0%
------ ----- -----
Total Venture Capital
Investments 100.0% 100.0% 100.0%
====== ====== ======
Liquidity and Capital Resources
Our primary sources of liquidity are cash, receivables and
freely marketable securities, net of short-term indebtedness. Our
secondary sources of liquidity are restricted securities of
companies that are publicly traded. At September 30, 2004, we have
contractually restricted common shares of NeuroMetrix, Inc. that
are publicly traded. We had no restricted securities of companies
that were publicly traded during 2003.
Nine Months ended September 30, 2004
At September 30, 2004, and December 31, 2003, our total net
primary liquidity was $53,009,203 and $27,563,886, respectively,
and our secondary liquidity was $9,998,103 and $0, respectively.
The increase in our primary source of liquidity from December
31, 2003, to September 30, 2004, is primarily owing to the receipt
of the net proceeds from the issuance of 3,450,000 new shares of
our common stock and the net proceeds from the sale of our
investment in NanoGram Devices Corporation, partially offset by our
investments in Agile Materials & Technologies, Inc., Continuum
Photonics, Inc., Crystal IS, Inc., CSwitch, Inc., Experion Systems,
Inc., Molecular Imprints, Inc., NanoGram Corporation, NanoOpto
Corporation, Nanopharma Corp., NeoPhotonics Corporation,
NeuroMetrix, Inc., Optiva, Inc., and Starfire Systems, Inc., and
the use of funds for net operating expenses. The increase in our
secondary source of liquidity from December 31, 2003, to September
30, 2004, is owing to the completion of the public offering of
NeuroMetrix.
Critical Accounting Policies
Critical accounting policies are those that are both important
to the presentation of our financial condition and results of
operations and require management's most difficult, complex or
subjective judgments. Our critical accounting policies are those
applicable to the valuation of investments.
Valuation of Portfolio Investments
As a business development company, we invest primarily in
illiquid securities, including debt and equity securities of
private companies. The investments are generally subject to
restrictions on resale and generally have no established trading
market. We value substantially all of our equity investments at
fair value as determined in good faith by our Valuation Committee.
The Valuation Committee, comprised of at least three or more
independent Board members, reviews and approves the valuation of
our investments pursuant to Valuation Procedures 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
our assets, external measures of value, such as public markets or
29
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.
Recent Developments
On October 5, 2004, we made a $400,000 follow-on investment in
a Senior Secured Convertible Bridge Note of a privately held
portfolio company.
On October 26, 2004, we made a $171,492 follow-on investment
in a privately held portfolio company.
On October 27, 2004, we made a $348,464 follow-on investment
in a Convertible Bridge Note of a privately held portfolio company.
On November 9, 2004, we made a $74,735 follow-on investment in
a Secured Convertible Bridge Note of a privately held portfolio
company and a $783,019 initial equity investment in a privately
held company.
RISK FACTORS
Investing in our common stock involves a number of significant
risks relating to our business and investment objective. You should
carefully consider the risks and uncertainties described below
before you purchase any of our common stock. These risks and
uncertainties are not the only ones we face. Unknown additional
risks and uncertainties, or ones that we currently consider
immaterial, may also impair our business. If any of these risks or
uncertainties materialize, our business, financial condition or
results of operations could be materially adversely affected. In
this event, the trading price of our common stock could decline,
and you could lose all or part of your investment.
Risks related to the companies in our portfolio.
- ------------------------------------------------
Investing in small, private companies involves a high degree of
risk and is highly speculative.
We have invested a substantial portion of our assets in
privately held development stage or start-up companies. These
businesses tend to lack management depth, to have limited or no
history of operations and to have not attained profitability. Tiny
technology companies are especially risky, involving scientific,
technological and commercialization risks. Because of the
speculative nature of these investments, these securities have a
significantly greater risk of loss than traditional investment
securities. Some of our venture capital investments are likely to
be complete losses or unprofitable, and some will never realize
their potential. We have been and will continue to be risk seeking
rather than risk averse in our approach to venture capital and
other investments. Neither our investments nor an investment in our
common stock is intended to constitute a balanced investment
program.
We may invest in companies working with technologies or
intellectual property that currently have few or no proven
commercial applications.
Nanotechnology, in particular, is a developing area of
technology, of which much of the future commercial value is
unknown, difficult to estimate and subject to widely varying
interpretations. There are as of yet relatively few nanotechnology
products commercially available. The timing of additional future
commercially available nanotechnology products is highly uncertain.
30
Our portfolio companies working with tiny technology may be
particularly susceptible to intellectual property litigation.
Research and commercialization efforts in tiny technology are
being undertaken by a wide variety of government, academic and
private corporate entities. As additional commercially viable
applications of tiny technology begin to emerge, ownership of
intellectual property on which these products are based may be
contested. Any litigation over the ownership of, or rights to, any
of our portfolio companies' technologies or products would have a
material adverse affect on those companies' values and may have a
material adverse effect on the value of our common stock.
Our portfolio companies may not successfully market their products.
Even if our portfolio companies are able to develop
commercially viable products, the market for new products and
services is highly competitive, rapidly changing and especially
sensitive to adverse general economic conditions. Commercial
success is difficult to predict, and the marketing efforts of our
portfolio companies may not be successful.
Unfavorable economic conditions could result in the inability of
our portfolio companies to access additional capital, leading to
financial losses in our portfolio.
Most of the companies in which we have made or will make
investments are susceptible to economic slowdowns or recessions. An
economic slowdown or adverse capital or credit market conditions
may affect the ability of a company in our portfolio to raise
additional capital from venture capital or other sources or to
engage in a liquidity event such as an initial public offering or
merger. These conditions may lead to financial losses in our
portfolio, which could have a material adverse effect on the value
of our common stock.
The value of our portfolio and the value of our common stock
could be adversely affected if the technologies utilized by our
portfolio companies are found to cause health or environmental
risks.
Our portfolio companies work with new technologies, which
could have potential environmental and health impacts. Tiny
technology in general and nanotechnology in particular are
currently the subject of health and environmental impact research.
If health or environmental concerns about tiny technology or
nanotechnology were to arise, our portfolio companies may incur
additional research, legal and regulatory expenses, might have
difficulty raising capital or could be forced out of business.
Such adverse health and environmental effects would have an
adverse effect on the value of our portfolio and on the value of
our common stock.
Risks related to the illiquidity of our investments.
- ----------------------------------------------------
We invest in illiquid securities and may not be able to dispose of
them when it is advantageous to do so, or ever.
Most of our investments are or will be equity or equity-linked
securities acquired directly from small companies. These equity
securities are generally subject to restrictions on resale or
otherwise have no established trading market. The illiquidity of
most of our portfolio of equity securities may adversely affect our
ability to dispose of these securities at times when it may be
advantageous for us to liquidate these investments. We may never be
able to dispose of these securities.
Unfavorable economic conditions could impair our ability to engage
in liquidity events.
Our business of making private equity investments and
positioning our portfolio companies for liquidity events may be
adversely affected by current and future capital markets and
31
economic conditions. The public equity markets currently provide
less opportunity for liquidity events than at times in the past
when there was more robust demand for initial public offerings,
even for more mature technology companies than those in which we
typically invest. The potential for public market liquidity could
further decrease and could lead to an inability to realize
potential gains or could lead to financial losses in our portfolio
and a decrease in our revenues, net income and assets. Recent
government reforms affecting stock markets, investment banks and
securities research practices may make it more difficult for
privately held companies to complete successful initial public
offerings of their equity securities. Slowdowns in initial public
offerings may also have an adverse effect on the frequency and
valuations of acquisitions of privately held companies. The lack
of opportunities to sell investments in privately held companies
also has an adverse effect on the ability of these companies to
raise capital from private sources.
Even if our portfolio companies complete initial public offerings,
the returns on our investments may be uncertain.
When companies in which we have invested as private entities
complete initial public offerings of their securities, these newly
issued securities are by definition unseasoned issues. Unseasoned
issues tend to be highly volatile and have uncertain liquidity,
which may negatively affect their price. In addition, we are
typically subject to lock-up provisions which prohibit us from
selling our investment into the public market for specified periods
of time after initial public offerings. The market price of
securities that we hold may decline substantially before we are
able to sell these securities. Most initial public offerings of
technology companies are listed on the Nasdaq National Market.
Recent government reforms of the Nasdaq National Market have made
market making by broker-dealers less profitable, which has caused
broker-dealers to reduce their market-making activities, thereby
making the market for unseasoned stocks less liquid.
Risks related to our company.
- -----------------------------
Because there is generally no established market in which to value
our investments, our Valuation Committee's value determinations may
differ materially from the values that a ready market or third
party would attribute to these investments.
There is generally no public market for the equity securities
in which we invest. Pursuant to the requirements of the 1940 Act,
we value substantially all of the equity securities in our
portfolio at fair value as determined in good faith by the
Valuation Committee of our Board of Directors pursuant to Valuation
Procedures established by the Board of Directors. As a result,
determining fair value requires that judgment be applied to the
specific facts and circumstances of each portfolio investment
pursuant to specified valuation principles and processes. We are
required by the 1940 Act to value specifically each individual
investment on a quarterly basis and record unrealized depreciation
for an investment that we believe has become impaired. Conversely,
we must record unrealized appreciation if we believe that the
underlying portfolio company has appreciated in value. Without a
readily ascertainable market value and because of the inherent
uncertainty of valuation, the fair value that we assign to our
investments may differ from the values that would have been used
had a ready market existed for the investments, and the difference
could be material. Any changes in fair value are recorded in our
consolidated statements of operations as a change in the "Net
(decrease) increase in unrealized appreciation on investments."
Because we are a non-diversified company with a relatively
concentrated portfolio, the value of our business is subject to
greater volatility than the value of companies with more broadly
diversified investments.
As a result of being able to invest all of our assets in the
securities of a small number of issuers, we are classified as a
non-diversified company. We may be more vulnerable to events
affecting a single issuer or industry and therefore subject to
greater volatility than a company whose investments are more
32
broadly diversified. Accordingly, an investment in our common stock
may present greater risk to you than an investment in a diversified
company.
We may be obligated to pay substantial amounts under our profit
sharing plan.
Our employee profit-sharing plan requires us to distribute to
our officers and employees 20% of any net after-tax realized income
as reflected on our consolidated statements of operations for that
year, less any non-qualifying gain. These distributions may have a
significant effect on the amount of distributions made to our
shareholders, if any.
Approximately 37% of the net asset value attributable to our
venture capital investment portfolio, or 13% of our net asset
value, as of September 30, 2004, is concentrated in one company,
NeuroMetrix, Inc., which is not a tiny technology company.
At September 30, 2004, we valued our investment in
NeuroMetrix, Inc., which is not a tiny technology company, at
$9,998,103, which represents 36.91% of the net asset value
attributable to our venture capital investment portfolio, or 13.07%
of our net asset value. Any downturn in the business outlook of
NeuroMetrix, Inc., or any failure of the products of NeuroMetrix,
Inc., to receive widespread acceptance in the marketplace, would
have a significant effect on our specific investment in
NeuroMetrix, Inc., and the overall value of our portfolio.
Approximately 39% of the net asset value attributable to our
venture capital investment portfolio, or 14% of our net asset
value, as of September 30, 2004, is not invested in tiny
technology.
Although all 17 of our investments added since August 2001
have been in tiny technology companies and although we consider 16
of the companies in our venture capital investment portfolio to be
tiny technology companies, at September 30, 2004, only 61.29% of
the net asset value attributable to our venture capital investment
portfolio, or 21.70% of our net asset value, was invested in tiny
technology companies, which may limit our ability to achieve our
investment objective.
We are dependent upon key management personnel for future success.
We are dependent for the selection, structuring, closing and
monitoring of our investments on the diligence and skill of our
senior management and other key advisers. We utilize lawyers and
outside consultants, including two of our directors, Dr. Kelly S.
Kirkpatrick and Lori D. Pressman, to assist us in conducting due
diligence when evaluating potential investments. There is generally
no publicly available information about the companies in which we
invest, and we rely significantly on the diligence of our employees
and advisers to obtain information in connection with our
investment decisions. Our future success to a significant extent
depends on the continued service and coordination of our senior
management team, and particularly depends on our Chairman and Chief
Executive Officer, Charles E. Harris. The departure of any of our
executive officers, key employees or advisers could materially
adversely affect our ability to implement our business strategy. We
do not maintain for our benefit any key man life insurance on any
of our officers or employees. Our President, Chief Operating
Officer and Chief Financial Officer, Mel P. Melsheimer, is
scheduled to retire on December 31, 2004, pursuant to the Mandatory
Retirement Plan. We could be adversely affected by his retirement.
We will need to hire additional employees as the size of our
portfolio increases.
We anticipate that it will be necessary for us to add
investment professionals with expertise in venture capital and/or
tiny technology to accommodate the increasing size of our
33
portfolio. We may need to provide additional scientific, business,
accounting, legal or investment training for our new hires. There is
competition for highly qualified personnel, and we may not be
successful in our efforts to recruit and retain highly qualified
personnel.
The market for venture capital investments, including tiny
technology investments, is highly competitive.
We face substantial competition in our investing activities
from many competitors, including but not limited to: private
venture capital funds; investment affiliates of large industrial,
technology, service and financial companies; small business
investment companies; wealthy individuals; and foreign investors.
Our most significant competitors typically have significantly
greater financial resources than we do. Many sources of funding
compete for a small number of attractive investment opportunities.
Hence, we face substantial competition in sourcing good investment
opportunities on terms of investment that are commercially
attractive.
In addition to the difficulty of finding attractive investment
opportunities, our status as a regulated business development
company may hinder our ability to participate in investment
opportunities or to protect the value of existing investments.
We are required to disclose on a quarterly basis the names and
business descriptions of our portfolio companies and the value of
any portfolio securities. Most of our competitors are not subject
to these disclosure requirements. Our obligation to disclose this
information could hinder our ability to invest in some portfolio
companies. Additionally, other current and future regulations may
make us less attractive as a potential investor than a competitor
not subject to the same regulations.
Our failure to make follow-on investments in our portfolio
companies could impair the value of our portfolio.
Following an initial investment in a portfolio company, we may
make additional investments in that portfolio company as "follow-
on" investments, in order to: (1) increase or maintain in whole or
in part our ownership percentage; (2) exercise warrants, options or
convertible securities that were acquired in the original or
subsequent financing; or (3) attempt to preserve or enhance the
value of our investment. Recently, "pay to play" provisions have
become common in venture capital transactions. These provisions
require proportionate investment in subsequent rounds of financing
in order to preserve preferred rights such as anti-dilution
protection or to prevent preferred shares from being converted to
common shares.
We may elect not to make follow-on investments or otherwise
lack sufficient funds to make those investments. We have the
discretion to make any follow-on investments, subject to the
availability of capital resources. The failure to make follow-on
investments may, in some circumstances, jeopardize the continued
viability of a portfolio company and our initial investment, or may
result in a missed opportunity for us to increase our participation
in a successful operation, or may cause us to lose some or all
preferred rights pursuant to "pay to play" provisions. Even if we
have sufficient capital to make a desired follow-on investment, we
may elect not to make a follow-on investment because we may not
want to increase our concentration of risk, because we prefer other
opportunities or because we are inhibited by compliance with
business development company requirements or the desire to maintain
our tax status.
34
Bank borrowing or the issuance of debt securities or preferred
stock by us to fund investments in portfolio companies or to fund
our operating expenses would make our total return to common
shareholders more volatile.
Use of debt or preferred stock as a source of capital entails
two primary risks. The first risk is that the use of debt leverages
our available common equity capital, magnifying the impact on net
asset value of changes in the value of our investment portfolio.
For example, a business development company that uses 33% leverage
(that is, $50 of leverage per $100 of common equity) will show a
1.5% increase or decline in net asset value for each 1% increase or
decline in the value of its total assets. The second risk is that
the cost of debt or preferred stock financing may exceed the return
on the assets the proceeds are used to acquire, thereby diminishing
rather than enhancing the return to common shareholders. To the
extent that we utilize debt or preferred stock financing for any
purpose, these two risks would likely make our total return to
common shareholders more volatile. In addition, we might be
required to sell investments, in order to meet dividend, interest
or principal payments, when it may be disadvantageous for us to do
so.
As provided in the 1940 Act and subject to some exceptions, we
can issue debt or preferred stock so long as our total assets
immediately after the issuance, less some ordinary course
liabilities, exceed 200% of the sum of the debt and any preferred
stock outstanding. The debt or preferred stock may be convertible
in accordance with SEC guidelines, which may permit us to obtain
leverage at more attractive rates. The requirement under the 1940
Act to pay, in full, dividends on preferred shares or interest on
debt before any dividends may be paid on our common stock means
that dividends on our common stock from earnings may be reduced or
eliminated. An inability to pay dividends on our common stock could
conceivably result in our ceasing to qualify as a regulated
investment company, or RIC, under the tax Code, which would in most
circumstances be materially adverse to the holders of our common
shares.
We are authorized to issue preferred stock, which would convey
special rights and privileges to its owners.
We are currently authorized to issue up to 2,000,000 shares of
preferred stock, under terms and conditions determined by our Board
of Directors. These shares would have a preference over our common
stock with respect to dividends and liquidation. The statutory
class voting rights of any preferred shares we would issue could
make it more difficult for us to take some actions that may, in the
future, be proposed by the Board and/or holders of common stock,
such as a merger, exchange of securities, liquidation or alteration
of the rights of a class of our securities if these actions were
perceived by the holders of the preferred shares as not in their
best interests. The issuance of preferred shares convertible into
shares of common stock might also reduce the net income and net
asset value per share of our common stock upon conversion. These
effects, among others, could have an adverse effect on your
investment in our common stock.
Loss of status as a RIC would reduce our net asset value and
distributable income.
We currently qualify as a RIC for 2003 under the tax Code. As
a RIC, we do not have to pay federal income taxes on our income
(including realized gains) that is distributed to our shareholders.
Accordingly, we are not permitted under accounting rules to
establish reserves for taxes on our unrealized capital gains. If
we failed to qualify for RIC status, to the extend that we had
unrealized gains, we would have to establish reserves for taxes,
which would reduce our net asset value, net of a reduction in the
reserve for employee profit sharing, accordingly. To the extent
that we, as a RIC, were to decide to make a deemed distribution of
net realized capital gains and retain the net realized capital
gains, we would have to establish appropriate reserves for taxes
upon making that decision.
35
We operate in a regulated environment.
We are subject to substantive SEC regulations as a business
development company. Securities and tax laws and regulations
governing our activities may change in ways adverse to our and our
shareholders' interests, and interpretations of these laws and
regulations may change with unpredictable consequences. Any change
in the laws or regulations that govern our business could have an
adverse impact on us or on our operations. Also, as business and
financial practices continue to evolve, they may render the
regulations under which we operate less appropriate and more
burdensome than they were when originally imposed.
Quarterly results fluctuate and are not indicative of future
quarterly performance.
Our quarterly operating results fluctuate as a result of a
number of factors. These factors include, among others, variations
in and the timing of the recognition of realized and unrealized
gains or losses, the degree to which we and our portfolio companies
encounter competition in our markets and general economic and
capital markets 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.
To the extent that we do not realize income or retain after-tax
realized capital gains, we may have a greater need for additional
capital to fund our investments and operating expenses.
As a RIC, we must annually distribute at least 90% of our
investment company taxable income as a dividend and may either
distribute or retain our realized net capital gains from
investments. As a result, these earnings may not be available to
fund investments. If we fail to generate net realized capital
gains or to obtain funds from outside sources, it would have a
material adverse effect on our financial condition and results of
operations as well as our ability to make follow-on and new
investments. Because of the structure and objectives of our
business, we generally expect to experience net operating losses
and rely on proceeds from sales of investments, rather than on
investment income, to defray a significant portion of our operating
expenses. These sales are unpredictable and may not occur. In
addition, as a business development company, we are generally
required to maintain a ratio of at least 200% of total assets to
total borrowings, which may restrict our ability to borrow to fund
such requirements.
Investment in foreign securities could result in additional
risks.
The Company may invest in foreign securities, although we
currently have no investments in foreign securities. If we invest
in securities of foreign issuers, we may be subject to risks not
usually associated with owning securities of U.S. issuers. These
risks can include fluctuations in foreign currencies, foreign
currency exchange controls, social, political and economic
instability, differences in securities regulation and trading,
expropriation or nationalization of assets, and foreign taxation
issues. In addition, changes in government administrations or
economic or monetary policies in the United States or abroad could
result in appreciation or depreciation of our securities and could
favorably or unfavorably affect our operations. It may also be more
difficult to obtain and enforce a judgment against a foreign
issuer. Any foreign investments made by us must be made in
compliance with U.S. and foreign currency restrictions and tax laws
restricting the amounts and types of foreign investments.
We will incur increased expenses as a result of recently enacted
laws and regulations affecting public companies.
Recently enacted laws and regulations affecting public
companies, including the provisions of the Sarbanes-Oxley Act of
2002 and rules adopted by the Securities and Exchange Commission,
including Rule 38a-1, and by the National association of Securities
Dealers, Inc., will result in increased expenses to us. The new
rules could make it more difficult or more costly for us to obtain
36
some types of insurance, including directors' and officers'
liability insurance, and we may be forced to accept reduced policy
limits and coverage or incur substantially higher costs to obtain
the same or similar coverage. The impact of these events also
could make it more difficult for us to attract and retain qualified
persons to serve on our board of directors, on our board committees
or as executive officers. We will incur increased expenses in
order to comply with these new rules, and we may not be able to
accurately predict the timing or amount of these expenses. As of
December 31, 2004, the auditors of many public companies, including
ours, will be providing opinions on the effectiveness of internal
control over financial reporting and on management's assessment of
the effectiveness of internal control over financial reporting.
There can be no assurance that we will receive an unqualified
opinion. In the event that we do not receive an unqualified
opinion, it could have a material, adverse effect on the cost and
availability of directors' and officers' liability insurance and on
our stock price.
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 our control. Although we believe 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 us or any other
person that our plans will be achieved.
37
Item 3. Quantitative and Qualitative Disclosures About Market
Risk
Our business activities contain elements of risk. We
consider the principal types of market risk to be valuation risk
and the risk associated with fluctuations in interest rates. We
consider the management of risk to be essential to our business.
Value, as defined in Section 2(a)(41) of the 1940 Act, is (i)
the market price for those securities for which a market quotation
is readily available and (ii) for all other assets is 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" contained in
"Item 1. Consolidated Financial Statements.")
Neither our investments nor an investment in us is intended
to constitute a balanced investment program. We are exposed to
public-market price fluctuations as a result of our publicly traded
portfolio, which may be composed primarily or entirely of highly
risky, volatile securities. Currently, 37% of the value of our
portfolio of investments consists of publicly traded securities.
In addition to our publicly traded portfolio, we have
invested a substantial portion of our assets in private development
stage or start-up companies. These private businesses tend to be
based on new technology and 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 a public market for these
investments, there is significantly greater risk of loss than is
the case with traditional investment securities. We expect that
some of our 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. Even when our
private equity investments complete initial public offerings
(IPOs), we are normally subject to lock-up agreements for a period
of time.
Because there is typically no public market for the equity
interests of many of the small privately held companies in which we
invest, the valuation of the equity interests in that portion of
our portfolio is determined in good faith by our Board of Directors
in accordance with our Asset Valuation Policy Guidelines. In the
absence of a readily ascertainable market value, the determined
value of our 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 our consolidated statements of operations as "Net
increase (decrease) in unrealized appreciation on investments."
We also invest in short-term money market instruments, and
both short and long-term U.S. Government and Agency Obligations.
To the extent that we invest in short and long-term U.S. Government
and Agency Obligations, changes in interest rates may result in
changes in the value of these Obligations which would result in an
increase or decrease of our net asset value. The level of interest
rate risk exposure at any given point in time depends on the market
environment and expectations of future price and market movements,
and will vary from period to period. If the average interest rate
on our portfolio of U. S. Government and Agency Obligations at
September 30, 2004, were to increase by 25, 75 and 150 basis
points, the value of the securities, and our net asset value, would
decrease by approximately $129,530, $388,590 and $777,180,
respectively.
In addition, we may from time to time borrow amounts on a
line of credit that we maintain. We currently have no borrowings
outstanding under our line of credit. To the extent we opt to
borrow money to make investments in the future, our net investment
income will be dependent upon the difference between the rate at
which we borrow funds and the rate at which we invest such funds.
As a result, there can be no assurance that a significant change in
market interest rates will not have a material adverse effect on
our net investment income in the event we choose to borrow funds
for investing purposes.
38
Item 4. Controls and Procedures
As of the end of the period covered by this report, our Chief
Executive Officer and our Chief Financial Officer conducted an
evaluation of our disclosure controls and procedures (as defined in
Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934).
Based upon this evaluation, our Chief Executive Officer and our
Chief Financial Officer during such period concluded that our
disclosure controls and procedures are effective in timely alerting
them of any material information relating to us that is required to
be disclosed by us in the reports it files or submits under the
Securities Exchange Act of 1934.
There have not been any significant changes in our internal
controls or in other factors that could significantly affect these
controls subsequent to the date of their evaluation, including any
corrective actions with regard to significant deficiencies and
material weaknesses.
39
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Not Applicable
Item 2. Changes in Securities and Use of Proceeds
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. Other Information
Not Applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3.1(a) Restated Certificate of Incorporation,
incorporated by reference as Exhibit 2.a to Pre-
Effective Amendment No. 1 to the Registration
Statement on Form N-2 dated March 22, 2004.
3.1(b) Restated By-Laws, incorporated by reference as
Exhibit 2.b to Pre-Effective Amendment No. 1 to
the Registration Statement on Form N-2 dated March
22, 2004.
10.2(a) Amendment No. 2 to Deferred Compensation
Agreement, incorporated by reference to Form 8-K
filed on October 15, 2004.
10.2(b) Amended and Restated Employment Agreement between
Harris & Harris Group, Inc. and Charles E. Harris
dated October 14, 2004, incorporated by reference
to Form 8-K filed on October 15, 2004.
31.1* Certification of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2* Certification of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1* Certification of CEO pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2* Certification of CFO pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
*filed herewith
40
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of
1934, the Registrant has caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized on behalf of
the Registrant as Vice President and as its chief accounting
officer.
Harris & Harris Group, Inc.
/s/ Helene B. Shavin
--------------------------------------
By: Helene B. Shavin, Vice President
and Controller
Date: November 12, 2004
41
EXHIBIT INDEX TO FORM 10-Q
31.1 Certification of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of CEO pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of CFO pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
42