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 June 30, 2002
[ ] 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)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
- -----------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
(212) 332-3600
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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 the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at August 5, 2002
- -----------------------------------------------------------------------------
Common Stock, $0.01 par value per share 11,498,845 shares
Harris & Harris Group, Inc.
Form 10-Q, June 30, 2002
TABLE OF CONTENTS
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.............................. 13
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................... 21
Financial Condition..................................................... 21
Results of Operations................................................... 23
Liquidity and Capital Resources......................................... 25
Risk Factors............................................................ 26
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 31
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................... 33
Item 2. Changes in Securities and Use of Proceeds....................... 33
Item 3. Defaults Upon Senior Securities................................. 33
Item 4. Submission of Matters to a Vote of Security Holders............. 33
Item 5. Other Information............................................... 33
Item 6. Exhibits and Reports on Form 8-K................................ 34
Exhibit Index........................................................... 34
Signature.................................................................34
Harris & Harris Group, Inc.
Form 10-Q, June 30, 2002
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated financial
statements reflect all adjustments that are, in the opinion of management,
necessary for a fair statement of the results for the interim period presented.
On June 30, 1994, shareholders of Harris & Harris Group, Inc. (the
"Company") approved a proposal to allow the Company to make an election to
become a Business Development Company ("BDC") under the amended Investment
Company Act of 1940. The Company made such election on July 26, 1995.
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, 2001
contained in the Company's 2001 Annual Report.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a Regulated Investment
Company ("RIC") under Sub-Chapter M of the Internal Revenue Code (the
"Code"). At that time, the Company was taxable under Sub-Chapter C of
the Code (a "C Corporation"). In order to qualify as a RIC, the Company
must, in general (1) annually derive at least 90 percent of its gross
income from dividends, interest and gains from the sale of securities;
(2) quarterly meet certain investment diversification requirements; and
(3) annually distribute at least 90 percent of its investment company
taxable income as a dividend. In addition to the requirement that the
Company must annually distribute at least 90 percent of its investment
company taxable income, the Company may either distribute or retain its
taxable net capital gains from investments, but any net capital gains
not distributed could be subject to corporate level tax. Further, the
Company could be subject to a four percent excise tax if it fails to
distribute 98 percent of its annual taxable income and would be subject
to income tax if it fails to distribute 100 percent of its taxable income.
Because of the specialized nature of its investment portfolio, the
Company could satisfy the diversification requirements under Sub-Chapter
M of the Code only if it received a certification from the Securities and
Exchange Commission ("SEC") that it is "principally engaged in the
furnishing of capital to other corporations which are principally engaged
in the development or exploitation of inventions, technological improvements,
new processes, or products not previously generally available."
On March 7, 2002, the Company received SEC certification and qualified
for RIC treatment for 2001 (as it had for 2000 and 1999). Although the
SEC certification for 2001 was issued, there can be no assurance that the
Company will receive such certification for subsequent years (to the
extent it needs additional certification as a result of changes in its
portfolio) or that it will actually qualify for Sub-Chapter M treatment
in subsequent years. In addition, under certain circumstances, even if
the Company qualified for Sub-Chapter M treatment in a given year, the
Company might take action in a subsequent year to ensure that it would
be taxed in that subsequent year as a C Corporation, rather than as a RIC.
1
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
June 30, 2002 December 31, 2001
(Unaudited) (Audited)
Investments, at value (Cost:
$23,942,142 at 6/30/02,
$37,714,285 at 12/31/01).............$ 24,954,644 $ 38,930,705
Cash and cash equivalents.............. 874,781 135,135
Restricted funds (Note 5).............. 654,839 482,020
Interest receivable.................... 0 82
Note receivable ($6,987, net of
reserve of $6,987 at 6/30/02)........ 0 10,487
Prepaid expenses....................... 51,269 14,833
Other assets........................... 282,875 109,105
------------ ------------
Total assets...........................$ 26,818,408 $ 39,682,367
============ ============
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities..........................$ 1,332,815 $ 1,039,350
Bank loan payable (Note 7)............. 0 12,495,777
Accrued profit sharing (Note 3)........ 427,567 178,282
Deferred rent.......................... 10,023 14,650
Current income tax (receivable)
liability............................ (35,728) 255,068
Deferred income tax liability (Note 6). 1,351,606 1,364,470
------------ ------------
Total liabilities...................... 3,086,283 15,347,597
------------ ------------
Commitments and contingencies (Note 7)
Net assets.............................$ 23,732,125 $ 24,334,770
============ ============
Net assets are comprised of:
Preferred stock, $0.10 par value,
2,000,000 shares authorized;
none issued..........................$ 0 $ 0
Common stock, $0.01 par value,
25,000,000 shares authorized;
10,692,971 issued at 6/30/02 and
12/31/01............................. 106,930 106,930
Additional paid in capital (Note 4).... 27,228,748 27,228,748
Additional paid in capital - common
stock warrants....................... 109,641 109,641
Accumulated net realized gain (loss)... 219,879 618,606
Accumulated unrealized appreciation
of investments, net of deferred tax
liability of $1,540,044 at 6/30/02
and 12/31/01........................... (527,542) (323,624)
Treasury stock at cost (1,828,740
shares at 6/30/02 and 12/31/01)...... (3,405,531) (3,405,531)
------------ ------------
Net assets.............................$ 23,732,125 $ 24,334,770
============ ============
Shares outstanding..................... 8,864,231 8,864,231
============ ============
Net asset value per outstanding share..$ 2.68 $ 2.75
============ ============
The accompanying notes are an integral part of these
consolidated financial statements.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30, June 30, June 30,
2002 2001 2002 2001
Investment income:
Interest from:
Fixed-income securities.....$ 40,135 $ 117,846 $ 94,271 $ 270,376
Affiliated companies........ 0 1,765 0 11,382
Other income................. 20,233 17,350 25,559 47,162
--------- ----------- ----------- ------------
Total investment income..... 60,368 136,961 119,830 328,920
Expenses:
Profit-sharing accrual
(reversal) (Note 3)......... 121,326 712,982 249,285 (133,308)
Salaries and benefits........ 264,589 256,212 519,965 555,916
Administration and
operations.................. 137,166 123,680 225,068 216,937
Professional fees............ 100,566 32,616 143,661 91,819
Rent......................... 43,856 48,393 86,580 90,465
Directors' fees and expenses. 36,102 23,366 77,178 46,356
Depreciation................. 6,737 7,500 12,685 15,000
Bank custody fees............ 1,744 2,779 5,583 6,425
Interest expense............. 3,000 0 10,776 0
--------- ----------- ----------- ------------
Total expenses.............. 715,086 1,207,528 1,330,781 889,610
--------- ----------- ----------- ------------
Operating loss before
income taxes................ (654,718) (1,070,567) (1,210,951) (560,690)
Income tax provision
(Note 6).................... 0 0 0 0
--------- ----------- ----------- ------------
Net operating loss............ (654,718) (1,070,567) (1,210,951) (560,690)
Net realized gain (loss)
on investments:
Realized gain (loss) on
investments................ 688,681 161,909 799,360 (1,032,743)
--------- ----------- ----------- ------------
Total realized gain (loss).. 688,681 161,909 799,360 (1,032,743)
Income tax benefit
(provision) (Note 6)........ 47,087 (22,641) 12,864 (52,275)
--------- ----------- ----------- ------------
Net realized gain (loss)
on investments.............. 735,768 139,268 812,224 (1,085,018)
Net realized income (loss).... 81,050 (931,299) (398,727) (1,645,708)
Net increase (decrease) in unrealized appreciation on investments:
Increase as a result of
investment gain............. 353,221 36,881 353,221 1,564,963
Increase on investments held. 71 3,216,789 45,077 3,216,789
Decrease on investments held. (53) (497,712) (602,216) (5,108,725)
--------- ----------- ----------- -------------
Net change in unrealized
appreciation
on investments.............. 353,239 2,755,958 (203,918) (326,973)
--------- ----------- ----------- ------------
Income tax benefit (Note 6).. 0 0 0 0
Net increase (decrease) in
unrealized appreciation
on investments.............. 353,239 2,755,958 (203,918) (326,973)
Net increase (decrease) in net assets
resulting from operations:
Total........................ $434,289 $1,824,659 $ (602,645) $(1,972,681)
======== ========== =========== ===========
Per outstanding share........ $ 0.05 $ 0.20 $ (0.07) $ (0.22)
======== ========== =========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended Six Months Ended
June 30, 2002 June 30, 2001
Cash flows from operating activities:
Net decrease in net assets resulting
from operations......................... $ (602,645) $(1,972,681)
Adjustments to reconcile net decrease
in net assets resulting from operations to
net cash used in operating activities:
Net realized and unrealized gain on
investments............................. (595,442) 1,359,716
Depreciation............................. 12,685 15,000
Changes in assets and liabilities:
Restricted funds......................... (172,819) (108,759)
Interest receivable...................... 82 28,234
Note receivable.......................... 10,487 0
Prepaid expenses......................... (36,436) 41,953
Other assets............................. (173,770) (1,113)
Accounts payable and accrued liabilities. 293,465 84,695
Payable to broker for unsettled trade.... 0 (115,005)
Accrued profit sharing................... 249,285 (2,225,872)
Current income tax liability............. (290,796) (5,734,899)
Deferred income tax liability............ (12,864) 0
Deferred rent............................ (4,627) (4,627)
------------ -----------
Net cash used in operating activities.... (1,323,395) (8,633,358)
Cash flows from investing activities:
Net sale of short-term investments
and marketable securities.............. 18,472,315 7,579,689
Proceeds from investments................ 780,605 2,112,796
Investment in private placements and
loans.................................. (4,675,000) (1,178,827)
Purchase of fixed assets................. (22,602) (3,555)
------------ ----------
Net cash provided by investing activities. 14,555,318 8,510,103
Cash flows from financing activities:
Payment of bank loan payable............. (12,495,777) 0
Collection on notes receivable........... 3,500 0
------------ -----------
Net cash used in financing activities.... (12,492,277) 0
------------ -----------
Net increase (decrease) in cash and cash equivalents:
Cash and cash equivalents at beginning
of the period........................... 135,135 253,324
Cash and cash equivalents at end of the
period.................................. 874,781 130,069
------------ -----------
Net increase (decrease) in cash and cash
equivalents............................ $ 739,646 $ (123,255)
============ ===========
Supplemental disclosures of cash flow information:
Income taxes paid........................ $ 290,748 $ 5,787,174
Interest paid............................ $ 19,106 $ 0
The accompanying notes are an integral part of
these consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30, June 30, June 30,
2002 2001 2002 2001
Changes in net assets
from operations:
Net operating loss..........$ (654,718) $(1,070,567) $(1,210,951) $ (560,690)
Net realized gain (loss) on
investments................ 735,768 139,268 812,224 (1,085,018)
Net increase in unrealized
appreciation on investments
as a result of gain........ 353,221 36,881 353,221 1,564,963
Net increase (decrease) in
unrealized appreciation
on investments held........ 18 2,719,077 (557,139) (1,891,936)
----------- ----------- ----------- -----------
Net increase (decrease) in
net assets resulting from
operations................. 434,289 1,824,659 (602,645) (1,972,681)
Net increase (decrease) in
net assets................. 434,289 1,824,659 (602,645) (1,972,681)
Net assets:
Beginning of the period..... 23,297,836 28,036,135 24,334,770 31,833,475
----------- ----------- ----------- -----------
End of the period...........$23,732,125 $29,860,794 $23,732,125 $29,860,794
=========== =========== =========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
5
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (9)(10)(11) -- 18.6% of total investments
Private Placement Portfolio (Illiquid) -- 18.6% of total investments
AlphaSimplex Group, LLC (2) -- Investment
advisory firm headed by Dr. Andrew W. Lo,
holder of the Harris & Harris Group
Chair at MIT................................(D) -- $ 4,087
Continuum Photonics, Inc. (1)(2)(4)(6) --
Develops optical networking components
by merging cutting-edge materials, MEMS
and electronics technologies -- 3.76% of
fully diluted equity
Series B Convertible Preferred Stock........(A) 2,000,000 1,000,000
Exponential Business Development Company
(1)(2)(5) -- Venture capital partnership
focused on early stage companies
Limited partnership interest................(A) -- 25,000
Kriton Medical, Inc. (1)(2)(5)(6) -- Develops
ventricular assist devices -- 1.73% of
fully diluted equity
Series B Convertible Preferred Stock........(A) 476,191 1,000,001
NanoOpto Corporation (1)(2)(4)(5)(6) --
Develops high performance, integrated
optical communication sub-components on a
chip by utilizing patented nano-manufacturing
technology -- 1.45% of fully diluted equity
Series A-1 Convertible Preferred Stock......(A) 267,857 625,000
Nantero, Inc. (1)(2)(5)(6) -- Develops a
high density nonvolatile random access
memory chip using nanotechnology -- 4.17%
of fully diluted equity
Series A Convertible Preferred Stock........(A) 345,070 489,999
NeoPhotonics Corporation (1)(2)(4)(5)(6) --
Develops and manufactures planar optical
devices and components using nanomaterials
deposition technology -- 1.76% of fully
diluted equity
Series D Convertible Preferred Stock........(A) 1,498,802 1,000,000
Optiva, Inc. (1)(2)(4)(6) -- Develops and
commercializes nanomaterials for advanced
optical applications -- 1.36% of fully diluted equity
Series C Convertible Preferred Stock........(A) 454,545 500,000
----------
Total Private Placement Portfolio (cost: $4,643,161).................$4,644,087
----------
Total Investments in Unaffiliated Companies (cost: $4,643,161).......$4,644,087
The accompanying notes are an integral part
of this consolidated schedule.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Non-Controlled Affiliated Companies (9)(10)(12) -- 52.0% of
total investments
Private Placement Portfolio (Illiquid) -- 52.0% of total investments
Experion Systems, Inc. (1)(2)(5)(6)(7) --
Develops and sells software to credit
unions -- 10.11% of fully diluted equity
Series A Convertible Preferred Stock..........(D) 187,500
Series B Convertible Preferred Stock..........(D) 22,500 $ 600,000
Nanopharma Corp. (1)(2)(4)(5)(6) --
Develops advanced nanoscopic drug
delivery vehicles and systems -- 14.69%
of fully diluted equity
Series A Convertible Preferred Stock..........(A) 684,516 700,000
Nanotechnologies, Inc. (1)(2)(4)(6) -- Develops
high-performance nanoscale materials for
industry -- 6.48% of fully diluted equity
Series B Convertible Preferred Stock..........(A) 1,538,837 750,000
NeuroMetrix, Inc. (1)(2)(5)(6) -- Develops
and sells medical devices for monitoring
neuromuscular disorders -- 13.03% of fully
diluted equity
Series A Convertible Preferred Stock..........(D) 875,000
Series B Convertible Preferred Stock..........(D) 625,000
Series C-2 Convertible Preferred Stock........(D) 1,148,100
Series E Convertible Preferred Stock..........(D) 266,665 6,708,225
PHZ Capital Partners L.P. (2)(8) -- Organizes
and manages investment partnerships utilizing
its proprietary algorithms -- 20.0% of fully
diluted equity
Limited partnership interest..................(D) -- 3,492,547
Questech Corporation (1)(2)(5)(6) --
Manufactures and markets proprietary metal
decorative tiles -- 6.74% of fully diluted
equity
Common Stock..................................(B) 646,954
Warrants at $5.00 expiring 11/15/04...........(B) 1,965
Warrants at $1.50 expiring 11/16/05...........(B) 1,250 724,588
Schwoo, Inc. (1)(2)(5)(6) -- Develops software
that automatically manages e-commerce security
infrastructure -- 14.88% of fully diluted
equity
Series B Convertible Preferred Stock..........(D) 2,306,194
Convertible Bridge Loans......................(D) $360,250
Series B Convertible Preferred Warrants.......(D) 934,985 0
-----------
Total Private Placement Portfolio (cost: $11,962,545)...............$12,975,360
-----------
Total Investments in Non-Controlled Affiliated Companies
(cost: $11,962,545)...............................................$12,975,360
-----------
The accompanying notes are an integral
part of this consolidated schedule.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
U.S. Government and Agency Obligations -- 29.4% of total investments
U.S. Treasury Bills -- due date 07/11/02......(K) $2,250,000 $ 2,248,718
U.S. Treasury Bills -- due date 07/18/02......(K) $ 550,000 $ 549,494
U.S. Treasury Bills -- due date 08/15/02......(K) $ 800,000 $ 798,248
U.S. Treasury Bills -- due date 08/22/02......(K) $1,900,000 $ 1,895,212
U.S. Treasury Bills -- due date 09/12/02......(K) $1,850,000 $ 1,843,525
-----------
Total Investments in U.S. Government (cost: $7,336,436)..............$ 7,335,197
-----------
Total Investments -- 100% (cost: $23,942,142)........................$24,954,644
===========
The accompanying notes are an integral part
of this consolidated schedule.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2002
(Unaudited)
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 Methods
of Valuation A to L.
(4) Initial investment was made during 2002. The amounts shown on the
schedule as cost represent the gross additions in 2002.
(5) No changes in valuation occurred in these investments during the
three months ended June 30, 2002.
(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) Previously named MyPersonalAdvocate.com, Inc.
(8) Harris Partners I, L.P. owns a 20 percent limited partnership interest
in PHZ Capital Partners L.P. The partners of Harris Partners I, L.P.
are Harris & Harris Enterprises, Inc. (sole general partner) and
Harris & Harris Group, Inc. (sole limited partner). Harris & Harris
Enterprises, Inc. is a 100 percent owned subsidiary of Harris & Harris
Group, Inc.
(9) Investments in unaffiliated companies consist of investments in which
the Company owns less than five percent of the portfolio company.
Investments in non-controlled affiliated companies consist of
investments in which the Company owns more than five percent but
less than 25 percent of the portfolio company. Investments in
controlled affiliated companies consist of investments in which the
Company owns more than 25 percent of the portfolio company.
(10) The percentage ownership of each portfolio company disclosed in
the Consolidated Schedule of Investments expresses the potential
common equity interest in each such portfolio company. The calculated
percentage represents the amount of the 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 all authorized
stock options, both granted and ungranted.
(11) The aggregate cost for federal income tax purposes of investments
in unaffiliated companies is $4,643,161. The gross unrealized
appreciation based on the tax cost for these securities is $926.
(12) The aggregate cost for federal income tax purposes of investments
in non-controlled affiliated companies is $11,962,545. The gross
unrealized depreciation based on the tax cost for these securities
is $3,754,453. The gross unrealized appreciation based on the tax
cost for these securities is $4,767,268.
The accompanying notes are an integral part
of this consolidated schedule.
9
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
The Company's investments can be classified into five broad categories for
valuation purposes:
1) EQUITY-RELATED SECURITIES
2) INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH
AND DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
3) LONG-TERM FIXED-INCOME SECURITIES
4) SHORT-TERM FIXED-INCOME INVESTMENTS
5) ALL OTHER INVESTMENTS
The Investment Company Act of 1940 (the "1940 Act") requires
periodic valuation of each investment in the Company's portfolio to
determine net asset value. Under the 1940 Act, unrestricted securities
with readily available market quotations are to be valued at the current
market value; all other assets must be valued at "fair value" as
determined in good faith by or under the direction of the Board of
Directors.
The Company's Board of Directors is responsible for (1) determining
overall valuation guidelines and (2) ensuring the valuation of
investments within the prescribed guidelines.
The Company's Investment and Valuation Committee, comprised of at
least three or more independent Board members, is responsible for
reviewing and approving the valuation of the Company's assets within
the guidelines established by the Board of Directors.
Fair value is generally defined as the amount that an investment
could be sold for in an orderly disposition over a reasonable time.
Generally, to increase objectivity in valuing the assets of the
Company, external measures of value, such as public markets or third-
party transactions, are utilized whenever possible. Valuation is not
based on long-term work-out value, nor immediate liquidation
value, nor incremental value for potential changes that may take place
in the future.
Valuation assumes that, in the ordinary course of its business,
the Company will eventually sell its investment.
The Company's valuation policy with respect to the five broad
investment categories is as follows:
EQUITY-RELATED SECURITIES
Equity-related securities are carried at fair value using
one or more of the following basic methods of valuation:
A. Cost: The cost method is based on the original cost to
the Company. This method is generally used in the early stages
of a company's development until significant positive or negative
events occur subsequent to the date of the original investment
that dictate a change to another valuation method. Some examples
of such events are: (1) a major recapitalization; (2) a major
10
refinancing; (3) a significant third-party transaction; (4) the
development of a meaningful public market for the company's
common stock; and (5) significant positive or negative changes
in the company's business.
B. Private Market: The private market method uses actual
third-party transactions in the company's securities as a basis
for valuation, using actual, executed, historical transactions
in the company's securities by responsible third parties. The
private market method may also use, where applicable,
unconditional firm offers by responsible third parties as a
basis for valuation.
C. Public Market: The public market method is used
when there is an established public market for the class of
the company's securities held by the Company. The Company
discounts market value for securities that are subject to
significant legal and contractual 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 is the last reported sales
price on the day of valuation. For other securities traded
in the over-the-counter market and listed securities for which
no sale was reported on that day, market value is the mean of
the closing bid price and asked price on that day.
This method is the preferred method of valuation when
there is an established public market for a company's securities,
as that market provides the most objective basis for valuation.
D. Analytical Method: The analytical method is generally
used to value an investment position when there is no established
public or private market in the company's securities or when the
factual information available to the Company dictates that an
investment should no longer be valued under either the cost or
private market method. This valuation method is inherently
imprecise and ultimately the result of reconciling the judgments
of the Company's Investment and Valuation Committee members,
based on the data available to them. The resulting valuation,
although stated as a precise number, is necessarily within a
range of values that vary depending upon the significance
attributed to the various factors being considered. Some of
the factors considered may include the financial condition and
operating results of the company, the long-term potential of
the business of the company, the values of similar securities
issued by companies in similar businesses, the proportion of
the company's securities owned by the Company and the nature
of any rights to require the company to register restricted
securities under applicable securities laws.
INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH
AND DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the
following basic methods of valuation:
E. Cost: The cost method is based on the original cost
to the Company. Such method is generally used in the early
stages of commercializing or developing intellectual property
or patents or research and development in technology or
product development until significant positive or adverse
events occur subsequent to the date of the original investment
that dictate a change to another valuation method.
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.
11
G. Analytical Method: The analytical method is used
to value an investment after analysis of the best available
outside information where the factual information available
to the Company dictates that an investment should no longer
be valued under either the cost or private market method.
This valuation method is inherently imprecise and ultimately
the result of reconciling the judgments of the Company's
Investment and Valuation Committee members. The resulting
valuation, although stated as a precise number, is necessarily
within a range of values that vary depending upon the
significance attributed to the various factors being
considered. Some of the factors considered may include
the results of research and development, product development
progress, commercial prospects, term of patent and projected
markets.
LONG-TERM FIXED-INCOME SECURITIES
H. Fixed-Income Securities for which market quotations are readily
available are carried at market value as of the time of valuation using the
most recent bid quotations when available.
Securities for which market quotations are not readily available are
carried at fair value using one or more of the following basic methods of
valuation:
I. Fixed-Income Securities are valued by independent pricing services
that provide market quotations based primarily on quotations from dealers
and brokers, market transactions, and other sources.
J. Other Fixed-Income Securities that are not readily marketable
are valued at fair value by the Investment and Valuation Committee.
SHORT-TERM FIXED-INCOME INVESTMENTS
K. Short-Term Fixed-Income Investments are valued at market value
at the time of valuation. Short-term debt with remaining maturity of 60
days or less is valued at amortized cost.
ALL OTHER INVESTMENTS
L. All Other Investments are reported at fair value as determined
in good faith by the Investment and Valuation Committee.
The reported values of securities for which market quotations are
not readily available and for other assets reflect the Investment and
Valuation Committee's judgment of fair values as of the valuation date
using the outlined basic methods of valuation. They do not necessarily
represent an amount of money that would be realized if the securities
had to be sold in an immediate liquidation. The Company makes many of
its portfolio investments with the view of holding them for a number of
years, and the reported value of such investments may be considered in
terms of disposition over a period of time. Thus valuations as of any
particular date are not necessarily indicative of amounts that may
ultimately be realized as a result of future sales or other dispositions
of investments held.
12
NOTES TO CONSOLIDATED 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 September 30, 1992 until the
election of BDC status, the Company operated as a closed-end, non-
diversified, investment company under the 1940 Act. Upon commencement
of operations as an investment company, the Company revalued all of its
assets and liabilities at fair value as defined in the 1940 Act. Prior
to such time, the Company was registered and filed under the reporting
requirements of the Securities and Exchange Act of 1934 as an operating
company and, while an operating company, operated directly and through
subsidiaries.
Harris & Harris Enterprises, Inc. ("Enterprises") is a 100 percent
wholly owned subsidiary of the Company. Enterprises holds the lease for
the office space, which it subleases to the Company and an unaffiliated
party; operates a financial relations and consulting firm; is a partner
in Harris Partners I, L.P. and is taxed as a C corporation. Harris
Partners I, L.P. is a limited partnership and owns a 20 percent limited
partnership interest in PHZ Capital Partners, L.P. The partners of
Harris Partners I, L.P. are Enterprises (sole general partner) and
the Company (sole limited partner).
The Company qualified for 2001 as a Regulated Investment Company
("RIC") under Sub-Chapter M of the Internal Revenue Code of 1986 (the
"Code"). There can be no assurance that the Company will qualify as
a RIC in 2002 or that, if it does qualify, it will continue to qualify
for subsequent years. In addition, even if the Company were to qualify
as a RIC for a given year, the Company might take action in a subsequent
year to ensure that it would be taxed in that subsequent year as a C
Corporation, rather than a RIC. As a RIC, the Company must, among other
things, distribute at least 90 percent of its taxable net income and
may either distribute or retain its taxable net realized capital gains
on investments.
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 funds.
13
Portfolio Investment Valuations. Investments are stated at "fair
value" as defined in the 1940 Act and in the applicable regulations of the
Securities and Exchange Commission. All assets are valued at fair value
as determined in good faith by, or under the direction of, the Board of
Directors. (See the "Asset Valuation Policy Guidelines" in the "Footnote
to Consolidated Schedule of Investments.")
Securities Transactions. Securities transactions are accounted for
on the date the securities are purchased or sold (trade date); dividend
income is recorded on the ex-dividend date; and interest income is
accrued as earned. Realized gains and losses on investment transactions
are determined on the specific identification basis for financial
reporting and tax reporting.
Income Taxes. Prior to January 1, 1999, the Company recorded income
taxes using the liability method in accordance with the provision of
Statement of Financial Accounting Standards No. 109. Accordingly, deferred
tax liabilities had been established to reflect temporary differences
between the recognition of income and expenses for financial reporting and
tax purposes, the most significant difference of which related to the
Company's unrealized appreciation on investments.
The June 30, 2002 consolidated financial statements include a
liability for deferred taxes on the remaining net built-in gains as of
December 31, 1998, net of the unutilized operating and capital loss
carryforwards incurred by the Company through December 31, 1998.
The December 31, 2001 consolidated financial statements also reflect
a tax provision on net realized long-term capital gains which the Company
retained for liquidity and to fund investment opportunities, rather than
distribute to shareholders as a cash distribution. Accordingly, the
Company declared a designated undistributed capital gain dividend for the
year. (See "Note 6. Income Taxes" and Item 2. "Management's Discussion
and Analysis of Financial Condition and Results of Operation -- Recent
Developments -- Sub-Chapter M Status.")
The Company pays federal, state and local income taxes on behalf
of its wholly owned subsidiary, Harris & Harris Enterprises, which is
a C corporation. (See Note 6. Income Taxes.)
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 June 30, 2002 and December 31, 2001, and the reported amounts of
revenues and expenses for the three months ended June 30, 2002 and
June 30, 2001. Actual results could differ from these estimates.
The interim financial data as of June 30, 2002 and for the six
months ended June 30, 2002 and June 30, 2001 is unaudited; however, in
the opinion of the Company, the interim data includes all adjustments,
consisting only of normal recurring adjustments, necessary for a fair
statement of the results for the interim periods.
NOTE 3. EMPLOYEE PROFIT-SHARING PLAN
On August 3, 1989, the shareholders of the Company approved the
1988 Long Term Incentive Compensation Plan (the "1988 Plan"). The
Company's 1988 Plan was cancelled as of December 31, 1997, canceling
all outstanding stock options and eliminating all potential stock
option grants. As a substitution for the 1988 Plan, the Company
adopted an employee profit-sharing plan.
As of January 1, 1998, the Company began implementing the Harris
& Harris Group, Inc. Employee Profit-Sharing Plan (the "1998 Plan")
that provides for profit sharing equal to 20 percent of the net
14
realized income of the Company as reflected on the Consolidated
Statements of Operations for such year, less the nonqualifying gain,
if any. The 1998 Plan was terminated by the Company as of December
31, 1999, subject to the payment of any amounts owed on the 1999
realized gains under the 1998 Plan.
In March 2000, the Company paid out 90 percent of the profit
sharing in the amount of $1,024,696 on the 1999 realized gains; the
remaining 10 percent or $113,855 was paid out in September 2000, upon
the completion and filing of the Company's 1999 federal tax return.
As of January 1, 2000, the Company implemented the Harris & Harris
Group, Inc. Employee Profit-Sharing Plan (the "Plan") that provides
for profit sharing equal to 20 percent of the net realized income of
the Company as reflected on the Consolidated Statement of Operations
of the Company for such year, less the nonqualifying gain, if any.
Under the Plan, net realized income of the Company includes
investment income, realized gains and losses, and operating expenses
(including taxes paid or payable by the Company), but is calculated
without regard to dividends paid or distributions made to shareholders,
payments under the Plan, unrealized gains and losses, and loss carryovers
from other years ("Qualifying Income"). The portion of net after-tax
realized gains attributable to asset values as of September 30, 1997 is
considered nonqualifying gain, which reduces Qualifying Income.
On July 23, 2002, the Board of Directors passed a resolution to
modify the Employee Profit-Sharing Plan to grandfather current employees
with regard to a significant portion of the existing profit-sharing
participation in existing portfolio investments. The grandfathering
would be equal to 90 percent of the percentage participation in the
existing non-tiny technology investments and 75 percent of the percentage
participation in the existing tiny-technology investments. The
grandfathered participation would be honored by the Company whether or
not an eligible participant were still employed by the Company or
were still alive (in the event of death, the grandfathered participations
would be paid to the eligible participant's estate), unless the eligible
participant had been dismissed for cause. With regard to new investments,
both current and new employees would be required to be employed by the
Company at the time of distribution in order to participate in profit
sharing.
As soon as practicable following the year-end audit, the Board of
Directors will determine whether, and if so how much, Qualifying Income
exists for a plan year, and 90 percent of the Qualifying Income will be
paid out to Plan participants pursuant to the distribution percentages
set forth in the Plan. The remaining 10 percent will be paid out after
the Company has filed its federal tax return for that year in which
Qualifying Income exists. Currently, the distribution amounts for each
officer and employee are as follows: Charles E. Harris, 13.790 percent;
Mel P. Melsheimer, 4.233 percent; Helene B. Shavin, 1.524 percent; and
Jacqueline M. Matthews, 0.453 percent. In one case, for a former
employee, who left the company for other than cause, the amount earned
will be accrued and may subsequently be paid to such participant.
Notwithstanding any provisions of the Plan, in no event may the
aggregate amount of all awards payable for any Plan year during which
the Company remains a "business development company" within the meaning
of 1940 Act be greater than 20 percent of the Company's "net income after
taxes" within the meaning of Section 57(n)(1)(B) of the 1940 Act. In
the event the awards exceed such amount, the awards will be reduced pro
rata.
The Plan may be modified, amended or terminated by the Company's
Board of Directors at any time with the stipulation that no such
modification, amendment or termination may adversely affect any
15
participant that has not consented to such modification, amendment or
termination. Nothing in this Plan shall preclude the Board of Directors
from, for any Plan Year subsequent to the current Plan Year, naming
additional Participants in the Plan or changing the Award Percentage
of any Full Participant or New Participant (subject to the overall
percentage limitations contained herein).
The Company calculates the Plan accrual at each quarter end based
on the net realized and gross unrealized gains at that date, net of
estimated operating expenses for the year. Any adjustments to the
Plan accrual are then reflected in the Consolidated Statements of
Operations for the quarter. The Plan accrual is not paid out until
the gains are realized. During the first six months of 2002,
primarily as a result of an increase in the net realized gains from
investments which are included in the bonus accrual calculation, the
cumulative accrual was increased by $249,285 to $427,567.
On April 26, 2000, the shareholders of the Company approved the
performance goals under the Plan in accordance with Section 162(m) of
the Code. The Code generally provides that a public company such as
the Company 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 any such officer/employee
exceeds $1 million in any tax year, unless the payment is made upon
the attainment of objective performance goals that are approved by
the Company's shareholders.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that, effective
January 1, 1998, 50 percent of all Directors' fees be used to
purchase Company common stock from the Company. However, effective
March 1, 1999, the Directors may purchase the Company's common stock
in the open market, rather than from the Company. During 1999, the
Directors bought directly from the Company 5,816 shares.
On January 27, 2000, the Company placed privately, with an
unaffiliated investor, for $3 million in cash, a one-year, 12 percent
note with one-year warrants to purchase 25,263 shares of the Company's
common stock at $11.8750 per share. Unless the note was prepaid, six
months after its issuance, the investor would have received additional
one-year warrants to purchase an additional $300,000 worth of the
Company's common stock at the then-current market price. During March
2000, with part of the proceeds from the sale of SciQuest.com stock,
the Company prepaid the Note. The Company incurred total interest costs
of $146,141: $36,500 in interest paid on the note and $109,641 on
warrants. The warrants expired unexercised.
Since 1998, the Company has repurchased a total of 1,859,047 of
its 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 the Company's recent 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 December 14, 2000, the Company declared a deemed dividend of
$1.78 per share for a total of $16,253,987, and in 2001, the Company
paid federal income taxes on behalf of shareholders of $0.62 per share
for a total of $5,688,896. The Company paid the tax at the corporate
rate on the distribution, and the shareholders received a tax credit
equal to their proportionate share of the tax paid.
On January 22, 2002, the Company announced a deemed dividend of
$0.0875 per share for 2001 for a total of $775,620, and in 2002 the
Company paid federal income taxes on behalf of shareholders of $0.030625
per share for a total of $271,467. The Company paid the tax at the
corporate rate on the distribution, and the shareholders received a
tax credit equal to their proportionate share of the tax paid.
16
The net of the total deemed dividends declared in 2000
($16,253,987) and 2001 ($775,620) and the taxes paid on behalf of
shareholders in 2000 ($5,688,896) and 2001 ($271,467) is considered
to be reinvested by the shareholders; therefore, during 2000 and 2001,
additional paid in capital has increased by $10,565,091 and $504,153,
respectively.
The tax character of the 2000 and 2001 deemed dividend is
long-term capital gain.
As of December 31, 2001, there are no distributable earnings. The
difference between the book basis and tax basis components of distributable
earnings is attributed to Built-In Gains generated at the time of the
Company's qualification as a RIC (see Note 6. "Income Taxes") and after
tax earnings that are not required to be distributed.
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment Agreement
with the Company (disclosed in a Form 8-K filed on October 27, 1999)
(the "Employment Agreement"), which superseded an employment agreement
that was about to expire on December 31, 1999. The Employment Agreement
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 the Company or Mr. Harris, by written notice, decides not to
extend the Term, in which case the Term will expire five years from the
date of the written notice.
During the period of employment, Mr. Harris shall serve as the
Chairman and Chief Executive Officer of the Company; be responsible for the
general management of the affairs of the Company and all its subsidiaries,
reporting directly to the Board of Directors of the Company; serve as a
member of the Board for the period of which he is and shall from time to
time be elected or reelected; and serve, if elected, as President of the
Company and as an officer and director of any subsidiary or affiliate of
the Company.
Mr. Harris is to receive compensation under his Employment Agreement
in the form of base salary of $208,315 for 2000, with automatic yearly
adjustments to reflect inflation. In addition, the Board may increase
such salary, and consequently decrease it, but not below the level provided
for by the automatic adjustments described above. Mr. Harris is also
entitled to participate in the Company's Profit-Sharing Plan as well as
in all compensation or employee benefit plans or programs, and to receive
all benefits, perquisites, and emoluments for which salaried employees are
eligible. Under the Employment Agreement, the Company is to furnish Mr.
Harris with certain perquisites which include a company car, membership
in certain clubs and up to a $5,000 annual reimbursement for personal,
financial or tax advice.
The Employment Agreement provides Mr. Harris with life insurance for
the benefit of his designated beneficiaries in the amount of $2,000,000;
provides reimbursement for uninsured medical expenses, not to exceed
$10,000 per annum, adjusted for inflation, over the period of the
contract; provides Mr. Harris and his spouse with long-term care
insurance; and disability insurance in the amount of 100 percent of
his base salary. These benefits are for the term of the Employment
Agreement.
The Employment Agreement provides for the Company to adopt a
supplemental executive retirement plan (the "SERP") for the benefit
of Mr. Harris. Under the SERP, the Company will cause an amount equal
to one-twelfth of Mr. Harris's current base salary to be credited each
month (a "Monthly Credit") to a special account maintained for this
purpose on the books of the Company for the benefit of Mr. Harris
(the "SERP Account"). The amounts credited to the SERP Account will
be deemed invested or reinvested in such mutual funds or U.S.
17
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' benefit under the SERP will equal the balance in the SERP
Account and such benefit will always be 100 percent vested (i.e., not
forfeitable). Mr. Harris will determine the form and timing of the
distribution of the balance in the SERP Account; provided, however,
in the event of termination, the balance in the SERP Account will be
distributed to Mr. Harris or his beneficiary, as the case may be, in a
lump-sum payment within 30 days of such termination. The Company will
establish a rabbi trust for the purpose of accumulating funds to satisfy
the obligations incurred by the Company under the SERP. The restricted
funds for the SERP Plan total $654,839 as of June 30, 2002. Mr. Harris'
rights to benefits pursuant to this SERP will be no greater than those of
a general creditor of the Company.
The Employment Agreement provides severance pay in the event of
termination without cause or by constructive discharge and also provides
for certain death benefits payable to the surviving spouse equal to the
executive's base salary for a period of two years.
In addition, Mr. Harris is entitled to receive severance pay pursuant
to the severance compensation agreement that he entered into with the
Company, effective August 15, 1990. The severance compensation agreement
provides that if, following a change in control of the Company, as defined
in the agreement, such individual's employment is terminated by the Company
without cause or by the executive within one year of such change in control,
the individual shall be entitled to receive compensation in a lump sum
payment equal to 2.99 times the individual's average annualized compensation
and payment of other welfare benefits. If Mr. Harris' 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, the Company adopted an employee benefits program
covering substantially all employees of the Company under a 401(k) Plan and
Trust Agreement. As of January 1, 1999, the Company adopted the Harris &
Harris Pension Plan and Trust, a money purchase plan which would allow the
Company to stay compliant with the 401(k) top-heavy regulations and deduction
limitation regulations. 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 the Company 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.
Contributions to the plan are at the discretion of the Company.
On June 30, 1994, the Company adopted a plan to provide medical and health
insurance for retirees, their spouses and dependents who, at the time of their
retirement, have ten years of service with the Company and have attained 50
years of age or have attained 45 years of age and have 15 years of service with
the Company. On February 10, 1997, the Company amended this plan to include
employees who "have seven full years of service and have attained 58 years of
age." The coverage is secondary to any government provided or subsequent
employer provided health insurance plans. Based upon actuarial estimates,
the Company provided an original reserve of $176,520 that was charged to
operations for the period ending June 30, 1994. As of June 30, 2002 the
Company had a reserve of $385,935 for the plan.
NOTE 6. INCOME TAXES
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification as a RIC under Sub-Chapter M of the Code.
As a RIC, the Company annually must distribute at least 90 percent of
its investment company taxable income as a dividend and may either
distribute or retain its realized net capital gains from investments.
To initially qualify as a RIC, among other requirements, the Company
had to pay a dividend to shareholders equal to the Company's cumulative
realized earnings and profits ("E&P"). On April 9, 1998,
18
the Company declared a one-time cash dividend of $0.75 per share to
meet this requirement (for a total of $8,019,728). The cash dividend
was paid on May 12, 1998.
The Company elected Sub-Chapter M status for the year ended
December 31, 1999. A corporation that elects to qualify as a RIC
continues to be taxable as a C Corporation on any gains realized
within 10 years of its qualification as a RIC from sales of assets
that were held by the corporation on the effective date of the
election ("C Corporation Assets") to the extent of any gain built
into the assets on such date ("Built-In Gain"). The Company had
Built-In Gains at the time of its qualification as a RIC. Prior
to 1999, the Company incurred ordinary and capital losses from
its operations. After the Company's election of RIC status,
those losses remained available to be carried forward to subsequent
taxable years. Recently issued Internal Revenue Service regulations
(issued in temporary and proposed form) confirm that such losses
may be used to offset realized Built-In Gains and, to the extent
so used, to eliminate C Corporation taxation of such gains.
Notwithstanding any such offset, however, the new regulations
also provide that all realized Built-In Gains (calculated without
regard to the offset, but net of any C Corporation tax imposed on
the Built-In Gains after application of the offset) must be
included in calculating a RIC's investment company taxable income
or net capital gains, as the case may be, and therefore appear to
require that such Built-In Gains must be distributed to avoid
Sub-Chapter M taxation of such investment company taxable income
or net capital gains (and, in the case of any Built-In Gains that
are includible in investment company taxable income, possible
loss of RIC status). The Company has previously used loss
carryforwards to offset Built-In Gains. As of January 1, 2002,
the Company had $501,640 of loss carryforwards remaining and
$4,663,457 of unrealized Built-In Gains. During the current
period, the Company did not realize any Built-In Gains.
Continued qualification as a RIC requires the Company to
satisfy certain portfolio diversification requirements in future
years. The Company's ability to satisfy those requirements may
not be controllable by the Company. (See Item 2. "Management's
Discussion and Analysis of Financial Condition and Results of
Operation -- Sub-Chapter M Status.") There can be no assurance
that the Company will qualify as a RIC in subsequent years.
During the six months ended June 30, 2002, the Company accrued a net tax
benefit of $12,864. The Company pays federal, state and local taxes on behalf
of its wholly owned subsidiary, Harris & Harris Enterprises, Inc., which is
taxed as a C Corporation.
For the three and six months ended June 30, 2002 and 2001, the Company's
income tax provision was allocated as follows:
Three Months Three Months Six Months Six Months
Ended Ended Ended Ended
June 30, 2002 June 30, 2001 June 30, 2002 June 30,2001
Net operating loss.....$ 0 $ 0 $ 0 $ 0
Net realized (loss)
gain on investments.... (47,087) 22,641 (12,864) 52,275
Net increase in
unrealized
appreciation on
investments............ 0 0 0 0
------------ ------------ ------------ -----------
Total income tax
(benefit)
provision..............$ (47,087) $ 22,641 $ (12,864) $ 52,275
============ ============ ============ ===========
The above tax (benefit) provision consists of the following:
Current................$ 0 $ 22,641 $ 0 $ 52,275
Deferred -- Federal.... (47,087) 0 (12,864) 0
------------ ------------ ------------ -----------
Total income tax
provision..............$ (47,087) $ 22,641 $ (12,864) $ 52,275
19
The Company's net deferred tax liability at June 30, 2002 and December 31,
2001 consists of the following:
June 30, 2002 December 31, 2001
Tax on unrealized appreciation on
built-in gains.............................$ 1,540,044 $ 1,540,044
Net operating loss and capital carryforward
on built-in gains.......................... (175,574) (175,574)
Net operating loss carryforward............ (12,864) 0
------------ -------------
Net deferred income tax liability..........$ 1,351,606 $ 1,364,470
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a ten-year lease with sublet
provisions for office space. In 1995, this lease was amended to
include additional office space. During 1999, the Company sublet
this space to an unaffiliated party. Rent expense under this lease
was $43,856 and $48,393 for the three months ended June 30, 2002
and June 30, 2001 and $86,580 and $90,465 for the six months ended
June 30, 2002 and June 30, 2001, respectively. Future minimum lease
payments in 2003 are $101,946.
On November 19, 2001, the Company established an asset account
line of credit of up to $12,700,000. The asset account line of credit
is secured by the Company's government agency securities. Under the
asset account line of credit, the Company may borrow up to 95 percent
of the current value of its government agency securities. The asset
line of credit bears interest at a rate of the Broker Call Rate plus 50
basis points. On April 4, 2002, the Company repaid the entire
outstanding balance under the asset line of credit.
NOTE 8. SUBSEQUENT EVENTS
On July 8, 2002, the Company filed a final prospectus under Rule
497 of the Securities Act of 1933 with the SEC for the issuance of
transferable rights to its shareholders. The rights allowed the
shareholders to subscribe for a maximum of 2,954,743 new shares of
the Company's common stock, of which 2,634,614 new shares were
subscribed for pursuant to the rights offering. Upon consummation
of the offer, the Company intended to raise gross proceeds of
approximately $6,648,172,without exclusion of expenses relating to
the offer. The actual amount of gross proceeds raised upon consummation
of the offer was $5,927,882, without exclusion of expenses relating
to the offer. The Company expects to invest, directly or indirectly,
the proceeds of the offer, excluding expenses, in accordance with its
investment objectives and policies within the 12 months following the
receipt of such proceeds, depending on the available investment
opportunities for the types of investments in which the Company
principally invests.
On July 23, 2002, the Board of Directors passed a resolution
to modify the Employee Profit-Sharing Plan to grandfather current
employees with regard to a significant portion of the existing profit-
sharing participation in existing portfolio investments. The
grandfathering would be equal to 90 percent of the percentage
participation in the existing non-tiny technology investments and 75
percent of the percentage participation in the existing tiny-technology
investments. The grandfathered participation would be honored by the
Company whether or not an eligible participant were still employed by
the Company or were still alive (in the event of death, the grandfathered
participations would be paid to the eligible participant's estate),
unless the eligible participant had been dismissed for cause. With
regard to new investments, both current and new employees would be
required to be employed by the Company at the time of distribution
in order to participate in profit sharing.
20
Harris & Harris Group had intended to ask shareholders at the Annual
Meeting to approve changing the name of the company to Tiny Technology Venture
Capital, Inc. However, the Company now believes that a recently adopted
rule of the Securities and Exchange Commission under the Investment
Company Act of 1940, as amended, (Rule 35d-1) would apply to business
development companies and would require, if the Company changed its
name, that the Company maintain investment of at least 80 percent of
its total assets in tiny-technology companies. In light of its need
to maintain liquidity for follow-on investments, the Company believes
that it would not be in the best interest of shareholders to adopt a
name that would prevent such liquidity. Accordingly, the Company will
not ask shareholders to approve a name change at the Annual Meeting, and
the Company will retain its name.
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The Company accounts for its operations utilizing accounting principles
generally accepted in the United States for investment companies. On this
basis, the principal measure of its financial performance is captioned "Net
increase (decrease) in net assets resulting from operations," which is the sum
of three elements. The first element is "Net operating (loss) income," which
is the difference between the Company's income from interest, dividends, and
fees and its operating expenses. The second element is "Net realized gain
(loss) on investments," which is the difference between the proceeds received
from dispositions of portfolio securities and their stated cost, net of
applicable income tax benefit (provision). These two elements are combined
in the Company's financial statements and reported as "Net realized 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 realized gain (loss) on investments" and "Net increase (decrease) in
unrealized appreciation on investments" are directly related. When a security
is sold to realize a gain (loss), net unrealized appreciation decreases
(increases) and net realized gain (loss) (decreases) increases.
Financial Condition
The Company's total assets and net assets were, respectively, $26,818,408
and $23,732,125 at June 30, 2002, compared with $39,682,367 and $24,334,770 at
December 31, 2001.
Among the significant changes in the six months ended June 30, 2002
were: (1) the payment of $271,467 in federal income taxes as a result of
the Company's deemed dividend distribution; (2) decline in the value of
the Company's investment in Experion Systems, Inc. of $600,000; (3)
decrease in bank loan payable of $12,495,777; (4) establishment of a
reserve against the note receivable of $6,897; and (5) the recording as
Other Assets of $176,726 of estimated costs associated with the filed
registration statement on Form N-2 with the SEC for issuance of
transferable rights to shareholders.
Net asset value per share ("NAV") was $2.68 at June 30, 2002, versus $2.75
at December 31, 2001.
The Company's shares outstanding remained unchanged during the six months
ended June 30, 2002.
The Company's financial condition is dependent on the success of its
investments. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack management
21
depth and have little or no history of operations. At June 30, 2002,
$17,619,447 or 65.7 percent of the Company's total assets (74.2 percent of
the Company's net assets) consisted of non-publicly traded securities at fair
value, of which net unrealized appreciation was $1,013,741.
The increase in the value of the non-publicly traded securities from
$13,120,978 at December 31, 2001 to $17,619,447 at June 30, 2002 resulted
primarily from the Company's six new tiny-technology enabled investments and
the liquidation of Informio, Inc. The increase was partially offset by the
net effect of an additional investment and decrease in valuation of the
Company's holdings in Experion Systems, Inc.
A summary of the Company's investment portfolio is as follows:
June 30, 2002 December 31, 2001
Investments, at cost..................... $23,942,142 $37,714,285
Unrealized appreciation.................. 1,012,502 1,216,420
----------- -----------
Investments, at fair value............... $24,954,644 $38,930,705
=========== ===========
The accumulated unrealized appreciation on investments net of deferred
taxes is ($351,966) at June 30, 2002, versus ($148,049) at December 31, 2001.
Following an initial investment in a private company, the Company may
make additional investments in such investee in order to: (1) increase its
ownership percentage; (2) exercise warrants, options or convertible securities
that were acquired in the original or subsequent financing; (3) preserve the
Company's proportionate ownership in a subsequent financing; or (4) attempt to
preserve or enhance the value of the Company's investment. There can be no
assurance that the Company will make follow-on investments or have sufficient
funds to make additional investments. The Company has the discretion to make
follow-on investments as it determines, subject to the availability of
capital resources. The failure to make such follow-on investments may, in
certain circumstances, jeopardize the continued viability of the investee
company and the Company's initial investment or may result in a missed
opportunity for the Company to increase its participation in a successful
operation. Even if the Company has sufficient capital to make a desired
follow-on investment, it may elect not to make a follow-on investment either
because it does not want to increase its concentration of risk, because it
prefers other opportunities, or because it is inhibited by compliance with
BDC or RIC requirements, even though the follow-on investment opportunity
appears attractive or would preserve rights pursuant to "pay to play"
provisions.
The following table is a summary of the cash investments made by the
Company in its private placement portfolio during the six months ended
June 30, 2002:
New Investments: Amount
- ---------------- ------
Continuum Photonics, Inc. $1,000,000
Nanopharma Corp. 700,000
NanoOpto Corporation 625,000
Nanotechnologies, Inc. 750,000
NeoPhotonics Corporation 1,000,000
Optiva, Inc. 500,000
Additional Investments:
- ----------------------
Experion Systems, Inc. $ 100,000
Total $4,675,000
22
Results of Operations
Investment Income and Expenses:
The Company had net operating loss of $1,210,951 and $560,690 for the
six months ended June 30, 2002 and June 30, 2001, respectively. The Company's
net operating loss reflected an increase to expenses of $441,171 in the six
months ended June 30, 2002 primarily related to increases in the employee
profit-sharing accrual and professional fees.
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 securities, including U.S. Government and
Agency Obligations. The amount of interest income earned varies with the
average balance of the Company's fixed-income portfolio and the average yield
on this portfolio.
The Company had interest income from fixed-income securities of
$94,271 and $270,376 for the six months ended June 30, 2002 and
June 30, 2001, respectively. The decrease of $176,105 or 65.1 percent
reflects primarily the steep decline in short-term interest rates during
the six months ended June 30, 2002 versus the six months ended
June 30, 2001.
The Company had interest income from affiliated companies of $0
and $11,382 for the six months ended June 30, 2002 and June 30, 2001,
respectively. The decrease of $11,382 is owing to the decrease in the
outstanding loans to investee companies since the second quarter of
2001. The amount of outstanding loans to investee companies varies.
The Company had other income of $25,559 and $47,162 for the six
months ended June 30, 2002 and June 30, 2001, respectively. Other
income primarily represents rental income from subletting office space
to an unaffiliated party. The rental income was offset in the six months
ended June 30, 2002 by a reserve against a note receivable and in the
six months ended June 30, 2001 by a gain on the sale of Company property.
Operating expenses were $1,330,781 and $889,610 for the six months ended
June 30, 2002 and June 30, 2001, respectively. The operating expenses of the
six months ended June 30, 2002 and 2001 reflect an increase (decrease) in the
employee profit-sharing accrual of $249,285 and ($133,308), respectively, owing
primarily to increases in realized gains in 2002 and decreases in unrealized
appreciation of investments in 2001 for the six-month period. Salaries and
benefits decreased $35,951 or 6.5 percent, primarily as a result of no bonus
payroll taxes in 2002. Professional fees increased $51,842 or 56.5 percent,
primarily as a result of new investment expenses. Director's fees and expenses
increased $30,822 or 66.5 percent, as a result of audit committee meetings
regarding the appointment of PricewaterhouseCoopers LLP as independent public
accountants for the Company for the year ending December 31, 2002; nominating
committee meetings resulting in the appointment of two additional members of
the Board of Directors; and additional expenses associated with the new
members. Interest expense increased $10,776, as a result of the interest
expense on the asset line of credit.
The Company had interest income from fixed-income securities of $40,135 and
$117,846 for the three months ended June 30, 2002 and June 30, 2001,
respectively, reflecting the steep decline in short-term interest rates
during the three months ended June 30, 2002, versus the three months
ended June 30, 2001. The Company had other income of $20,233 and
$17,350 for the three months ended June 30, 2002 and June 30, 2001,
respectively. Other income primarily represents rental income from
subletting office space to an unaffiliated party. In the second
quarter of 2002, other income included a $3,500 payment received on
the fully reserved note receivable.
23
Operating expenses were $715,086 and $1,207,528 for the three months
ended June 30, 2002 and June 30, 2001, respectively. The operating
expenses of the second quarter of 2001 reflect an increase in the
employee profit-sharing accrual of $712,982, owing to an increase in
unrealized appreciation of investments for the three months ended
June 30, 2001. The operating expenses of the second quarter of 2002
reflect an increase in profit sharing of $121,326, owing to an increase
in realized gains for the three months ended June 30, 2002. Professional
fees increased $67,950 or 208.3 percent primarily as a result of new
investment expenses. Directors' fees and expenses increased $12,736 or
54.5 percent primarily as a result of the increased expenses associated
with two additional members of the Board of Directors.
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.
Because such sales cannot be predicted, the Company attempts to maintain
adequate working capital to provide for fiscal periods when there are
no such sales.
Realized Gains and Losses on Portfolio Securities:
During the six months ended June 30, 2002 and 2001, the Company
realized gains (losses) of $799,360 and ($1,032,743), respectively.
During the six months ended June 30, 2002, the Company's realized gains
of $799,360 consisted primarily of $55,498 received from the Nanophase
Technologies Litigation Settlement Fund and $1,108,226 from its
partnership interest in PHZ Capital Partners L.P., offset by a loss of
$350,583 on the dissolution of Informio, Inc.
During the six months ended June 30, 2001, the Company realized
losses of $1,032,743, consisting primarily of a loss on the sale of
350,000 shares of SciQuest.com common stock offset by a gain of $277,177
from the Company's partnership interest in PHZ Capital Partners L.P.
During the three months ended June 30, 2002 and June 30, 2001,
the Company realized gains of $688,681 and $161,909, respectively.
During the three months ended June 30, 2002, the Company realized a
net gain of $688,681, consisting primarily of a gain of $986,187 from
its partnership interest in PHZ Capital Partners L.P., offset by a loss
of $350,583 on the dissolution of Informio, Inc.
During the three months ended June 30, 2001, the Company realized
a net gain of $161,909, consisting primarily of a gain of $204,744 from
its partnership interest in PHZ Capital Partners L.P. and a loss of
$38,890 on the sale of its position in Kana Communications.
Unrealized Appreciation and Depreciation of Portfolio Securities:
The Board of Directors values the portfolio securities on a quarterly
basis pursuant to the Company's Asset Valuation guidelines in accordance with
the 1940 Act. (See "Footnote to Consolidated Schedule of Investments" contained
in "Item 1. Consolidated Financial Statements.")
Net unrealized appreciation on investments decreased by $203,918 or
16.8% during the six months ended June 30, 2002, from $1,216,420 to
$1,012,502, primarily as a result of the decline in the value of the
Company's holdings in Experion Systems, Inc., offset by the increase
in unrealized appreciation of $353,221 as a result of the realization
of the loss on the dissolution of Informio, Inc.
Net unrealized appreciation on investments decreased by $326,973 or
3.6 percent during the six months ended June 30, 2001, from $8,947,928
to $8,620,955, primarily as a result of the decline in the value of the
Company's holdings of Essential.com and Experion Systems, Inc. of
$2,204,000 and $480,000, respectively. This decrease was offset by
an increase in the value of Nanophase Technologies Corporation of
$800,290 and an increase in unrealized appreciation of $1,528,082
24
as a result of the realization of the loss on the sale of the Company's
position in SciQuest.com.
Net unrealized appreciation increased by $353,239 or 53.6% during
the three months ended June 30, 2002, from $659,263 to $1,012,502, owing
primarily to the increase in unrealized appreciation of $353,221 as a
result of the realization of the loss on the dissolution of Informio, Inc.
Net unrealized appreciation increased by $2,755,958 or 47.0 percent
during the three months ended June 30, 2001, from $5,864,997 to $8,620,955,
owing primarily to the increase in the value of the Company's position
in Nanophase Technologies Corporation of $3,088,204, offset by a decline
in the value of the Company's investment in Experion Systems, Inc. of
$480,000.
The changes in the values of Experion Systems, Inc. reflect the
extreme volatility of private and small capitalization, high technology
stocks, as well as the inherent risks at all times of such investments
(see "Risk Factors").
Liquidity and Capital Resources
The Company's primary sources of liquidity are cash, receivables
and freely tradable marketable securities. The Company's secondary sources
of liquidity are restricted securities of companies that are publicly
traded. At June 30, 2002 and December 31, 2001, respectively, the
Company's total primary liquidity was $8,258,570 and $13,459,654. On
both of the corresponding dates, the Company's total secondary liquidity
was $0 as the Company had no publicly traded securities. The Company's
tertiary source of liquidity is its holding of PHZ Capital Partners L.P.,
from which the Company received cash distributions in the first six months
of 2002 of $581,616.
The decrease in the Company's primary source of liquidity from
December 31, 2001 to June 30, 2002 is primarily owing to the: (1) payment
of federal income taxes of $271,467; (2) investment in Nanopharma Corp.
of $700,000; (3) investment in NanoOpto Corporation of $625,000; (4)
investment in NeoPhotonics Corporation of $1,000,000; (5) investment
in Experion Systems, Inc. of $100,000; (6) investment in Continuum
Photonics, Inc. of $1,000,000; (7) investment in Nanotechnologies, Inc.
of $750,000; (8) investment in Optiva, Inc. of $500,000; and (9) use of
funds for operating expenses.
From December 31, 2001 to June 30, 2002, the Company's liabilities
for accrued employee profit sharing increased by $121,326 or 39.6 percent
to $427,567, primarily as a result of an increase in the realized gains
from investments included in the bonus accrual calculation.
The Company's total income tax liability decreased by $303,660 or
18.7 percent to $1,315,878, primarily as a result of the payment of taxes
in connection with the deemed dividend distribution.
Recent Developments -- Sub-Chapter M Status
On March 7, 2002, the Company received SEC certification and qualified
for RIC treatment for 2001. Although the SEC certification for 1999, 2000
and 2001 was issued, there can be no assurance that the Company will receive
such certification for subsequent years (to the extent it needs additional
certification as a result of changes in its portfolio) or that it will
actually qualify as a RIC for subsequent years. In addition, under
certain circumstances, even if the Company qualified for Sub-Chapter M
treatment in a given year, the Company might take action in a subsequent
year to ensure that it would be taxed in that subsequent year as a C
Corporation, rather than as a RIC.
25
On January 22, 2002, the Company announced that its Board of Directors
had declared a deemed dividend for 2001 of $0.0875 per share for a total
of $775,620 and paid corporate taxes on behalf of shareholders of $0.030625
per share for a total of $271,467.
Risk Factors
Investing in the Company's stock is highly speculative and the investor could
lose some or all of the amount invested.
The value of the Company's common stock may decline and may be
affected by numerous market conditions, which could result in the loss of
some or all of the amount invested in the Company's shares of common stock.
The securities markets frequently experience extreme price and volume
fluctuations which affect market prices for securities of companies
generally and technology and very small capitalization companies in
particular. Because of the Company's focus on the technology and very
small capitalization sectors and because it is a small capitalization
company, its stock price is especially likely to be affected by these market
conditions. General economic conditions, and general conditions in the
life sciences, nanotechnology, tiny technology, material sciences,
Internet and information technology and other high technology industries,
will also affect the Company's stock price. During the first quarter of
2002, the Company decided to make all of its new private equity investments
in tiny technology, including nanotechnology, microsystems and
microelectromechanical systems (MEMS). Tiny technology investments are
new and especially risky, involving science and technology risks as well
as commercialization risks.
Investing in the Company's common stock may be inappropriate for the investor's
risk tolerance.
The Company's investments, in accordance with its investment objective
and principal strategies, result in a far above average amount of risk and
volatility and may well result in loss of principal. The Company's
investments in portfolio companies are highly speculative and aggressive and,
therefore, an investment in its shares may not be suitable for investors for
whom such risk is inappropriate.
The market for venture capital investments, including tiny technology
investments, is highly competitive. In addition to finding attractive
investment opportunities, in some cases, the Company's status as a regulated
business development company may hinder its ability to participate in
investment opportunities or to protect the value of existing investments
because of "pay to play" provisions in which preferred protections such as
dilution protection may be forfeited or preferred stock may be converted to
common stock by failure to invest in subsequent rounds of financing.
The Company faces substantial competition in its investing activities
from private venture capital funds, investment affiliates of large
industrial, technology, service and financial companies, small business
investment companies, wealthy individuals and foreign investors. As a
result, the sources of funding are many, but attractive investment
opportunities are too few. Hence, the Company faces substantial
competition in sourcing good investment opportunities on terms of
investment that are commercially attractive. Further, as a regulated
business development company, the Company is required to disclose quarterly
the name and business description of portfolio companies and value of
any portfolio securities. Most of the Company's competitors are not
subject to such disclosure requirements. The Company's obligation to
disclose such information could hinder its ability to invest in certain
portfolio companies. Additionally, other regulations, current and
future, may make the Company less attractive as a potential investor
to a given portfolio company than a private venture capital fund not
subject to the same regulations. Also,
26
compliance with certain regulations applicable to the Company's business may
prevent the Company from making follow-on investments that would be in the
Company's and its investors' best interest.
The Company operates in a regulated environment.
The Company is subject to substantive SEC regulations as a BDC.
Securities and tax laws and regulations governing the Company's activities
may change in ways adverse to the Company's and its shareholders' interests
and interpretations of such laws and regulations may change with unpredictable
consequences. Any change in the law or regulations that govern the Company's
business could have an adverse impact on the Company or its operations.
Also, as business and financial practices continue to evolve, they may render
the regulations under which the Company operates less appropriate and more
burdensome than they were when originally imposed.
The Company is dependent upon key management personnel for future success.
The Company is dependent for the selection, structuring, closing
and monitoring of its investments on the diligence and skill of its
senior management and other management members. The Company utilizes
outside consultants, including its two newest Directors, Dr. Kelly S.
Kirkpatrick and Lori D. Pressman, and lawyers to assist the Company in
conducting due diligence when evaluating potential investments. The future
success of the Company depends to a significant extent on the continued
service and coordination of its senior management team, particularly
Charles E. Harris, the Company's Chairman and Chief Executive Officer.
The departure of any of the executive officers or key employees could
materially adversely affect the Company's ability to implement its
business strategy. The Company does not maintain for its benefit any
key man life insurance on any of its officers or employees.
Investing in small, private companies involves a high degree of risk
and is highly speculative.
There are significant risks inherent in the Company's venture
capital business. The Company has invested a substantial portion of
its assets in privately held development stage or start-up companies.
These privately held businesses tend to be thinly capitalized, unproven,
small companies with risky technologies that lack management depth and
have not attained profitability or have no history ofoperations.
Because of the speculative nature and the lack of a public market
for these investments, there is significantly greater risk of loss than
is the case with traditional investment securities. The Company expects
that some of its venture capital investments will be a complete loss or
will be unprofitable and that some will appear to be likely to become
successful but never realize their potential. The Company has been
risk seeking rather than risk averse in its approach to venture capital
and other investments. Neither the Company's investments nor an
investment in the Company is intended to constitute a balanced
investment program. Tiny technology companies in particular are
unproven, with significant science and technology risks as well as
commercialization risks. 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. Such sales are unpredictable
and may not occur.
The Company invests in securities that are illiquid and may not be
able to dispose of such securities when it is advantageous to do so.
Most of the investments of the Company are or will be equity
securities acquired directly from small companies. The Company's
portfolio of equity securities are and will usually be subject to
restrictions on resale or otherwise have no established trading
market. The illiquidity of most of the Company's portfolio of
equity securities may adversely affect the ability of the Company
to dispose of such securities at times when it may be
advantageous for the Company to liquidate such investments.
27
The inability of the Company's portfolio companies to market
successfully their products would have a negative impact on its
investment returns.
Even if the Company's portfolio companies are able to develop
commercially viable products, the market for new products and
services is highly competitive, rapidly changing and especially
sensitive to adverse general economic conditions. Commercial
success is difficult to predict and the marketing efforts of the
Company's portfolio companies may not be successful.
Because there is generally no established market in which to value the
Company's investments, the Company's Investment and Valuation Committee's
determination of their values may differ materially from the values that a
ready market or third party would attribute to these investments.
There is typically no public market for equity securities of the small
privately held companies in which the Company invests. As a result, the
valuation of most of the equity securities in the Company's portfolio is
subject to the good faith estimate of the Company's Board of Directors.
(See "Asset Valuation Policy Guidelines" in "Footnote to Consolidated
Schedule of Investments" contained in Item 1. "Consolidated Financial
Statements.") In the absence of a readily ascertainable market value, the
estimated value of the Company's portfolio of equity securities may differ
significantly from the values that would be placed on the portfolio if a
ready market for the equity securities existed. The Company adjusts quarterly
the valuation of its portfolio to reflect the Investment and Valuation
Committee's estimate of the current fair value of each investment in its
portfolio. Any changes in estimated fair value are recorded in the Company's
consolidated statements of operations as a change in the "Net (decrease)
increase in unrealized appreciation on investments." (See Item 2.
"Management's Discussion and Analysis of Financial Condition and Results
of Operations.")
Quarterly results may fluctuate and are not indicative of future
quarterly performance.
The Company's quarterly operating results could 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 the Company and its portfolio companies
encounter competition in their markets and general economic and market
conditions. As a result of these factors, results for any one quarter
should not be relied upon as being indicative of performance in future
quarters. (See Item 2. "Management's Discussion and Analysis of Financial
Condition and Results of Operations.")
Loss of pass-through tax treatment would substantially reduce net assets
and income available for dividends.
The Company currently qualifies as a RIC under the Code for pass-through
treatment because it meets certain diversification and distribution
requirements under the Code. The Company would cease to qualify for pass-
through tax treatment if it were unable to comply with these requirements.
The Company also could be subject to a four percent excise tax (and, in
certain cases, corporate level income tax) if it failed to make certain
gain or income distributions. (See Item 2. "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Recent
Developments -- Sub-Chapter M Status.") The lack of pass-through tax
treatment could have a material adverse effect on the total return, if
any, obtainable from an investment in the Company. If the Company fails
to qualify as a RIC, the Company would become subject to Federal income
tax as if it were an ordinary C Corporation, which tax would result in a
corresponding reduction in the Company's net assets and the amount of
income available for distribution to the Company's stockholders.
28
During some periods, there are few opportunities to take early stage
companies public or sell them to established companies.
During some periods, there may be few opportunities to gain liquidity
or realize a gain on an otherwise successful investment, as the market
for initial public offerings may be moribund, particularly for early stage,
high technology companies. During such periods or other periods, it may
also be difficult to sell such companies to established companies. The
lack of exit strategies during such periods also tends to have an
adverse effect on the ability of private equity companies to raise
capital privately.
Because the Company must distribute income, the Company will continue
to need additional capital to fund its investments and operating expenses.
The Company will continue to need capital to fund investments and to
pay for operating expenses. As a RIC, the Company annually must distribute
at least 90 percent of its investment company taxable income as a dividend
and may either distribute or retain its realized net capital gains from
investments. As a result, such earnings may not be available to fund
investments. If the Company fails to generate net realized long-term
capital gains or to obtain funds from outside sources, it could have a
material adverse effect on the Company's financial condition and results
as well as its ability to make follow-on and new investments. The
Company is not normally permitted to establish reserves for taxes on
unrealized capital gains. In addition, as a BDC, the Company is generally
required to maintain a ratio of at least 200 percent of total assets to
total borrowings, which may restrict its ability to borrow in certain
circumstances.
Loss of status as a RIC would reduce the Company's net asset value by
forcing it to establish currently unestablished reserves for taxes.
As a RIC, the Company does not pay Federal income taxes on its
income that is distributed to its shareholders. It is not permitted
to establish reserves for taxes on its unrealized capital gains. If
the Company failed to qualify for RIC status, it would have to establish
such reserves for taxes, which would reduce its net asset value, net of
a reduction in the reserve for employee profit sharing, accordingly. To
the extent that the Company, as a RIC, were to decide to make a deemed
distribution of net realized capital gains and were to retain such net
realized capital gains, it would have to establish appropriate reserves
for taxes upon making such a decision and subsequently pay such taxes.
Leveraging by the Company could result in making the Company's total
return to common shareholders more volatile.
Leverage entails two primary risks. The first risk is that the use
of leverage magnifies the impact on the common shareholders of changes in
net asset value. For example, a fund 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 leverage will
exceed the return on the securities acquired with the proceeds of
leverage, thereby diminishing rather than enhancing the return to common
shareholders. If the Company were to utilize leverage, these two risks
would generally make its total return to common shareholders more
volatile. In addition, the Company might be required to sell investments
in order to meet dividend or interest payments on the debt or preferred
stock when it might be disadvantageous to do so.
29
As provided in the 1940 Act and subject to certain exceptions, the
Company can issue debt or preferred stock so long as its total assets
immediately after such issuance, less certain ordinary course liabilities,
exceed 200% of the amount of the debt outstanding and exceed 200% of the
sum of the amount of the preferred stock and debt outstanding. Such debt
or preferred stock may be convertible in accordance with SEC guidelines
which may permit the Company to obtain leverage at attractive rates. A
leveraged capital structure creates certain special risks and potential
benefits not associated with unleveraged funds having similar investment
objectives and policies. Any investment income or gains from the capital
represented by preferred shares or debt which is in excess of the
dividends payable thereon will cause the total return of the common
shares to be higher than would otherwise be the case. Conversely, if the
investment performance of the capital represented by preferred shares or
debt fails to cover the dividends payable thereon, the total return of
the common shares would be less or, in the case of negative returns,
would result in higher negative returns to a greater extent than would
otherwise be the case. 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 the common shares means that dividends on the
common shares from earnings may be reduced or eliminated. Although an
inability to pay dividends on the common shares could conceivably result
in the Company ceasing to qualify as a RIC under the Code, which would
be materially adverse to the holders of the common shares, such inability
could be avoided through the use of mandatory redemption requirements
designed to ensure that the Company maintains the necessary asset coverage.
The class voting rights of preferred shares could make it more
difficult for the Company to take certain actions that may, in the future,
be proposed by the Board and/or the holders of common stock, such as a merger,
exchange of securities, liquidation or alteration of the rights of a class
of the Company's securities if such action would be adverse to the preferred
shares.
Preferred shares will be issued only if the Company's Board of Directors
determines in light of all relevant circumstances known to the Board that to
do so would be in the Company's best interest and in the best interest of
the Company's common shareholders. The circumstances that the Board will
consider before issuing preferred shares include not only the dividend rate
on the preferred shares in comparison to the Company's historical performance,
but also such matters as the terms on which the Company can call the preferred
shares and the Company's ability to meet the asset coverage tests and other
requirements imposed by the rating agencies for such preferred shares.
The issuance of preferred shares convertible into shares of common stock
might also reduce the net income and net asset value per share of the common
shares upon conversion. Such income dilution would occur if the Company could,
from the investments made with the proceeds of the preferred shares, earn an
amount per common share issuable upon conversion greater than the dividend
required to be paid on the amount of preferred stock convertible into one
share of common stock. Such net asset value dilution would occur if preferred
shares were converted at a time when the net asset value per common share was
greater than the conversion price.
Unfavorable economic conditions could result in financial losses for the
Company as well as impair its ability to engage in liquidity events.
Most of the companies in which the Company has made or will make
investments are susceptible to economic slowdowns or recessions. An
economic slowdown, capital markets conditions or credit squeeze may
affect the ability of a company to raise additional capital from venture
capital or other private equity sources or to engage in a liquidity event
such as an initial public offering or merger. These conditions could lead
to financial losses in the Company's portfolio. Unfavorable economic
conditions also could increase the Company's cost of capital.
30
On September 11, 2001, the World Trade Center in New York City and the
Pentagon near Washington, DC were targets of terrorists attacks. As a result
of these events and other general economic conditions, it was especially
difficult for small companies to sell new products and services or to raise
new capital, and the United States equity markets experienced declines. For
the quarter ended September 30, 2001, the Nasdaq Composite Index declined 31%.
The Company's business of making private equity investments and
positioning them for liquidity events also may be adversely affected by
current and future market and economic conditions. Significant changes
in the public equity markets could have an effect on the valuations of
privately held companies and on the potential for liquidity events involving
such companies, and such changes could adversely affect the amount and
timing of gains that may be realized on the Company's investments.
The Company invests in privately held companies that may complete initial
public offerings. These types of companies can be highly volatile and have
uncertain liquidity.
When companies in which the Company has invested as private entities
complete initial public offerings, they are by definition unseasoned issues.
Typically, they have relatively small capitalizations. Thus, they can be
expected to be highly volatile and of uncertain liquidity. If they are
perceived as suffering from adverse news or developments and/or the capital
markets are in a negative phase, not only their market prices, but also
their liquidity can be expected to be affected negatively. Historically,
the Company has also invested in unseasoned publicly traded companies
with similar characteristics and thus with similar exposure to potential
negative volatility and illiquidity. The decimalization of the stock
markets, particularly Nasdaq, may have decreased liquidity of stocks in
general and small capitalization issues in particular. In addition, the
imposition of decimalization on the stock exchanges, particularly Nasdaq,
may have reduced liquidity and increased volatility and riskiness of
small, thinly traded public companies because it may have lessened the
incentive for dealers to market and make markets in smaller issues.
Forward-Looking Statements
The information contained herein contains certain forward-looking
statements. These statements include the plans and objectives of
management for future operations and financial objectives, portfolio
growth and availability of funds. These forward-looking statements
are subject to the inherent uncertainties in predicting future results
and conditions. Certain factors that could cause actual results and
conditions to differ materially from those projected in these forward-
looking statements are set forth herein. Other factors that could cause
actual results to differ materially include the uncertainties of
economic, competitive and market conditions, and future business
decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company.
Although the Company believes that the assumptions underlying the
forward-looking statements included herein are reasonable, any of the
assumptions could be inaccurate and therefore there can be no assurance
that the forward-looking statements included or incorporated by
reference herein will prove to be accurate. Therefore, the inclusion
of such information should not be regarded as a representation by the
Company or any other person that the objectives and plans of the
Company will be achieved.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company's business activities contain elements of risk. The
Company considers a principal type of market risk to be valuation
risk. Investments are stated at "fair value" as defined in the 1940
Act and in the applicable regulations of the SEC. All assets are
valued at fair value as determined in good faith by, or under the
direction of, the Board of Directors. (See the "Asset Valuation
Policy Guidelines" in the "Footnote to Consolidated
31
Schedule of Investments contained in "Item 1. Consolidated Financial
Statements.")
Neither the Company's investments nor an investment in the Company
is intended to constitute a balanced investment program. The Company has
exposure to public-market price fluctuations to the extent of its publicly
traded portfolio, which portfolio may be composed primarily or entirely
of highly risky, volatile securities.
The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack management
depth and have not attained profitability or have no history of operations.
Because of the speculative nature and the lack of a public market for these
investments, there is significantly greater risk of loss than is the case
with traditional investment securities. The Company expects that some of
its venture capital investments will be a complete loss or will be
unprofitable and that some will appear to be likely to become successful
but never realize their potential. Even when the Company's private equity
investments complete initial public offerings (IPOs), the Company is
normally subject to lock-up agreements for a period of time.
Because there is typically no public market for the equity interests
of the small privately held companies in which the Company invests, the
valuation of the equity interests in the Company's portfolio is subject
to the estimate of the Company's Board of Directors in accordance with
the Company's Asset Valuation Policy Guidelines. In the absence of a
readily ascertainable market value, the estimated value of the Company's
portfolio of equity interests may differ significantly from the values
that would be placed on the portfolio if a ready market for the equity
interests existed. Any changes in valuation are recorded in the Company's
consolidated statements of operations as "Net increase (decrease) in
unrealized appreciation on investments."
32
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
Changes in and Disagreements With Accountants on Accounting and Financial
Disclosure
On February 26, 2002, the Company appointed the accounting firm of
PricewaterhouseCoopers LLP as independent public accountants for the
Company for the fiscal year ending December 31, 2002. Arthur
Andersen LLP was dismissed upon completion of the December 31,
2001 audit. The decision to change accountants was approved by the
Company's Audit Committee and is subject to ratification by its
stockholders.
In connection with its audits for the two most recent fiscal years,
(1) there were no disagreements with Arthur Andersen on any matter
of accounting principle or practice, financial statement disclosure,
auditing scope or procedure, whereby such disagreements, if not
resolved to the satisfaction of Arthur Andersen, would have caused
them to make reference thereto in their report on the financial
statements for such years; and (2) there have been no reportable
events (as defined in Item 304(a)(1)(v) of Regulation S-K).
The reports of Arthur Andersen on the financial statements of the
Company for the past two years contained no adverse opinion or
disclaimer of opinion and were not qualified or modified as to
uncertainty, audit scope or accounting principle.
The Company has not consulted with PricewaterhouseCoopers LLP
during the last two years or subsequent interim periods on either
the application of accounting principles to a specified transaction
either completed or proposed or the type of audit opinion
PricewaterhouseCoopers LLP might issue on the Company's financial
statements.
The Company requested that Arthur Andersen furnish a letter addressed
to the SEC stating whether or not Arthur Andersen agrees with the
above statements. A copy of such letter to the SEC, dated
March 1, 2002, was filed as Exhibit 16.1 to the Form 8-K filed with
the SEC on March 1, 2002.
33
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3.1(a) Restated Certificate of Incorporation of the Company, as
amended, incorporated by reference to Exhibit 3.1(a) to the
Company's Form 10-K for the year ended December 31, 1995.
3.1(b) Restated By-laws of the Company, incorporated by reference to
Exhibit 3.1(b) to the Company's Form 10K for the year ended
December 31, 1995.
4.1 Specimen Certificate of Common Stock, incorporated by reference
to Exhibit 4 to Company's Registration Statement on Form N-2
filed October 29, 1992.
10.22 Harris & Harris Group, Inc. Employee Profit-Sharing Plan,
incorporated by reference as Exhibit 10.22 to the Company's
Form 10K for the year ended December 31, 1999.
11.0* Computation of per share earnings. See Consolidated Statements
of Operations.
99.0 Certification of CEO and CFO pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
(b) Reports on Form 8-K
On March 1, 2002, the Company filed a Form 8-K stating that on
February 26, 2002, the Company appointed the accounting firm of
PricewaterhouseCoopers LLP as independent accountants for the fiscal year
ending December 31, 2002. Arthur Andersen was dismissed upon completion
of the December 31, 2001 audit.
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
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.
/s/ Helene B. Shavin
---------------------------
By: Helene B. Shavin,
Vice President and Controller
Date: August 14, 2002
34