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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended June 30, 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.
- --------------------------------------------------------------
(Exact name of registrant as specified in its charter)
New York 13-3119827
- --------------------------------------------------------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
111 West 57th Street, New York, New York 10019
- --------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
(212) 582-0900
- --------------------------------------------------------------
(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 August 6, 2003
- -----------------------------------------------------------------
Common Stock, $0.01 par 11,498,845 shares
value per share
Harris & Harris Group, Inc.
Form 10-Q, June 30, 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
Background and Overview................................ 22
Results of Operations.................................. 24
Financial Condition.................................... 27
Cash Flow.............................................. 30
Liquidity and Capital Resources........................ 31
Risk Factors........................................... 33
Item 3. Quantitative and Qualitative Disclosures
About Market Risk...................................... 40
Item 4. Controls and Procedures....................... 41
PART II OTHER INFORMATION
Item 1. Legal Proceedings.............................. 42
Item 2. Changes in Securities and Use of Proceeds...... 42
Item 3. Defaults Upon Senior Securities................ 42
Item 4. Submission of Matters to a Vote of
Security Holders............................... 42
Item 5. Other Information.............................. 42
Item 6. Exhibits and Reports on Form 8-K............... 43
Signature.............................................. 44
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.
1
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
June 30, 2003 December 31, 2002
(Unaudited) (Audited)
Investments, at value
(Cost: $37,534,201 at 6/30/03,
$30,206,935 at 12/31/02)................ $34,354,451 $27,486,822
Cash and cash equivalents................. 192,977 5,967,356
Restricted funds (Note 5)................. 1,002,303 756,944
Funds in escrow........................... 0 750,000
Receivable from portfolio company......... 0 786,492
Interest receivable....................... 18 189
Income tax receivable..................... 78,289 0
Prepaid expenses.......................... 61,876 96,631
Other assets.............................. 213,298 107,535
----------- -----------
Total assets.............................. $35,903,212 $35,951,969
=========== ===========
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities.. $ 1,725,095 $ 1,451,568
Payable to broker for unsettled trade..... 0 5,696,725
Bank loan payable (Note 8)................ 7,983,520 0
Accrued profit sharing (Note 3)........... 1,523 15,233
Deferred rent............................. 27,520 5,397
Current income tax liability.............. 0 857,656
Deferred income tax liability (Note 6).... 669,344 669,344
----------- -----------
Total liabilities......................... 10,407,002 8,695,923
Commitments and contingencies (Note 7) ----------- -----------
Net assets................................ $25,496,210 $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 6/30/03 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............. (162,379) 1,137,820
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $844,918 at 6/30/03
and 12/31/02............................ (4,024,669) (3,565,032)
Treasury stock, at cost (1,828,740
shares at 6/30/03 and 12/31/02)......... (3,405,531) (3,405,531)
----------- -----------
Net assets................................ $25,496,210 $27,256,046
=========== ===========
Shares outstanding........................ 11,498,845 11,498,845
=========== ===========
Net asset value per outstanding share..... $ 2.22 $ 2.37
=========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Six Months Ended
June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
Investment income:
Interest from:
Fixed-income securities... $ 32,009 $ 40,135 $ 78,255 $ 94,271
Other income............... 18,555 20,233 36,985 25,559
----------- ------------ ------------ ------------
Total investment income... 50,564 60,368 115,240 119,830
Expenses:
Profit-sharing accrual
(Note 3).................. 0 121,326 0 249,285
Salaries and benefits...... 361,703 264,589 723,899 519,965
Administration and
operations................ 143,590 137,166 238,702 225,068
Professional fees.......... 150,136 100,566 217,294 143,661
Rent....................... 71,441 43,856 119,318 86,580
Directors' fees and
expenses.................. 33,680 36,102 90,045 77,178
Depreciation............... 10,150 6,737 20,130 12,685
Bank custody fees.......... 2,222 1,744 4,409 5,583
Interest expense........... 4,631 3,000 12,892 10,776
----------- ------------ ------------ ------------
Total expenses.......... 777,553 715,086 1,426,689 1,330,781
----------- ------------ ------------ ------------
Operating loss before
income taxes.............. (726,989) (654,718) (1,311,449) (1,210,951)
Income tax provision
(Note 6).................. 0 0 0 0
----------- ------------ ------------ ------------
Net operating loss.......... (726,989) (654,718) (1,311,449) (1,210,951)
Net realized gain on
investments:
Realized gain on
investments............... 28,140 688,681 28,572 799,360
----------- ------------ ------------ ------------
Total realized gain..... 28,140 688,681 28,572 799,360
Income tax (provision)
benefit (Note 6).......... (14,349) 47,087 (17,322) 12,864
----------- ------------ ------------ ------------
Net realized gain (loss)
on investments............ 13,791 735,768 11,250 812,224
----------- ------------ ------------ ------------
Net realized (loss) income.. (713,198) 81,050 (1,300,199) (398,727)
Net increase (decrease) in
unrealized appreciation on
investments:
Increase as a result of
investment gain........... 0 353,221 0 353,221
Decrease as a result of
investment gain........... (18,031) 0 (18,031) 0
Increase on investments
held...................... 462,021 71 689,859 45,077
Decrease on investments
held...................... (275,501) (53) (1,131,465) (602,216)
----------- ----------- ------------ ------------
Net change in unrealized
appreciation
on investments........ 168,489 353,239 (459,637) (203,918)
Income tax benefit
(Note 6).................. 0 0 0 0
----------- ----------- ------------ -----------
Net increase (decrease) in
unrealized appreciation
on investments............ 168,489 353,239 (459,637) (203,918)
----------- ----------- ------------ -----------
Net (decrease) increase in
net assets resulting from
operations:
Total...................... $ (544,709) $ 434,289 $ (1,759,836) $ (602,645)
=========== =========== ============ ===========
Per outstanding share...... $ (0.05) $ 0.05 $ (0.15) $ (0.07)
=========== =========== ============ ===========
The accompanying notes are an integral part of these consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended Six Months Ended
June 30, 2003 June 30, 2002
Cash flows from operating activities:
Net decrease in net assets resulting
from operations.............................. $ (1,759,836) $ (602,645)
Adjustments to reconcile net decrease in net
assets resulting from operations to net cash
used in operating activities:
Realized and unrealized gain (loss) on
investments................................. 431,065 (595,442)
Depreciation................................. 20,130 12,685
Changes in assets and liabilities:
Restricted funds............................. (245,359) (172,819)
Receivable from investment company........... 786,492 0
Funds in escrow.............................. 750,000 0
Interest receivable.......................... 171 82
Income tax receivable........................ (78,289) 0
Note receivable.............................. 0 10,487
Prepaid expenses............................. 34,755 (36,436)
Other assets................................. (105,763) (173,770)
Accounts payable and accrued liabilities..... 273,527 293,465
Payable to broker for unsettled trade........ (5,696,725) 0
Accrued profit sharing....................... (13,710) 249,285
Current income tax liability................. (857,656) (290,796)
Deferred income tax liability................ 0 (12,864)
Deferred rent................................ 22,123 (4,627)
--------------- ---------------
Net cash used in operating activities........ (6,439,075) (1,323,395)
Cash flows from investing activities:
Net (purchase) sale of short-term investments
and marketable securities.................. (4,385,459) 18,472,315
Proceeds from investments.................... 15,709 780,605
Investment in private placements and loans... (2,945,618) (4,675,000)
Purchase of fixed assets..................... (3,456) (22,602)
--------------- ---------------
Net cash (used in) provided by investing
activities..................................... (7,318,824) 14,555,318
Cash flows from financing activities:
Proceeds from note payable................... 7,983,520 0
Payment of bank loan payable................. 0 (12,495,777)
Collection on notes receivable............... 0 3,500
--------------- ---------------
Net cash provided by (used in) financing
activities................................. 7,983,510 (12,492,277)
--------------- ---------------
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.................................. 192,977 874,781
--------------- ---------------
Net increase (decrease) in cash and
cash equivalents............................ $ (5,774,379) $ 739,646
=============== ===============
Supplemental disclosures of cash flow information:
Income taxes paid............................ $ 575,100 $ 290,748
Interest paid.................................$ 10,784 $ 19,106
The accompanying notes are an integral part of these consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Six Months Ended
June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
Changes in net assets
from operations:
Net operating loss....... $ (726,989) $ (654,718) $ (1,311,449) $ (1,210,951)
Net realized gain on
investments............. 13,791 735,768 11,250 812,224
Net (decrease) increase
in unrealized
appreciation on
investments as a
result of gain.......... (18,031) 353,221 (18,031) 353,221
Net increase (decrease)
in unrealized
appreciation on
investments held........ 186,520 18 (441,606) (557,139)
------------- ------------- ------------- -------------
Net (decrease) increase
in net assets resulting
from operationS.......... (544,709) 434,289 (1,759,836) (602,645)
Net (decrease) increase
in net assets.............. (544,709) 434,289 (1,759,836) (602,645)
Net assets:
Beginning of the period.. 26,040,919 23,297,836 27,256,046 24,334,770
-------------- ------------- ------------- -------------
End of the period........ $ 25,496,210 $ 23,732,125 $ 25,496,210 $ 23,732,125
============== ============= ============= =============
The accompanying notes are an integral part of these consolidated financial statements.
5
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (8)(9)(10)
- -- 10.8% of total investments
Private Placement Portfolio (Illiquid) --
10.8% 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....................(B) -- $ 106,250
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 86,380
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 Corporation (1)(2)(4)(6)(13) -- Develops a
broad suite of intellectual property utilizing
nanotechnology -- 1.81% of fully diluted equity
Series 1 Preferred Stock..............................(A) 63,210 21,672
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) 267,857 128,292
Nanosys, Inc. (1)(2)(4)(5)(6) -- Develops nanotechnology-
enabled systems incorporating novel and patent-
protected zero and one-dimensional nanometer-scale
materials -- 1.72% of fully diluted equity
Series C Convertible Preferred Stock..................(A) 803,428 1,500,000
Nantero, Inc. (1)(2)(5)(6) -- Develops a high density
nonvolatile random access memory chip using
nanotechnology -- 4.15% of fully diluted equity
Series A Convertible Preferred Stock..................(A) 345,070 489,999
NeoPhotonics Corporation (1)(2)(6)(13)(14) --
Develops and manufactures planar optical devices
and components using nanomaterials deposition
technology -- 1.54% of fully diluted equity
Series D Convertible Preferred Stock..................(D) 1,498,802 106,276
Optiva, Inc. (1)(2)(5)(6) -- Develops and commercializes
nanomaterials for advanced applications -- 1.98%
of fully diluted equity
Series C Convertible Preferred Stock..................(B) 1,249,999 1,250,000
----------
Total Private Placement Portfolio (cost: $6,829,869).............................$3,713,869
----------
Total Investments in Unaffiliated Companies (cost: $6,829,869)...................$3,713,869
----------
The accompanying notes are an integral part of this consolidated schedule.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated Companies
(8)(9)(11) -- 31.5% of total investments
Private Placement Portfolio (Illiquid) --
31.5% 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
Chlorogen, Inc. (1)(2)(4)(6) -- Develops patented
chloroplast technology to produce plant-made
proteins -- 6.76% of fully diluted equity
Series A Convertible Preferred Stock..................(A) 3,000,000 525,900
Experion Systems, Inc. (1)(2)(5)(7) -- Develops and
sells software to credit unions -- 12.44% 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
NanoGram Devices Corporation (1)(2)(4)(6)(14) --
Develops power components for biomedical
applications by utilizing a patented nanomaterial
synthesis process -- 5.02% of fully diluted equity
Series A-1 Convertible Preferred Stock................(A) 63,210
Series A-2 Convertible Preferred Stock................(A) 750,000 813,210
Nanopharma Corp. (1)(2)(5)(6) -- Develops advanced
nanoscopic drug delivery vehicles and systems --
14.69% of fully diluted equity
Series A Convertible Preferred Stock..................(D) 684,516 350,000
Nanotechnologies, Inc. (1)(2)(6) -- Develops high-
performance nanoscale materials for industry --
6.48% of fully diluted equity
Series B Convertible Preferred Stock..................(B) 1,538,837
Series C Convertible Preferred Stock..................(B) 235,720 1,277,681
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: $10,868,128)...........................$10,803,805
-----------
Total Investments in Non-Controlled Affiliated Companies (cost: $10,868,128)....$10,803,805
-----------
The accompanying notes are an integral part of this consolidated schedule.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
U.S. Government and Agency Obligations -- 57.7% of total investments
U.S. Treasury Bills -- due date 07/10/03..............(J) $3,223,000 $ 3,222,323
U.S. Treasury Bills -- due date 07/17/03..............(J) 2,000,000 1,999,260
U.S. Treasury Bills -- due date 08/14/03..............(J) 3,040,000 3,036,990
U.S. Treasury Bills -- due date 08/21/03..............(J) 2,000,000 1,997,660
U.S. Treasury Bills -- due date 09/18/03..............(J) 1,600,000 1,596,944
U.S. Treasury Bills -- due date 09/25/05..............(J) 8,000,000 7,983,600
-----------
Total Investments in U.S. Government (cost: $19,836,204)........................$19,836,777
-----------
Total Investments -- 100% (cost: $37,534,201)...................................$34,354,451
===========
The accompanying notes are an integral part of this consolidated schedule.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 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 June 30, 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 $6,829,869.
The gross unrealized appreciation based on the tax cost
for these securities is $103,171. The gross unrealized
depreciation based on the tax cost for these securities
is $3,219,171.
(11) The aggregate cost for federal income tax purposes of
investments in non-controlled affiliated companies is
$10,868,128. The gross unrealized appreciation based on
the tax cost for these securities is $2,772,007. The
gross unrealized depreciation based on the tax cost for
these securities is $2,836,330.
(12) Non-registered investment company.
(13) On April 30, 2003, NeoPhotonics Corporation distributed
its shares in NanoGram Corporation to shareholders of
record on November 14, 2002. The Company received
63,210 shares of Series 1 Preferred Stock.
(14) On April 30, 2003, NeoPhotonics Corporation distributed
its shares in NanoGram Devices Corporation to shareholders
of record on November 14, 2002. The Company received
63,210 shares of Series A-1 Convertible Preferred Stock.
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.
I. Fixed-Income 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:
Independent pricing services that provide quotations based primarily on
quotations from dealers and brokers, market transactions, and other sources.
Fair value as determined in good faith by the Valuation Committee.
SHORT-TERM FIXED-INCOME INVESTMENTS
J. Short-Term Fixed-Income Investments are valued at market value at
the time of valuation. Short-term debt with remaining maturity of 90 days or
less is valued at amortized cost.
ALL OTHER INVESTMENTS
K. 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 June 30, 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 June 30, 2003, and
December 31, 2002, and the reported amounts of revenues and expenses for the
three months ended June 30, 2003, and June 30, 2002. The most significant
estimates relate to the fair valuations of investments for the three months
ended June 30, 2003, and June 30, 2002. Actual results could differ from
these estimates.
NOTE 3. EMPLOYEE PROFIT SHARING PLAN
As of January 1, 2000, the Company implemented the Harris & Harris
Group, Inc. Employee Profit-Sharing Plan (the "Plan") that provides for profit
sharing 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.
14
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 beneficiary),
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 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.
15
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.
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. Since
the completion of the offer, the Company has invested $4,695,618 in accordance
with its investment objectives and policies. The Company intends to invest
the balance of the proceeds over the next several months 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 primarily attributed to Built-In Gains generated at the time of
the Company's qualification as a RIC (see Note 6. "Income Taxes") and
nondeductible deferred compensation.
16
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment Agreement
with the Company (disclosed in a Form 8-K filed on October 27, 1999) (the
"Employment Agreement"), which superseded an employment agreement that was
about to expire on December 31, 1999. The Employment Agreement shall
terminate on December 31, 2004 ("Term") subject to either an earlier
termination or an extension in accordance with the terms; on January 1, 2000
and on each day thereafter, the Term extends automatically by one day unless
at any time the Company or Mr. Harris, by written notice, decides not to
extend the Term, in which case the Term will expire five years from the date
of the written notice.
During the period of employment, Mr. Harris shall serve as the Chairman
and Chief Executive Officer of the Company; be responsible for the general
management of the affairs of the Company and all its subsidiaries, reporting
directly to the Board of Directors of the Company; serve as a member of the
Board for the period of which he is and shall from time to time be elected or
reelected; and serve, if elected, as President of the Company and as an
officer and director of any subsidiary or affiliate of the Company.
Mr. Harris is to receive compensation under his Employment Agreement in
the form of base salary of $208,315 for 2000, with automatic yearly
adjustments to reflect inflation. In addition, the Board may increase such
salary, and consequently decrease it, but not below the level provided for by
the automatic adjustments described above. Mr. Harris is also entitled to
participate in the Company's Profit-Sharing Plan as well as in all
compensation or employee benefit plans or programs, and to receive all
benefits, perquisites, and emoluments for which salaried employees are
eligible. Under the Employment Agreement, the Company is to furnish Mr.
Harris with certain perquisites which include a company car, membership in
certain clubs and up to a $5,000 annual reimbursement for personal, financial
or tax advice.
The Employment Agreement provides Mr. Harris with life insurance for the
benefit of his designated beneficiaries in the amount of $2,000,000; provides
reimbursement for uninsured medical expenses, not to exceed $10,000 per annum,
adjusted for inflation, over the period of the contract; provides Mr. Harris
and his spouse with long-term care insurance; and disability insurance in the
amount of 100 percent of his base salary. These benefits are for the term of
the Employment Agreement.
The Employment Agreement provides for the Company to adopt a
supplemental executive retirement plan (the "SERP") for the benefit of Mr.
Harris. Under the SERP, the Company will cause an amount equal to one-twelfth
of Mr. Harris's current 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
$1,002,303 as of June 30, 2003. Mr. Harris' rights to benefits pursuant to
this SERP will be no greater than those of a general creditor of the Company.
17
The Employment Agreement provides severance pay in the event of
termination without cause or by constructive discharge and also provides for
certain death benefits payable to the surviving spouse equal to the
executive's base salary for a period of two years.
In addition, Mr. Harris is entitled to receive severance pay pursuant to
the severance compensation agreement that he entered into with the Company,
effective August 15, 1990. The severance compensation agreement provides that
if, following a change in control of the Company, as defined in the agreement,
such individual's employment is terminated by the Company without cause or by
the executive within one year of such change in control, the individual shall
be entitled to receive compensation in a lump sum payment equal to 2.99 times
the individual's average annualized compensation and payment of other welfare
benefits. If Mr. Harris' termination is without cause or is a constructive
discharge, the amount payable under the Employment Agreement will be reduced
by the amounts paid pursuant to the severance compensation agreement.
As of January 1, 1989, the Company adopted an employee benefits program
covering substantially all employees of the Company under a 401(k) Plan and
Trust Agreement. As of January 1, 1999, the Company adopted the Harris &
Harris Pension Plan and Trust, a money purchase plan which would allow the
Company to stay compliant with the 401(k) top-heavy regulations and deduction
limitation regulations. In 2001, Congress enacted the Economic Growth and Tax
Relief Reconciliation Act of 2001 which has increased the deduction limits for
plans such as the 401(k) Plan. This Act eliminates the need for the Company
to maintain two separate plans. Effective December 31, 2001, the Pension Plan
merged into the 401(k) Plan, with the 401(k) Plan being the surviving plan.
Contributions to the plan are at the discretion of the Company
On June 30, 1994, the Company adopted a plan to provide medical and
dental 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. The annual premium cost
to the Company with respect to the entitled retiree shall not exceed $12,000,
subject to an index for inflation. Based upon actuarial estimates, the
Company provided an original reserve of $176,520 that was charged to
operations for the period ending June 30, 1994. As of June 30, 2003, the
Company had a reserve of $446,302 for the plan.
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
18
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 is being
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 remaining.
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 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 the Company's 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.
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.
19
For the three and six months ended June 30, 2003, and 2002, the
Company's income tax provision was allocated as follows:
Three Months Three Months Six Months Six Months
Ended Ended Ended Ended
June 30, 2003 June 30, 2002 June 30, 2003 June 30,2002
Net operating loss......... $ 0 $ 0 $ 0 $ 0
Net realized gain (loss)
on investments........... 14,349 (47,087) 17,322 (12,864)
Net increase in unrealized
appreciation on
investments.............. 0 0 0 0
--------- --------- ---------- ---------
Total income tax (benefit)
provision................ $ 14,349 $ (47,087) $ 17,322 $ (12,864)
========= ========= ========== =========
The above tax (benefit) provision consists of the following:
Current.................... $ 14,349 $ 0 $ 17,322 $ 0
Deferred -- Federal........ 0 (47,087) 0 (12,864)
--------- --------- ---------- ---------
Total income tax provision. $ 14,349 $( 47,087) $ 17,322 $ (12,864)
========= ========= ========== =========
The Company's net deferred tax liability at June 30, 2003, and December
31, 2002, consists of the following:
June 30, 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.
On April 17, 2003, the Company signed a seven-year sublease for office
space at 111 West 57th Street in New York City to replace its existing lease
which expires on July 31, 2003. Minimum sublease payments in 2003 are
$49,626. Future minimum sublease payments in each of the following years are:
2004 -- $134,816; 2005--$138,187; 2006 -- $141,641; 2007 -- $145,182; 2008 --
$148,811; and thereafter for the remaining term -- $203,571.
NOTE 8. ASSET ACCOUNT LINE OF CREDIT
On November 19, 2001, 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 June 30, 2003
and June 30, 2002 was $7,983,520 and $0, respectively. The asset line of
credit bears interest at a rate of the Broker Call Rate plus 50 basis points.
At June 30, 2003, the asset account line of credit accrued interest at a
rate of 3.5%.
20
NOTE 9. SUBSEQUENT EVENTS
On July 2, 2003, the Company sold its investment in $8,000,000 of U.S.
Treasury Bills due September 25, 2003. The proceeds of $7,982,244 were used
to repay the entire outstanding balance of $7,983,520 under the asset line of
credit.
On August 1, 2003, the Company made a follow-on investment of $323,000
in the preferred stock of a privately held tiny-technology company.
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 information contained in this section should be read in conjunction
with the Company's June 30, 2003 Consolidated Financial Statements and the
Company's year-end 2002 Consolidated Financial Statements and the Notes
thereto.
Background and Overview
The Company incorporated under the laws of the state of New York in
August 1981 as Sovereign Thoroughbreds, Inc. ("Sovereign") to own and manage
thoroughbred-horse breeding stock. In 1983, Sovereign completed an initial
public offering and invested $406,936 in Otisville BioTech, Inc.
("Otisville"), which also completed an initial public offering. In 1984,
Charles E. Harris purchased a controlling interest in Sovereign, which at the
time held the controlling interest in Otisville. Under Mr. Harris's control,
the Company divested its other assets and became a financial services company,
with the investment in Otisville as the initial focus of its business
activity. The Company hired new management for Otisville, and Otisville
acquired new technology targeting the development of a human blood substitute.
In 1986, operating as a financial services company, the Company changed
its name to The Lexington Group, Inc., and eventually, the Company operated
two wholly-owned insurance brokerage subsidiaries and a wholly-owned trust
company subsidiary. In 1988, in conjunction with the acquisition of one of
these insurance brokerage operations, C.D. Harris (which was previously
unrelated to Charles E. Harris or his family), the Company changed its name to
Harris & Harris Group, Inc. In 1989, Otisville changed its name to Alliance
Pharmaceutical Corporation ("Alliance"). By 1990, the Company had completed
selling its $406,936 investment in Alliance for total proceeds of $3,923,559.
In 1992, the Company sold its insurance brokerage and trust company
subsidiaries to their respective managements and registered as an investment
company under the 1940 Act. In 1992, the Company commenced operations as a
closed-end, non-diversified investment company. In 1995, the Company elected
to become a business development company subject to the provisions of Sections
55 through 65 of the 1940 Act. Throughout the Company's corporate history, it
has made early-stage venture capital investments in a variety of industries.
In 1994, the Company made its first nanotechnology investment. Since August
2001, it has made initial investments exclusively in tiny technology,
including its last 12 initial 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, have
little or no history of operations and are developing unproven technologies.
At June 30, 2003, $14,517,674 or 56.9 percent of the Company's net assets
consisted of venture capital investments at fair value, net of unrealized
depreciation of $3,180,323. At December 31, 2002, $12,036,077 or 44.2 percent
of the Company's net assets consisted of venture capital investments at fair
value, of which net unrealized depreciation was $2,718,389. At December 31,
2001, $13,120,978 or 53.9 percent of the Company's net assets consisted of
venture capital investments at fair value, of which net unrealized
appreciation was $1,215,444.
Since the Company's investment in Otisville in 1983, it has made a total
of 53 venture capital investments, including four private investments in
public equities. The Company has sold 35 of these 53 investments, realizing
total proceeds of $105,659,158 on its invested capital of $37,366,522. Sixteen
of these 35 investments were profitable. The average and median holding
periods for these 35 investments were 3.57 years and 3.20 years respectively.
22
The Company values the 18 venture capital investments currently in its
portfolio at $14,517,674, as compared with a cost to it of $17,697,997. As of
June 30, 2003, the average and median holding periods for its 18 current
venture capital investments are 2.52 years and 1.31 years, respectively.
The Company has broad discretion in the investment of its capital.
However, the Company invests primarily in illiquid equity securities of
private companies. Generally, these investments take the form of preferred
stock, are subject to restrictions on resale and have no established trading
market. Its principal objective is to achieve long-term capital appreciation.
Therefore, a significant portion of its investment portfolio 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 and is not expected to be material to the Company's results
of operations.
The Company values its investments each quarter at fair value as
determined in good faith by its Valuation Committee within guidelines
established by its Board of Directors in accordance with the 1940 Act. (See
"Footnote to Consolidated Schedule of Investments" contained in "Consolidated
Financial Statements.")
General business and capital markets conditions in 2002 and 2003 have
been adverse for the venture capital industry. There have been few
opportunities to take venture capital-backed companies public or sell them to
established companies. It has been difficult to finance venture capital-backed
companies privately. And, it has been difficult in general for venture capital
firms themselves to raise capital.
The Company presents the financial results of its operations utilizing
accounting principles generally accepted in the United States for investment
companies. On this basis, the principal measure of its financial performance
during any period is the net increase/(decrease) in its net assets resulting
from its operating activities, which is the sum of the following three
elements:
(1) Net Operating Income/(Loss) -- the difference between the
Company's income from interest, dividends, and fees and its operating expenses.
(2) Net Realized Gain/(Loss) on Investments -- the difference between
the net proceeds of dispositions of portfolio securities and their stated cost.
(3) Net Increase/(Decrease) in Unrealized Appreciation on Investments
- -- the net change in the fair value of the Company's investment portfolio.
Because of the structure and objectives of its business, the Company
generally expects to experience net operating losses and seeks to generate
increases in its net assets from operations through the long term appreciation
of its venture capital investments. The Company has in the past relied, and
continues to rely, on proceeds from sales of investments, rather than on
investment income, to defray a significant portion of its operating expenses.
Because such sales are unpredictable, the Company attempts to maintain
adequate working capital to provide for fiscal periods when there are no such
sales.
23
Results of Operations
Three months ended June 30, 2003, as compared to the three months ended June
30, 2002
The Company had a net decrease in net assets resulting from operations
of $544,709 in the three months ended June 30, 2003, compared to a net
increase in net assets resulting from operations of $434,289 in the three
months ended June 30, 2002.
Investment Income and Expenses:
- ------------------------------
The Company had net operating losses of $726,989 and $654,718 for the
three months ended June 30, 2003, and June 30, 2002, respectively. In the
three months ended June 30, 2003, the Company's net operating loss reflected
an increase to expenses primarily related to increases in salaries and
benefits, professional fees and rent expense.
Operating expenses were $777,553 and $715,086 for the three months ended
June 30, 2003, and June 30, 2002, respectively. The operating expenses of the
second quarter of 2003 reflect no expense for employee profit-sharing. In the
three months ended June 30, 2003, versus the three months ended June 30, 2002,
salaries and benefits increased by $97,114 or 36.7 percent, primarily as a
result of an additional employee and mandatory retirement plan pension
expense. Professional fees increased primarily as a result of an increase in
independent accounting and legal expenses associated with the preparation of
the Company's proxy statement and legal and consulting expenses associated
with the preparation of the mandatory retirement plan and revision of the
retiree medical and health insurance plan.
Realized Gains and Losses on Portfolio Securities:
- -------------------------------------------------
During the three months ended June 30, 2003, and June 30, 2002, the
Company realized gains of $28,140 and $688,681, respectively.
During the three months ended June 30, 2002, the Company realized a net
gain of $688,681, consisting primarily of a gain of $986,187 from its
partnership interest in PHZ Capital Partners L.P., offset by a loss of
$350,583 on the dissolution of Informio, Inc.
Unrealized Appreciation and Depreciation of Portfolio Securities:
- ----------------------------------------------------------------
Net unrealized depreciation on investments decreased by $168,489 or five
percent during the three months ended June 30, 2003, from $3,348,239 at March
31, 2003, to $3,179,750 at June 30, 2003.
During the three months ended June 30, 2003, the Company recorded a net
decrease of $184,493 in unrealized depreciation of its venture capital
investments.
Six Months ended June 30, 2003, as compared to the six months ended June 30,
2002
The Company had net decreases in net assets resulting from operations of
$1,759,836 and $602,645 in the six months ended June 30, 2003, and June 30,
2002, respectively.
24
Investment Income and Expenses:
- ------------------------------
The Company had net operating losses of $1,311,449 and $1,210,951 for
the six months ended June 30, 2003, and June 30, 2002, respectively. In the
six months ended June 30, 2003, the Company's net operating loss reflected an
increase to expenses primarily related to increases in salaries and benefits,
professional fees and rent expense offset by a decrease in the employee
profit-sharing accrual.
Operating expenses were $1,426,689 and $1,330,781 for the six months
ended June 30, 2003, and June 30, 2002, respectively. Operating expenses in
the six months ended June 30, 2003, versus the six months ended June 30, 2002,
changed primarily for the following reasons:
(1) Operating expenses for the six months ended June 30, 2003,
included no expense for employee profit-sharing, versus $249,285 in such
expense for the six months ended June 30, 2002.
(2) Salaries and benefits increased by $203,934 or 39.2 percent,
primarily as a result of the addition of an employee and mandatory
retirement plan pension expense.
(3) Professional fees increased, primarily as a result of an increase
in independent accounting and legal expenses associated with the implementation
of the Sarbanes-Oxley Act; legal expenses associated with the preparation of
the Company's proxy statement; and legal and consulting expenses associated
with the preparation of the mandatory retirement plan and revision of the
retiree medical and health insurance plan.
Realized Gains and Losses on Portfolio Securities:
- -------------------------------------------------
During the six months ended June 30, 2003, and June 30, 2002, the
Company realized gains of $28,572 and $799,360, respectively.
During the six months ended June 30, 2003, the Company neither sold nor
liquidated any venture capital investments.
During the six months ended June 30, 2002, the Company's realized net
gains of $799,360 consisted primarily of $1,108,226 from its partnership
interest in PHZ Capital Partners L.P., offset by a loss of $350,583 on the
dissolution of Informio, Inc.
Unrealized Appreciation and Depreciation of Portfolio Securities:
- ----------------------------------------------------------------
Net unrealized depreciation on investments increased by $459,637 or 16.9
percent during the six months ended June 30, 2003, from $2,720,113 at December
31, 2002, to $3,179,750 at June 30, 2003.
During the six months ended June 30, 2003, the Company recorded a net
increase of $461,934 in unrealized depreciation of its venture capital
investments.
25
Year ended December 31, 2002, as compared to years ended December 31, 2001, and
2000
The Company had net decreases in net assets resulting from operations
of $2,722,194, $6,889,238 and $15,507,207 in the years ended December 31, 2002,
December 31, 2001, and December 31, 2000, respectively.
Investment Income and Expenses:
- ------------------------------
The Company had net operating (loss) income of ($1,871,088) in 2002,
($524,560) in 2001 and $3,310,250 in 2000. The net operating (loss) income
for 2002, 2001 and 2000 reflected a decrease in the employee profit-sharing
accrual that resulted in a reversal of expenses of $163,049 in 2002, $984,021
in 2001 and $4,812,675 in 2000. When unrealized appreciation as of a certain
date subsequently decreases or increases, the profit-sharing accrual decreases
or increases accordingly, resulting in a decrease or increase to expenses.
Operating expenses in 2002 were $2,124,549, reflecting an increase of
$1,089,328 from $1,035,221 in 2001. Of this increase, $820,972 was a reversal
of the profit sharing accrual. Operating expenses for 2002 also reflect an
increase in salaries and benefits, primarily owing to an increase in the
retirement medical benefit expense and the expense of a new employee, starting
in September 2002, and an increase in professional fees, primarily as a result
of expenses associated with new investments and preparation of the Company's
proxy statement.
Operating expenses in 2001 were $1,035,221, reflecting an increase of
$3,658,421 from $(2,623,200) in 2000. Of this increase, $3,828,654 was a
reversal of the profit sharing accrual, offset by a decrease in all other
expenses of $170,233.
Realized Gains and Losses on Sales of Portfolio Securities:
- ----------------------------------------------------------
During the three years ended December 31, 2002, December 31, 2001, and
December 31, 2000, the Company sold various investments and received
distributions, resulting in net realized income from investments of
$3,284,737, $1,394,781 and $19,065,267, respectively.
During the year ended December 31, 2002, Informio, Inc. approved a plan
of liquidation, the Company sold its interest in Schwoo, Inc. and the
Company's partnership interest in PHZ Capital Partners, L.P. was liquidated.
The Company recorded realized income from investments of $3,284,737,
consisting primarily of realized income of $4,776,360 from the liquidation of
its partnership interest in PHZ Capital Partners L.P. The Company recorded
realized losses of $350,583 and $1,248,825 from the liquidation of Informio,
Inc. and sale of the Company's previously written-off investment in Schwoo,
Inc., respectively.
During 2001, the Company recorded realized income from investments of
$1,394,781, consisting primarily of realized income (losses) from sales of:
Nanophase Technologies Corporation, $2,762,696; Genomica Corporation,
$1,022,905; Essential.com, Inc., ($1,349,512); shares of SciQuest.com, Inc.
purchased in the open market, ($1,258,679); and MedLogic Global Corporation,
($1,033,765). The Company also recorded realized income of $1,266,729 from
its partnership interest in PHZ Capital Partners L.P. As a result of the
income and losses realized during 2001, unrealized appreciation increased by
$3,948,271.
26
During 2000, the Company recorded realized income from investments of
$19,065,267, consisting primarily of realized income (losses) from sales of
Alliance Pharmaceutical Corp., $9,693,446, and the Company's private-equity
investments in SciQuest.com, Inc., $7,407,377.
Unrealized Appreciation and Depreciation of Portfolio Securities:
- ----------------------------------------------------------------
In 2002, net unrealized appreciation on investments decreased by
$3,936,533 or 323.6 percent, from $1,216,420 at December 31, 2001, to
($2,720,113) at December 31, 2002, primarily as a result of decreases in the
valuations of the Company's venture capital investments, including a decrease
in unrealized appreciation of NeuroMetrix, Inc. of $1,986,081.
In 2001, net unrealized appreciation on investments decreased by
$7,731,508 or 86.4 percent, from $8,947,928 at December 31, 2000, to
$1,216,420 at December 31, 2001, primarily as a result of decreases in the
valuations of the Company's holdings of Nanophase Technologies Corporation,
Genomica Corporation and Schwoo, Inc. of $5,499,664, $1,540,375 and
$1,248,827, respectively, offset by an increase in unrealized appreciation of
$1,528,082 and $1,033,775 as a result of the realization of the loss on the
sale of the Company's positions in SciQuest.com, Inc. and MedLogic Global
Corporation.
In 2000, net unrealized appreciation on investments decreased by
$37,934,593 or 80.9 percent from $46,882,521 at December 31, 1999, to
$8,947,928 at December 31, 2000, primarily as a result of decreases in the
valuations of the Company's holdings in SciQuest.com, Inc. of $26,102,456
(net of gain of $7,407,377 realized on sale) and Kana Communications, Inc.
of $3,816,204 (net of gain of $1,054,818 realized on sale), offset by an
increase in the value of the Company's holding in Nanophase Technologies
Corporation of $3,709,449.
During the year ended December 31, 2002, we experienced a net decrease
in unrealized depreciation of the Company's venture capital investments of
$3,933,834.
Financial Condition
Six Months ended June 30, 2003
The Company's total assets and net assets were $35,903,212 and
$25,496,210, respectively, at June 30, 2003, compared with $35,951,969 and
$27,256,046 at December 31, 2002.
Net asset value per share ("NAV") was $2.22 at June 30, 2003, versus
$2.37 at December 31, 2002. The Company's shares outstanding remained
unchanged during the six months ended June 30, 2003.
Significant developments in the six months ended June 30, 2003, were an
increase in bank loan payable of $7,983,520 and an increase in the value of
the Company's investment in U.S. Treasury Bills of $4,386,032.
The increase in the value of the venture capital investments, from
$12,036,077 at December 31, 2002, to $14,517,674 at June 30, 2003, resulted
primarily from the Company's three new venture capital investments and one
follow-on investment, partially offset by a net decrease in the value of the
Company's other venture capital investments.
27
The following table is a summary of additions to the Company's portfolio
of venture capital investments during the six months ended June 30, 2003:
New Investment Amount
-------------- ----------
Chlorogen, Inc. $ 525,900
NanoGram Devices Corporation $ 750,000
Nanosys, Inc. $1,500,000
Follow-on Investment
--------------------
Nanotechnologies, Inc. $ 169,718
----------
Total $2,945,618
==========
Year ended December 31, 2002
At December 31, 2002, as compared with December 31, 2001, the Company's
total assets decreased by $3,730,398 or 9.4 percent to $35,951,969, and its
net assets increased by $2,921,276 or 12 percent to $27,256,046.
NAV was $2.37 on 11,498,845 shares outstanding at December 31, 2002,
versus $2.75 on 8,864,231 shares outstanding at December 31, 2001.
Among the significant developments during the year ended December 31,
2002, were: (1) payment of $271,467 in federal income taxes as a result of the
Company's deemed dividend distribution to shareholders; (2) net decrease in
the unrealized appreciation of the Company's venture capital investments of
$3,933,834, including a decrease in the unrealized appreciation of
NeuroMetrix, Inc. of $1,986,081; (3) decrease in bank loan payable of
$12,495,777; (4) net proceeds of $5,643,470 pursuant to the issuance and
exercise of transferable rights for 2,634,614 new shares of the Company's
common stock, bringing the Company's shares outstanding as of December 31,
2002, to 11,498,845 shares, versus 8,864,231 shares outstanding at December
31, 2001; and (5) receipt of $5,700,000 in cash and a recorded receivable in
the amount of $786,492 related to the liquidation of the Company's partnership
interest in PHZ Capital Partners L.P.
The value of the venture capital investments decreased by $1,084,901,
from $13,120,978 at December 31, 2001, to $12,036,077 at December 31, 2002,
reflecting increases from new and additional investments offset by investment
write-downs and the liquidation of investments. Increases from new and
follow-on investments totaled $7,195,988. Write-downs totaled $5,213,959.
The liquidations of Informio, Inc. and the Company's partnership interest in
PHZ Capital Partners L.P. resulted in decreases in venture capital investments
of a total of $3,072,382, based on their respective values at December 31,
2001.
28
The following table is a summary of additions to our portfolio of
venture capital investments for the year ended December 31, 2002:
New Investment Amount
-------------- ------------
Agile Materials & Technologies, Inc. $1,000,000
Continuum Photonics, Inc. $1,000,000
Nanopharma Corp. $ 700,000
NanoOpto Corporation $ 625,000
Nanotechnologies, Inc. $ 750,000
Neo Photonics Corporation $1,000,000
Optiva, Inc. $1,250,000
Follow-on Investment
--------------------
Experion Systems, Inc. $ 517,706
NeuroMetrix, Inc. $ 353,282
----------
Total $7,195,988
==========
Year Ended December 31, 2001
At December 31, 2001, as compared with December 31, 2000, the Company's
total assets decreased by $3,661,056 or 8.4 percent to $39,682,367, and its
net assets decreased by $7,498,705 or 23.6 percent to $24,334,770.
NAV was $2.75 at December 31, 2001, versus $3.51 at December 31, 2000.
NAV was reduced by $0.02 in 2000 by the cash dividend paid by the Company to
shareholders.
Among the significant developments during the year ended December 31,
2001, were: (1) payment of $5,709,884 in federal income taxes as a result of
the Company's deemed dividend distribution; (2) net decrease in the unrealized
appreciation of the Company's venture capital investments of $7,731,465,
including a write-off for book purposes of the value of the Company's holdings
in Schwoo, Inc. of $1,248,827; (3) sales of the Company's holdings in
Nanophase Technologies Corporation, Genomica Corporation, SciQuest.com, Inc.,
Essential.com and MedLogic Global Corporation; and (4) change in the Company's
valuation policy as of March 31, 2001, in accordance with newly promulgated
SEC guidelines. The Company changed its valuation policy by no longer
discounting publicly held securities for liquidity considerations. (See "Asset
Valuation Policy Guidelines" in the "Footnote to Consolidated Schedule of
Investments." )
The following table is a summary of additions to our portfolio of
venture capital investments for the year ended December 31, 2001:
New Investment Amount
-------------- ------------
Schwoo, Inc. $ 888,577
Nantero, Inc. $ 489,999
Follow-on Investment
--------------------
Experion Systems, Inc. $ 80,000
Loan
----
Schwoo, Inc. $ 360,250
----------
Total $1,818,826
==========
29
The following table summarizes fair value of our entire investment
portfolio, as compared with its cost, at June 30, 2003, and December 31, 2002,
and December 31, 2001:
June 30, December 31,
2003 2002 2001
----------- ------------ -----------
Investments, at Cost....... $37,534,201 $30,206,935 $37,714,285
Unrealized depreciation.... (3,179,750) (2,720,113) 1,216,420
----------- ----------- -----------
Investments, at fair value. $34,354,451 $27,486,822 $38,930,705
=========== =========== ===========
_______________
The accumulated unrealized (depreciation) appreciation on investments net of
deferred taxes was ($3,389,458) at December 31, 2002, versus ($148,049) at
December 31, 2001. The accumulated unrealized (depreciation) on investments
net of deferred taxes was $3,849,094 at June 30, 2003, versus ($3,389,458) at
December 31, 2002.
The following table summarizes the composition of our venture capital
portfolio at June 30, 2003, and at December 31, 2002, and December 31, 2001:
June 30, December 31,
Category 2003 2002 2001
-------- ----------- ------------ -----------
Tiny Technology............ 57.0% 49.0% 9.3%
Other Venture Capital
Investments................ 43.0% 51.0% 90.7%
----- ----- -----
Total Venture Capital
Investments................ 100.0% 100.0% 100.0%
===== ===== =====
Cash Flow
Year ended December 31, 2002
Cash flow provided by operating activities for the year ended December
31, 2002, was $1,923,048, primarily as a result of the following changes from
December 31, 2001, to December 31, 2002: payable to broker for unsettled trade
increased by $5,969,725; funds held in escrow increased by $750,000; and
receivable from a partnership liquidation increased by $786,492. In addition,
net realized and unrealized loss on investments was $651,797, and the net
decrease in net assets resulting from operations was $2,722,194.
Cash provided by investing activities for the year ended December 31,
2002, was $10,751,980, reflecting the decrease in the Company's investment in
U.S. Treasury Bills of $10,358,006 and the proceeds from the liquidation of
investments of $7,631,100, offset by investments in private placements of
$7,195,988.
Cash used in financing activities for the year ended December 31, 2002,
was $6,842,807, reflecting the payment of the outstanding balance on the asset
line of credit of $12,495,777, offset by the net proceeds from a rights
offering of $5,643,470. The Company intended to invest in tiny technology,
under normal circumstances, directly or indirectly, the net proceeds of the
rights offering in accordance with its investment objectives and policies,
within the 12 months following the receipt of the net proceeds of the rights
offering, depending on the available investment opportunities.
30
Liquidity and Capital Resources
The Company's 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.
Six Months ended June 30, 2003
At June 30, 2003, and December 31, 2002, the Company's total net
primary liquidity was $12,134,541 and $16,508,057, respectively. 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 Company's tertiary source of liquidity was its partnership interest in PHZ
Capital Partners L.P., which was liquidated effective December 31, 2002. The
Company received the final distribution of $786,492 from PHZ Capital Partners
L.P. in the first quarter of 2003.
The decrease in the Company's net primary sources of liquidity from
December 31, 2002, to June 30, 2003, is primarily owing to: (1) payment of
federal, state and local taxes; (2) investment in Chlorogen, Inc.; (3)
investment in Nanotechnologies, Inc.; (4) investment in Nanosys, Inc.; and (5)
use of funds for net operating expenses.
From December 31, 2002, to June 30, 2003, the Company's liability for
accrued employee profit sharing decreased by $13,710 to $1,523, or 90 percent
as a result of the payment of $13,710 for 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 $935,945, from
$1,527,000 at December 31, 2002 to $591,055 at June 30, 2003, primarily as a
result of federal, state and local payments made for income earned in 2002.
Year ended December 31, 2002
At December 31, 2002, December 31, 2001, and December 31, 2000, the
Company's net primary liquidity was $16,508,057, $13,459,654 and $23,039,736,
respectively. On the corresponding dates, the Company's secondary liquidity
was $0, $0 and $3,040,679. The Company's tertiary source of liquidity was its
partnership interest in PHZ Capital Partners L.P., from which the Company
received cash distributions in 2002, 2001 and 2000 of $6,588,661, $172,068 and
$280,326, respectively. Effective December 31, 2002, the Company liquidated
its 20 percent partnership interest in PHZ, for $5,700,000 on December 31,
2002, and a final distribution of $786,492 on January 16, 2003. At December
31, 2002, the final distribution of $786,492 is included in net primary
liquidity as a receivable.
The increase in the Company's net primary liquidity from December 31,
2001, to December 31, 2002, is the net result of: (1) payment of federal
income taxes; (2) investment in Nanopharma Corp.; (3) investment in NanoOpto
Corporation; (4) investment in NeoPhotonics Corporation; (5) investment in
Experion Systems, Inc.; (6) investment in Continuum Photonics, Inc.; (7)
investment in Nanotechnologies, Inc.; (8) investment in Optiva, Inc.; (9)
investment in Agile Materials & Technologies, Inc.; (10) investment in
NeuroMetrix, Inc.; (11) funds held in escrow for a pending venture capital
investment; and (12) use of funds for operating expenses; offset by raising
$5,643,470, net of expenses, from a rights offering of common stock by the
Company that closed July 31, 2002.
31
From December 31, 2001, to December 31, 2002, restricted funds increased
by $274,924 or 57.0 percent, owing to the Company's 2002 contribution of
$147,478 to the Supplemental Executive Retirement Plan, or SERP account, and
net changes in the account from income earned and changes in investments
valuations.
From December 31, 2001, to December 31, 2002, the Company's liability
for accrued profit sharing decreased by $163,049 to $15,233, to reflect the
estimated amount to be paid out under the profit-sharing plan. Current income
tax liability increased by $602,588 to $857,656, owing primarily to income
recorded in association with the liquidation of the Company's partnership
interest in PHZ Capital Partners L.P.
On November 19, 2001, the Company established an asset account line of
credit of up to $12,700,000. The asset account line of credit is secured by
the Company's Government Agency securities. Under the asset account line of
credit, the Company may borrow up to 95 percent of the current value of its
Government Agency securities. The Company's outstanding balance under the
asset line of credit at December 31, 2002, and December 31, 2001, was $0 and
$12,495,777, respectively. The asset line of credit bears interest at a rate
of the Broker Call Rate plus 50 basis points.
The Company's net primary sources of liquidity are more than adequate to
cover the Company's gross cash operating expenses over the next 12 months.
Such gross cash operating expenses totaled $2,256,991, $1,992,341 and
$2,051,086 in 2002, 2001 and 2000, respectively.
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 those that require management's most difficult, complex or subjective
judgments. The Company's critical accounting policies are those applicable to
the valuation of investments.
Valuation of Portfolio Investments
As a business development company, the Company invests primarily in
illiquid securities including debt and equity securities of private companies.
The investments are generally subject to restrictions on resale and generally
have no established trading market. The Company values substantially all of
its equity investments at fair value as determined in good faith by the
Company's Valuation Committee. The Valuation Committee, comprised of at least
three or more independent Board members, reviews and approves the valuation of
the Company's investments 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.
32
Recent Developments -- Portfolio Companies
On January 16, 2003, the Company received $786,492 as final payment in
the liquidation of the Company's partnership interest in PHZ Capital Partners
L.P.
On February 3, 2003, the Company announced that it had invested $750,000
in a convertible preferred security of NanoGram Devices Corporation. NanoGram
Devices has developed and is commercializing specialized power sources for
medical devices and other medical equipment based on its patented, laser-based
nanomaterials synthesis technology.
On August 1, 2003, the Company made a follow-on investment of $323,000
in preferred stock of one of our privately held tiny-technology companies that
has not yet announced this financing.
Recent Developments -- Other
The qualification of the Company as a RIC under Sub-Chapter M of the
Code depends on it satisfying certain technical requirements regarding its
income, investment portfolio and distributions. 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.
RISK FACTORS
Investing in our common stock involves a number of significant risks
relating to our business and investment objective. You should carefully
consider the risks and uncertainties described below before you purchase any
of our common stock. These risks and uncertainties are not the only ones we
face. Unknown additional risks and uncertainties, or ones that we currently
consider immaterial, may also impair our business. If any of these risks or
uncertainties materialize, our business, financial condition or results of
operations could be materially adversely affected. In this event, the trading
price of our common stock could decline, and you could lose all or part of
your investment.
Risks related to the companies in our portfolio.
- ------------------------------------------------
Investing in small, private companies involves a high degree of risk and is
highly speculative.
We have invested a substantial portion of our assets in privately held
development stage or start-up companies. These businesses tend to lack
management depth, to have limited or no history of operations and to have not
attained profitability. Tiny technology companies are especially risky,
involving scientific, technological and commercialization risks. Because of
the speculative nature of these investments, these securities have a
significantly greater risk of loss than traditional investment securities.
Some of our venture capital investments are likely to be complete losses or
unprofitable and some will never realize their potential. We have been risk
seeking rather than risk averse in our approach to venture capital and other
investments. Neither our investments nor an investment in our common stock is
intended to constitute a balanced investment program.
33
We may invest in companies working with technologies or intellectual property
which currently have few or no proven commercial applications.
Nanotechnology, in particular, is a developing area of technology, of
which much of the future commercial value is unknown, difficult to estimate
and subject to widely varying interpretations. There are relatively few
nanotechnology products currently commercially available. The timing of
additional future commercially available nanotechnology products is highly
uncertain.
Our portfolio companies working with tiny technology may be particularly
susceptible to intellectual property disputes.
Research and commercialization efforts in tiny technology are being
undertaken by a wide variety of government, academic and private corporate
entities. As additional commercially viable applications of tiny technology
begin to emerge, ownership of the intellectual property on which these
products are based may be contested in some cases. Any dispute over the basic
ownership of our portfolio companies' technologies or products would have a
material adverse affect on that company's value.
Our portfolio companies may not be able to market their products successfully.
Even if our portfolio companies are able to develop commercially viable
products, the market for new products and services is highly competitive,
rapidly changing and especially sensitive to adverse general economic
conditions. Commercial success is difficult to predict, and the marketing
efforts of our portfolio companies may not be successful.
Unfavorable economic conditions could result in financial losses in our
portfolio.
Most of the companies in which we have made or will make investments are
susceptible to economic slowdowns or recessions. An economic slowdown, capital
markets conditions or credit squeeze may affect the ability of a company in
our portfolio 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 can be expected to lead to
financial losses in our portfolio.
Risks related to the illiquidity of our investments.
- ---------------------------------------------------
We invest in illiquid securities and may not be able to dispose of them when
it is advantageous to do so, or ever.
Most of our investments are or will be equity securities acquired
directly from small companies. These equity securities are generally subject
to restrictions on resale or otherwise have no established trading market. The
illiquidity of most of our portfolio of equity securities may adversely affect
our ability to dispose of these securities at times when it may be
advantageous for us to liquidate these investments. We may never be able to
dispose of these securities.
Unfavorable economic conditions could impair our ability to engage in
liquidity events or to find additional capital required by our portfolio
companies.
Our business of making private equity investments and positioning them
for liquidity events may be adversely affected by current and future capital
markets and economic conditions. The public equity markets currently provide
little opportunity for liquidity events, even for more mature technology
companies than the ones in which we typically invest. The potential for
public market liquidity could further decrease and could lead to an inability
to realize potential gain or could lead to financial losses in our portfolio
34
and a decrease in our revenues, net income and assets. Recent regulatory
changes have made the process of completing an initial public offering of
equity securities more difficult and uncertain. Recent government reforms
affecting stock markets, investment banks and securities research practices
may make it more difficult for privately held companies to complete successful
initial public offerings of their equity securities. The lack of exit
strategies also tends to have an adverse effect on the ability of private
companies to raise capital.
Even if our portfolio companies complete an initial public offering, the
returns on our investments may be uncertain.
When companies in which we have invested as private entities complete
initial public offerings of their securities, these newly issued securities
are by definition unseasoned issues. Unseasoned issues tend to be highly
volatile and have uncertain liquidity, which may negatively affect their
price. In addition, we are typically subject to lock-up provisions which
prohibit us from selling our investment into the public market for specified
periods of time after an initial public offering. The market price of
securities that we hold may decline substantially before we are able to sell
these securities. Most initial public offerings of technology companies are
listed on the Nasdaq National Market. Recent government reforms of the Nasdaq
National Market have made market making by broker-dealers less profitable,
which has caused broker-dealers to reduce their market making activities,
thereby making the market for unseasoned stocks less liquid.
Risks related to our company.
- ----------------------------
Because there is generally no established market in which to value our
investments, our Valuation Committee's value determinations may differ
materially from the values that a ready market or third party would attribute
to these investments.
There is generally no public market for the equity securities of the
companies in which we invest. Pursuant to the requirements of the 1940 Act, we
value substantially all of the equity securities in our portfolio at fair
value as determined in good faith by the Valuation Committee of the Board of
Directors within the guidelines established by the Board of Directors. Because
there is typically no readily ascertainable market value for our investments,
our Board of Directors determines in good faith the fair value of these
investments pursuant to a valuation policy. There is no single standard for
determining fair value in good faith. As a result, determining fair value
requires that judgment be applied to the specific facts and circumstances of
each portfolio investment pursuant to specified valuation principles and
processes. We are required by the 1940 Act to value specifically each
individual investment on a quarterly basis and record unrealized depreciation
for an investment that we believe has become impaired. Conversely, we must
record unrealized appreciation if we believe that the underlying portfolio
company has appreciated in value. Without a readily ascertainable market value
and because of the inherent uncertainty of valuation, the fair value that we
assign to our investments may differ from the values that would have been used
had a ready market existed for the investments, and the difference could be
material. Any changes in estimated fair value are recorded in our consolidated
statements of operations as a change in the "Net (decrease) increase in
unrealized appreciation on investments."
Because we are a non-diversified company with a relatively concentrated
portfolio, the value of our business is subject to greater volatility than the
value of companies with more broadly diversified investments.
As a result of investing a greater portion of our assets in the
securities of a smaller number of issuers, we are classified as a non-
diversified company. We may be more vulnerable to events affecting a single
issuer or industry and therefore subject to greater volatility than a company
35
whose investments are more broadly diversified. Accordingly, an investment in
our common stock may present greater risk to you than an investment in a
diversified company.
We may be obligated to pay substantial amounts under our profit sharing plan.
Our employee profit-sharing plan requires us to distribute to our
officers and employees 20 percent of our net realized income as reflected on
our consolidated statements of operations for that year, less the non-
qualifying gain, if any. These distributions may have a significant effect on
the amount of distributions made to our shareholders, if any.
Approximately 35 percent of the fair value of our investment portfolio,
as of June 30, 2003, is concentrated in one company, NeuroMetrix, Inc., which
is not a tiny technology company.
We valued our investment in NeuroMetrix, Inc., which is not a tiny
technology company, at $5,075,426, which represents 34.96 percent of the fair
value of our equity investment portfolio (19.91 percent of the net asset
value) at June 30, 2003. Any downturn in the business outlook of NeuroMetrix,
Inc., or any failure of the products of NeuroMetrix, Inc. to receive
widespread acceptance in the marketplace, would have a significant effect on
our specific investment and the overall value of our portfolio.
Approximately 57 percent of the fair value of our investment portfolio, as of
June 30, 2003, is invested in tiny technology.
A significant portion of our current net asset value is composed of
investments in short-term government securities and cash. Although all 12 of
our portfolio investments added since August 2001 have been in tiny technology
companies, and although thirteen of the companies in our current equity
investment portfolio are considered tiny technology companies, only 56.99
percent of the fair value of our equity investment portfolio (32.45 percent of
the net asset value) at June 30, 2003, is invested in tiny technology
companies, which may limit our ability to achieve our investment objective and
our mission.
We are dependent upon key management personnel for future success.
We are dependent for the selection, structuring, closing and monitoring
of our investments on the diligence and skill of our senior management and
other key advisers. We utilize lawyers and outside consultants, including two
of our directors, Dr. Kelly S. Kirkpatrick and Lori D. Pressman, to assist us
in conducting due diligence when evaluating potential investments. There is
generally no publicly available information about the companies in which we
invest, and we rely significantly on the diligence of our employees and
advisers to obtain information in connection with our investment decisions.
Our future success to a significant extent depends on the continued service
and coordination of our senior management team, and particularly depends on
our Chairman and Chief Executive Officer, Charles E. Harris. The departure of
any of our executive officers, key employees or advisers could materially
adversely affect our ability to implement our business strategy. We do not
maintain for our benefit any key man life insurance on any of our officers or
employees.
We will need to hire additional employees as the size of our portfolio
increases.
We anticipate that it will be necessary for us to add investment
professionals with expertise in tiny technology to accommodate the increasing
size of our portfolio. We may need to provide additional scientific, business
or investment training for our hires. There is competition for highly
qualified personnel and we may not be successful in our efforts to recruit and
retain highly qualified personnel.
36
The market for venture capital investments, including tiny technology
investments, is highly competitive.
We face substantial competition in our investing activities from many
competitors, including but not limited to private venture capital funds,
investment affiliates of large industrial, technology, service and financial
companies, small business investment companies, wealthy individuals and
foreign investors. Our most significant competitors typically have
significantly greater financial resources than we do. Many sources of funding
compete for a small number of attractive investment opportunities. Hence, we
face substantial competition in sourcing good investment opportunities on
terms of investment that are commercially attractive.
In addition to the difficulty of finding attractive investment opportunities,
our status as a regulated business development company may hinder our ability
to participate in investment opportunities or to protect the value of existing
investments.
We are required to disclose on a quarterly basis the name and business
description of our portfolio companies and the value of any portfolio
securities. Most of our competitors are not subject to these disclosure
requirements. Our obligation to disclose this information could hinder our
ability to invest in some portfolio companies. Additionally, other current and
future regulations may make us less attractive as a potential investor than a
competitor not subject to the same regulations.
Our failure to make follow-on investments in our portfolio companies could
impair the value of our portfolio.
Following an initial investment in portfolio companies, we may make
additional investments in the portfolio companies as "follow-on" investments,
in order to: (1) increase or maintain in whole or in part our ownership
percentage; (2) exercise warrants, options or convertible securities that were
acquired in the original or subsequent financing; or (3) attempt to preserve
or enhance the value of our investment. Recently, "pay to play" provisions
have become common in venture capital transactions. These provisions require
proportionate investment in subsequent rounds of financing in order to
preserve preferred rights such as anti-dilution protection or to prevent
preferred shares from being converted to common shares.
We may elect not to make follow-on investments or otherwise lack
sufficient funds to make those investments. We have the discretion to make any
follow-on investments, subject to the availability of capital resources. The
failure to make follow-on investments may, in some circumstances, jeopardize
the continued viability of a portfolio company and our initial investment, or
may result in a missed opportunity for us to increase our participation in a
successful operation, or may cause us to lose some or all preferred rights
pursuant to "pay to play" provisions. Even if we have sufficient capital to
make a desired follow-on investment, we may elect not to make a follow-on
investment because we may not want to increase our concentration of risk,
because we prefer other opportunities or because we are inhibited by
compliance with business development company requirements or the desire to
maintain our RIC tax status.
Our issuance of debt securities to fund investments in portfolio companies or
to fund our operating expenses could make our total return to common
shareholders more volatile. These securities could include fixed-maturity
instruments paying interest or dividend-paying preferred stock.
Our use of debt as a source of capital would entail two primary risks.
The first risk is that the use of debt leverages our available equity capital,
magnifying the impact on net asset value of changes in the value of our
37
investment portfolio. For example, a business development company 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 debt financing may exceed the return on the assets it is used to
acquire, thereby diminishing rather than enhancing the return to common
shareholders. If we were to utilize debt financing for any purpose, these two
risks would likely make our total return to common shareholders more volatile.
In addition, we might be required to sell investments in order to meet
dividend or interest payments when it may be disadvantageous for us to do so.
As provided in the 1940 Act and subject to some exceptions, we can issue
debt or preferred stock so long as our total assets immediately after the
issuance, less some ordinary course liabilities, exceed 200 percent of the sum
of the debt and any preferred stock outstanding. The debt or preferred stock
may be convertible in accordance with SEC guidelines, which may permit us to
obtain leverage at more attractive rates. The requirement under the 1940 Act
to pay in full dividends on preferred shares or interest on debt before any
dividends may be paid on the common shares means that dividends on the common
shares from earnings may be reduced or eliminated. An inability to pay
dividends on the common shares could conceivably result in our ceasing to
qualify as a RIC under the Code, which would be materially adverse to the
holders of the common shares.
The class voting rights of preferred shares we may issue could make it
more difficult for us to take some actions that may, in the future, be
proposed by the board and/or the holders of common stock, such as a merger,
exchange of securities, liquidation or alteration of the rights of a class of
our securities if these actions were perceived by the holders of the preferred
shares as not in their best interests.
The issuance of preferred shares convertible into shares of common stock
might also reduce the net income and net asset value per share of the common
shares upon conversion. This income dilution would occur if we could, from the
investments made with the proceeds of the preferred shares, earn an amount per
common share issuable upon conversion greater than the dividend required to be
paid on the amount of preferred stock convertible into one share of common
stock. Net asset value dilution would occur if preferred shares were converted
at a time when the net asset value per common share was greater than the
conversion price.
Loss of status as a RIC would reduce our net asset value and distributable
income.
We currently qualify as a regulated investment company, or RIC, under
the Code. As a RIC, we do not have to pay Federal income taxes on our income
(including realized gains) that is distributed to our shareholders.
Accordingly, we are not permitted under accounting rules to establish reserves
for taxes on our unrealized capital gains. If we failed to qualify for RIC
status, we would have to establish reserves for taxes, which would reduce our
net asset value, net of a reduction in the reserve for employee profit
sharing, accordingly. To the extent that we, as a RIC, were to decide to make
a deemed distribution of net realized capital gains and were to retain the net
realized capital gains, we would have to establish appropriate reserves for
taxes upon making that decision.
Investing in our shares of common stock may be inappropriate for the
investor's risk tolerance.
Our investment objective and strategies result in a high degree of risk
in our investments and may result in losses in the value of our investment
portfolio. Our investments in portfolio companies are highly speculative and,
therefore, an investor in our shares of common stock may lose his or her
entire investment.
38
We operate in a regulated environment.
We are subject to substantive SEC regulations as a business development
company. Securities and tax laws and regulations governing our activities may
change in ways adverse to our and our shareholders' interests, and
interpretations of these laws and regulations may change with unpredictable
consequences. Any change in the laws or regulations that govern our business
could have an adverse impact on us or on our operations. Also, as business and
financial practices continue to evolve, they may render the regulations under
which we operate less appropriate and more burdensome than they were when
originally imposed.
Quarterly results fluctuate and are not indicative of future quarterly
performance.
Our quarterly operating results fluctuate as a result of a number of
factors. These factors include, among others, variations in and the timing of
the recognition of realized and unrealized gains or losses, the degree to
which we and our portfolio companies encounter competition in our markets and
general economic and capital markets conditions. As a result of these factors,
results for any one quarter should not be relied upon as being indicative of
performance in future quarters.
We may be obligated to pay substantial amounts under our profit sharing plan.
Our employee profit-sharing plan requires us to distribute to our
officers and employees 20 percent of our net after-tax realized income as
reflected on our consolidated statements of operations for that year, less the
non-qualifying gain, if any. These distributions may have a significant effect
on the amount of distributions made to our shareholders, if any.
To the extent that we distribute income instead of electing to retain after-
tax realized capital gains, our need for additional capital to fund our
investments and operating expenses will be greater.
We 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 we fail to
generate net realized capital gains or to obtain funds from outside sources,
it would have a material adverse effect on our financial condition and results
as well as our ability to make follow-on and new investments. In addition, as
a business development company, we are generally required to maintain a ratio
of at least 200 percent of total assets to total borrowings, which may
restrict our ability to borrow.
Investment in foreign securities could result in additional risks.
We currently have no investments in foreign securities. If we invest in
securities of foreign issuers, we may be subject to risks not usually
associated with owning securities of U.S. issuers. These risks can include
fluctuations in foreign currencies, foreign currency exchange controls,
social, political and economic instability, differences in securities
regulation and trading, expropriation or nationalization of assets, and
foreign taxation issues. In addition, changes in government administrations or
economic or monetary policies in the United States or abroad could result in
appreciation or depreciation of our securities and could favorably or
unfavorably affect our operations. It may also be more difficult to obtain and
enforce a judgment against a foreign issuer. Any foreign investments made by
us must be made in compliance with U.S. and foreign currency restrictions and
tax laws restricting the amounts and types of foreign investments.
39
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 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."
While the Company invests in short-term money market and U.S.
Government and Agency Obligations and draws down on the asset line of credit,
the Company does not consider a change in interest rates to result in
significant risks.
40
Item 4. Controls and Procedures
As of the end of the period covered by this 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 during such
period 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.
41
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
On May 5, 2003, the Company held its Annual Meeting of Shareholders for
the following purposes: (1) to elect directors of the Company; (2) to ratify,
confirm and approve the Audit Committee's selection of PricewaterhouseCoopers
LLP as the Company's independent accountant for its fiscal year ending
December 31, 2003; and (3) to approve a proposal to authorize the Company to
offer long-term rights to purchase shares of the Company's common stock. At
the close of business on the record date (March 26, 2003), an aggregate of
11,498,845 shares of common stock were issued and outstanding.
All of the nominees at the May 5, 2003 Annual Meeting were elected
directors:
Nominees For Withheld
-------- ----------- ------------
Dr. C. Wayne Bardin 10,979,467 124,411
Dr. Phillip A. Bauman 10,981,641 122,237
G. Morgan Browne 10,980,277 123,601
Dugald A. Fletcher 10,977,806 126,072
Charles E. Harris 10,980,987 122,891
Dr. Kelly S. Kirkpatrick 10,982,471 121,407
Glenn E. Mayer 10,977,375 126,503
Lori D. Pressman 10,981,970 121,908
Charles E. Ramsey 10,981,721 122,157
James E. Roberts 10,979,471 124,407
With respect to proposal number two, described as a proposal "to
ratify, confirm and approve the Audit Committee's selection of
PricewaterhouseCoopers LLP" as the Company's independent accountant for its
fiscal year ending December 31, 2003, the affirmative votes cast were
10,990,137, the negative votes cast were 23,603 and those abstaining were
90,138.
With respect to proposal number three, described as a proposal "to
authorize the Company to offer long-term rights to purchase shares of the
Company's common stock at an exercise price that, at the time such rights
are issued, will not be less than the greater of the market value of the
Company's common stock or the net asset value of the Company's common stock.
Such rights may be part of or accompanied by other securities of the
Company (such as convertible preferred stock or convertible debt)." The
affirmative votes cast were 4,652,997 , the negative votes cast were 194,926
and those abstaining were 94,462.
Item 5. Other Information
Not Applicable
42
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.
31.01* Certification of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.02* Certification of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.01* Certification of CEO pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
32.02* 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 June 30, 2003
----------------------------------------------------------------
The Company filed a report on Form 8-K on May 8, 2003, concerning
NAV at March 31, 2003.
_____________
*filed herewith
43
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized on behalf of the Registrant and as
its chief accounting officer.
Harris & Harris Group, Inc.
/s/ Helene B. Shavin
---------------------
By: Helene B. Shavin,
Vice President and Controller
Date: August 14, 2003
44