SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
_X_ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1996
or
___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from_________to_________
Commission File Number 0-11576
Harris & Harris Group, Inc.
(Exact name of registrant as specified in its charter)
New York 13-3119827
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
One Rockefeller Plaza
Suite 1430
New York, New York 10020
(Address of principal executive offices)
(212) 332-3600
(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 the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. The number of shares of
common stock, par value $.01 per share, outstanding on April 30, 1996 was
10,383,902.
Harris & Harris Group, Inc.
Form 10-Q, March 31, 1996
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION Page Number
Item 1. Financial Statements
Statement of Assets and Liabilities. . . . . . . . . . . . . . . . 2
Statement of Operations. . . . . . . . . . . . . . . . . . . . . . 3
Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . . 4
Statement of Changes in Net Assets . . . . . . . . . . . . . . . . 5
Schedule of Investments. . . . . . . . . . . . . . . . . . . . . . 6 - 13
Notes to Financial Statements. . . . . . . . . . . . . . . . . . . 14 - 18
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Financial Condition. . . . . . . . . . . . . . . . . . . . . . . . 19
Results of Operations. . . . . . . . . . . . . . . . . . . . . . . 20
Liquidity and Capital Resources. . . . . . . . . . . . . . . . . . 21
Risks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . 23
Item 2. Changes in Securities. . . . . . . . . . . . . . . . . . . 23
Item 3. Defaults Upon Senior Securities. . . . . . . . . . . . . . 23
Item 4. Submission of Matters to a Vote of Security Holders. . . . 23
Item 5. Other Information. . . . . . . . . . . . . . . . . . . . . 23
Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . 23
Exhibit Index. . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Signature. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Harris & Harris Group, Inc.
Form 10-Q, March 31, 1996
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
The information furnished in the accompanying financial statements
reflects all adjustments that are, in the opinion of management, necessary for
a fair presentation of the results for the interim period presented.
On June 30, 1994, the Company's shareholders approved a proposal to
allow the Company to make an election to become a Business Development Company
("BDC") under the Investment Company Act of 1940, as amended. The Company
made such election on July 26, 1995. Certain information and disclosures
normally included in the 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
financial statements should be read in conjunction with the audited financial
statements and notes thereto for the year ended December 31, 1995 contained in
the Company's 1995 Annual Report.
1
STATEMENT OF ASSETS AND LIABILITIES
ASSETS
March 31, 1996 December 31, 1995
(Unaudited) (Audited)
Investments, at value (See accompanying
schedule of investments and notes). . . . $ 33,925,572 $ 35,929,289
Cash. . . . . . . . . . . . . . .. . . . . . 478,410 364,354
Receivable from brokers. . . . . . . . . . . 3,011,374 205,789
Interest receivable. . . . . . . . . . . . . 308,730 300,718
Taxes receivable . . . . . . . . . . . . . . 574,710 367,929
Prepaid expenses . . . . . . . . . . . . . . 71,127 86,976
Other assets . . . . . . . . . . . . . . . . 311,597 269,500
------------ ------------
Total assets . . . . . . . . . . . . . . . . $ 38,681,520 $ 37,524,555
============ ============
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities. . $ 372,800 $ 352,129
Deferred rent . . . . . . . . . . . . . . . 57,573 59,887
Deferred income tax liability (Note 5). . . 981,757 550,630
------------ ------------
Total liabilities . . . . . . . . . . . . . 1,412,130 962,646
------------ ------------
Commitments and contingencies (Note 6)
Net assets. . . . . . . . . . . . . . . . . $ 37,269,390 $ 36,561,909
============ ============
Net assets are comprised of:
Preferred stock, $0.10 par value,
2,000,000 shares authorized;
none issued. . . . . . . . . . . . . . . $ 0 $ 0
Common stock, $0.01 par value,
25,000,000 shares authorized;
10,383,902 issued and outstanding
at 3/31/96 and 10,333,902 issued and
outstanding at 12/31/95. . . . . . . . . 103,839 103,339
Additional paid in capital. . . . . . . . . 15,851,166 15,691,978
Accumulated net realized income . . . . . . 19,114,966 19,362,249
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $1,126,367 at 3/31/96
and $698,250 at 12/31/95 . . . . . . . . 2,199,419 1,404,343
------------ ------------
Net assets. . . . . . . . . . . . . . . . . $ 37,269,390 $ 36,561,909
============ ============
Shares outstanding. . . . . . . . . . . . . 10,383,902 10,333,902
------------ ------------
Net asset value per outstanding share . . . $ 3.59 $ 3.54
============ ============
The accompanying notes are an integral part of these financial statements.
2
STATEMENT OF OPERATIONS
(UNAUDITED)
Three Months Ended
March 31, 1996
Investment income:
Interest from:
Fixed-income securities . . . . . . . . . . . . . $ 227,338
Affiliated companies . . . . . . . . . . . . . . . 10,000
Dividend income--Unaffiliated companies. . . . . . . 4,090
Other income . . . . . . . . . . . . . . . . . . . . 24,896
------------
Total income . . . . . . . . . . . . . . . . . . . 266,324
Expenses:
Salaries and benefits. . . . . . . . . . . . . . . . 396,631
Administration and operations. . . . . . . . . . . . 122,212
Professional fees. . . . . . . . . . . . . . . . . . 126,905
Depreciation and amortization. . . . . . . . . . . . 10,000
Rent . . . . . . . . . . . . . . . . . . . . . . . . 38,346
Directors' fees and expenses . . . . . . . . . . . . 12,400
Custodian fees . . . . . . . . . . . . . . . . . . . 3,116
------------
Total expenses . . . . . . . . . . . . . . . . . . 709,610
------------
Operating loss before income taxes . . . . . . . . . (443,286)
Income tax benefit (Note 5). . . . . . . . . . . . . 154,130
------------
Net operating loss . . . . . . . . . . . . . . . . . . (289,156)
Net realized gain on investments:
Realized gain on sale of investments . . . . . . . . 64,420
------------
Total realized gain. . . . . . . . . . . . . . . . 64,420
Income tax provision (Note 5). . . . . . . . . . . . (22,547)
------------
Net realized gain on investments . . . . . . . . . . 41,873
------------
Net realized loss. . . . . . . . . . . . . . . . . . . (247,283)
Net increase (decrease) in unrealized appreciation on investments:
Decrease on investments held . . . . . . . . . . . . (96,999)
Increase on investments held . . . . . . . . . . . . 1,320,193
------------
Total unrealized appreciation on investments . . . 1,223,194
Income tax provision (Note 5). . . . . . . . . . . . (428,118)
------------
Net increase in unrealized appreciation
on investments . . . . . . . . . . . . . . . . . . 795,076
------------
Net increase in net assets from operations:
Total. . . . . . . . . . . . . . . . . . . . . . . . $ 547,793
============
Per outstanding share. . . . . . . . . . . . . . . . $ 0.05
============
The accompanying notes are an integral part of these financial statements.
3
STATEMENT OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31, 1996
Cash flows from operating activities:
Net increase in net assets
resulting from operations. . . . . . . . . . . . . $ 547,793
Adjustments to reconcile increase (decrease) in
net assets from operations to net cash provided
used in operating activities:
Net realized and unrealized gain on investments. . (1,287,614)
Deferred income taxes. . . . . . . . . . . . . . . 431,127
Depreciation . . . . . . . . . . . . . . . . . . . 10,000
Other. . . . . . . . . . . . . . . . . . . . . . . (2,314)
Changes in assets and liabilities:
Receivable from brokers. . . . . . . . . . . . . . (2,805,585)
Prepaid expenses . . . . . . . . . . . . . . . . . 15,849
Interest receivable. . . . . . . . . . . . . . . . (8,012)
Taxes receivable . . . . . . . . . . . . . . . . . (134,593)
Other assets . . . . . . . . . . . . . . . . . . . (27,400)
Accounts payable and accrued liabilities . . . . . 20,671
Purchase of fixed assets . . . . . . . . . . . . . (24,697)
------------
Net cash used in operating activities. . . . . . . . (3,264,775)
Cash flows from investing activities:
Net sale of short-term investments . . . . . . . . . 10,306,640
Purchase of investments. . . . . . . . . . . . . . . (13,478,458)
Proceeds from sale of investments. . . . . . . . . . 6,463,149
------------
Net cash provided by investing activities. . . . . . 3,291,331
Cash flows from financing activities:
Proceeds from exercise of stock options. . . . . . . 87,500
------------
Net cash provided by financing activities. . . . . . 87,500
Cash at beginning of period. . . . . . . . . . . . . . 364,354
Cash at end of period. . . . . . . . . . . . . . . . . 478,410
------------
Net increase in cash . . . . . . . . . . . . . . . . . $ 114,056
============
Supplemental disclosures of cash flow information:
Income taxes paid. . . . . . . . . . . . . . . . . . $ 0
The accompanying notes are an integral part of these financial statements.
4
STATEMENT OF CHANGES IN NET ASSETS
(UNAUDITED)
Three Months Ended
March 31, 1996
Changes in net assets from operations:
Net operating loss. . . . . . . . . . . . . . . . . . $ (289,156)
Net realized gain on investments. . . . . . . . . . . 41,873
Net increase in unrealized
appreciation on investments held. . . . . . . . . . 795,076
------------
Net increase in net assets
resulting from operations. . . . . . . . . . . . . 547,793
Capital stock transactions:
Proceeds from exercise of
stock options . . . . . . . . . . . . . . . . . . . 87,500
Tax benefit of exercise of
stock options . . . . . . . . . . . . . . . . . . . 72,188
------------
Net increase from capital
stock transactions. . . . . . . . . . . . . . . . . 159,688
------------
Net increase
in net assets . . . . . . . . . . . . . . . . . . . . 707,481
Net assets:
Beginning of period . . . . . . . . . . . . . . . . . 36,561,909
------------
End of period . . . . . . . . . . . . . . . . . . . . $ 37,269,390
============
The accompanying notes are an integral part of these financial statements.
5
SCHEDULE OF INVESTMENTS MARCH 31, 1996
(UNAUDITED)
Method of
Valuation (3) Shares Value
Investments in Unaffiliated Companies (9) -- 15.9% of total investments
Publicly-Traded Portfolio (Common Stock unless noted otherwise)
Oil and Gas Related -- 1.1%
CORDEX Petroleums Inc. (1)(5)
Argentinian oil and gas exploration
Class A Common Stock . . . . . . . . . . . (C) 4,052,080 $ 367,490
Biotechnology and Healthcare Related -- 6.9%
Alliance Pharmaceutical Corporation (1)(5) (C) 70,000 1,216,250
Magellan Health Services, Inc.(1)(2)(5)(6) (C) 54,368 1,121,340
Mining Companies -- 0.6%
Cambior, Inc (1)(4). . . . . . . . . . . . (C) 14,500 195,750
------------
Total Publicly-Traded Portfolio (cost: $1,338,154). . . . . . . $ 2,900,830
Private Placement Portfolio (Illiquid) -- 7.3%
CORDEX Petroleums Inc. (1)(2)(5)
Argentinian oil and gas exploration
Special Warrants . . . . . . . . . . . . . (C) 1,667,000 $ 0
Exponential Business Development Company
(1)(2)(5) Venture capital partnership
focused on early stage companies
Limited partnership interest . . . . . . . (A) - - 25,000
Princeton Video Image, Inc. (1)(2)(7)(8)
Real time sports and entertainment
advertising
3.6% of fully-diluted equity . . . . . . . (B) 24,600 861,000
Warrants: 43,800 at $12.50 expiring 5/96;
6,700 at $2.25 expiring 8/97 . . . . . . . (D) 50,500 1,204,925
PureSpeech, Inc. (1)(2)(4)(7)
Software development company specializing
in innovative speech recognition technology
3.7% of fully-diluted equity
Series A Convertible Preferred Stock . . . (A) 76,190 399,998
------------
Total Private Placement Portfolio (cost: $520,498). . . . . . . $ 2,490,923
------------
Total Investments in Unaffiliated Companies (cost: $1,858,652) $ 5,391,753
------------
The accompanying notes are an integral part of this schedule.
6
SCHEDULE OF INVESTMENTS MARCH 31, 1996
(UNAUDITED)
Method of Shares/
Valuation (3) Principal Value
Private Placement in Non-Controlled Affiliates (Illiquid) -- 24.5%
Dynecology Incorporated (1)(2)(5)(7) -- Develops
various environmental intellectual properties --
Option expiring 12/13/98 to purchase at $15 per
share 135,000 shares of Common Stock equaling
18.1% of fully-diluted equity. . . . . . . . . (D) - - $ 55,000
Gel Sciences, Inc. (1)(2)(5)(7) -- Develops
engineered response gels for controlled
release systems -- 9.5% of fully-diluted equity
Warrants -- 72,728 at $.55 expiring 01/01/00 . (A) - -
Common Stock . . . . . . . . . . . . . . . . . (A) 41,250
Series A Preferred Stock . . . . . . . . . . . (A) 22,275
Series B Preferred Stock . . . . . . . . . . . (A) 1,181,819 676,812
Harber Brothers Productions, Inc. (1)(2)(5)(7)
-- Finances, produces and markets media
products that combine entertainment, music,
learning and interactivity -- 21.5% of
fully-diluted equity
Series A Voting Convertible Preferred Stock. . (A) 967,500 967,500
Highline Capital Management, LLC. (2)(5)(7)
-- Organizes and manages investment partnership
24.9% of fully-diluted equity. . . . . . . . . (A) - - 500,000
Intaglio, Ltd. (1)(2)(5) -- Manufactures and
markets proprietary decorative tiles and signs
-- 20.4% of fully-diluted equity
Common Stock . . . . . . . . . . . . . . . . . (B) 565,792 2,263,168
Warrants at $4.00 expiring 11/28/01 . . . . . (A) 166,667 167
Micracor, Inc. (1)(2)(7) -- Designs and
manufactures advanced solid state photonic
systems -- 8.6% of fully-diluted equity
Series F Preferred Stock -- 444,444 shares and
1,199,999 Warrants at $2.25 expiring 7/20/99 . (A) - - 1,000,000
10% Convertible Note . . . . . . . . . . . . . (D) $ 100,000 104,860
Nanophase Technologies Corporation (1)(2)(5)(7)
-- Manufactures and markets inorganic crystals
of nanometric dimensions
10.1% of fully-diluted equity
Series D Convertible Preferred Stock . . . . . (A) 1,162,204 1,162,204
PHZ Capital Partners Limited Partnership (1)(2)(7)
Organizes and manages investment partnership . (B) - - 1,000,000
20.0% of fully-diluted equity
One year 8% note due 9/22/96 . . . . . . . . . (A) $ 500,000 500,000
Sonex International Corporation (1)(2)
-- Manufactures and markets an ultrasonic
toothbrush for home use
17.6% of fully-diluted equity
Series A Non-voting Convertible Preferred Stock(D) 588,935 73,485
Common Stock . . . . . . . . . . . . . . . . . (D) 34,000 4,242
------------
Total Private Placement Portfolio
in Non-Controlled Affiliates (cost: $10,410,521) $ 8,307,438
------------
The accompanying notes are an integral part of this schedule.
7
SCHEDULE OF INVESTMENTS MARCH 31, 1996
(UNAUDITED)
Method of
Valuation (3) Shares Value
Private Placement Portfolio in Controlled Affiliates (Illiquid) -- 16.0%
Genomica Corporation (1)(2)(4)(7)(10) -- Develops
software that enables the study of complex
genetic diseases -- 29.2% of fully-diluted equity
Series A Convertible Preferred Stock . . . .(A) 1,660,200 $ 1,000,304
Common Stock . . . . . . . . . . . . . . . .(A) 199,800
nFX Corporation (1)(2)(7) --
Develops neural-network software
37.8% of fully-diluted equity
Series A Voting Convertible Preferred Stock .(B) 1,294,288 2,888,980
Series B Voting Convertible Preferred Stock .(B) 689,920 1,539,979
------------
Total Private Placement Portfolio
in Controlled Affiliates (cost: $3,537,024) . . . . . . . . . $ 5,429,263
------------
U.S. Government Obligations -- 43.6%
U.S. Treasury Note dated 03/01/93 due date
02/28/98 -- 5.8% yield. . . . .. . . . . . . (C) $ 4,942,200
U.S. Treasury Bill dated 02/15/96 due date
08/15/96 -- 5.1% yield . . . . . . . . . . . (A) 5,126,847
U.S. Treasury Bill dated 05/14/95 due date
05/02/96 -- 5.2% yield . . . . . . . . . . . (A) 4,728,071
------------
Total Investments in U.S. Government Obligations
(cost: $14,793,589) . . . . . . . . . . . . . . . . . . . . . $ 14,797,118
------------
Total Investments -- 100% (cost: $30,599,786) . . . . . . . . . $ 33,925,572
============
The accompanying notes are an integral part of this schedule.
8
SCHEDULE OF INVESTMENTS MARCH 31, 1996
(UNAUDITED)
Notes to Schedule of Investments
1. Represents a non-income producing security. Equity investments that have
not paid dividends within the last twelve 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 Methods
of Valuation A to L.
4. These investments were made during 1996.
5. No activity occurred in these investments during the three months ended
March 31, 1996.
6. Formerly named National Mentor Holding Corp., Magellan Health Services,
Inc. was later acquired by Charter Medical Corporation, which
subsequently changed its name to Magellan Health Services, Inc.
7. These investments are in development stage companies. A development
stage company is defined as a company that is devoting substantially all
of its efforts to establishing a new business, and either has not yet
commenced its planned principal operations or has commenced such
operations but has not realized significant revenue from them.
8. Formerly Princeton Electronic Billboard, Inc.
9. Investments in unaffiliated companies consist of investments where the
Company owns less than 5% of the investee company. Investments in
non-controlled affiliated companies consist of investments where the
Company owns more than 5% but less than 25% of the investee company.
Investments in controlled affiliated companies consist of investments
where the Company owns more than 25% of the investee company.
10. Genomica Corporation was founded by Harris & Harris Group, Inc., Cold
Spring Harbor Laboratory and Falcon Technology Partners, LP. Mr. G. Morgan
Browne serves on the Board of Harris & Harris Group, Inc., and is
Administrative Director of Cold Spring Harbor Laboratory.
11. The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $3,425,424. The gross unrealized appreciation
based on tax cost for these securities is $3,556,010. The gross
unrealized depreciation on the cost of these securities is $130,586.
12. The percentage ownership of each investee disclosed in the Schedule of
Investments expresses the potential common equity interest in each such
investee. The calculated percentage represents the amount of issuer's
common stock the Company owns or can acquire as a percentage of the
issuer's total outstanding common stock plus common shares reserved for
issued and outstanding warrants, convertible securities and stock
options.
The accompanying notes are an integral part of this schedule.
9
FOOTNOTE TO SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
The Company's investments can be classified into five broad categories for
valuation purposes:
1) EQUITY-RELATED SECURITIES
2) INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND
DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
3) LONG-TERM FIXED-INCOME SECURITIES
4) SHORT-TERM FIXED-INCOME INVESTMENTS
5) ALL OTHER INVESTMENTS
The Investment Company Act of 1940, as amended (the "1940 Act"), requires
periodic valuation of each investment in the Company's portfolio to determine
net asset value. Under the 1940 Act, unrestricted securities with readily
available market quotations are to be valued at the current market value; all
other assets must be valued at "fair value" as determined in good faith by or
under the direction of the Board of Directors.
The Company's Board of Directors is responsible for 1) determining overall
valuation guidelines and 2) ensuring the valuation of investments within the
prescribed guidelines.
The Company's Investment and Valuation Committee, comprised of at least
three or more Board members, is responsible for reviewing and approving the
valuation of the Company's assets within the guidelines established by the
Board of Directors.
Fair value is generally defined as the amount that an investment could be
sold for in an orderly disposition over a reasonable time. Generally, to
increase objectivity in valuing the assets of the Company, external measures
of value, such as public markets or third-party transactions are utilized
whenever possible. Valuation is not based on long-term work-out value, nor
immediate liquidation value, nor incremental value for potential changes that
may take place in the future.
Valuation assumes that, in the ordinary course of its business, the Company
will eventually sell its investment.
The Company's valuation policy with respect to the five broad investment
categories is as follows:
10
EQUITY-RELATED SECURITIES
Equity-related securities are carried at fair value using one or more of
the following basic methods of valuation:
A. Cost: The cost method is based on the original cost to the Company.
This method is generally used in the early stages of a company's development
until significant positive or negative events occur subsequent to the date of
the original investment that dictate a change to another valuation method.
Some examples of such events are: l) a major recapitalization; 2) a major
refinancing; 3) a significant third-party transaction; 4) the development of a
meaningful public market for the company's common stock; 5) material positive
or negative changes in the company's business.
B. Private Market: The private market method uses actual third-party
transactions in the company's securities as a basis for valuation, using
actual, executed, historical transactions in the company's securities by
responsible third parties. The private market method may also use, where
applicable, unconditional firm offers by responsible third parties as a basis
for valuation.
C. Public Market: The public market method is used when there is an
established public market for the class of the company's securities held by
the Company. The Company discounts market value for securities that are
subject to significant legal, contractual or practical restrictions. Other
securities, for which market quotations are readily available, are carried at
market value as of the time of valuation.
Market value for securities traded on securities exchanges or on the NASDAQ
National Market System is the last reported sales price on the day of
valuation; other securities traded in the over-the-counter market and listed
securities for which no sale was reported on that day is the mean of the
closing bid price and asked price on that day.
This method is the preferred method of valuation when there is an
established public market for a company's securities, as that market provides
the most objective basis for valuation.
D. Analytical Method: The analytical method is generally used to value an
investment position when there is no established public or private market in
the company's securities or when the factual information available to the
Company dictates that an investment should no longer be valued under either
the cost or private market method. This valuation method is inherently
imprecise and ultimately the result of reconciling the judgments of the
Company's Investment and Valuation Committee members, based on the data
available to them. The resulting valuation, although stated as a precise
number, is necessarily within a range of values that vary depending upon the
significance attributed to the various factors being considered. Some of the
factors considered may include the financial condition and operating results
of the company, the long-term potential of the business of the company, the
values of similar securities issued by companies in similar businesses, the
proportion of the company's securities owned by the Company and the nature of
any rights to require the company to register restricted securities under
applicable securities laws.
11
INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND DEVELOPMENT IN
TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the following basic
methods of valuation:
E. Cost: The cost method is based on the original cost to the Company.
Such method is generally used in the early stages of commercializing or
developing intellectual property or patents or research and development in
technology or product development until significant positive or adverse events
occur subsequent to the date of the original investment that dictate a change
to another valuation method.
F. Private Market: The private market method uses actual third-party
investments in intellectual property or patents or research and development in
technology or product development as a basis for valuation, using actual
executed historical transactions by responsible third parties. The private
market method may also use, where applicable, unconditional firm offers by
responsible third parties as a basis for valuation.
G. Analytical Method: The analytical method is used to value an investment
after analysis of the best available outside information where the factual
information available to the Company dictates that an investment should no
longer be valued under either the cost or private market method. This
valuation method is inherently imprecise and ultimately the result of
reconciling the judgments of the Company's Investment and Valuation Committee
members. The resulting valuation, although stated as a precise number, is
necessarily within a range of values that vary depending upon the significance
attributed to the various factors being considered. Some of the factors
considered may include the results of research and development, product
development progress, commercial prospects, term of patent and projected
markets.
LONG-TERM FIXED-INCOME SECURITIES
H. Fixed-Income Securities for which market quotations are readily
available are carried at market value as of the time of valuation using most
recent bid quotations when available.
Securities for which market quotations are not readily available are
carried at fair value using one or more of the following basic methods of
valuation:
12
I. Fixed-Income Securities are valued by independent pricing services that
provide market quotations based primarily on quotations from dealers and
brokers, market transactions, and other sources.
J. Other Fixed-Income Securities that are not readily marketable are valued
at fair value by the Investment and Valuation Committee.
SHORT-TERM FIXED-INCOME INVESTMENTS
K. Short-Term Fixed-Income Investments are valued at market value at the
time of valuation. Short-term debt with remaining maturity of 60 days or less
is valued at amortized cost.
ALL OTHER INVESTMENTS
L. All Other Investments are reported at fair value as determined in good
faith by the Investment and Valuation Committee.
The reported values of securities for which market quotations are not
readily available and for other assets reflect the Investment and Valuation
Committee's judgment of fair values as of the valuation date using the
outlined basic methods of valuation. They do not necessarily represent an
amount of money that would be realized if the securities had to be sold in an
immediate liquidation. The Company makes many of its portfolio investments
with the view of holding them for a number of years, and the reported value of
such investments may be considered in terms of disposition over a period of
time. Thus valuations as of any particular date are not necessarily indicative
of amounts that may ultimately be realized as a result of future sales or
other dispositions of investments held.
13
NOTES TO FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1. THE COMPANY
Harris & Harris Group, Inc. (the "Company") is a venture capital
investment company operating as a business development company ("BDC") under
the Investment Company Act of 1940 ("1940 Act"). A BDC is a specialized type
of investment company under the 1940 Act. The Company operates as an
internally managed investment company whereby its officers and employees,
under the general supervision of its Board of Directors, conduct its
operations.
The Company elected to become a BDC on July 26, 1995, after receiving
the necessary approvals. From July 31, 1992 until the election of BDC status,
the Company operated as a closed-end, non-diversified, investment company
under the 1940 Act. Upon commencement of operations as an investment company,
the Company revalued all of its assets and liabilities at fair value as
defined in the 1940 Act. Prior to such time, the Company was registered and
filed under the reporting requirements of the Securities Exchange Act of 1934
as an operating company and, while an operating company, operated directly and
through subsidiaries.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies followed
in the preparation of the financial statements:
Portfolio Investment Valuations. Investments are stated at "fair value"
as defined in the 1940 Act and in the applicable regulations of the
Commission. All assets are valued at fair value as determined in good faith
by, or under the direction of, the Board of Directors. See the Asset Valuation
Policy Guidelines in the Footnote to Schedule of Investments.
Securities Transactions. Securities transactions are accounted for on
the date the securities are purchased or sold (trade date); dividend income is
recorded on the ex-dividend date; and interest income is accrued as earned.
Realized gains and losses on investment transactions are determined on the
first-in first-out basis for financial reporting and tax basis.
Income Taxes. The Company records income taxes using the liability
method in accordance with the provision of Statement of Financial Accounting
Standards No. 109. Accordingly, deferred tax liabilities have been
established to reflect temporary differences
between the recognition of income and expense for financial reporting and tax
purposes, the most significant difference of which relates to the Company's
unrealized appreciation on investments.
14
Reclassifications. Certain reclassifications have been made to the
December 31, 1995 financial statements to conform to the March 31, 1996
presentation.
Estimates by Management. The preparation of the financial statements in
conformity with Generally Accepted Accounting Principles requires management
to make estimates and assumptions that affect the reported amounts of assets
and liabilities as of March 31, 1996 and December 31, 1995, and the reported
amounts of revenues and expenses for the three months ended March 31, 1996.
Actual results could differ from these estimates.
NOTE 3. STOCK OPTION PLAN AND WARRANTS OUTSTANDING
On August 3, 1989, the shareholders of the Company approved the 1988
Long Term Incentive Compensation Plan. On June 30, 1994, the shareholders of
the Company approved various amendments to the 1988 Long Term Incentive
Compensation Plan: 1) to conform to the provisions of the Business Development
Company regulations under the 1940 Act, which allow for the issuance of stock
options to qualified participants; 2) to increase the reserved shares under
the amended plan; 3) to call the plan the 1988 Stock Option Plan, as Amended
and Restated (the "1988 Plan"); and 4) to make various other amendments. On
October 20, 1995, the shareholders of the Company approved an amendment to the
1988 Plan authorizing automatic 20,000 share grants of non-qualified stock
options to newly elected non-employee directors of the Company.
Under the 1988 Plan, the number of shares of common stock of the Company
reserved for issuance is equal to 20 percent of the outstanding shares of
common stock of the Company at the time of grant. However, so long as
warrants, options, and rights issued to persons other than the Company's
directors, officers, and employees at the time of grant remain outstanding,
the number of reserved shares under the 1988 Plan may not exceed 15 percent of
the outstanding shares of common stock of the Company at the time of grant,
subject to certain adjustments.
At March 31, 1996, there were 2,076,780 shares of common stock reserved
for the issuance of stock option awards under the Amended 1988 Plan, of which
1,403,763 were subject to outstanding options and warrants and 673,017 were
available for future awards.
The 1988 Plan provides for the issuance of incentive stock options and
non-qualified stock options to eligible employees as determined by the
Compensation Committee of the Board (the "Committee"), which is composed of
four non-employee directors. The Committee also has the authority to construe
and interpret the 1988 Plan; to establish rules for the administration of the
1988 Plan; and, subject to certain limitations, to amend the terms and
conditions of any outstanding awards. Options may be exercised for up to 10
years from the date of grant at prices not less than the fair market value of
the Company's common stock at the date of grant. The 1988 Plan provides that
payment by the optionee upon exercise of an option may be made using cash or
Company stock held by the optionee.
15
The following table summarizes changes in outstanding stock options
under the 1988 Plan:
Option Exercise
Number of Shares Price Per Share
---------------- ---------------
Outstanding at December 31, 1995 1,050,000 $ 1.1875 - $5.7500
Issued 60,000 $6.1875
Canceled 0 0
Exercised 50,000 $1.7500
--------- ------------------
Outstanding at March 31, 1996 1,060,000 $ 1.1875 - $6.1875
========= ==================
As of March 31, 1996, there were outstanding warrants to purchase
343,763 shares of common stock at a price of $2.0641 per share expiring in
1999.
NOTE 4. EMPLOYEE BENEFITS
As of August 15, 1990, the Company entered into non-competition,
employment and severance contracts with its Chairman, Charles E. Harris, and
with its Executive Vice President, C. Richard Childress, pursuant to which
they are to receive compensation in the form of salaries and other benefits.
These contracts were amended on June 30, 1992, January 3, 1993, and June 30,
1994. The term of the contracts expires on December 31, 1999.
Base salaries are to be increased annually to reflect inflation and in
addition may be increased by such amounts as the Board of Directors of the
Company (the "Board") deems appropriate.
In addition, Messrs. Harris and Childress are entitled under certain
circumstances to receive severance pay under the employment and severance
contracts.
As of January 1, 1989, the Company adopted an employee benefits
program covering substantially all employees of the Company under a 401(k)
Plan and Trust Agreement. The Company's contributions to the plan are
determined by the Compensation Committee in the fourth quarter.
On June 30, 1994, the Company adopted a plan to provide medical and
health insurance for retirees, their spouses and dependents who, at the time
of their retirement, have ten years of service with the Company and have
attained 50 years of age or have attained 45 years of age and have 15 years of
service with the Company. The coverage is secondary to any government
provided or subsequent employer provided health insurance plans. Based upon
actuarial estimates, the Company provided a reserve of $206,630 as of December
31, 1995 for estimated future benefits under the described plan.
16
NOTE 5. INCOME TAXES
The Company has not elected tax treatment available to regulated
investment companies under Subchapter M of the Internal Revenue Code.
Accordingly, for federal and state income tax purposes, the Company is taxed
at statutory corporate rates on its income, which enables the Company to
offset any future net operating losses against prior years' net income. The
Company may carry back operating losses against net income three years and
carry forward such losses fifteen years.
For the three months ended March 31, 1996, the Company's income tax
provision was allocated as follows:
Three months
ended 3/31/96
Investment operations. . . . . . . . . . . . . . . . . . . . ($ 154,130)
Realized gain on investments . . . . . . . . . . . . . . . . 22,547
Increase in unrealized appreciation on investments . . . . . 428,118
---------
Total income tax provision. . . . . . . . . . . . . . . $ 296,535
=========
The above tax provision consists of the following:
Three months
ended 3/31/96
Current -- Federal. . . . . . . . . . . . ($ 134,593)
Deferred -- Federal . . . . . . . . . . . 431,128
---------
Total income tax provision. . . . . . . . $ 296,535
=========
The effective tax rate differs from the Federal statutory rate primarily
as a result of tax deductible expenses not allowed for book.
The Company's deferred tax liability at March 31, 1996 consists of the
following:
Unrealized appreciation on investments. . . $ 1,126,367
Medical retirement benefits . . . . . . . . (72,320)
Other . . . . . . . . . . . . . . . . . . . (72,290)
-----------
Net deferred income tax liability . . . . . $ 981,757
===========
The exercise of nonqualified stock options and certain warrants give
rise to compensation which is includable in the taxable income of recipients
and deductible by the Company for federal and state income tax purposes.
Compensation resulting from increases in the fair market value of the
Company's common stock subsequent to the date of grant of the applicable
exercised stock options and warrants is not recognized, in accordance with
Accounting Principles Board Opinion No. 25, as an expense for financial
accounting purposes.
17
NOTE 6. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a ten-year lease with sublet provisions
for its office space. Rent expense under this lease for the three months
ended March 31, 1996, amounted to $38,346. Future minimum lease payments in
each of the following years are: 1997 -- $164,484; 1998 -- $168,768; 1999 --
$176,030; 2000 -- $178,560; 2001 -- $178,560; thereafter $280,506.
The Company has guaranteed a three-year lease obligation of
approximately $21,000 per annum for the office space of one of its investees,
Highline Capital Management LLC.
In December 1993, the Company and MIT announced the establishment by the
Company of the Harris & Harris Group Senior Professorship at MIT. Prior to
the arrangement for the establishment of this Professorship, the Company had
made gifts of stock in start-up companies to MIT. These gifts, together with
the contribution of $700,000 in cash in 1993, which was expensed by the
Company in 1993, were used to establish this named chair.
The Company contributed to MIT $3,280, $20,000 and $20,000 in 1993,
1994, and 1995, respectively. These amounts represent the cost basis to the
Company of the securities donated. These contributions will be applied to the
MIT Pledge at their market value at the time the shares become publicly traded
or otherwise monetized in a commercial transaction and are free from
restriction as to sale by MIT.
At March 31, 1996, the Company would have to fund additional cash and/or
property that would have to be valued at a total of $756,720 by December, 1998
in order for the Senior Professorship to become permanent.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Statement of Operations
The Company accounts for its operations under Generally Accepted
Accounting Principles for investment companies. On this basis, the principal
measure of its financial performance is captioned "Net increase (decrease) in
net assets from operations," which is the sum of three elements. The first
element is "Net operating loss," which is the difference between the Company's
income from interest, dividends, and fees and its operating expenses, net of
applicable income taxes (or credit). The second element is "Net realized gain
(loss) on investments," which is the difference between the proceeds received
from dispositions of portfolio securities and their stated cost, net of
applicable income taxes (or credit). These two elements are combined in the
Company's financial statements and reported as "Net realized income (loss)."
The third element, "Net increase (decrease) in unrealized appreciation on
investments," is the net change in the fair value of the Company's investment
portfolio, net of increase (decrease) in deferred income taxes that would
become payable if the unrealized appreciation were realized through the sale
or other disposition of the investment portfolio.
18
"Net realized gain (loss) on investments" and "Net increase (decrease) in
unrealized appreciation on investments" are directly related in that when a
security is sold to realize a gain (loss), net unrealized appreciation
decreases (increases) and net realized gain increase (decreases).
Financial Condition
The Company's total assets and net assets were, respectively,
$38,681,520 and $37,269,390 at March 31, 1996 versus $37,524,555 and
$36,561,909 at December 31, 1995. Net asset value per share was $3.59 at
March 31, 1996, versus $3.54 at December 31, 1995.
The Company's financial condition is dependent on the success of its
investments. The Company has invested and expects to continue to invest a
substantial portion of its assets in private development stage or start-up
companies. These private businesses tend to be thinly capitalized, unproven,
small companies that lack management depth or have no history of operations.
At March 31, 1996, 42 percent of the Company's $39 million in total assets
consisted of investments at fair value in private businesses, of which net
unrealized appreciation was $1.7 million. At December 31, 1995, 36 percent of
the Company's $38 million in total assets consisted of investments at fair
value in private businesses, of which net unrealized appreciation was $0.8
million.
A summary of the Company's investment portfolio is as follows:
March 31, 1996 December 31, 1995
Investments, at cost $ 30,599,786 $ 33,826,696
Unrealized appreciation 3,325,786 2,102,593
------------ ------------
Investments, at fair value $ 33,925,572 $ 35,929,289
============ ============
19
Following an initial investment in a private company, the Company may
make additional investments in such investee in order to increase its
ownership percentage, to exercise warrants or options that were acquired in a
prior financing, to preserve the Company's proportionate ownership in a
subsequent financing or in attempt to preserve or enhance the value of the
Company's investment. Such additional investments are referred to as
"follow-on" investments. There can be no assurance that the Company will make
follow-on investments or have sufficient funds to make additional investments.
The failure to make such follow-on investments could jeopardize the viability of
the investee company and the Company's investment or could result in a missed
opportunity for the Company to participate to a greater extent in an
investee's successful operations. The Company attempts to maintain adequate
liquid capital to be in a position to make follow-on investments in its
private investee portfolio companies. The Company may elect not to make a
follow-on investment either because it does not want to increase its
concentration of risk or because it prefers other opportunities, even if the
follow-on investment opportunity appears attractive.
The following table is a summary of the cash investment changes in the
Company's private placement portfolio during the three months ended March 31,
1996:
Amount
------
PureSpeech, Inc. (1) $ 399,998
Genomica, Inc. (1) 1,000,304
nFX Corporation (2) 440,000
Micracor, Inc. (2) 103,000
-----------
$ 1,943,302
===========
(1) New investee company
(2) Addition to existing investment in an investee company
Results of Operations
Investment Income and Expenses:
The Company's principal objective is to achieve capital appreciation.
Therefore, a significant portion of the investment portfolio is structured to
maximize the potential for capital appreciation and provides little or no
current yield in the form of dividends or interest. The Company does earn
interest income from fixed-income investments. The amount of interest income
varies based upon the average level of cash funds invested during the year and
fluctuations in interest rates. The Company had interest income of $227,338
for the three months ended March 31, 1996. The Company also received
consulting and administrative fees from certain portfolio companies which
totaled $24,896.
20
Operating expenses were $709,610 for the three months ended March 31,
1996. Most of the Company's operating expenses are related to employee and
director compensation, office expenses and legal and accounting fees.
Net operating losses before taxes were $443,286 for the three months
ended March 31, 1996. The Company has in the past relied, and continues to
rely to a large extent, upon proceeds from sales of investments, rather that
investment income to defray a significant portion of its operating expenses.
Because such sales cannot be predicted with certainty, the Company attempts to
maintain adequate working capital to provide for fiscal periods when there are
no such sales.
Realized Gains and Losses on Sales of Portfolios Securities:
During the three months ended March 31, 1996, the Company sold various
public securities realizing a net gain of $64,420.
Unrealized Appreciation and Depreciation of Portfolio Securities:
Net unrealized appreciation on investments increased during the three
months ended March 31, 1996, from $2,102,593 to $3,325,786, owing primarily to
increased valuations for Princeton Video Image, Inc., PHZ Capital Partners and
Alliance Pharmaceutical Corp., offset by the decreased valuation of Sonex
International Corporation and Dynecology, Inc.
Liquidity and Capital Resources
The Company reported total cash, receivables and marketable securities
(the primary measure of liquidity) at March 31, 1996 of $22,071,694, versus
$23,833,891 at December 31, 1995. Management believes that its cash,
receivables and marketable securities provide it with sufficient liquidity for
its operations.
21
Risks
Pursuant to Section 64 (b) (1) of the Investment Company Act of 1940, a
business development company is required to describe the risk factors involved
in an investment in the securities of such company due to the nature of the
company's investment portfolio. There are significant risks inherent in the
registrant's venture capital business. The Company has invested and will
continue to invest a substantial portion of its assets in private development
stage or start-up companies. These private businesses tend to be thinly
capitalized, unproven, small companies that lack management depth and have not
attained profitability or have no history of operations. Because of the
speculative nature and the lack of public market for these investments, there
is significantly greater risk of loss than is the case with traditional
investment securities. The Company expects that some of its venture capital
investments will be a complete loss or will be unprofitable and that some will
appear to be likely to become successful but never realize that potential.
The Company has and shall continue to be risk seeking rather than risk adverse
in its approach to its venture capital and other investments. Neither the
Company's investments nor an investment in the Company is intended to
constitute a balanced investment program. The Company does not currently
intend to pay cash dividends. The Company has in the past relied and
continues to rely to a large extent upon proceeds from sales of investments
rather than investment income to defray a significant portion of its operating
expenses.
22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 2. Changes in Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) See Exhibit Index for Exhibits to the Form 10Q.
(b) None
23
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
27. Financial Data Schedule
24
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.
Harris & Harris Group, Inc.
By:/s/____________________________
Rachel M. Pernia, Vice President,
Treasurer, Controller and Principal
Accounting Officer
Date: May 15, 1996
25