UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended September 30, 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
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(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 November 1, 2002
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Common Stock, $0.01 par value per share 11,498,845 shares
Harris & Harris Group, Inc.
Form 10-Q, September 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 . . . . . . . . . . . . . . . . . . . . . . . . . 32
Item 4. Controls and Procedures. . . . . . . . . . . . . . . 33
PART II OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . 34
Item 2. Changes in Securities and Use of Proceeds . . . . . . 34
Item 3. Defaults Upon Senior Securities . . . . . . . . . . . 34
Item 4. Submission of Matters to a Vote of Security Holders . 34
Item 5. Other Information . . . . . . . . . . . . . . . . . . 34
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . 34
Signature . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Harris & Harris Group, Inc.
Form 10-Q, September 30, 2002
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated
financial statements reflects all adjustments that are, in the
opinion of management, necessary for a fair statement of the
results for the interim period presented.
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 qualify for or 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
September 30, 2002 December 31, 2001
(Unaudited) (Audited)
Investments, at value (Cost:
$30,117,427 at 9/30/02,
$37,714,285 at 12/31/01)...............$31,502,104 $38,930,705
Cash and cash equivalents............... 412,404 135,135
Restricted funds (Note 5)............... 745,646 482,020
Interest receivable..................... 90 82
Note receivable ($3,987, net of reserve
of $3,987 at 9/30/02)................. 0 10,487
Prepaid expenses........................ 20,587 14,833
Other assets............................ 104,154 109,105
----------- -----------
Total assets............................$32,784,985 $39,682,367
=========== ===========
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities............................$ 1,507,600 $ 1,039,350
Bank loan payable (Note 7).............. 0 12,495,777
Accrued profit sharing (Note 3)......... 427,047 178,282
Deferred rent........................... 7,710 14,650
Current income tax liability............ 76,371 255,068
Deferred income tax liability (Note 6).. 707,174 1,364,470
----------- -----------
Total liabilities....................... 2,725,902 15,347,597
----------- -----------
Commitments and contingencies (Note 7)
Net assets..............................$30,059,083 $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;
13,327,585 issued at 9/30/02 and
10,692,971 issued at 12/31/01.......... 133,276 106,930
Additional paid in capital (Note 4)..... 32,868,372 27,228,748
Additional paid in capital - common
stock warrants......................... 109,641 109,641
Accumulated net realized gain (loss).... (148,604) 618,606
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $882,748 at 9/30/02
and $1,540,044 at 12/31/01............. 501,929 (323,624)
Treasury stock at cost (1,828,740
shares at 9/30/02 and 12/31/01)........ (3,405,531) (3,405,531)
----------- -----------
Net assets..............................$30,059,083 $24,334,770
=========== ===========
Shares outstanding...................... 11,498,845 8,864,231
=========== ===========
Net asset value per outstanding share...$ 2.61 $ 2.75
=========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Nine Months Ended
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2002 2001 2002 2001
Investment income:
Interest from:
Fixed-income securities.....$ 46,508 $ 100,538 $ 140,779 $ 370,914
Affiliated companies........ 0 9,436 0 20,818
Other income................. 30,905 24,519 56,464 71,681
----------- ------------ ------------ ------------
Total investment income...... 77,413 134,493 197,243 463,413
Expenses:
Profit-sharing (reversal)
accrual (Note 3)............ (520) (1,028,995) 248,765 (1,162,303)
Salaries and benefits........ 259,974 228,038 779,939 783,953
Administration and
operations.................. 85,511 68,885 310,579 285,820
Professional fees............ 120,903 48,956 264,564 140,775
Rent......................... 43,040 44,364 129,620 134,830
Directors' fees and expenses. 38,207 22,020 115,385 68,375
Depreciation................. 8,176 7,500 20,861 22,500
Custodian fees............... 1,555 3,780 7,138 10,205
Interest expense (Note 4).... 0 0 10,776 0
----------- ------------ ----------- -----------
Total expenses............. 556,846 (605,452) 1,887,627 284,155
----------- ------------ ----------- -----------
Operating (loss) income
before income taxes......... (479,433) 739,945 (1,690,384) 179,258
Income tax provision
(Note 6).................... 0 0 0 0
----------- ------------ ----------- -----------
Net operating (loss) income... (479,433) 739,945 (1,690,384) 179,258
Net realized gain (loss) on
investments:
Realized gain (loss) on
investments................. 252,750 1,590,171 1,052,110 557,428
----------- ------------ ----------- -----------
Total realized gain (loss). 252,750 1,590,171 1,052,110 557,428
Income tax provision
(Note 6).................... (141,800) (123,546) (128,936) (175,821)
----------- ------------ ----------- -----------
Net realized gain (loss)
on investments.............. 110,950 1,466,625 923,174 381,607
Net realized (loss) income.... (368,483) 2,206,570 (767,210) 560,865
Net increase (decrease) in
unrealized appreciation on
investments:
Increase as a result of
investment sales............ 360,250 3,237,775 713,471 4,802,738
Decrease as a result of
investment sales............ 0 (854,467) 0 (854,467)
Increase on investments held. 2,347,172 16,130 2,392,249 3,232,919
Decrease on investments held. (2,335,247) (8,296,645) (2,937,463) (13,405,372)
----------- ------------ ----------- ------------
Net Change in unrealized
appreciation on investments. 372,175 (5,897,207) 168,257 (6,224,182)
Income tax benefit (Note 6).. 657,296 90,462 657,296 90,462
----------- ------------ ----------- ------------
Net increase (decrease) in
unrealized appreciation
on investments.............. 1,029,471 (5,806,745) 825,553 (6,133,720)
----------- ------------ ----------- ------------
Net increase (decrease) in
net assets resulting from
operations:
Total........................$ 660,988 $ (3,600,175) $ 58,343 $ (5,572,855)
=========== ============ =========== ============
Per outstanding share........$ .06 $ (.39) $ .01 $ (.63)
=========== ============ =========== ============
The accompanying notes are an integral part
of these consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended Nine Months Ended
September 30, 2002 September 30, 2001
Cash flows from operating activities:
Net increase (decrease) in net assets
resulting from operations.................$ 58,343 $ (5,572,855)
Adjustments to reconcile net decrease
in net assets resulting from operations
to net cash used in operating activities:
Net realized and unrealized loss (gain)
on investments.......................... (1,220,367) 5,666,752
Deferred income taxes.................... 0 90,462
Depreciation............................. 20,982 22,500
Changes in assets and liabilities:
Restricted funds......................... (263,626) (162,637)
Interest receivable...................... (8) 18,799
Notes receivable......................... 10,487 1,000
Prepaid expenses......................... (5,754) 63,539
Other assets............................. 4,951 (4,968)
Accounts payable and accrued liabilities. 468,250 111,136
Payable to broker for unsettled trade.... 0 (115,005)
Payable for treasury stock purchase...... 0 338,000
Accrued profit sharing................... 248,765 (3,483,241)
Current income tax liability............. (178,697) (5,708,790)
Deferred income tax liability............ (657,296) 0
Deferred rent............................ (6,940) (6,940)
------------- -------------
Net cash used in operating activities.... (1,520,910) (8,742,248)
Cash flows from investing activities:
Net sale of U.S. Treasury & Governmental
Agency Securities and purchase of
marketable securities................... 13,184,105 8,181,247
Proceeds from sale or liquidation of
investments............................. 1,140,191 2,656,118
Investment in private placements and
loans................................... (5,675,000) (1,818,826)
Purchase of fixed assets................. (27,810) (3,555)
------------- -------------
Net cash provided by investing
activities.............................. 8,621,486 9,014,984
Cash flows from financing activities:
Payment of bank loan payable............. (12,495,777) 0
Proceeds from rights offering net of
expenses................................. 5,665,970 0
Collection on note receivable............ 6,500 0
------------- -------------
Net cash used in financing activities.... (6,823,307) 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.............................. 412,404 526,060
------------- -------------
Net increase (decrease) in cash and
cash equivalents........................$ 277,269 $ 272,736
============= =============
Supplemental disclosures of cash flow
information:
Income taxes paid........................$ 307,585 $ 5,794,149
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 Nine Months Ended
Sept. 30, 2002 Sept. 30, 2001 Sept. 30, 2002 Sept. 30, 2001
Changes in net
assets from
operations:
Net operating
(loss) gain
income.........$ (479,433) $ 739,945 $(1,690,384) $ 179,258
Net realized
gain on
investments.... 110,950 1,466,625 923,174 381,607
Net increase
in unrealized
appreciation
on investments
as a result of
gain........... 360,250 2,473,770 713,471 4,038,733
Net increase
(decrease) in
unrealized
appreciation
on investments
held........... 669,221 (8,280,515) 112,082 (10,172,453)
----------- ----------- ---------- ------------
Net increase
(decrease) in
net assets
resulting from
operations..... 660,988 (3,600,175) 58,343 (5,572,855)
Changes in net
assets from capital
stock transactions:
Proceeds from
sale of common
stock.......... 26,346 0 26,346 0
Additional paid
in capital on
common stock
issued......... 5,639,624 0 5,639,624 0
Purchase of
treasury stock. 0 (338,000) 0 (338,000)
----------- ---------- ---------- ----------
Net increase in
net assets
resulting from
capital stock
transactions... 5,665,970 (338,000) 5,665,970 (338,000)
----------- ---------- ---------- ----------
Net increase
(decrease) in
net assets...... 6,326,958 (3,938,175) 5,724,313 (5,910,855)
Net assets:
Beginning of
the period..... 23,732,125 29,860,795 24,334,770 31,833,475
----------- ----------- ----------- -----------
End of the
period.........$30,059,083 $25,922,620 $30,059,083 $25,922,620
=========== =========== =========== ===========
The accompanying notes are an integral part
of these consolidated financial statements.
5
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (9)(10)(11) - 14.7% of total investments
Private Placement Portfolio (Illiquid) - 14.7% 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) -- $ 4,862
Continuum Photonics, Inc. (1)(2)(4)(5)(6) --
Develops optical networking components by
merging cutting-edge materials, MEMS and
electronics technologies -- 3.73% 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 communications 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 -- 4.15%
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)(5)(6) -- Develops and
commercializes nanomaterials for advanced
applications -- 1.34% of fully diluted equity
Series C Convertible Preferred Stock..........(A) 454,545 500,000
----------
Total Private Placement Portfolio (cost: $4,643,864)...................$4,644,862
----------
Total Investments in Unaffiliated Companies (cost: $4,643,864)........ $4,644,862
----------
The accompanying notes are an integral part
of this consolidated schedule.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated Companies (9)(10)(12) - 45.2% of
total investments
Private Placement Portfolio (Illiquid) - 45.2% of total investments
Agile Materials & Technologies, Inc.
(1)(2)(4)(6) -- Develops and sells
variable integrated passive electronic
equipment components -- 8.68% of
fully diluted equity
Series A Convertible Preferred Stock..........(A) 3,732,736 $1,000,000
Experion Systems, Inc. (1)(2)(5)(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)(5)(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) -- Develops and
sells medical devices for monitoring
neuromuscular disorders -- 13.03% of
fully diluted equity
Series A Convertible Preferred Stock..........(B) 875,000
Series B Convertible Preferred Stock..........(B) 625,000
Series C-2 Convertible Preferred Stock........(B) 1,148,100
Series E Convertible Preferred Stock..........(B) 266,665 4,372,148
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..................(B) -- 6,086,271
Questech Corporation (1)(2)(5) --
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 --
11.19% of fully diluted equity
Series B Convertible Preferred Stock..........(D) 2,306,194
Series B Convertible Preferred Warrants.......(D) 934,985 0
-----------
Total Private Placement Portfolio (cost: $12,848,917).................$14,233,007
-----------
Total Investments in Non-Controlled Affiliated Companies
(cost: $12,848,917)...................................................$14,233,007
-----------
The accompanying notes are an integral part of
this consolidated schedule.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
U.S. Government and Agency Obligations - 40.1% of total investments
U.S. Treasury Bills -- due date 10/10/02........(K) $4,900,000 $ 4,897,893
U.S. Treasury Bills -- due date 10/31/02........(K) $2,000,000 $ 1,997,280
U.S. Treasury Bills -- due date 11/14/02........(K) $ 730,000 $ 728,577
U.S. Treasury Bills -- due date 11/21/02........(K) $2,070,000 $ 2,065,363
U.S. Treasury Bills -- due date 11/29/02........(K) $ 945,000 $ 942,562
U.S. Treasury Bills -- due date 12/26/02........(K) $2,000,000 $ 1,992,560
-----------
Total Investments in U.S. Government (cost: $12,624,646)..............$12,624,235
-----------
Total Investments -- 100% (cost: $30,117,427).........................$31,502,104
===========
The accompanying notes are an integral part of
this consolidated schedule.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 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 Asset Valuation Policy Guidelines.
(4) Initial investment was made during 2002.
(5) No changes in valuation occurred in these investments during
the three months ended September 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 equity interest in each such portfolio company. The
calculated percentage represents the amount of the issuer's
equity securities the Company owns or can acquire as a
percentage of the issuer's total outstanding equity securities
plus equity securities reserved for issued and outstanding
warrants, convertible securities and all authorized stock
options, both granted and ungranted.
(11) The aggregate cost for federal income tax purposes of
investments in unaffiliated companies is $4,643,864. The gross
unrealized appreciation based on the tax cost for these
securities is $998.
(12) The aggregate cost for federal income tax purposes of
investments in non-controlled affiliated companies is
$12,848,917. The gross unrealized depreciation based on the tax
cost for these securities is $3,394,201. The gross unrealized
appreciation based on the tax cost for these securities is
$4,778,291.
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.
The values assigned to these investments are based on
available information and do not necessarily represent amounts
that might ultimately be realized, as such amounts depend on
future circumstances and cannot reasonably be determined until
the individual investments are actually liquidated.
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. 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 as 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
the Company's Investment and Valuation Committee within the
guidelines established by 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 September 30, 2002 consolidated financial statements
include a liability for deferred taxes on the remaining net
built-in gains, 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 operating
expenses and investment opportunities, rather than distribute
them to shareholders as cash distributions. 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 September 30,
2002 and December 31, 2001, and the reported amounts of revenues
and expenses for the three months ended September 30, 2002 and
September 30, 2001. Actual results could differ from these
estimates.
The interim financial data as of September 30, 2002 and
for the nine months ended September 30, 2002 and September 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
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
14
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 Company defines tiny technology to
be investments in nanotechnology, microsystems and
microelectromechanical systems (MEMS). 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, which include follow-on
investments in tiny technology and non-tiny technology, 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. On October 15, 2002, the Company's shareholders
approved this modification to the Employee Profit-Sharing Plan.
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 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), except for
grandfathered participations.
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 nine 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 $248,765 to $427,047.
15
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.
On October 15, 2002, the shareholders of the Company
approved the amendment and restatement of the Company's
existing Employee Profit-Sharing Plan.
NOTE 4. CAPITAL TRANSACTIONS
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.
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. The
actual amount of gross proceeds raised upon completion of the
offer was $5,927,882; net proceeds were $5,665,970, after
expenses of $261,912. The Company intends to invest, under
normal circumstances, directly or indirectly, the net proceeds of
the offer 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.
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 purchases made by the Directors.
On July, 23, 2002, because of the Company's strategic decision
to invest in tiny technology, the Board of Directors reaffirmed
its commitment not to authorize the purchase of additional shares
of stock in the foreseeable future.
On 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.
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.
16
The tax character of the 2000 and 2001 deemed dividend is
long-term capital gain.
As of December 31, 2001, there were 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 to expire on December 31, 1999.
The Employment Agreement will 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 provides him
with 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. 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
17
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 established 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 $745,646 as of September 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 September
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 qualify
initially as a RIC, among other requirements, the Company had to
pay a dividend to shareholders equal to the Company's cumulative
realized earnings and profits ("E&P"). On April 9, 1998, the
Company declared a one-time cash dividend of $0.75 per share to
meet this requirement (for a total of $8,019,728). The cash
dividend was paid on May 12, 1998.
18
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 September 30, 2002, the Company had
$501,640 of loss carryforwards remaining and $2,064,048 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 2002 and
future years. The Company may elect to make investments that would
disqualify it as a RIC, and the Company's ability to satisfy
those diversification 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 for 2002 and subsequent years.
During the nine months ended September 30, 2002, the Company
accrued a net tax benefit of $528,360. 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 nine months ended September 30, 2002 and
2001, the Company's income tax provision was allocated as
follows:
Three Three Nine Nine
Months Months Months Months
Ended Ended Ended Ended
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2002 2001 2002 2001
Net operating
loss $ 0 $ 0 $ 0 $ 0
Net realized gain
(loss) on
investments 141,800 123,546 128,936 175,821
Net increase
in unrealized
appreciation
on investments (657,296) (90,462) (657,296) (90,462)
---------- -------- ---------- --------
Total income
tax (benefit)
provision $ (515,496) $ 33,084 $ (528,360) $ 85,359
========== ======== ========== ========
The above tax (benefit) provision consists of the following:
Current $ 141,800 $123,546 $ 128,936 $175,821
Deferred -- Federal (657,296) (90,462) (657,296) (90,462)
--------- -------- --------- --------
Total income tax
provision $(515,496) $ 33,084 $(528,360) $ 85,359
========= ======== ========= ========
19
The Company's net deferred tax liability at September 30,
2002 and December 31, 2001 consists of the following:
September 30, 2002 December 31, 2001
Tax on unrealized appreciation
on built-in gains $ 722,417 $ 1,540,044
Net operating loss and capital
carryforward on built-in gains (175,574) (175,574)
Tax on unrealized income 160,331 0
------------ --------------
Net deferred income tax liability $ 707,174 $ 1,364,470
============ ==============
NOTE 7. COMMITMENTS AND CONTINGENCIES
Rent expense under the lease was $43,040 and $44,364 for the
three months ended September 30, 2002 and September 30, 2001 and
$129,620 and $134,830 for the nine months ended September 30,
2002 and September 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 collateralized 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 of $12,496,777 under the asset line of credit.
NOTE 8. SUBSEQUENT EVENTS
On November 1, 2002, the Company announced that it had
entered into a definitive agreement, effective December 31, 2002,
to liquidate its 20 percent interest in privately owned PHZ
Capital Partners L.P. The amount of cash and the tax effects
that the liquidation of the Company's interest will generate will
be determined upon closing of PHZ's books for the year 2002 and
completion of the Company's annual audit for the year 2002. The
Company had historically valued its interest in PHZ at its
capital account book value. For the period ended September 30,
2002, the fair value of the Company's interest in PHZ has been
estimated based on the capital account value and, in light of the
agreement, a premium to book value as outlined in the agreement.
NOTE 9. INTERIM FINANCIAL STATEMENTS
The interim financial statements of the Company have been
prepared in accordance with the instructions to Form 10-Q and
Article 10 of Regulations S-X. Accordingly, they do not include
all information and disclosures necessary for a presentation of
the Company's financial position, results of operations and cash
flows in conformity with generally accepted accounting principles
in the United States of America. In the opinion of management,
these financial statements reflect all adjustments, consisting
only of normal recurring accruals, necessary for a fair
presentation of the Company's financial position, results of
operations and cash flows for such periods. The results of
operations for any interim period are not necessarily indicative
of the results for the full year. These financial statements
should be read in conjunction with the financial statements and
notes thereto contained in the Company's Annual Report on Form
10-K for the fiscal year ended December 31, 2001.
20
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
(loss) income." 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, $32,784,985 and $30,059,083 at September 30, 2002,
compared with $39,682,367 and $24,334,770 at December 31, 2001.
Among the significant changes in the nine months ended
September 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) decline in
the value of the Company's investment in NeuroMetrix, Inc. of
$2,336,077; (4) increase in the value of the Company's investment
in PHZ Capital Partners L.P. of $3,165,270; (5) decrease in bank
loan payable of $12,495,777; and (6) net proceeds of $5,665,970
from the rights offering.
Net asset value per share ("NAV") was $2.61 at September 30,
2002, versus $2.75 at December 31, 2001. As a result of the
rights offering, the Company's shares outstanding increased by
2,634,614 during the nine months ended September 30, 2002, from
8,864,231 to 11,498,845.
The Company's financial condition is dependent on the
success of its investments. The Company has invested a
substantial portion of its assets in private development stage or
start-up companies. These private businesses tend to be thinly
capitalized, unproven, small companies that lack management depth
and have little or no history of operations. At September 30,
2002, $18,877,869 or 57.6 percent of the Company's total assets
(62.8 percent of the Company's net assets) consisted of non-
publicly traded securities at fair value, of which net unrealized
appreciation was $1,215,445.
The increase in the value of the non-publicly traded
securities from $13,120,978 at December 31, 2001 to $18,877,869
at September 30, 2002 reflected: the Company's seven new tiny-
technology enabled investments; the liquidation of Informio,
Inc.; an increase in the valuation of the Company's investment in
PHZ Capital Partners L.P.; the net effect of an additional
investment and decrease in valuation of the Company's holdings in
Experion Systems, Inc.; and a decrease in valuation of
NeuroMetrix, Inc.
21
A summary of the Company's investment portfolio is as
follows:
September 30, 2002 December 31, 2001
Investments, at cost $30,117,427 $37,714,285
Unrealized appreciation 1,384,677 1,216,420
----------- -----------
Investments, at fair value $31,502,104 $38,930,705
=========== ===========
The accumulated unrealized appreciation on investments net
of deferred taxes is $677,503 at September 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 or other coercive provisions, which have become
more common in venture capital investing since the general stock
market decline began in 2000. Alternatively, in order to try to
protect existing value or rights or prevent dilution, the Company
might elect to make follow-on investments even though they would
jeopardize the Company's RIC status or disqualify the Company
from RIC status. Loss of RIC status could have an adverse effect
on the price of the Company's common stock.
The following table is a summary of the cash investments
made by the Company in its private placement portfolio during the
nine months ended September 30, 2002:
New Investments: Amount
Agile Materials & Technologies, Inc. $1,000,000
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 $5,675,000
==========
22
Results of Operations
Investment Income and Expenses:
The Company had net operating (loss) income of ($1,690,384)
and $179,258 for the nine months ended September 30, 2002 and
September 30, 2001, respectively. The Company's net operating
income in the first nine months of 2001 reflected a reversal in
the employee profit-sharing account of $1,162,303; in the first
nine months of 2002, there was an accrual in the employee profit-
sharing account of $248,765. Professional fees in the first nine
months of 2002 were $264,564 versus $140,775 in the first nine
months of 2001.
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 $140,779 and $370,914 for the nine months ended
September 30, 2002 and September 30, 2001, respectively. The
decrease of $230,135 or 62.0 percent reflects primarily the steep
decline in short-term interest rates during the nine months ended
September 30, 2002 versus the nine months ended September 30,
2001.
The Company had interest income from affiliated companies of
$0 and $20,818 for the nine months ended September 30, 2002 and
September 30, 2001, respectively. The decrease of $20,818 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 $56,464 and $71,681 for the
nine months ended September 30, 2002 and September 30, 2001,
respectively. Other income primarily represents rental income
from subletting office space to an unaffiliated party. Other
income in the nine months ended September 30, 2002 included a
reserve against a note receivable and in the nine months ended
September 30, 2001, it included a gain on the sale of Company
property.
Operating expenses were $1,887,627 and $284,155 for the nine
months ended September 30, 2002 and September 30, 2001,
respectively. The operating expenses of the nine months ended
September 30, 2002 and 2001 reflect an increase (reversal) in the
employee profit-sharing accrual of $248,765 and ($1,162,303),
respectively, owing primarily to increases in realized gains in
2002 and decreases in unrealized appreciation of investments in
2001 for the nine-month period. In the first nine months of 2002
versus the first nine months of 2001, salaries and benefits
decreased by $4,014 or 0.5 percent, primarily as a result of no
bonus payroll taxes in 2002 offset by new employee expenses.
Professional fees increased $123,789 or 87.9 percent, primarily
as a result of expenses associated with new investments and
preparation of the Company's proxy statement. Directors' fees
and expenses increased $47,010 or 68.8 percent, as a result of a
special board meeting; 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 $46,508 and $100,538 for the three months ended September 30,
2002 and September 30, 2001, respectively, primarily reflecting
the steep decline in short-term interest rates during the three
months ended September 30, 2002, versus the three months ended
23
September 30, 2001. The Company had other income of $30,905 and
$24,519 for the three months ended September 30, 2002 and
September 30, 2001, respectively. Other income primarily
represents rental income from subletting office space to an
unaffiliated party. In the third quarter of 2002, other income
included a $3,000 payment received on a fully reserved note
receivable and $3,500 in directors' fees from PHZ Capital
Partners L.P.
Operating expenses were $556,846 and ($605,452) for the
three months ended September 30, 2002 and September 30, 2001,
respectively. The operating expenses of the third quarter of
2002 reflect an increase in professional fees of $120,903 or
84.2%, owing primarily to new investment expenses and expenses
associated with the preparation of the Company's proxy statement.
The operating expenses of the third quarter of 2001 reflect a
decrease in the employee profit-sharing accrual of $1,028,995,
owing to a decrease in unrealized appreciation of investments for
the three months ended September 30, 2001.
The Company has in the past relied, and continues to rely
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 nine months ended September 30, 2002 and 2001,
the Company realized gains of $1,052,110 and $557,428,
respectively. During the nine months ended September 30, 2002,
the Company's realized gains of $1,052,110 consisted primarily of
$120,133 received from the Nanophase Technologies Litigation
Settlement Fund and $1,661,892 from its partnership interest in
PHZ Capital Partners L.P., offset by a realized loss of $350,583
on the dissolution of Informio, Inc. and a realized loss of
$360,249 on the sale of Schwoo, Inc. convertible bridge loans.
During the nine months ended September 30, 2001, the Company
realized net gains of $557,428 consisting primarily of realized
gains (losses) from sales of SciQuest.com, Inc., ($1,528,082);
Essential.com, Inc. ($1,349,523); Genomica Corporation,
$1,022,970; Nanophase Technologies Corporation, $2,762,696; and
MedLogic Global Corporation ($1,033,765). The Company also
recorded a gain of $473,586 from its partnership interest in PHZ
Capital Partners L.P.
During the three months ended September 30, 2002 and
September 30, 2001, the Company realized gains of $252,750 and
$1,590,171, respectively. During the three months ended
September 30, 2002, the Company realized a net gain of $252,750,
consisting primarily of $64,631 received from the Nanophase
Technologies Litigation Settlement Fund and a gain of $553,666
from its partnership interest in PHZ Capital Partners L.P.,
offset by a realized loss of $360,249 on the sale of Schwoo, Inc.
convertible bridge loans.
During the three months ended September 30, 2001, the
Company realized net gains of $1,590,171 consisting primarily of
a realized gain of $196,409 from the Company's partnership
interest in PHZ Capital Partners L.P. and a net gain of
$1,402,496 on the realized gains from sales of its positions in
Nanophase Technologies Corporation and Genomica Corporation,
offset by realized losses from its sales of Essential.com, Inc.
and MedLogic Global Corporation.
Unrealized Appreciation and Depreciation of Portfolio
Securities:
The Company's Investment and Valuation Committee values the
portfolio securities on a quarterly basis pursuant to the
Company's Asset Valuation guidelines established by the Board of
Directors in accordance with the 1940 Act. (See "Footnote to
Consolidated Schedule of Investments" contained in Item 1.
"Consolidated Financial Statements.")
24
During the nine months ended September 30, 2002, net
unrealized appreciation on investments increased by $168,257 or
13.8% from $1,216,421 to $1,384,678, primarily as a result of an
increase in the unrealized appreciation of the Company's
investment in PHZ Capital Partners L.P. of $2,392,035, an
increase in unrealized appreciation of $353,221 as a result of
the realization of the loss on the dissolution of Informio, Inc.,
an increase in unrealized appreciation of $360,250 as a result of
the realization of the loss on the sale of the Schwoo, Inc.
convertible bridge loans, offset by declines in the value of the
Company's holdings of Experion Systems, Inc. of $600,000 and
NeuroMetrix, Inc. of $2,336,077.
During the nine months ended September 30, 2001, net
unrealized appreciation on investments decreased by $6,224,182 or
69.6 percent from $8,947,928 to $2,723,746, primarily as a result
of declines in the values of the Company's holdings of Nanophase,
Genomica, Essential.com and Experion Systems, Inc. of $5,499,664,
$1,540,375, $854,467 and $480,000, respectively. This decrease
was offset by increases in unrealized appreciation of $1,528,082
and $1,033,775 as a result of realizations of losses on the sales
of the Company's positions in SciQuest.com and MedLogic.
During the three months ended September 30, 2002, net
unrealized appreciation increased by $372,175 or 36.8 percent
from $1,012,503 to $1,384,678, owing primarily to the increase in
unrealized appreciation of the Company's investment in PHZ
Capital Partners L.P. of $2,347,100 and increase in unrealized
appreciation of $360,250 as a result of the realization of the
loss on the sale of the Schwoo, Inc. convertible bridge loans,
offset by the decline in the value of the Company's holdings in
NeuroMetrix, Inc. of $2,336,077.
During the three months ended September 30, 2001, net
unrealized appreciation decreased by $5,897,209 or 68.4 percent
from $8,620,955 to $2,723,746, owing primarily to the sale of the
Company's positions in Genomica Corporation and Nanophase
Technologies Corporation and to a decline in the value of the
Company's investment in Experion Systems of $480,000 and in
Informio of $353,221.
The changes in the values of Experion Systems, Inc. and
NeuroMetrix, 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 September
30, 2002 and December 31, 2001, respectively, the Company's total
primary sources of liquidity were $13,036,729 and $13,459,654.
On both of the corresponding dates, the Company's total secondary
source of 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 nine months of 2002 of
$888,661.
The decrease in the Company's primary source of liquidity
from December 31, 2001 to September 30, 2002 is owing primarily
to: (1) payment of federal income taxes of $307,585; (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; (9) investment in
Agile Materials & Technologies, Inc. of $1,000,000; (10) use of
funds for operating expenses offset by raising of $5,665,970 net
of expenses from the rights offering.
25
From December 31, 2001 to September 30, 2002, the Company's
liabilities for accrued employee profit sharing increased by
$248,765 or 139.5 percent to $427,047, 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
$835,992 or 51.6 percent to $783,545, primarily as a result of
the payment of taxes in connection with the deemed dividend
distribution and the reduction of the deferred tax liability
owing to the decrease in valuation of NeuroMetrix, Inc.
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. The Company might elect to
make follow-on investments even though they would jeopardize the
Company's RIC status or disqualify the Company from RIC status.
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. Loss of RIC status could have an adverse effect
on the price of the Company's common stock.
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.
26
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 or other coercive provisions which have become
more common in venture capital investing since the general stock
market decline began in 2000, 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,
compliance with certain regulations applicable to the Company's
business may prevent or discourage 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 two of its
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.
27
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 of operations. Because of the speculative nature
and the lack of a public market for these investments, there is
significantly greater risk of loss than is the case with
traditional investment securities. The Company expects that some
of its venture capital investments will be a complete loss or will
be unprofitable and that some will appear to be likely to become
successful but never realize their potential. The Company has
been risk seeking rather than risk averse in its approach to
venture capital and other investments. Neither the Company's
investments nor an investment in the Company is intended to
constitute a balanced investment program. 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, 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
makes many of its portfolio investments with the view of holding
them for a number of years. The Company's portfolio of equity
securities are and will usually be subject to restrictions on
resale or otherwise have no established trading market. The
illiquidity of most of the Company's portfolio of equity
securities may adversely affect the ability of the Company to
dispose of such securities at times when it may be advantageous
for the Company to liquidate such investments.
The inability of the Company's portfolio companies to 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 Investment and Valuation Committee within the guidelines
established by the 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.")
28
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. Loss
of RIC status could have an adverse effect on the price of the
Company's common stock.
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. Thus, the Company's business and the
Company's common stock are unusually vulnerable to adverse
economic and capital markets conditions.
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.
29
Loss of status as a RIC could 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,
to the extent that it had unrealized capital gains, it would have
to establish such reserves for taxes, which would reduce its net
asset value accordingly, net of a reduction in the reserve for
employee profit sharing. When the Company, as a RIC, decides to
make a deemed distribution of net realized capital gains and to
retain such net realized capital gains, it has 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.
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.
30
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 and capital markets 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 greatly increase the
probability of financial losses in the Company's portfolio.
Unfavorable economic and capital markets conditions also tend to
increase the Company's cost of capital and restrict the Company's
access to capital.
On September 11, 2001, the World Trade Center in New York
City and the Pentagon near Washington, DC were targets of
terrorist 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 possibility of future
terrorist attacks should be considered to be a risk factor for
the Company and its investee companies.
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
31
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. In general,
reforms of Nasdaq intended to make it a more visible and
efficient market may have had the effect of making it
unprofitable for dealers to make markets in smaller issues,
thereby decreasing the liquidity of such 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 its 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 the Investment and Valuation Committee under the
guidelines established by the Board of Directors. (See the
"Asset Valuation Policy Guidelines" in the "Footnote to
Consolidated Schedule of Investments contained in Item 1.
"Consolidated Financial Statements.")
Neither 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
Investment and Valuation Committee under the guidelines
32
established by the Board of Directors. 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."
Item 4. Controls and Procedures
The Company has established and maintains disclosure controls and
procedures designed to ensure that the information required to be
disclosed in its filings under the Securities Exchange Act of 1934
is recorded, processed, summarized, and reported on a timely basis.
Within 90 days prior to the filing date of this report, under the
supervision and with the participation of the Company's Chief
Executive Officer and the Chief Financial Officer, the Company has
evaluated the effectiveness of the Company's disclosure controls
and procedures. Based on that evaluation, the CEO and CFO concluded
that the Company's disclosure controls and procedures are effective
in timely alerting them of any material information relating to the
Company that is required to be disclosed by the Company in the
reports that it files or submits under the Securities Exchange
Act of 1934. There were no significant changes in the Company's
internal controls or in other factors that could significantly affect
those controls subsequent to the date of the evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Not Applicable
Item 2. Changes in Securities and Use of Proceeds
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. Other Information
Not Applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
--------
3.1(a) Restated Certificate of Incorporation 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 filed during the quarter ended
September 30, 2002
---------------------------------------------------
None
34
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: November 13, 2002
35
Certifications
I, Charles E. Harris, Chief Executive Officer of the Company,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of Harris
& Harris Group, Inc.
2. Based on my knowledge, this quarterly report does not
contain any untrue statement of a material fact or omit to
state a material fact necessary to make the statements made,
in light of the circumstances under which such statements
were made, not misleading with respect to the period covered
by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries, is
made known to us by others within those entities,
particularly during the period in which this quarterly
report is being prepared;
b. evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date within
90 days prior to the filing date of this quarterly
report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls and
procedures based on our evaluation as of the Evaluation
Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of
registrant's board of directors (or persons fulfilling the
equivalent function):
a. all significant deficiencies in the design or operation
of internal controls which could adversely affect the
registrant's ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies
and material weaknesses.
By: /s/ Charles E. Harris
--------------------------
Date: November 13, 2002 Charles E. Harris, Chief
Executive Officer
36
I, Mel P. Melsheimer, Chief Financial Officer of the Company,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of Harris
& Harris Group, Inc.
2. Based on my knowledge, this quarterly report does not
contain any untrue statement of a material fact or omit to
state a material fact necessary to make the statements made,
in light of the circumstances under which such statements
were made, not misleading with respect to the period covered
by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report,
fairly present in all material respects the financial
condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to
ensure that material information relating to the
registrant, including its consolidated subsidiaries, is
made known to us by others within those entities,
particularly during the period in which this quarterly
report is being prepared;
b. evaluated the effectiveness of the registrant's
disclosure controls and procedures as of a date within
90 days prior to the filing date of this quarterly
report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls and
procedures based on our evaluation as of the Evaluation
Date;
5. The registrant's other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of
registrant's board of directors (or persons fulfilling the
equivalent function):
a. all significant deficiencies in the design or operation
of internal controls which could adversely affect the
registrant's ability to record, process, summarize and
report financial data and have identified for the
registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves
management or other employees who have a significant
role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have
indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors
that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies
and material weaknesses.
By: /s/ Mel P. Melsheimer
--------------------------
Date: November 13, 2002 Charles E. Harris, Chief
Financial Officer
37