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 March 31, 2003
[ ] 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.
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(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 by check mark whether the registrant is an
accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [ X ]
Indicate the number of shares outstanding of each of the
issuer's classes of common stock, as of the latest practicable
date.
Class Outstanding at May 7, 2003
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Common Stock, $0.01 par 11,498,845 shares
value per share
Harris & Harris Group, Inc.
Form 10-Q, March 31, 2003
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...... 22
Financial Condition................................ 22
Results of Operations.............................. 23
Liquidity and Capital Resources.................... 24
Risk Factors....................................... 26
Item 3. Quantitative and Qualitative Disclosures
About Market Risk.................................. 31
Item 4. Controls and Procedures................... 32
PART II OTHER INFORMATION
Item 1. Legal Proceedings.......................... 33
Item 2. Changes in Securities and Use of Proceeds.. 33
Item 3. Defaults Upon Senior Securities............ 33
Item 4. Submission of Matters to a Vote of
Security Holders........................... 33
Item 5. Other Information.......................... 33
Item 6. Exhibits and Reports on Form 8-K........... 33
Signature.......................................... 34
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated
financial statements reflects all adjustments that are, in the
opinion of management, necessary for a fair statement of the
results for the interim period presented.
Harris & Harris Group, Inc. (the "Company") is an internally
managed, closed-end investment company that has elected to be
treated as a business development company under the Investment
Company Act of 1940. Certain information and disclosures
normally included in the consolidated financial statements in
accordance with Generally Accepted Accounting Principles have
been condensed or omitted as permitted by Regulation S-X and
Regulation S-K. It is suggested that the accompanying
consolidated financial statements be read in conjunction with the
audited consolidated financial statements and notes thereto for
the year ended December 31, 2002 contained in the Company's 2002
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, gains from the sale of securities and
similar sources; (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 to the extent it fails to distribute at least 98 percent of
its annual taxable income and would be subject to income tax to
the extent it fails to distribute 100 percent of its investment
company 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 April 2, 2003, the Company received SEC certification for
2002, permitting it to qualify for RIC treatment for 2002 (as it
had for 1999-2001). Although the SEC certification for 2002 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.
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
March 31, 2003 December 31, 2002
(Unaudited) (Audited)
Investments, at value
(Cost: $38,148,077 at
3/31/03, $30,206,935
at 12/31/02).............. $34,799,838 $27,486,822
Cash and cash equivalents.. 115,948 5,967,356
Restricted funds (Note 5).. 762,532 756,944
Funds in escrow............ 0 750,000
Receivable from portfolio
company................... 0 786,492
Interest receivable........ 22,086 189
Income tax receivable...... 72,546 0
Prepaid expenses........... 75,867 96,631
Other assets............... 109,607 107,535
----------- -----------
Total assets............... $35,958,424 $35,951,969
=========== ===========
LIABILITIES & NET ASSETS
Accounts payable and
accrued liabilities....... $ 1,519,347 $ 1,451,568
Payable to broker for
unsettled trade........... 0 5,696,725
Bank loan payable (Note 8). 7,724,207 0
Accrued profit sharing
(Note 3).................. 1,523 15,233
Deferred rent.............. 3,084 5,397
Current income tax
liability................. 0 857,656
Deferred income tax
liability (Note 6)........ 669,344 669,344
----------- -----------
Total liabilities.......... 9,917,505 8,695,923
----------- -----------
Commitments and contingencies
(Note 7)
Net assets................. $26,040,919 $27,256,046
=========== ===========
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 3/31/03 and
12/31/02.................. 133,276 133,276
Additional paid in capital
(Note 4).................. 32,845,872 32,845,872
Additional paid in capital
- common stock warrants... 109,641 109,641
Accumulated net realized
gain...................... 550,819 1,137,820
Accumulated unrealized
appreciation of
investments, net of
deferred tax liability
of $844,918 at 3/31/03
and 12/31/02.............. (4,193,158) (3,565,032)
Treasury stock, at cost
(1,828,740 shares at
3/31/03 and 12/31/02)..... (3,405,531) (3,405,531)
----------- -----------
Net assets................. $26,040,919 $27,256,046
=========== ===========
Shares outstanding......... 11,498,845 11,498,845
=========== ===========
Net asset value per
outstanding share......... $ 2.26 $ 2.37
=========== ===========
The accompanying notes are an integral
part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2003 March 31, 2002
Investment income:
Interest from
unaffiliated issuers.... $ 46,246 $ 54,136
Other income............. 18,430 5,326
Total investment income. 64,676 59,462
Expenses:
Profit-sharing accrual
(Note 3)................ 0 127,959
Salaries and benefits.... 362,196 255,376
Administration and
operations.............. 95,112 87,902
Professional fees........ 67,158 43,095
Rent..................... 47,877 42,724
Directors' fees and
expenses................ 56,365 41,076
Depreciation............. 9,980 5,948
Custodian fees........... 2,187 3,839
Interest expense
(Note 4)................ 8,261 7,776
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Total expenses.......... 649,136 615,695
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Operating loss before
income taxes............ (584,460) (556,233)
Income tax provision
(Note 6)................ 0 0
----------- -------------
Net operating loss........ (584,460) (556,233)
Net realized gain on investments:
Realized gain on
investments............. 432 110,679
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Total realized gain... 432 110,679
Income tax provision
(Note 6)................ (2,973) (34,223)
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Net realized (loss)
gain on investments..... (2,541) 76,456
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Net realized loss......... (587,001) (479,777)
Net decrease in unrealized
appreciation on investments:
Decrease as a result of
investment sales........ 0 0
Increase as a result of
investment sales........ 0 0
Increase on investments
held.................... 227,838 45,006
Decrease on investments
held.................... (855,964) (602,163)
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Change in unrealized
appreciation on
investments........... (628,126) (557,157)
Income tax provision
(Note 6)................ 0 0
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Net decrease in
unrealized appreciation
on investments.......... (628,126) (557,157)
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Net decrease in net assets
resulting from operations:
Total.................... $(1,215,127) $ (1,036,934)
=========== =============
Per outstanding share.... $ (0.11) $ (0.12)
=========== =============
The accompanying notes are an integral
part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2003 March 31, 2002
Cash flows from
operating activities:
Net decrease in net
assets resulting from
operations............... $(1,215,127) $(1,036,934)
Adjustments to reconcile
net decrease in net assets
resulting from operations
to net cash used in
operating activities:
Net realized and
unrealized loss on
investments............ 627,694 442,349
Depreciation............. 9,980 5,948
Changes in assets and liabilities:
Restricted funds......... (5,588) (72,947)
Receivable from
investment company...... 786,492 0
Funds in escrow.......... 750,000 0
Interest receivable...... (21,897) 82
Note receivable.......... 0 10,487
Current income tax
receivable.............. (72,546) 0
Prepaid expenses......... 20,764 (56,284)
Other assets............. (2,072) 17,627
Accounts payable and
accrued liabilities..... 67,779 (9,597)
Payable to broker for
unsettled trade......... (5,696,725) 0
Accrued profit sharing... (13,710) 127,959
Current income tax
liability............... (857,656) (256,875)
Deferred rent............ (2,313) (2,313)
----------- -----------
Net cash used in
operating activities.... (5,624,925) (830,498)
Cash flows from investing
activities:
Net (purchase) sale of
short-term investments
and marketable
securities.............. (7,211,448) 6,753,035
Proceeds from
investments............. 12,088 180,211
Investment in private
placements and loans.... (750,000) (2,425,000)
Purchase of fixed assets. (1,330) (1,821)
----------- -----------
Net cash (used in)
provided by investing
activities.............. (7,950,690) 4,506,425
Cash flows from financing
activities:
Payment of bank loan
payable................. 0 (3,499,037)
Proceeds from bank loan
payable................. 7,724,207 0
----------- -----------
Net cash provided by
(used in) financing
activities.............. 7,724,207 (3,499,037)
Net increase (decrease) in
cash and cash equivalents:
Cash and cash
equivalents at beginning
of the period........... 5,967,356 135,135
Cash and cash
equivalents at end of
the period.............. 115,948 312,025
----------- -----------
Net (decrease) increase
in cash and cash
equivalents............. $(5,851,408) $ 176,890
=========== ===========
Supplemental disclosures
of cash flow information:
Income taxes paid........ $ 565,000 $ 290,748
Interest paid............ $ 0 $ 11,108
The accompanying notes are an integral
part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2003 March 31, 2002
Changes in net assets
from operations:
Net operating loss....... $ (584,460) $ (556,233)
Net realized (loss)
gain on investments..... (2,541) 76,456
Net increase in
unrealized appreciation
on investments as a
result of sales......... 0 0
Net decrease in
unrealized appreciation
on investments held..... (628,126) (557,157)
------------ -----------
Net decrease in net
assets resulting from
operations.............. (1,215,127) (1,036,934)
Net decrease in net
assets.................... (1,215,127) (1,036,934)
------------ -----------
Net assets:
Beginning of the period.. 27,256,046 24,334,770
----------- -----------
End of the period........ $26,040,919 $23,297,836
=========== ===========
The accompanying notes are an integral
part of these consolidated financial statements.
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CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated
Companies (8)(9)(10) -- 9.2%
of total investments
Private Placement Portfolio
(Illiquid) -- 9.2% of total
investments
AlphaSimplex Group, LLC (2)(12)
-- Investment advisory firm
headed by Dr. Andrew W. Lo,
holder of the Harris & Harris
Group Chair at MIT
Limited Liability Company interest....(D) -- $ 4,301
Continuum Photonics, Inc.
(1)(2)(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...(D) 2,000,000 123,394
Exponential Business Development
Company (1)(2)(5)(12) -- 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...(D) 476,191 0
NanoGram Devices Corporation
(1)(2)(4)(6) -- Develops power
components for biomedical
applications by utilizing a
patented nanomaterial synthesis
process -- 4.63% of fully diluted
equity
Series A-2 Convertible Preferred Stock.(B) 750,000 750,000
NanoOpto Corporation (1)(2)(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.(D) 267,857 237,866
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)(6) --
Develops and manufactures planar
optical devices and components
using nanomaterials deposition
technology -- 1.76% of fully
diluted equity
Series D Convertible Preferred Stock...(D) 1,498,802 320,071
Optiva, Inc. (1)(2)(5)(6) -- Develops
and commercializes nanomaterials
for advanced applications -- 1.99%
of fully diluted equity
Series C Convertible Preferred Stock...(B) 1,249,999 1,250,000
----------
Total Private Placement Portfolio (cost: $6,143,161).......$3,200,631
----------
Total Investments in Unaffiliated Companies
(cost: $6,143,161).........................................$3,200,631
----------
The accompanying notes are an integral
part of this consolidated schedule.
- 6 -
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled
Affiliated Companies (8)(9)(11)
- -- 25.7% of total investments
Private Placement Portfolio
(Illiquid) -- 25.7% of total
investments
Agile Materials & Technologies,
Inc. (1)(2)(5)(6) -- Develops
and sells variable integrated
passive electronic equipment
components -- 8.15% 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
-- 12.86% of fully diluted equity
Series A Convertible Preferred Stock...(B) 294,118
Series B Convertible Preferred Stock...(B) 35,294
Series C Convertible Preferred Stock...(B) 222,184 $1,037,000
Nanopharma Corp. (1)(2)(6) --
Develops advanced nanoscopic drug
delivery vehicles and systems --
14.69% of fully diluted equity
Series A Convertible Preferred Stock...(A) 684,516 350,000
Nanotechnologies, Inc. (1)(2)(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)(5) --
Develops and sells medical devices
for monitoring neuromuscular disorders
-- 12.10% 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) 499,996
Series E-1 Convertible Preferred Stock.(B) 235,521 5,075,426
Questech Corporation (1)(2)(5) --
Manufactures and markets proprietary
metal decorative tiles -- 6.68% of
fully diluted equity
Common Stock...........................(B) 646,954
Warrants at $5.00 expiring 11/15/04....(B) 1,966
Warrants at $1.50 expiring 11/16/05....(B) 1,250
Warrants at $1.50 expiring 12/14/06....(B) 8,500
Warrants at $1.50 expiring 11/21/07....(B) 3,750 724,588
----------
Total Private Placement Portfolio (cost: $9,359,300)........$8,937,014
----------
Total Investments in Non-Controlled Affiliated Companies
(cost: $9,359,300)..........................................$8,937,014
----------
The accompanying notes are an integral
part of this consolidated schedule.
- 7 -
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
U.S. Government and Agency
Obligations -- 65.1% of total
investments
U.S. Treasury Bills --
due date 04/10/03....................(K) $3,450,000 $ 3,448,896
U.S. Treasury Bills --
due date 04/17/03....................(K) 5,100,000 5,097,195
U.S. Treasury Bills --
due date 04/24/03....................(K) 2,700,000 2,697,921
U.S. Treasury Bills --
due date 05/22/03....................(K) 3,700,000 3,694,080
Federal Home Loan Bank Note --
due date 02/15/05....................(H) 7,700,000 7,724,101
-----------
Total Investments in U.S. Government (cost: $22,645,616)...$22,662,193
-----------
Total Investments -- 100% (cost: $38,148,077)..............$34,799,838
===========
The accompanying notes are an integral
part of this consolidated schedule.
- 8 -
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2003
(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 2003.
(5) No changes in valuation occurred in these investments during
the three months ended March 31, 2003.
(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) 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.
(9) The percentage ownership of each portfolio company disclosed
in the Consolidated Schedule of Investments expresses the
potential equity interest in each such portfolio company. The
calculated percentage represents the amount of the issuer's
equity securities 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.
(10) The aggregate cost for federal income tax purposes of
investments in unaffiliated companies is $6,143,161. The
gross unrealized appreciation based on the tax cost for
these securities is $1,140. The gross unrealized depreciation
based on the tax cost for these securities is $2,943,670.
(11) The aggregate cost for federal income tax purposes of
investments in non-controlled affiliated companies is
$9,359,300. The gross unrealized appreciation based on
the tax cost for these securities is $2,414,044. The
gross unrealized depreciation based on the tax cost for
these securities is $2,836,330.
(12) Non-registered investment company.
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 Valuation Committee (formerly named the
"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 value using one or
more of the following basic methods of valuation:
- 10 -
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
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 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.
- 11 -
F. Private Market: The private market method uses actual
third-party investments in intellectual property or patents or
research and development in technology or product development as
a basis for valuation, using actual executed historical
transactions by responsible third parties. The private market
method may also use, where applicable, unconditional firm offers
by responsible third parties as a basis for valuation.
G. Analytical Method: The analytical method is used to
value an investment after analysis of the best available outside
information where the factual information available to the
Company dictates that an investment should no longer be valued
under either the cost or private market method. This valuation
method is inherently imprecise and ultimately the result of
reconciling the judgments of the Company's 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 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 Valuation Committee.
The reported values of securities for which market
quotations are not readily available and for other assets
reflect the 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 owned, until December 31, 2002, 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 Harris & Harris Group, Inc. (sole limited
partner).
The Company filed for the 1999 tax year to elect treatment
as a Regulated Investment Company ("RIC") under Sub-Chapter M of
the Internal Revenue Code of 1986 (the "Code") and qualified for
the same treatment for 2000-2002. There can be no assurance that
the Company will qualify as a RIC for 2003 and subsequent years
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 factors, distribute at least
90 percent of its investment company taxable income and may
either distribute or retain its realized net capital gains on
investments.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting
policies followed in the preparation of the consolidated
financial statements:
Principles of Consolidation. The consolidated financial
statements have been prepared in accordance with accounting
principles generally accepted in the United States for investment
companies and include the accounts of the Company and its wholly
owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
Cash and Cash Equivalents. Cash and cash equivalents
include money market instruments with maturities of less than
three months.
- 13 -
Portfolio Investment Valuations. Investments are stated at
"value" as defined in the 1940 Act and in the applicable
regulations of the Securities and Exchange Commission. Value, as
defined in Section 2(a)(41) of the 1940 Act, is (i) the market
price for those securities for which a market quotation is
readily available and (ii) for all other assets is as determined
in good faith by, or under the direction of, the Board of
Directors. (See "Asset Valuation Policy Guidelines" in the
"Footnote to Consolidated Schedule of Investments.")
Securities Transactions. Securities transactions are
accounted for on the date the securities are purchased or sold
(trade date); dividend income is recorded on the ex-dividend
date; and interest income is accrued as earned. Realized gains
and losses on investment transactions are determined on specific
identification for financial reporting and tax reporting.
Income Taxes. Prior to January 1, 1999, the Company
recorded income taxes using the liability method in accordance
with the provision of Statement of Financial Accounting Standards
No. 109. Accordingly, deferred tax liabilities had been
established to reflect temporary differences between the
recognition of income and expenses for financial reporting and
tax purposes, the most significant difference of which relates to
the Company's unrealized appreciation on investments.
The March 31, 2003 consolidated financial statements include
a provision for deferred taxes on the remaining net built-in
gains as of December 31, 1998, net of the unutilized operating
and capital loss carryforwards incurred by the Company through
December 31, 1998.
The Company pays federal, state and local income taxes on
behalf of its wholly owned subsidiary, Harris & Harris
Enterprises, which is a C corporation. (See "Note 6. Income
Taxes.")
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 March 31, 2003,
and December 31, 2002, and the reported amounts of revenues and
expenses for the three months ended March 31, 2003, and March 31,
2002. The most significant estimates relate to the fair
valuations of investments for the three months ended March 31,
2003, and March 31, 2002. Actual results could differ from these
estimates.
NOTE 3. EMPLOYEE PROFIT SHARING PLAN
On August 3, 1989, the shareholders of the Company approved
the 1988 Long Term Incentive Compensation Plan (the "1988
Plan"). The Company's 1988 Plan was cancelled as of December
31, 1997, canceling all outstanding stock options and
eliminating all potential stock option grants. As a
substitution for the 1988 Plan, the Company adopted an employee
profit-sharing plan.
As of January 1, 1998, the Company implemented the Harris &
Harris Group, Inc. Employee Profit-Sharing Plan (the "1998 Plan")
that provided for profit sharing equal to 20 percent of the net
realized income of the Company as reflected on the Consolidated
Statements of Operations for such year, less the nonqualifying
gain, if any. The 1998 Plan was terminated by the Company as of
December 31, 1999, subject to the payment of any amounts owed on
the 1999 realized gains under the 1998 Plan.
In March 2000, the Company paid out 90 percent of the
profit sharing in the amount of $1,024,696 on the 1999 realized
gains; the remaining 10 percent or $113,855 was paid out in
September 2000, upon the completion and filing of the Company's
1999 federal tax return.
- 14 -
As of January 1, 2000, the Company implemented the Harris &
Harris Group, Inc. Employee Profit-Sharing Plan (the "Plan") that
provides for profit sharing by its officers and employees equal
to 20 percent of the net realized income of the Company as
reflected on the consolidated statements of operations of the
Company for such year, less the nonqualifying gain, if any.
Under the Plan, net realized income of the Company includes
investment income, realized gains and losses, and operating
expenses (including taxes paid or payable by the Company), but is
calculated without regard to dividends paid or distributions made
to shareholders, payments under the Plan, unrealized gains and
losses, and loss carry-overs 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.
As soon as practicable following the year-end audit, the
Compensation Committee (the "Committee") 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.
As of January 1, 2003, the Company implemented the Amended
and Restated Harris & Harris Group, Inc. Employee Profit-Sharing
Plan (the "2002 Plan"). The shareholders of the Company approved
the performance goals under the 2002 Plan in accordance with
Section 162(m) of the Internal Revenue Code of 1986 ("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.
Under the 2002 Plan, net realized income of the Company
includes investment income, realized qualifying gains and losses,
and operating expenses (including taxes paid or payable by the
Company), but is calculated without regard to dividends paid or
loss carry-overs from other years ("Qualifying Income").
Under the 2002 Plan, awards previously granted to the Plan's
four current Participants (Messrs. Harris and Melsheimer and Mss.
Shavin and Matthews, herein referred to as the "grandfathered
participants") will be reduced by 10% with respect to "Non-Tiny
Technology Investments" (as defined in the 2002 Plan) and by 25%
with respect to "Tiny Technology Investments" (as defined in the
2002 Plan) and will become permanent. These reduced awards are
herein referred to as "grandfathered participations." The amount
by which such awards are reduced will be allocable and
reallocable each year by the Compensation Committee ("Committee")
among current and new participants as awards under the 2002 Plan.
The grandfathered participations will be honored by the Company
whether or not the grandfathered participant is still employed by
the Company or is still alive (in the event of death, the
grandfathered participations will be paid to the grandfathered
participant's estate), unless the grandfathered participant is
dismissed for cause, in which case all awards, including the
grandfathered participations, will be immediately cancelled and
forfeited. With regard to new investments and follow-on
investments made after the date on which the first new employee
begins participating in the 2002 Plan, both current and new
participants will be required to be employed by the Company at
the end of a plan year in order to participate in profit sharing
on such investments with respect to such year.
Notwithstanding any provisions of the 2002 Plan, in no event
may the aggregate amount of all awards payable for any Plan Year
during which 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
- 15 -
57(n)(1)(B) of the 1940 Act. In the event the awards as
calculated exceed such amount, the awards will be reduced pro
rata.
The 2002 Plan may be modified, amended or terminated by the
Committee at any time. Notwithstanding the foregoing, the
grandfathered participations may not be modified. Nothing in the
2002 Plan will preclude the Committee from naming additional
participants in the 2002 Plan or, except for grandfathered
participations, changing the Award Percentage of any Participant
(subject to the overall percentage limitations contained in the
2002 Plan). Under the 2002 Plan, the distribution amounts for
non-grandfathered investments for each officer and employee
currently are as follows: Charles E. Harris, 10.790 percent; Mel
P. Melsheimer, 4.233 percent; Douglas W. Jamison, 3.0 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 reason other than due to termination for cause, any
amount earned will be accrued and may subsequently be paid to
such participant.
The grandfathered participations are set forth below:
Grandfathered Participations
Officer/Employee Non-Tiny Technology (%) Tiny Technology (%)
Charles E. Harris 12.41100 10.34250
Mel P. Melsheimer 3.80970 3.17475
Helene B. Shavin 1.37160 1.14300
Jacqueline M. Matthews .40770 .33975
Total 18.00000 15.00000
Accordingly, an additional 2.00% of Qualifying Income with
respect to grandfathered Non-Tiny Technology Investments, 5.00%
of Qualifying Income with respect to grandfathered Tiny
Technology Investments and the full 20.00% of Qualifying Income
with respect to new investments are available for allocation and
reallocation from year to year. Currently, Douglas W. Jamison is
allocated 0.80% of the Non-Tiny Technology Grandfathered
Participations and 2.00% of the Tiny Technology Grandfathered
Participations.
The Company calculates the profit-sharing accrual at each
quarter end based on the realized and unrealized gains at that
date, net of operating expenses for the year. Any adjustments to
the profit-sharing accrual are then reflected in the Consolidated
Statements of Operations for the quarter. The profit-sharing
accrual is not paid out until the gains are realized. During the
first quarter of 2003, the Company, under the Harris & Harris
Group, Inc. Employee Profit-Sharing Plan, paid out 90 percent of
the 2002 profit sharing in the amount of $13,710. The remaining
10 percent of the 2002 profit sharing, $1,523, will be paid out
upon the completion and filing of the Company's 2002 federal tax
return.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that, effective
January 1, 1998, 50 percent of all Directors' fees be used to
purchase Company common stock from the Company. However,
effective March 1, 1999, the directors may purchase the Company's
common stock in the open market, rather than from the Company.
Since 1998, the Company has repurchased a total of 1,859,047
of its shares for a total of $3,496,388, including commissions
and expenses, at an average price of $1.88 per share. These
treasury shares were reduced by the purchases made by the
Directors. On July 23, 2002, because of the Company's 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.
- 16 -
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 $5,643,470, after
expenses of $284,412. 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.
As of December 31, 2002, there are no distributable
earnings. The difference between the book basis and tax basis
components of distributable earnings is attributed to Built-In
Gains generated at the time of the Company's qualification as a
RIC (see Note 6. "Income Taxes") and after tax earnings that
are not required to be distributed.
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment
Agreement with the Company (disclosed in a Form 8-K filed on
October 27, 1999) (the "Employment Agreement"), which superseded
an employment agreement that was about to expire on December 31,
1999. The Employment Agreement shall terminate on December 31,
2004 ("Term") subject to either an earlier termination or an
extension in accordance with the terms; on January 1, 2000 and on
each day thereafter, the Term extends automatically by one day
unless at any time the Company or Mr. Harris, by written notice,
decides not to extend the Term, in which case the Term will
expire five years from the date of the written notice.
During the period of employment, Mr. Harris shall serve as
the Chairman and Chief Executive Officer of the Company; be
responsible for the general management of the affairs of the
Company and all its subsidiaries, reporting directly to the Board
of Directors of the Company; serve as a member of the Board for
the period of which he is and shall from time to time be elected
or reelected; and serve, if elected, as President of the Company
and as an officer and director of any subsidiary or affiliate of
the Company.
Mr. Harris is to receive compensation under his Employment
Agreement in the form of base salary of $208,315 for 2000, with
automatic yearly adjustments to reflect inflation. In addition,
the Board may increase such salary, and consequently decrease it,
but not below the level provided for by the automatic adjustments
described above. Mr. Harris is also entitled to participate in
the Company's Profit-Sharing Plan as well as in all compensation
or employee benefit plans or programs, and to receive all
benefits, perquisites, and emoluments for which salaried
employees are eligible. Under the Employment Agreement, the
Company is to furnish Mr. Harris with certain perquisites which
include a company car, membership in certain clubs and up to a
$5,000 annual reimbursement for personal, financial or tax
advice.
The Employment Agreement provides Mr. Harris with life
insurance for the benefit of his designated beneficiaries in the
amount of $2,000,000; provides reimbursement for uninsured
medical expenses, not to exceed $10,000 per annum, adjusted for
inflation, over the period of the contract; provides Mr. Harris
and his spouse with long-term care insurance; and disability
insurance in the amount of 100 percent of his base salary. These
benefits are for the term of the Employment Agreement.
- 17 -
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 annual salary
to be credited each month (a "Monthly Credit") to a special
account maintained for this purpose on the books of the Company
for the benefit of Mr. Harris (the "SERP Account"). The amounts
credited to the SERP Account will be deemed invested or
reinvested in such mutual funds or U.S. Government securities as
determined by Mr. Harris. The SERP Account will be credited and
debited to reflect the deemed investment returns, losses and
expenses attributed to such deemed investments and reinvestments.
Mr. Harris's benefit under the SERP will equal the balance in
the SERP Account and such benefit will always be 100 percent
vested (i.e., not forfeitable). Mr. Harris will determine the
form and timing of the distribution of the balance in the SERP
Account; provided, however, in the event of the termination, the
balance in the SERP Account will be distributed to Mr. Harris or
his beneficiary, as the case may be, in a lump-sum payment within
30 days of such termination. The Company will establish a rabbi
trust for the purpose of accumulating funds to satisfy the
obligations incurred by the Company under the SERP. The
restricted funds for the SERP Plan total $762,532 as of March 31,
2003. 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. During 2002, contributions to the plan that have
been charged to salaries and benefits totaled approximately
$51,500.
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 March 31,
2003, the Company had a reserve of $446,302 for the plan.
- 18 -
On March 20, 2003, in order to begin planning for eventual
management succession, the Board of Directors voted to establish
a mandatory retirement plan for individuals who are employed by
the Company in a bona fide executive or high policy making
position. There are currently two such individuals, the Chairman
and CEO, and the President and COO. Under this plan, mandatory
retirement will take place effective December 31 of the year in
which the eligible individuals attain the age of 65. On an
annual basis beginning in the year in which the designated
individual attains the age of 65, a committee of the Board
consisting of non-interested directors may determine to postpone
the mandatory retirement date for that individual for one
additional year for the benefit of the Company.
Under applicable law prohibiting discrimination in
employment on the basis of age, the Company can impose a
mandatory retirement age of 65 for its executives or employees in
high policy-making positions only if each employee subject to the
mandatory retirement age is entitled to an immediate retirement
benefit at retirement age of at least $44,000 per year. The
benefits payable at retirement to Charles E. Harris, the
Company's Chairman and Chief Executive Officer, and Mel P.
Melsheimer, the Company's President, Chief Operating Officer and
Chief Financial Officer, under the Company's existing retirement
plans do not equal this threshold. Mr. Harris has offered, for
the benefit of the Company, to waive his right to exclude certain
other benefits from this calculation, which makes it unlikely
that any provision will have to be made for him in order for the
Company to comply with this threshold requirement. For Mr.
Melsheimer, however, a new plan must be established to provide
him with the difference between the benefit required under the
age discrimination laws and that provided under the Company's
existing plans. The expense to the Company of providing the
benefit under this new plan is currently estimated to be
$450,000. This benefit will be unfunded, and the expense will be
amortized over the fiscal periods through the year ended December
31, 2004.
NOTE 6. INCOME TAXES
The Company elected Sub-Chapter M status for the year ended
December 31, 1999. On February 23, 1999, the Company declared a
cash dividend of $0.35 per share (for a total of $3,647,017),
thereby distributing part of the long-term capital gain generated
in 1999 by the sale of NBX Corporation to 3Com Corporation.
Approximately $143,261 of the long-term capital gain for 1999 was
not distributed during 1999. Accordingly, on September 20, 2000,
the Company declared a $0.02 dividend (for a total of $184,817).
For the year ended December 31, 1999, the Company incurred
approximately $20,000 in excise taxes.
Provided that a proper election is made, a corporation
taxable under Sub-Chapter C of the Internal Revenue Code (a "C
Corporation") that elects to qualify as a RIC continues to be
taxable as a C Corporation on any gains realized within 10 years
of its qualification as a RIC (the "Inclusion Period") from
sales of assets that were held by the corporation on the
effective date of the RIC election ("C Corporation Assets") to
the extent of any gain built into the assets on such date
("Built-In Gain"). (If the corporation fails to make a proper
election, it is taxable on its Built-In Gain as of the effective
date of its RIC election.) The Company had Built-In Gains at the
time of its qualification as a RIC and made the election to be
taxed on any Built-In Gain realized during the Inclusion Period.
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. The Company has previously used loss
carryforwards to offset Built-In Gains. As of January 1, 2003,
the Company had $501,640 of loss carryforwards remaining and
$4,663,457 of unrealized Built-In Gains.
Continued qualification as a RIC requires the Company to
satisfy certain investment asset diversification requirements in
future years. The Company's ability to satisfy those
requirements may not be controllable by the Company. There can
- 19 -
be no assurance that the Company will qualify as a RIC in
subsequent years.
To the extent that the Company retains capital gains, and
declares a deemed dividend to shareholders, the dividend is
taxable to the shareholders. The Company would pay tax, at the
corporate rate, on the distribution, and the shareholders would
receive a tax credit equal to their proportionate share of the
tax paid. The Company took advantage of this rule for 2000 and
2001. The Company's financial statements for 2000 and 2001
include a tax liability of $5,709,884 and $290,748, respectively.
The taxes paid by the Company's shareholders as a result of its
deemed dividend declaration for 2000 ($5,688,896) and 2001
($271,467) are reflected as a deduction to the additional paid-in
capital in the Company's Consolidated Statement of Assets and
Liabilities rather than an expense in the Consolidated Statement
of Operations.
During the three months ended March 31, 2003, the Company
accrued a net tax provision of $2,973. 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 months ended March 31, 2003, and 2002, the
Company's income tax provision was allocated as follows:
Three Months Ended Three Months Ended
March 31, 2003 March 31, 2002
Investment operations $ 0 $ 0
Net realized gain on
investments 2,973 34,223
Net decrease in unrealized
appreciation on investments 0 0
----------- -----------
Total income tax provision $ 2,973 $ 34,223
=========== ===========
The above tax provision consists of the following:
Current $ 2,973 $ 34,223
Deferred -- Federal 0 0
----------- -----------
Total income tax provision $ 2,973 $ 34,223
=========== ===========
The Company's net deferred tax liability at March 31, 2002,
and December 31, 2001, consists of the following:
March 31, 2003 December 31, 2002
Tax on unrealized
appreciation on investments $ 844,918 $ 844,918
Net operating loss and
capital carryforward (175,574) (175,574)
------------- -------------
Net deferred income tax
liability $ 669,344 $ 669,344
============= =============
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a 10-year lease with sublet
provisions for office space. In 1995, this lease was amended to
include additional office space. During 1999, the Company sublet
this additional space to an unaffiliated party. Rent expense
under this lease for the year ended December 31, 2002 was
$178,561. Minimum lease payments in 2003 are $101,946.
- 20 -
NOTE 8. ASSET ACCOUNT LINE OF CREDIT
On November 19, 2001, the Company established an asset
account line of credit of up to $12,700,000. The asset account
line of credit is secured by the Company's government and
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 and government agency securities. The
Company's outstanding balance under the asset line of credit at
March 31, 2003 and March 31, 2002 was $7,724,207 and $8,996,740
respectively. The asset line of credit bears interest at a rate
of the Broker Call Rate plus 50 basis points. At March 31,
2003, the asset account line of credit accrued interest at a
rate of 3.5%.
NOTE 9. SUBSEQUENT EVENTS
On April 1, 2003, the Company sold its investment in
$7,700,000 of Federal Home Loan Bank Notes. The proceeds of
$7,748,561 were used to repay the entire outstanding balance of
$7,724,207 under the asset line of credit.
On April 7, 2003, the Company invested $1,500,000 in Series
C convertible preferred stock of privately held Nanosys, Inc.
Nanosys, Inc. is focused on the development of nanotechnology-
enabled systems incorporating novel and patent-protected zero and
one-dimensional nanometer-scale materials such as nanowires,
nanotubes and nanodots (quantum dots).
On April 8, 2003, Kriton Medical, Inc. filed for Chapter 11
bankruptcy. The Company wrote off its investment in Kriton in
2002.
The Company has entered into a seven-year sublease for
office space in New York City to replace its existing lease which
is expiring July 31, 2003. The Company plans to occupy this new
space beginning in August 2003. The rent for the first 12 months
will be $126,086.
NOTE 10. 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, 2002.
- 21 -
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 income (loss)," which is the
difference between the Company's income from interest, dividends,
and fees and its operating expenses. The second element is "Net
realized (loss) gain on investments," which is the difference
between the proceeds received from dispositions of portfolio
securities and their stated cost, net of applicable income tax
provisions (benefits). 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 (loss) gain on investments" and "Net increase
(decrease) in unrealized appreciation on investments" are
directly related. When a security is sold to realize a (loss)
gain, net unrealized appreciation (increases) decreases and net
realized (loss) gain increases (decreases).
Financial Condition
The Company's total assets and net assets were,
respectively, $35,958,424 and $26,040,919 at March 31, 2003,
compared with $35,951,969 and $27,256,046 at December 31, 2002.
Among the significant developments in the first quarter of
2003 were: (1) the payment of $933,972 in federal, state and
local taxes; (2) investment in NanoGram Devices Corporation of
$750,000; (3) decline in the value of the Company's investment in
Continuum Photonics, Inc. of $395,595; (4) decline in the value
of the Company's investment in Nanopharma Corp. of $350,000; (5)
decline in the value of the Company's investment in NeoPhotonics
Corporation of $110,369; (6) increase in the value of the
Company's investment in NanoOpto Corporation of $209,466; (7)
increase in bank loan payable of $7,724,207; and (8) receipt of
$786,492 as final payment from the liquidation of the Company's
partnership interest in PHZ Capital Partners L.P.
Net asset value per share ("NAV") was $2.26 at March 31,
2003, versus $2.37 at December 31, 2002.
The Company's shares outstanding remained unchanged during
the three months ended March 31, 2003.
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 March 31, 2003,
$12,137,645 or 33.8 percent of the Company's total assets (46.6
percent of the Company's net assets) consisted of non-publicly
traded securities at fair value, net of unrealized depreciation
of $3,364,816.
The increase in the value of the non-publicly traded
securities from $12,036,077 at December 31, 2002 to $12,137,645
at March 31, 2003 resulted primarily from the Company's new
investment in NanoGram Devices Corporation and an increase in the
valuation of the Company's holdings in NanoOpto Corporation. The
increase was partially offset by decreases in the valuation of
the Company's holdings in Continuum Photonics, Inc., Nanopharma
Corp. and NeoPhotonics Corporation.
- 22 -
A summary of the Company's investment portfolio is as
follows:
March 31, 2003 December 31, 2002
Investments, at cost $ 38,148,077 $ 30,206,935
Unrealized depreciation (3,348,239) (2,720,113)
------------ ------------
Investments, at fair value $ 34,799,838 $ 27,486,822
============ ============
The accumulated unrealized depreciation on investments net
of deferred taxes is $4,017,583 at March 31, 2003, versus
$3,389,458 at December 31, 2002.
Following an initial investment in a private company, the
Company may make additional investments in such investee in order
to: (1) increase or maintain in whole or in part 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 portfolio 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 because it does not want to increase its
concentration of risk, because it prefers other opportunities, or
because it is inhibited by compliance with BDC or RIC
requirements, even though the follow-on investment opportunity
appears attractive or would preserve rights pursuant to "pay to
play" provisions.
The Company made one new investment of $750,000 in its
private placement portfolio during the three months ended March
31, 2003, in NanoGram Devices Corporation.
Results of Operations
Investment Income and Expenses:
The Company had net operating loss of $584,460 and $556,233
for the three months ended March 31, 2003, and March 31, 2002,
respectively.
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 $46,246 and $54,136 for the three months ended
March 31, 2003 and March 31, 2002, respectively. The decrease of
$7,890 or 14.6 percent reflects the decline in interest rates
during 2002 and the beginning of 2003.
- 23 -
The Company had other income of $18,430 and $5,326 for the
three months ended March 31, 2003, and March 31, 2002,
respectively. Other income primarily represents rental income
from subletting office space to an unaffiliated party. The
rental income was offset in the three months ended March 31,
2002, by a reserve against a note receivable.
Operating expenses were $649,136 and $615,695 for the three
months ended March 31, 2003, and March 31, 2002, respectively.
The operating expenses for the first quarter of 2003 include no
expense for employee profit-sharing versus $127,459 in such
expense in the first quarter of 2002. In the first three months
of 2003 versus the first three months of 2002, salaries and
benefits increased by $106,820 or 41.8 percent, primarily as a
result of the addition of an employee and pension expense.
Professional fees increased by $24,063 or 55.8 percent, primarily
as a result of an increase in independent accounting and legal
expenses associated with the implementation of the Sarbanes Oxley
Act and legal expenses associated with the preparation of the
Company's proxy statement. Directors' fees and expenses
increased by $15,289 or 37.2 percent as a result of two
additional directors in the first three months of 2003 versus the
first three months of 2002 and meetings of the Ad Hoc Long-Term
Planning Committee and the Board of Directors regarding long-term
planning.
The Company has in the past relied, and continues to rely to
a large extent, upon proceeds from sales of investments, rather
than investment income, to defray a significant portion of its
operating expenses. Because such sales cannot be predicted, the
Company attempts to maintain adequate working capital to provide
for fiscal periods when there are no such sales.
Realized Gains and Losses on Portfolio Securities:
During the three months ended March 31, 2003, and 2002, the
Company recorded net realized income from investments of $432 and
$110,679, respectively. During the three months ended March 31,
2002, the Company's realized income consisted primarily of cash
received from the Nanophase Technologies Litigation Settlement
Fund and income from the Company's partnership interest in PHZ
Capital Partners L.P.
Unrealized Appreciation and Depreciation of Portfolio
Securities:
The Company's 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.")
Net unrealized depreciation on investments increased by
$628,126 or 23.1 percent during the three months ended March 31,
2003, from $2,720,113 to $3,348,239, primarily as a result of the
decline in the value of the Company's holdings in Continuum
Photonics, Inc., Nanopharma Corp. and NeoPhotonics Corporation of
$395,595, $350,000 and $110,369, respectively, partially offset
by an increase in the value of the Company's holdings in NanoOpto
Corporation of $209,466.
Net unrealized appreciation on investments decreased by
$557,157 or 45.8 percent during the three months ended March 31,
2002, from $1,216,421 to $659,264, primarily as a result of the
decline in the value of the Company's holdings of Experion
Systems, Inc. of $600,000.
Liquidity and Capital Resources
The Company's net primary sources of liquidity are cash,
receivables and freely marketable securities, net of short-term
indebtedness. The Company's secondary sources of liquidity are
restricted securities of companies that are publicly traded. The
Company's tertiary source of liquidity had been its holding of
PHZ Capital Partners L.P., which was liquidated effective
December 31, 2002. The Company received the final distribution
from PHZ Capital Partners L.P. in the first quarter of 2003 of
- 24 -
$786,492. At March 31, 2003, and December 31, 2002, respectively,
the Company's total net primary liquidity was $15,131,960 and
$16,508,057. On both of the corresponding dates, the Company's
secondary liquidity was $0 as the Company had no restricted
securities of companies that are publicly traded.
The decrease in the Company's primary source of liquidity
from December 31, 2002, to March 31, 2003, is primarily owing to
the payment of federal, state and local taxes of $933,972 and the
use of funds for operating expenses.
From December 31, 2002, to March 31, 2003, the Company's
liability for accrued employee profit sharing decreased by
$13,710 or 90 percent to $1,523 as a result of the payment of
$13,710 of the 2002 profit sharing. The remaining 2002 profit
sharing accrual of $1,523 will be paid upon the completion and
filing of the Company's 2002 federal tax return.
The Company's total net income tax liability decreased by
$930,202 from $1,527,000 to $596,798, primarily as a result of
federal, state and local payments for income earned in 2002.
Critical Accounting Policies
Critical accounting policies are those that are both
important to the presentation of the Company's financial
condition and results of operations and require management's
most difficult, complex or subjective judgments. The Company's
critical accounting policies are those applicable to the
valuation of investments.
Recent Developments -- Portfolio Companies
On April 7, 2003, the Company invested $1,500,000 in Series
C convertible preferred stock of privately held Nanosys, Inc.
Nanosys, Inc. is focused on the development of nanotechnology-
enabled systems incorporating novel and patent-protected zero and
one-dimensional nanometer-scale materials such as nanowires,
nanotubes and nanodots (quantum dots).
On April 8, 2003, Kriton Medical, Inc. filed for Chapter 11
bankruptcy. The Company wrote off its investment in Kriton in
2002.
Recent Developments -- Sub-Chapter M Status
On April 2, 2003, the Company received SEC certification and
qualified for RIC treatment for 2002. Although the SEC
certification for 1999-2002 was issued, there can be no assurance
that the Company will receive such certification for subsequent
years (to the extent it needs additional certification as a
result of changes in its portfolio) or that it will actually
qualify as a RIC for subsequent years. In addition, under certain
circumstances, even if the Company qualified for Sub-Chapter M
treatment in a given year, the Company might take action in a
subsequent year to ensure that it would be taxed in that
subsequent year as a C Corporation, rather than as a RIC.
- 25 -
Risk Factors
Investing in the Company involves a number of significant risks
relating to the Company's business and investment objectives. In
addition to the risks set forth below, other risks that could
impact the Company's business and investment objectives include:
o the ongoing global economic downturn, coupled with the
U.S.'s occupation of Iraq;
o risks associated with the possible disruption of the
Company's operations because of terrorism;
o SARS; and
o other risks and uncertainties as may be detailed from
time to time in the Company public announcements or
SEC filings.
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 its initial equity investments
exclusively in tiny-technology companies, including
nanotechnology, microsystems and microelectromechanical systems
(MEMS). Tiny technology investments are new and especially
risky, involving science and technology risks as well as
commercialization risks.
Investing in the Company's common stock may be inappropriate for
the investor's risk tolerance.
The Company's investments, in accordance with its investment
objective and principal strategies, result in a far above average
amount of risk and volatility and may well result in loss of
principal. The Company's investments in portfolio companies are
highly speculative and aggressive and, therefore, an investment
in its shares may not be suitable for investors for whom such
risk is inappropriate.
The Company operates in a highly competitive environment.
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 that 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.
- 26 -
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
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
shareholders' 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 laws 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.
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
- 27 -
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 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 determination of the Company's 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 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 Valuation Committee's
determination of the current fair value of each investment in
its portfolio. Any changes in fair value are recorded in the
Company's consolidated statements of operations as a change in
the "Net (decrease) increase in unrealized appreciation on
investments." (See Item 2. "Management's Discussion and
Analysis of Financial Condition and Results of Operations.")
Quarterly results may fluctuate and are not indicative of future
quarterly performance.
The Company's quarterly operating results could fluctuate as
a result of a number of factors. These factors include, among
others, variations in and the timing of the recognition of
realized and unrealized gains or losses, the degree to which the
Company and its portfolio companies encounter competition in
their markets and general economic and market conditions. As a
result of these factors, results for any one quarter should not
be relied upon as being indicative of performance in future
quarters. (See Item 2. "Management's Discussion and Analysis of
Financial Condition and Results of Operations.")
- 28 -
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
effective pass-through tax treatment because, among other
factors, 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. Even if it qualifies as a RIC for a
taxable year, the Company could be subject to a four percent
excise tax (and, in certain cases, corporate level income tax)
to the extent it failed to make certain gain or income
distributions. 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 permitted to
establish reserves for taxes on unrealized capital gains. In
addition, as a BDC, the Company is generally required to maintain
a ratio of at least 200 percent of total assets to total
borrowings, which may restrict its ability to borrow in certain
circumstances.
Loss of status as a RIC could reduce the Company's net asset
value by forcing it to establish currently unestablished reserves
for taxes.
As a RIC, the Company generally 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 any
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.
- 29 -
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 percent leverage (that is, $50 of leverage per $100
of common equity) will show a 1.5 percent increase or decline in
net asset value for each 1 percent 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 percent of the amount of
the debt outstanding and exceed 200 percent 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.
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.
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.
- 30 -
The Company invests in privately held companies that may complete
initial public offerings. Securities of these types of companies
can be highly volatile and have uncertain liquidity.
When companies in which the Company has invested as private
entities complete initial public offerings, they are by
definition unseasoned issues. Typically, they have relatively
small capitalizations. Thus, they can be expected to be highly
volatile and of uncertain liquidity. If they are perceived as
suffering from adverse news or developments and/or the capital
markets are in a negative phase, not only their market prices,
but also their liquidity can be expected to be affected
negatively. Historically, the Company has also invested in
unseasoned publicly traded companies with similar characteristics
and thus with similar exposure to potential negative volatility
and illiquidity. In addition, the imposition of decimalization
and other reforms 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 a principal type of market risk to be
valuation risk. Investments are stated at " value" as defined in
the 1940 Act and in the applicable regulations of the SEC.
Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the
market price for those securities for which a market quotation is
readily available and (ii) for all other assets is as determined
in good faith by, or under the direction of, the Board of
Directors. (See 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
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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 determination of the
Company's Board of Directors in accordance with the Company's
Asset Valuation Policy Guidelines. In the absence of a readily
ascertainable market value, the determined 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
Within the 90-day period prior to the filing date of this
quarterly report, the Company's Chief Executive Officer and Chief
Financial Officer conducted an evaluation of the Company's
disclosure controls and procedures (as defined in Rules 13a-14
and 15d-14 of the Securities Exchange Act of 1934). Based upon
this evaluation, the Company's Chief Executive Officer and Chief
Financial Officer 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 it files or submits
under the Securities Exchange Act of 1934.
There have not been any significant changes in the
Company's internal controls or in other factors that could
significantly affect these controls subsequent to the date of
their evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
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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
10.1* Harris & Harris Group, Inc. Executive Mandatory
Retirement Benefit Plan.
10.2* Amendment No. 1 to Deferred Compensation Agreement.
11.0* Computation of per share earnings. See
Consolidated Statements of Operations.
99* Certification of CEO pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
99* Certification of 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
March 31, 2003
None
_____________
*filed herewith
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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: May 14, 2003
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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 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: May 14, 2003 Charles E. Harris,
Chief Executive Officer
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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 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: May 14, 2003 Mel P. Melsheimer,
Chief Financial Officer
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