UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended September 30, 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 October 31, 2003
- -----------------------------------------------------------------
Common Stock, $0.01 11,498,845 shares
par value per share
Harris & Harris Group, Inc.
Form 10-Q, September 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.................................... 26
Liquidity and Capital Resources........................ 27
Risk Factors........................................... 29
Item 3. Quantitative and Qualitative Disclosures
About Market Risk...................................... 36
Item 4. Controls and Procedures....................... 37
PART II OTHER INFORMATION
Item 1. Legal Proceedings.............................. 38
Item 2. Changes in Securities and Use of Proceeds...... 38
Item 3. Defaults Upon Senior Securities................ 38
Item 4. Submission of Matters to a Vote of Security
Holders........................................ 38
Item 5. Other Information.............................. 38
Item 6. Exhibits and Reports on Form 8-K............... 38
Signature.............................................. 39
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," "us," "our" and
"we") 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 our 2002 Annual Report.
On September 25, 1997, our Board of Directors approved a
proposal to seek qualification of us as a Regulated Investment
Company ("RIC") under Sub-Chapter M of the Internal Revenue Code
(the "Code"). At that time, we were taxable under Sub-Chapter C
of the Code (a "C Corporation"). In order to qualify as a RIC, we
must, in general (1) annually derive at least 90 percent of our
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 our investment company taxable
income as a dividend. In addition to the requirement that we
must annually distribute at least 90 percent of our investment
company taxable income, we may either distribute or retain our
taxable net capital gains from investments, but any net capital
gains not distributed could be subject to corporate level tax.
Further, we could be subject to a four percent excise tax to the
extent we fail to distribute at least 98 percent of our annual
taxable income and would be subject to income tax to the extent
we fail to distribute 100 percent of our investment company
taxable income.
Because of the specialized nature of our investment
portfolio, we could satisfy the diversification requirements
under Sub-Chapter M of the Code only if we received a
certification from the Securities and Exchange Commission ("SEC")
that we are "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, we received SEC certification for 2002,
permitting us to qualify for RIC treatment for 2002 (as we had
for 1999-2001). Although the SEC certification for 2002 was
issued, there can be no assurance that we will qualify for or
receive such certification for subsequent years (to the extent we
need additional certification as a result of changes in our
portfolio) or that we will actually qualify for Sub-Chapter M
treatment in subsequent years. In addition, under certain
circumstances, even if we qualified for Sub-Chapter M treatment
in a given year, we might take action in a subsequent year to
ensure that we would be taxed in that subsequent year as a C
Corporation, rather than as a RIC.
1
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
September 30, 2003 December 31, 2002
(Unaudited) (Audited)
Investments, at value (Cost:
$35,510,134 at 9/30/03, $30,206,935
at 12/31/02)........................... $32,632,851 $27,486,822
Cash and cash equivalents................ 239,605 5,967,356
Restricted funds (Note 5)................ 1,099,051 756,944
Funds in escrow.......................... 0 750,000
Receivable from portfolio company........ 0 786,492
Interest receivable...................... 342 189
Income tax receivable.................... 83,595 0
Prepaid expenses......................... 23,939 96,631
Other assets............................. 312,649 107,535
----------- -----------
Total assets............................. $34,392,032 $35,951,969
=========== ===========
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities. $ 1,846,053 $ 1,451,568
Payable to broker for unsettled trade.... 0 5,696,725
Bank loan payable (Note 8)............... 7,609,500 0
Accrued profit sharing (Note 3).......... 0 15,233
Deferred rent............................ 41,223 5,397
Current income tax liability............. 0 857,656
Deferred income tax liability (Note 6)... 669,344 669,344
----------- -----------
Total liabilities........................ 10,166,120 8,695,923
----------- -----------
Commitments and contingencies (Note 7)
Net assets............................... $24,225,912 $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 9/30/03 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............ (1,735,144) 1,137,820
Accumulated unrealized depreciation of
investments, net of deferred tax
liability of $844,918 at 9/30/03
and 12/31/02........................... (3,722,202) (3,565,032)
Treasury stock, at cost (1,828,740
shares at 9/30/03 and 12/31/02)........ (3,405,531) (3,405,531)
----------- -----------
Net assets............................... $24,225,912 $27,256,046
=========== ===========
Shares outstanding....................... 11,498,845 11,498,845
=========== ===========
Net asset value per outstanding share.... $ 2.11 $ 2.37
=========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Nine Months Ended
Sept. 30, 2003 Sept. 30, 2002 Sept. 30, 2003 Sept. 30, 2002
Investment income:
Interest from fixed-
income securities........ $ 25,910 $ 46,508 $ 104,165 $ 140,779
Other income.............. 4,702 30,905 41,687 56,464
----------- ----------- ----------- -----------
Total investment income. 30,612 77,413 145,852 197,243
Expenses:
Profit-sharing accrual
(reversal) (Note 3)...... 0 (520) 0 248,765
Salaries and benefits..... 360,116 259,974 1,084,015 779,939
Administration and
operations............... 85,536 85,511 324,238 310,579
Professional fees......... 59,277 120,903 276,571 264,564
Rent...................... 49,885 43,040 169,203 129,620
Directors' fees and
expenses................. 31,250 38,207 121,295 115,385
Depreciation.............. 11,408 8,176 31,538 20,861
Bank custody fees......... 1,499 1,555 5,908 7,138
Interest expense.......... 3,987 0 16,879 10,776
----------- ----------- ----------- -----------
Total expenses.......... 602,958 556,846 2,029,647 1,887,627
----------- ----------- ----------- -----------
Operating loss before
income taxes............. (572,346) (479,433) (1,883,795) (1,690,384)
Income tax provision
(Note 6)................. 0 0 0 0
----------- ----------- ----------- -----------
Net operating loss......... (572,346) (479,433) (1,883,795) (1,690,384)
Net realized (loss) gain
on investments:
Realized (loss) gain on
investments.............. (1,003,919) 252,750 (975,347) 1,052,110
----------- ----------- ----------- -----------
Total realized (loss)
gain................... (1,003,919) 252,750 (975,347) 1,052,110
Income tax benefit
(provision) (Note 6)..... 3,500 (141,800) (13,822) (128,936)
----------- ----------- ----------- -----------
Net realized (loss) gain
on investments........... (1,000,419) 110,950 (989,169) 923,174
----------- ----------- ----------- -----------
Net realized loss.......... (1,572,765) (368,483) (2,872,964) (767,210)
Net increase (decrease) in
unrealized appreciation on
investments:
Increase as a result of
investment sales......... 1,000,001 360,250 1,000,001 713,471
Decrease as a result of
investment sales......... 0 0 (18,031) 0
Increase on investments
held..................... 67,982 2,347,172 757,841 2,392,249
Decrease on investments
held..................... (765,516) (2,335,247) (1,896,981) (2,937,463)
----------- ----------- ----------- -----------
Net change in unrealized
appreciation on
investments............ 302,467 372,175 (157,170) 168,257
Income tax benefit
(Note 6)................. 0 657,296 0 657,296
----------- ----------- ----------- -----------
Net increase (decrease) in
unrealized appreciation
on investments........... 302,467 1,029,471 (157,170) 825,553
----------- ----------- ----------- -----------
Net (decrease) increase in
net assets resulting from
operations:
Total..................... $(1,270,298) $ 660,988 $(3,030,134) $ 58,343
=========== =========== =========== ===========
Per outstanding share..... $ (.11) $ .06 $ (.26) $ .01
=========== =========== =========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended Nine Months Ended
Sept. 30, 2003 Sept. 30, 2002
Cash flows from operating activities:
Net (decrease) in net assets resulting
from operations............................... $(3,030,134) $ 58,343
Adjustments to reconcile net decrease
in net assets resulting from operations
to net cash used in operating activities:
Realized and unrealized (loss) gain on
investments................................. 1,132,517 (1,220,367)
Depreciation................................. 31,538 20,982
Changes in assets and liabilities:
Restricted funds.............................. (342,107) (263,626)
Receivable from portfolio company............. 786,492 0
Funds in escrow............................... 750,000 0
Interest receivable........................... (153) (8)
Income tax receivable......................... (83,595) 0
Note receivable............................... 0 10,487
Prepaid expenses.............................. 72,692 (5,754)
Other assets.................................. (40,927) 4,951
Accounts payable and accrued liabilities...... 394,485 468,250
Payable to broker for unsettled trade......... (5,696,725) 0
Accrued profit sharing........................ (15,233) 248,765
Current income tax liability.................. (857,656) (178,697)
Deferred income tax liability................. 0 (657,296)
Deferred rent................................. 35,826 (6,940)
----------- ------------
Net cash used in operating activities......... (6,862,980) (1,520,910)
Cash flows from investing activities:
Net (purchase) sale of short-term investments
and marketable securities.................... (2,975,719) 13,184,105
Proceeds from investments..................... 26,791 1,140,191
Investment in private placements and loans.... (3,331,118) (5,675,000)
Purchase of fixed assets...................... (195,725) (27,810)
----------- -----------
Net cash (used in) provided by investing
activities................................... (6,475,771) 8,621,486
Cash flows from financing activities:
Proceeds from note payable.................... 7,609,500 0
Payment of note payable....................... 0 (12,495,777)
Proceeds from rights offering, net............ 0 5,665,970
Collection on notes receivable................ 1,500 6,500
----------- ------------
Net cash provided by (used in) financing
activities................................... 7,611,000 (6,823,307)
----------- ------------
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................................... 239,605 412,404
----------- ------------
Net increase (decrease) in cash and
cash equivalents............................. $(5,727,751) $ 277,269
=========== ============
Supplemental disclosures of cash flow information:
Income taxes paid............................. $ 575,100 $ 307,585
Interest paid................................. $ 15,441 $ 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 Nine Months Ended
Sept. 30, 2003 Sept. 30, 2002 Sept. 30, 2003 Sept. 30, 2002
Changes in net assets
from operations:
Net operating loss....... $ (572,346) $ (479,433) $(1,883,795) $(1,690,384)
Net realized (loss)
gain on investments..... (1,000,419) 110,950 (989,169) 923,174
Net increase in
unrealized appreciation
on investments as a
result of sales......... 1,000,001 360,250 981,970 713,471
Net (decrease) increase
in unrealized
appreciation on
investments held........ (697,534) 669,221 (1,139,140) 112,082
----------- ----------- ----------- -----------
Net (decrease) increase
in net assets resulting
from operations......... (1,270,298) 660,988 (3,030,134) 58,343
Changes in net assets from
capital stock transactions:
Proceeds from sale of
common stock............ 0 26,346 0 26,346
Additional paid in
capital on common
stock issued............ 0 5,639,624 0 5,639,624
----------- ---------- ----------- ----------
Net increase in net
assets resulting from
capital stock
transactions............ 0 5,665,970 0 5,665,970
----------- ----------- ----------- -----------
Net (decrease) increase
in net assets............. (1,270,298) 6,326,958 (3,030,134) 5,724,313
Net assets:
Beginning of the period.. 25,496,210 23,732,125 27,256,046 24,334,770
----------- ----------- ----------- -----------
End of the period........ $24,225,912 $30,059,083 $24,225,912 $30,059,083
=========== =========== =========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
5
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (8)(9)(10)
- -- 11.9% of total investments
Private Placement Portfolio (Illiquid) -- 11.9%
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) -- $ 112,500
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 0
Exponential Business Development Company
(1)(2)(5)(12) -- Venture capital partnership
focused on early stage companies
Limited Partnership interest......................(A) -- 25,000
Heartware, Inc. (1)(2)(6)(15) -- Develops
ventricular assist devices -- 0% percent
of fully diluted equity
Series A-2 Non-Voting Preferred Stock.............(D) 47,620 0
NanoGram Corporation (1)(2)(4)(5)(6)(13) --
Develops a broad suite of intellectual
property utilizing nanotechnology -- 1.81%
of fully diluted equity
Series 1 Convertible 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
-- 2.30% of fully diluted equity
Series A-1 Convertible Preferred Stock............(B) 267,857
Series B Convertible Preferred Stock..............(B) 146,921 110,067
Nanosys, Inc. (1)(2)(4)(5)(6) -- Develops
nanotechnology-enabled systems incorporating
novel and patent-protected zero and one-
dimensional nanometer-scale materials --
1.68% of fully diluted equity
Series C Convertible Preferred Stock..............(A) 803,428 1,500,000
Nantero, Inc. (1)(2)(6) -- Develops a high
density nonvolatile random access memory
chip using nanotechnology -- 3.35% of fully
diluted equity
Series A Convertible Preferred Stock..............(B) 345,070
Series B Convertible Preferred Stock..............(B) 207,051 861,309
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 7,865
Optiva, Inc. (1)(2)(5)(6) -- Develops and
commercializes nanomaterials for advanced
applications -- 1.96% of fully diluted equity
Series C Convertible Preferred Stock..............(B) 1,249,999 1,250,000
----------
Total Private Placement Portfolio (cost: $6,215,542).......................$3,888,413
----------
Total Investments in Unaffiliated Companies (cost: $6,215,542).............$3,888,413
----------
The accompanying notes are an integral part of
this consolidated schedule.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated
Companies (8)(9)(11) -- 31.6% of total
investments
Private Placement Portfolio (Illiquid)
- -- 31.6% of total investments
Agile Materials & Technologies, Inc.
(1)(2)(6) -- Develops and sells
variable integrated passive electronic
equipment components -- 8.15% of fully
diluted equity
Series A Convertible Preferred Stock...............(D) 3,732,736 $ 500,000
Chlorogen, Inc. (1)(2)(4)(5)(6) --
Develops patented chloroplast technology
to produce plant-made proteins -- 7.22%
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)(5)(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)(5)(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 10/25/04................(B) 1,966
Warrants at $1.50 expiring 11/16/05................(B) 1,250
Warrants at $1.50 expiring 08/03/06................(B) 8,500
Warrants at $1.50 expiring 11/21/07................(B) 3,750 724,588
-----------
Total Private Placement Portfolio (cost: $10,868,128).....................$10,303,805
-----------
Total Investments in Non-Controlled Affiliated Companies
(cost: $10,868,128).......................................................$10,303,805
-----------
The accompanying notes are an integral part
of this consolidated schedule.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2003
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
U.S. Government and Agency Obligations --
56.5% of total investments
U.S. Treasury Bills -- due date 10/09/03...........(J) $4,264,000 $ 4,263,275
U.S. Treasury Bills -- due date 10/16/03...........(J) 1,000,000 999,660
U.S. Treasury Bills -- due date 10/23/03...........(J) 831,000 830,576
U.S. Treasury Bills -- due date 11/13/03...........(J) 1,330,000 1,328,604
U.S. Treasury Bills -- due date 11/20/03...........(J) 1,800,000 1,797,786
U.S. Treasury Bills -- due date 12/18/03...........(J) 1,600,000 1,596,944
U.S. Treasury Notes -- due date 09/30/05...........(H) 7,600,000 7,623,788
-----------
Total Investments in U.S. Government (cost: $18,426,464)....................$18,440,633
-----------
Total Investments -- 100% (cost: $35,510,134)...............................$32,632,851
===========
The accompanying notes are an integral part of this
consolidated schedule.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 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 September 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 we own less than five percent of
the portfolio company. Investments in non-controlled
affiliated companies consist of investments in which we
own more than five percent but less than 25 percent of
the portfolio company. Investments in controlled
affiliated companies consist of investments in which we
own 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 we own 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 $6,215,542. The
gross unrealized appreciation based on the tax cost for
these securities is $157,557. The gross unrealized
depreciation based on the tax cost for these securities
is $2,484,686.
(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 $3,336,330.
(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. We 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. We received 63,210 shares
of Series A-1 Convertible Preferred Stock.
(15) On July 10, 2003, we received 47,620 shares of Series A-2
Non-Voting Preferred stock of Heartware, Inc., a new
company formed to acquire the assets and assume certain
liabilities of Kriton Medical, Inc. as part of Kriton's
bankruptcy.
The accompanying notes are an integral part of
this consolidated schedule.
9
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
Our 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 our 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.
Our Board of Directors is responsible for (1) determining
overall valuation guidelines and (2) ensuring the valuation of
investments within the prescribed guidelines.
Our Valuation Committee, comprised of at least three or more
independent Board members, is responsible for reviewing and
approving the valuation of our 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
our assets, 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.
Our 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 our original cost.
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 us. We discount 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 us 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 our
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 we own 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 our original cost.
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 us
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 our 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, projected markets, and
other subjective factors.
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 60 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," "us," "our"
and "we") 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. We operate as
an internally managed investment company whereby our officers
and employees, under the general supervision of our Board of
Directors, conduct our operations.
We elected to become a BDC on July 26, 1995, after receiving
the necessary approvals. From September 30, 1992, until the
election of BDC status, we operated as a closed-end, non-
diversified investment company under the 1940 Act. Upon
commencement of operations as an investment company, we revalued
all of our assets and liabilities at fair value as defined in the
1940 Act. Prior to such time, we were 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 held
the lease for the office space until it expired on July 31, 2003,
which it sublet to the Company and an unaffiliated party; 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. Currently,
Harris Partners I, L.P. owns our interest in AlphaSimplex Group,
LLC. The partners of Harris Partners I, L.P. are Enterprises
(sole general partner) and Harris & Harris Group, Inc. (sole
limited partner).
We 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 we
will qualify as a RIC for 2003 and subsequent years or that if we
do qualify, we will continue to qualify for subsequent years. In
addition, even if we were to qualify as a RIC for a given year,
we might take action in a subsequent year to ensure that we would
be taxed in that subsequent year as a C Corporation, rather than
as a RIC. As a RIC, we must, among other factors, distribute at
least 90 percent of our investment company taxable income and may
either distribute or retain our 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, we 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 our unrealized
appreciation on investments.
The September 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 us through
December 31, 1998.
We pay federal, state and local income taxes on behalf of
our wholly owned subsidiary, Harris & Harris Enterprises, which
is a C corporation. (See "Note 6. Income Taxes.")
Estimates by Management. The preparation of the
consolidated financial statements in conformity with accounting
principles generally accepted in the United States requires
management to make estimates and assumptions that affect the
reported amounts of assets and liabilities as of September 30,
2003, and December 31, 2002, and the reported amounts of revenues
and expenses for the three months ended September 30, 2003, and
September 30, 2002. The most significant estimates relate to the
fair valuations of investments for the three months ended
September 30, 2003, and September 30, 2002. Actual results could
differ from these estimates.
NOTE 3. EMPLOYEE PROFIT SHARING PLAN
As of January 1, 2000, we implemented the Harris & Harris
Group, Inc. Employee Profit-Sharing Plan (the "Plan") that
provides for profit sharing by our officers and employees equal
to 20 percent of our net realized income as reflected on our
consolidated statements of operations for such year, less
nonqualifying gains, if any.
Under the Plan, our net realized income includes investment
income, realized gains and losses, and operating expenses
(including taxes paid or payable by us), 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 we
have filed our federal tax return for that year in which
Qualifying Income exists.
14
As of January 1, 2003, we implemented the Amended and
Restated Harris & Harris Group, Inc. Employee Profit-Sharing Plan
(the "2002 Plan"). Our shareholders 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 us 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 our
shareholders.
Under the 2002 Plan, our net realized income includes
investment income, realized qualifying gains and losses, and
operating expenses (including taxes paid or payable by us), 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
then 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 Committee among current and new
participants as awards under the 2002 Plan. The grandfathered
participations will be honored by us whether or not the
grandfathered participant is still employed by us 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 us 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 we remain a "business development company" within
the meaning of 1940 Act be greater than 20 percent of our "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.
We calculate 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, we 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, was paid out upon the completion and filing of
our 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 our common stock from us. However, effective March 1,
1999, the Board of Directors approved that Directors may purchase
our common stock in the open market, rather than from us.
Since 1998, we have repurchased a total of 1,859,047 of our
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 our 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, we filed a final prospectus under Rule 497
of the Securities Act of 1933 with the SEC for the issuance of
transferable rights to our shareholders. The rights allowed the
shareholders to subscribe for a maximum of 2,954,743 new shares
of our 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 offering, we have invested
$5,081,118 in accordance with our investment objectives and
policies. We intend 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 we
principally invest.
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 our 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 us (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 we 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
our Chairman and Chief Executive Officer; be responsible for the
general management of our affairs and all our subsidiaries,
reporting directly to our Board of Directors; 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 our
President and as an officer and director of any subsidiary or
affiliate of us.
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
our 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, we will 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 us to adopt a
supplemental executive retirement plan (the "SERP") for the
benefit of Mr. Harris. Under the SERP, we 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 our books 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 of his employment, 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. We will establish a rabbi trust for
the purpose of accumulating funds to satisfy the obligations
incurred by us under the SERP. The restricted funds for the SERP
Plan total $1,099,051 as of September 30, 2003. Mr. Harris'
rights to benefits pursuant to this SERP will be no greater than
those of a general creditor of us.
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 us, effective August 15, 1990. The severance
compensation agreement provides that if, following a change in
our control, as defined in the agreement, such individual's
employment is terminated by us 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's
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, we adopted an employee benefits
program covering substantially all of our employees under a
401(k) Plan and Trust Agreement. As of January 1, 1999, we
adopted the Harris & Harris Pension Plan and Trust, a money
purchase plan which would allow us 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 us 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 our discretion.
On June 30, 1994, we 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
us and have attained 50 years of age or have attained 45 years of
age and have 15 years of service with us. On February 10, 1997,
we 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 us with respect to the entitled retiree shall not exceed
$12,000, subject to an index for inflation. Based upon actuarial
estimates, we provided an original reserve of $176,520 that was
charged to operations for the period ending June 30, 1994. As of
September 30, 2003, we 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
us 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
our benefit.
Under applicable law prohibiting discrimination in
employment on the basis of age, we can impose a mandatory
retirement age of 65 for our 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, our Chairman
and Chief Executive Officer, and Mel P. Melsheimer, our
President, Chief Operating Officer and Chief Financial Officer,
under our existing retirement plans do not equal this threshold.
Mr. Harris has offered, for our benefit, to waive his right to
exclude certain other benefits from this calculation, which makes
it unlikely that any provision will have to be made for him in
order for us to comply with this threshold requirement. For Mr.
18
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 our existing
plans. The expense to us 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
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.)
We had Built-In Gains at the time of our qualification as a RIC
and made the election to be taxed on any Built-In Gain realized
during the Inclusion Period. Prior to 1999, we incurred ordinary
and capital losses from operations. After our election of RIC
status, those losses remained available to be carried forward to
subsequent taxable years. We have previously used loss
carryforwards to offset Built-In Gains. As of January 1, 2003,
we had $501,640 of loss carryforwards remaining and $4,663,457 of
unrealized Built-In Gains remaining.
Continued qualification as a RIC requires us to satisfy
certain investment asset diversification requirements in future
years. Our ability to satisfy those requirements may not be
controllable by us. There can be no assurance that we will
qualify as a RIC in subsequent years.
To the extent that we retain capital gains and declare a
deemed dividend to shareholders, the dividend is taxable to the
shareholders. We 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. We took
advantage of this rule for 2000 and 2001. Our financial
statements for 2000 and 2001 include a tax liability of
$5,709,884 and $290,748, respectively. The taxes paid by our
shareholders as a result of our deemed dividend declaration for
2000 ($5,688,896) and 2001 ($271,467) are reflected as a
deduction to the additional paid-in capital in our Consolidated
Statement of Assets and Liabilities rather than an expense in the
Consolidated Statement of Operations.
We pay federal, state and local taxes on behalf of our
wholly owned subsidiary, Harris & Harris Enterprises, Inc., which
is taxed as a C Corporation.
19
For the three and nine months ended September 30, 2003, and
2002, our income tax provision was allocated as follows:
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
Sept. 30, 2003 Sept. 30, 2002 Sept. 30, 2003 Sept. 30,2002
Net operating loss...... $ 0 $ 0 $ 0 $ 0
Net realized (loss)
gain on investments..... (3,500) 141,800 13,822 128,936
Net increase (decrease)
in unrealized
appreciation on
investments............. 0 (657,296) 0 (657,296)
--------- ---------- --------- ---------
Total income (benefit)
tax provision........... $ (3,500) $(515,496) $ 13,822 $(528,360)
========= ========= ========= =========
The above (benefit) tax provision consists of the following:
Current................. $ (3,500) $ 141,800 $ 13,822 $ 128,936
Deferred -- Federal..... 0 (657,296) 0 (657,296)
--------- --------- --------- ---------
Total income tax
provision............... $ (3,500) $(515,496) $ 13,822 $(528,360)
========= ========= ========= =========
Our net deferred tax liability at September 30, 2003, and
December 31, 2002, consists of the following:
September 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, we signed a 10-year lease for office space
which expired on July 31, 2003. On April 17, 2003, we signed a
seven-year sublease for office space at 111 West 57th Street in
New York City to replace the expired lease. Rent expense was
$49,855 and $43,040 for the three months ended September 30,
2003, and September 30, 2002, and $169,203 and $129,620 for the
nine months ended September 30, 2003, and September 30, 2002,
respectively. Minimum sublease payments remaining in 2003 are
$33,084. 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, we established an asset account line
of credit of up to $12,700,000. The asset account line of
credit is collateralized by our government and government agency
securities. Under the asset account line of credit, we may
borrow up to 95 percent of the current value of our government
and government agency securities. Our outstanding balance under
the asset line of credit at September 30, 2003 and September 30,
2002 was $7,609,500 and $0, respectively. The asset line of
credit bears interest at a rate of the Broker Call Rate plus 50
basis points, which was 3.25% at September 30, 2003.
20
NOTE 9. SUBSEQUENT EVENTS
On October 1, 2003, we sold our investment in $7,600,000 of
U.S. Treasury Notes due September 30, 2005. The proceeds of
$7,619,000 were used to repay the entire outstanding balance of
$7,609,500 under the asset line of credit.
NOTE 10. INTERIM FINANCIAL STATEMENTS
Our interim financial statements 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 our
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
our 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 our
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 our September 30, 2003 Consolidated Financial
Statements and our year-end 2002 Consolidated Financial
Statements and the Notes thereto.
Background and Overview
We incorporated under the laws of the state of New York in
August 1981. In 1983, we completed an initial public offering
and invested $406,936 in Otisville BioTech, Inc. ("Otisville"),
which also completed an initial public offering later that year.
In 1984, Charles E. Harris purchased a controlling interest in
us, thereby also becoming the control person in Otisville. We
then divested our other assets and became a financial services
company, with the investment in Otisville as the initial focus of
our business activity. We hired new management for Otisville,
and Otisville acquired new technology targeting the development
of a human blood substitute.
By 1988, we operated two insurance brokerages and a trust
company as wholly-owned subsidiaries. In 1989, Otisville changed
its name to Alliance Pharmaceutical Corporation ("Alliance"), and
by 1990, we had completed selling our $406,936 investment in
Alliance for total proceeds of $3,923,559.
In 1992, we sold our insurance brokerage and trust company
subsidiaries to their respective managements and registered as an
investment company under the 1940 Act, commencing operations as a
closed-end, non-diversified investment company. In 1995, we
elected to become a business development company subject to the
provisions of Sections 55 through 65 of the 1940 Act. Throughout
our corporate history, we have made early-stage venture capital
investments in a variety of industries. In 1994, we made our
first nanotechnology investment. Since August 2001, we have made
initial investments exclusively in tiny technology, including our
last 12 initial investments.
Since our investment in Otisville in 1983, we have made a
total of 54 venture capital investments, including four private
investments in public equities. We have sold 36 of these 54
investments, realizing total proceeds of $105,659,158 on our
invested capital of $38,366,523. Sixteen of these 36 investments
were profitable. The average and median holding periods for these
36 investments were 3.6 years and 3.2 years, respectively. At
September 30, 2003, we valued the 18 venture capital investments
remaining in our portfolio at $14,192,218, or 58.6 percent of our
net assets, net of unrealized depreciation of $2,891,452. At
September 30, 2003, the average and median holding periods for
our 18 current venture capital investments are 2.6 years and 1. 6
years, respectively.
We have invested a substantial portion of our 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
September 30, 2003, $14,192,218 or 58.6 percent of our net assets
consisted of venture capital investments at fair value, net of
unrealized depreciation of $2,891,452. At December 31, 2002,
$12,036,077 or 44.2 percent of our 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 our net assets consisted of
venture capital investments at fair value, of which net
unrealized appreciation was $1,215,444.
22
We value our investments each quarter at fair value as
determined in good faith by our Valuation Committee within
guidelines established by our Board of Directors in accordance
with the 1940 Act. (See "Footnote to Consolidated Schedule of
Investments" contained in "Consolidated Financial Statements.")
We have broad discretion in the investment of our capital.
However, we invest primarily in illiquid equity securities of
private companies. Generally, these investments take the form of
convertible preferred stock, are subject to restrictions on
resale and have no established trading market. Our principal
objective is to achieve long-term capital appreciation.
Therefore, a significant portion of our investment portfolio
provides little or no current yield in the form of dividends or
interest. We do 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 our fixed-income portfolio and the average yield on
this portfolio and is not expected to be material to our results
of operations.
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. During
this period, it has been difficult to finance venture capital-
backed companies privately and in general, for venture capital
funds themselves to raise capital.
We present the financial results of our operations utilizing
accounting principles generally accepted in the United States for
investment companies. On this basis, the principal measure of our
financial performance during any period is the net
increase/(decrease) in our net assets resulting from our
operating activities, which is the sum of the following three
elements:
(1) Net Operating Income / (Loss) - the difference
between our income from interest, dividends, and
fees and our 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
our investment portfolio.
Because of the structure and objectives of our business, we
generally expect to experience net operating losses and seek to
generate increases in our net assets from operations through the
long term appreciation of our venture capital investments. We
have in the past relied, and continue to rely, on proceeds from
sales of investments, rather than on investment income, to defray
a significant portion of our operating expenses. Because such
sales are unpredictable, we attempt to maintain adequate working
capital to provide for fiscal periods when there are no such
sales.
23
Results of Operations
Three months ended September 30, 2003, as compared to the three
months ended September 30, 2002
We had a net decrease in net assets resulting from
operations of $1,270,298 in the three months ended September 30,
2003, compared to a net increase in net assets resulting from
operations of $660,988 in the three months ended September 30,
2002. We had a net increase in net assets resulting from capital
stock transactions of $0 in the three months ended September 30,
2003, compared to a net increase in net assets resulting from
capital transactions of $5,665,970 in the three months ended
September 30, 2002.
Investment Income and Expenses:
We had net operating losses of $572,346 and $479,433 for the
three months ended September 30, 2003, and September 30, 2002,
respectively. In the three months ended September 30, 2003, our
larger net operating loss reflected a net increase to expenses
primarily related to an increase in salaries and benefits offset
by a decrease in professional fees.
Operating expenses were $602,958 and $556,846 for the three
months ended September 30, 2003, and September 30, 2002,
respectively. In the three months ended September 30, 2003, as
compared with the three months ended September 30, 2002, salaries
and benefits increased by $100,142 or 38.5 percent, primarily as
a result of an additional employee, and as a result of mandatory
retirement plan pension expense that is being amortized through
December 31, 2004. In the three months ended September 30, 2003,
as compared with the three months ended September 30, 2002,
professional fees decreased by $61,626, or 51.0 percent,
primarily as a result of a shift in the timing of the expenses
associated with the preparation of our proxy statement.
Realized Gains and Losses on Portfolio Securities:
During the three months ended September 30, 2003, and
September 30, 2002, we realized losses of $1,003,919 and gains of
$252,750, respectively.
During the three months ended September 30, 2003, we
realized net losses of $1,003,919, consisting primarily of a loss
of $1,000,001 on the realized loss resulting from the bankruptcy
of Kriton Medical, Inc. from which we did not receive any direct
distribution. During the three months ended September 30, 2002,
we realized a net gain of $252,750, consisting primarily of a
gain of $553,666 from our partnership interest in PHZ Capital
Partners L.P., offset by a realized loss of $360,249 on the sale
of Schwoo, Inc. convertible bridge loans.
Unrealized Appreciation and Depreciation of Portfolio Securities:
Net unrealized depreciation on investments decreased by
$302,467 or 9.5 percent during the three months ended September
30, 2003, from $3,179,750 at June 30, 2003, to $2,877,283 at
September 30, 2003.
During the three months ended September 30, 2003, we
recorded a net decrease of $288,871 in unrealized depreciation of
our venture capital investments.
24
Nine Months ended September 30, 2003, as compared to the nine
months ended September 30, 2002
We had a net decrease in net assets resulting from
operations of $3,030,134 in the nine months ended September 30,
2003, and a net increase in net assets resulting from operations
of $58,343 in the nine months ended September 30, 2002.
Investment Income and Expenses:
We had net operating losses of $1,883,795 and $1,690,384 for
the nine months ended September 30, 2003, and September 30, 2002,
respectively.
Operating expenses were $2,029,647 and $1,887,627 for the
nine months ended September 30, 2003, and September 30, 2002,
respectively. Operating expenses in the nine months ended
September 30, 2003, as compared with the nine months ended
September 30, 2002, changed primarily for the following reasons:
(1) Operating expenses for the nine months ended
September 30, 2003, included no expense for
employee profit-sharing, as compared with $248,765
in such expense for the nine months ended
September 30, 2002.
(2) Salaries and benefits increased by $304,076 or 39.0
percent, primarily as a result of the addition of an
employee and mandatory retirement plan pension expense
that is being amortized through December 31, 2004.
(3) Rent expense increased by $39,583 or 30.5 percent
as a result of expenses incurred during the transition
period to our new office space.
Realized Gains and Losses on Portfolio Securities:
During the nine months ended September 30, 2003, we realized
net losses of $975,347. During the nine months ended September
30, 2002, we realized net gains of $1,052,110.
During the nine months ended September 30, 2003, we realized
a loss of $1,000,001 resulting from the bankruptcy of Kriton
Medical, Inc. from which we did not receive any direct
distribution.
During the nine months ended September 30, 2002, we realized
net gains of $1,052,110 consisting primarily of $1,661,892 from
our partnership interest in PHZ Capital Partners L.P., offset by
a loss of $350,583 on the dissolution of Informio, Inc. and a
loss of $360,249 on the sale of Schwoo, Inc. convertible bridge
loans.
Unrealized Appreciation and Depreciation of Portfolio Securities:
Net unrealized depreciation on investments increased by
$157,170 during the nine months ended September 30, 2003, from
$2,720,113 at December 31, 2002, to $2,877,283 at September 30,
2003.
25
During the nine months ended September 30, 2003, we recorded
a net increase of $173,063 in unrealized depreciation of our
venture capital investments.
Financial Condition
Nine Months ended September 30, 2003
Our total assets and net assets were $34,392,032 and
$24,225,912, respectively, at September 30, 2003, compared with
$35,951,969 and $27,256,046 at December 31, 2002.
Net asset value per share ("NAV") was $2.11 at September 30,
2003, versus $2.37 at December 31, 2002. Our shares outstanding
remained unchanged during the nine months ended September 30,
2003.
Significant developments in the nine months ended September
30, 2003, were an increase in bank loan payable of $7,609,500 and
an increase in the value of our investment in U.S. Treasury
obligations of $2,989,888.
The increase in the value of our venture capital
investments, from $12,036,077 at December 31, 2002, to
$14,192,218 at September 30, 2003, resulted primarily from our
three new venture capital investments and three follow-on
investments, partially offset by a net decrease in the value of
our venture capital investments.
The following table is a summary of additions to our
portfolio of venture capital investments during the nine months
ended September 30, 2003:
New Investment Amount
Chlorogen, Inc. $ 525,900
NanoGram Devices Corporation $ 750,000
Nanosys, Inc. $1,500,000
Follow-on Investment
NanoOpto Corporation $ 62,500
Nanotechnologies, Inc. $ 169,718
Nantero, Inc. $ 323,000
----------
Total $3,331,118
==========
26
The following table summarizes fair value of our entire
investment portfolio, as compared with its cost, at September 30,
2003, and December 31, 2002, and December 31, 2001:
September 30, December 31,
2003 2002 2001
Investments, at cost.... $35,510,134 $30,206,935 $37,714,285
Unrealized (depreciation)
appreciation.......... (2,877,283) (2,720,113) 1,216,420
----------- ------------ -----------
Investments, at fair
value................. $32,632,851 $27,486,822 $38,930,705
=========== =========== ===========
_______________
The accumulated unrealized depreciation on investments net of
deferred taxes was $3,722,202 at September 30, 2003, $3,565,032
at December 31, 2002, and $323,624 at December 31, 2001.
The following table summarizes the fair value composition
of our venture capital portfolio at September 30, 2003, December
31, 2002, and December 31, 2001:
Category September 30, December 31, December 31,
2003 2002 2001
Tiny Technology 56.0% 49.0% 9.3%
Other Venture
Capital Investments 44.0% 51.0% 90.7%
----- ----- -----
Total Venture
Capital Investments 100.0% 100.0% 100.0%
===== ===== =====
Liquidity and Capital Resources
Our primary sources of liquidity are cash, receivables and
freely marketable securities, net of short-term indebtedness. Our
secondary sources of liquidity are restricted securities of
companies that are publicly traded. We currently have no
restricted securities of companies that are publicly traded.
Nine Months ended September 30, 2003
At September 30, 2003, and December 31, 2002, our total
net primary liquidity was $11,154,675 and $16,508,057,
respectively. On both of the corresponding dates, our secondary
liquidity was $0, as we had no restricted securities of companies
that are publicly traded. Our tertiary source of liquidity was
our partnership interest in PHZ Capital Partners L.P., which was
liquidated effective December 31, 2002. We received the final
distribution of $786,492 from PHZ Capital Partners L.P. in the
first quarter of 2003.
The decrease in our net primary sources of liquidity from
December 31, 2002, to September 30, 2003, is primarily owing to:
(1) payment of federal, state and local taxes; (2) investment in
Chlorogen, Inc.; (3) investment in Nanosys, Inc.; (4) investment
in NanoOpto Corporation; (5) investment in Nanotechnologies,
Inc.; (6) investment in Nantero, Inc.; and (7) use of funds for
net operating expenses.
At September 30, 2003, our liability for accrued employee
profit sharing was $0, as compared with $15,233 at December 31,
2002, as a result of the payment of $15,233 for the 2002 profit
sharing.
27
Our total net income tax liability decreased by $941,251,
from $1,527,000 at December 31, 2002 to $585,749 at September 30,
2003, primarily as a result of federal, state and local tax
payments made for income earned in 2002.
Critical Accounting Policies
Critical accounting policies are those that are both
important to the presentation of our financial condition and
results of operations and those that require management's most
difficult, complex or subjective judgments. Our critical
accounting policies are those applicable to the valuation of
investments.
Valuation of Portfolio Investments
As a business development company, we invest 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. We value substantially all of our equity investments at
fair value as determined in good faith by our Valuation
Committee. The Valuation Committee, comprised of at least three
or more independent Board members, reviews and approves the
valuation of our 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 our assets, 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.
Recent Developments
On July 22, 2003, the Board of Directors approved a
resolution stating that we are committed to maintaining the
privacy of our shareholders and to safeguarding their non-public
personal information. Generally, we do not receive any non-
public personal information relating to our shareholders,
although some non-public personal information of our shareholders
may become available to us. We do not disclose any non-public
personal information about our shareholders or former
shareholders to anyone, except as permitted by law or as is
necessary in order to service shareholder accounts (for example,
to a transfer agent or third party administrator). We restrict
access to non-public personal information about our shareholders
to our employees and to employees of our service providers and
their affiliates with a legitimate business need for the
information. We maintain physical, electronic and procedural
safeguards designed to protect the non-public personal
information of our shareholders.
28
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 and will continue to
be 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.
We may invest in companies working with technologies or
intellectual property which currently has 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 as of yet relatively few
nanotechnology products 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
intellectual property on which these products are based may be
contested. Any dispute over the ownership of, or rights to, any
of our portfolio companies' technologies or products would have a
material adverse affect on that company's value and may have a
material adverse effect on the value of our common stock.
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.
29
Unfavorable economic conditions could result in the inability of
our portfolio companies to access additional capital, leading to
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 or adverse capital or credit market
conditions may affect the ability of a company in our
portfolio to raise additional capital from venture capital or
other sources or to engage in a liquidity event such as an
initial public offering or merger. Such conditions may lead to
financial losses in our portfolio, which could have a material
adverse effect on the value of our common stock.
If the technologies utilized by our portfolio companies are
found to cause health or environmental risks it could have an
adverse effect on the value of our portfolio and on the value
of our common stock.
Our portfolio companies work with new technologies, which
could have potential environmental and health impacts. Tiny
technology in general and nanotechnology in particular are
currently the subject of health and environmental impact
research. If health or environmental concerns about tiny
technology or nanotechnology were to arise, our portfolio
companies may incur additional research, legal and regulatory
expenses, might have difficulty raising capital or could be
forced out of business. This would have an adverse effect on
the value of our portfolio and on the value of our common stock.
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 or equity-
linked 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.
Our business of making private equity investments and
positioning our portfolio companies 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 those in which we typically invest.
The potential for public market liquidity could further decrease
and could lead to an inability to realize potential gains or
could lead to financial losses in our portfolio and a decrease in
our revenues, net income and assets. 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. Slowdowns in initial public offerings also have an
adverse effect on the frequency and valuations of acquisitions of
privately held companies. The lack of exit opportunities also
has an adverse effect on the ability of privately held companies
to raise capital.
30
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 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. 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 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.
31
Approximately 36 percent of the fair value of our venture capital
investment portfolio, as of September 30, 2003, is concentrated
in one company, NeuroMetrix, Inc., which is not a tiny technology
company.
At September 30, 2003, we valued our investment in
NeuroMetrix, Inc., which is not a tiny technology company, at
$5,075,426, which represents 35.8 percent of the fair value of
our venture capital investment portfolio, or 21.0 percent of our
net asset value. 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 in
NeuroMetrix, Inc. and the overall value of our portfolio.
Approximately 44 percent of the fair value of our venture capital
investment portfolio, as of September 30, 2003, is not invested
in tiny technology.
Although all 12 of our portfolio investments added since
August 2001 have been in tiny technology companies, and although
we consider 13 of the companies in our current equity investment
portfolio to be tiny technology companies, at September 30, 2003,
only 56.0 percent of the fair value of our venture capital
investment portfolio, 32.8 percent of our net asset value, is
invested in tiny technology companies, which may limit our
ability to achieve our investment objective.
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.
32
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 a portfolio company, we
may make additional investments in that portfolio company 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.
Bank borrowing or the issuance of debt securities or preferred
stock by us to fund investments in portfolio companies or to fund
our operating expenses would make our total return to common
shareholders more volatile.
Use of debt or preferred stock as a source of capital would
entail two primary risks. The first risk is that the use of debt
leverages our available common equity capital, magnifying the
impact on net asset value of changes in the value of our
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
33
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 or preferred stock financing may exceed the return on the
assets the proceeds are used to acquire, thereby diminishing
rather than enhancing the return to common shareholders. To the
extent that we utilize debt or preferred stock 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, interest
or principal 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 our
common stock means that dividends on our common stock from
earnings may be reduced or eliminated. An inability to pay
dividends on our common stock 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.
We are authorized to issue preferred stock, which would convey
special rights and privileges to its owners.
We are currently authorized to issue up to 2,000,000 shares
of preferred stock, under terms and conditions determined by our
Board of Directors. Such shares would have a preference over our
common stock with respect to dividends and liquidation. The
statutory class voting rights of any preferred shares we would
issue could make it more difficult for us to take some actions
that may, in the future, be proposed by the Board and/or 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 our
common stock upon conversion. These effects, among others, could
have an adverse effect on your investment in our common stock.
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, to the extend that we had unrealized gains, 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 retain the net realized capital gains, we would have to
establish appropriate reserves for taxes upon making that
decision.
34
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.
To the extent that we do not realize income or retain after-tax
realized capital gains, we may have a greater need for additional
capital to fund our investments and operating expenses.
As a RIC, we must annually distribute at least 90 percent of
our investment company taxable income as a dividend and may
either distribute or retain our 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 of
operations as well as our ability to make follow-on and new
investments. Because of the structure and objectives of our
business, we generally expect to experience net operating losses
and rely on proceeds from sales of investments, rather than on
investment income, to defray a significant portion of our
operating expenses. Such sales are unpredictable and may not
occur. 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 to fund such requirements.
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.
35
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 our control. Although we
believe 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 us or any other person that our plans will be
achieved.
Item 3. Quantitative and Qualitative Disclosures About Market
Risk
Our business activities contain elements of risk. We
consider 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 our investments nor an investment in us is intended
to constitute a balanced investment program. We have exposure to
public-market price fluctuations to the extent of our publicly
traded portfolio, which portfolio may be composed primarily or
entirely of highly risky, volatile securities.
We have invested a substantial portion of our assets in
private development stage or start-up companies. These private
businesses tend to be based on new technology and 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. We expect that some of our 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 our private equity
investments complete initial public offerings (IPOs), we are
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 we
invest, the valuation of the equity interests in our portfolio is
subject to the determination of our Board of Directors in
accordance with our Asset Valuation Policy Guidelines. In the
absence of a readily ascertainable market value, the determined
value of our 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 our consolidated
statements of operations as "Net increase (decrease) in
unrealized appreciation on investments."
While we invest in short-term money market and U.S.
Government and Agency Obligations and draw down on the asset line
of credit, we do not consider a change in interest rates to
result in significant risks.
36
Item 4. Controls and Procedures
As of the end of the period covered by this report, our
Chief Executive Officer and Chief Financial Officer conducted an
evaluation of our disclosure controls and procedures (as defined
in Rules 13a-14 and 15d-14 of the Securities Exchange Act of
1934). Based upon this evaluation, our Chief Executive Officer
and Chief Financial Officer during such period concluded that our
disclosure controls and procedures are effective in timely
alerting them of any material information relating to us that is
required to be disclosed by us in the reports it files or submits
under the Securities Exchange Act of 1934.
There have not been any significant changes in our 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.
37
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
None
Item 5. Other Information
Not Applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.1* Harris & Harris Group, Inc. Executive
Mandatory Retirement Benefit Plan.
10.2* Amendment No. 1 to Deferred Compensation
Agreement.
11.0* Computation of per share earnings. See
Consolidated Statements of Operations.
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
September 30, 2003
The Company filed a report on Form 8-K on
July 22, 2003, concerning NAV at June 30, 2003.
_____________
*filed herewith
38
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: November 6, 2003
39