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SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
Form 10-K
Annual Report Pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended Commission File No. 0-11576
December 31, 1998
HARRIS & HARRIS GROUP, INC.
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(Exact Name of Registrant Specified in Its Charter)
New York 13-3119827
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (212) 332-3600
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock $ .01 par value
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(Title of class)
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 if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. [X]
The aggregate market value of the Common Stock held by non-affiliates of
Registrant as of March 5, 1999 was $17,230,640 based on the last sale price
as quoted by Nasdaq National Market on such date (only officers and
directors are considered affiliates for this calculation).
As of March 5, 1999, the registrant had 10,426,648 shares of common stock,
par value $.01 per share, outstanding.
TABLE OF CONTENTS
Page
PART I
Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . 1
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . 7
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . 7
Item 4. Submission of Matters to a Vote of Security Holders . . 7
PART II
Item 5. Market for Company's Common Equity and Related
Stockholder Matters . . . . . . . . . . . . . . . . . 8
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . 9
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . . . . . . . 10
Item 7a. Quantitative and Qualitative Disclosures About Market
Risk . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 8. Financial Statements and Supplementary Data . . . . . . 21
Item 9. Disagreements on Accounting and Financial Disclosure. . 42
PART III
Item 10. Directors and Executive Officers of the Company . . . . 42
Item 11. Executive Compensation. . . . . . . . . . . . . . . . . 42
Item 12. Security Ownership of Certain Beneficial Owners
and Management. . . . . . . . . . . . . . . . . . . . 42
Item 13. Certain Relationships and Related Transactions. . . . . 42
PART IV
Item 14. Exhibits, Financial Statements, Schedules and
Reports on Form 8-K . . . . . . . . . . . . . . . . . 43
Signatures. . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Exhibit Index . . . . . . . . . . . . . . . . . . . . . . . . . . 47
PART I
Item 1. Business
Harris & Harris Group, Inc. (the "Registrant" or "Company") is a venture
capital investment company, operating as a Business Development Company ("BDC")
under the Investment Company Act of 1940 (the "1940 Act"). The Company's
objective is to achieve long-term capital appreciation, rather than current
income, from its investments. The Company has invested a substantial
portion of its assets in private development stage or start-up companies and
in the development of new technologies in a broad range of industry segments.
These private businesses tend to be thinly capitalized, unproven, small
companies that lack management depth and have not attained profitability or
have no history of operations. The Company may also invest, to the extent
permitted under the 1940 Act, in publicly traded securities, including high
risk securities as well as investment grade securities. The Company may
participate in expansion financing and leveraged buyout financing
of more mature operating companies as well as other investments. As a
venture capital company, the Company invests in and provides managerial
assistance to its private investees which, in its opinion, have significant
potential for growth. There is no assurance that the Company's investment
objective will be achieved.
The Company was incorporated under the laws of the State of New York in
August 1981. Prior to September 30, 1992, the Company had a class of
securities registered, and filed under the reporting requirements, of the
Securities Exchange Act of 1934 (the "1934 Act") as an operating company.
On that date the Company commenced operations as a closed-end, non-
diversified investment company under the 1940 Act. On July 26, 1995, the
Company elected to become a BDC subject to the provisions of Sections 55
through 65 of the 1940 Act. As a BDC, the Company operates as an internally
managed investment company whereby its officers and employees, under the
general supervision of its Board of Directors, conduct its operations.
On September 25, 1997, the Company's Board of Directors approved a proposal
to seek qualification of the Company as a Regulated Investment Company ("RIC")
under Sub-Chapter M of the Internal Revenue Code (the "Code"). At that time,
the Company was taxable under Sub-Chapter C of the Code (a "C Corporation").
On April 8, 1998, the Company announced that it had received a certification
from the Securities and Exchange Commission ("SEC") for 1997 relating to the
Company's status under section 851(e) of the Code. That certification was
necessary for the Company to qualify as a RIC for 1998 and subsequent
taxable years.
Pursuant to the Company's receipt of the section 851(e) certification
and its intention to qualify as a RIC, the Company's Board of Directors
declared and paid a one-time cash dividend of $0.75 per share, for a total
of $8,019,728, to meet one of the Company's requirements for qualification
for Sub-Chapter M tax treatment. On February 17, 1999, the Company received
rulings from the Internal Revenue Service (the "IRS") regarding other issues
relevant to the Company's tax status as a RIC. (See "Note 6 of Notes to
Financial Statements" contained in "Item 8. Financial Statements and
Supplementary Data" & "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Recent Developments - Sub-
Chapter M Status".)
1
The qualification of the Company as a RIC under Sub-Chapter M of the Code
depends on it satisfying certain technical requirements regarding its income,
investment portfolio, and distributions. The Company was unable to satisfy
these requirements for the 1998 tax year owing to the nature of the Company's
ownership interest in one of its investee companies, and therefore it will
not elect Sub-Chapter M status for 1998. In addition, because the Company
realized taxablelosses in 1998, it was not strategically advantageous for
the Company to elect Sub-Chapter M tax status for 1998. Moreover, the
Company received a tax opinion in 1998 that the Company interprets to mean
that its tax-loss carryforward at December 31, 1998 of approximately $7.1
million (resulting in a tax credit of approximately $2.5 million) would be
applicable as a qualifying RIC to its unrealized gains as of December 31,
1998. That opinion was confirmed in one of the rulings received from the
IRS in February 1999.
The Company changed the nature of its ownership interest in the non-
qualifying investee company effective January 1, 1999 in order to meet the
Sub-Chapter M requirements. However, there can be no assurance that the
Company will qualify for Sub-Chapter M treatment for 1999 or subsequent
years. In addition, under certain circumstances, even if the Company were
qualified for Sub-Chapter M treatment in 1999 and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than a RIC.
Venture Capital Investments
The Company has invested a substantial portion of its assets in private
development stage or start-up companies. The Company may initially own 100
percent of the securities of a start-up investee company for a period of
time and may control such company for a substantial period. In connection
with its venture capital investments, the Company may be involved in
recruiting management, formulating operating strategies, product development,
marketing and advertising, assisting in financial plans, as well as providing
management in the initial start-up stages and establishing corporate goals.
The Company may assist in raising additional capital for such companies from
other potential investors and may subordinate its own investment to that of
other investors. The Company may introduce such companies to potential
joint-venture partners, suppliers and customers. In addition, the Company
may assist in establishing relationships with investment bankers and other
professionals. The Company may also assist with mergers and acquisitions.
The Company may also find it necessary or appropriate to provide additional
capital of its own. The Company may derive income from such companies for
the performance of any of the above services. Because of the speculative
nature of these investments and the lack of any market for such securities,
there is significantly greater risk of loss than is the case with traditional
investment securities. The Company expects that some of its venture
capital investments will be a complete loss or will be unprofitable and that
some will appear likely to become successful, but never realize their
potential. The Company has in the past sought, and will continue in the
future to seek, investments that offer the potential for significantly
higher returns but that involve a significantly greater degree of risk than
other investments.
2
The Company may control an investee company for which it has provided
venture capital, or it may be represented on the company's board of
directors by one or more of its officers or directors, who may also serve
as officers of such company. Particularly during the early stages of an
investment, the Company may in effect be conducting the operations of the
investee company. As a venture company emerges from the developmental stage
with greater management depth and experience, the Company expects that its
role in the company's operations will diminish. The Company seeks to assist
each investee company in establishing its own independent capitalization,
management and board of directors. The Company expects to be able to reduce
its active involvement in the management of its investment in those
start-up companies that become successful by a liquidity event, such as a
public offering or sale of a company.
The Company has invested a substantial portion of its assets in
securities that do not pay interest or dividends and that are subject to
legal or contractual restrictions on resale that may adversely affect the
liquidity and marketability of such securities.
In addition to the information discussed above, please see "Item 8.
Financial Statements and Supplementary Data."
Intellectual Property
The Company believes there is a role for organizations like itself that
can assist in technology transfer. Scientists and institutions that develop
and patent intellectual property increasingly seek the rewards of
entrepreneurial commercialization of their inventions, particularly as
governmental, philanthropic and industrial funding for research has become
harder to obtain. The Company believes that several factors combine to give
it a high value-added role to play in the commercialization of technology:
its experience in organizing and developing successful new companies; its
willingness to invest its own capital at the highest risk- seed stage; its
access to high-grade institutional sources of intellectual property; its
experience in mergers, acquisitions and divestitures; its access to and
knowledge of the capital markets; and its willingness to do as much of the
early work as it is qualified to do.
The Company invests principally in securities issued by companies involved
in: 1) research and development of a technology and/or obtaining licensing
rights to intellectual property or patents; 2) outright acquisition of
intellectual property or patents; and 3) formation and funding of companies
or joint ventures to commercialize intellectual property. Income from the
Company's investments in intellectual property or its development may take
the form of participation in licensing or royalty income or some other form
of remuneration. At some point during the commercialization of a technology,
the Company's investment may be transformed into ownership of securities of
a development stage or start-up company as discussed above. Investing in
intellectual property is highly risky.
3
Illiquidity of Investments
Many of the Company's investments consist of securities acquired directly
from the issuer in private transactions. These investments may be subject to
restrictions on resale or otherwise be illiquid. The Company does not
anticipate that there will be any established trading market for such
securities. Additionally, many of the securities that the Company may
invest in will not be eligible for sale to the public without registration
under the Securities Act of 1933, as amended, which could prevent or delay
any sale by the Company of such investments or reduce the amount of proceeds
that might otherwise be realized therefrom. Restricted securities generally
sell at a price lower than similar securities not subject to restrictions on
resale. Further, even if a portfolio company registers its securities and
becomes a reporting company under the 1934 Act, the Company may be considered
an insider by virtue of its board representation or otherwise and would be
restricted in sales of such company's securities.
Managerial Assistance
The Company generally is required by the 1940 Act to make significant
managerial assistance available with respect to investee companies that the
Company treats as qualifying assets for purposes of the 70 percent test
(see "Regulation"). "Making available significant managerial assistance" as
defined in the 1940 Act with respect to a BDC such as the Company means (a)
any arrangement whereby a BDC, through its directors, officers, employees or
general partners, offers to provide, and if accepted, does so provide,
significant guidance and counsel concerning the management, operations, or
business objectives and policies of a portfolio company; or (b) the exercise
by a BDC of a controlling influence over the management or policies of a
portfolio company by a BDC acting individually or as a part of a group
acting together which controls such portfolio company. The Company believes
that providing managerial assistance to its investees is critical to its
business development activities. The nature, timing and amount of managerial
assistance provided by the Company vary depending upon the particular
requirements of each investee company.
The Company may be involved with its investees in recruiting management,
product planning, marketing and advertising and the development of financial
plans, operating strategies and corporate goals. In this connection, the
Company may assist clients in developing and utilizing accounting procedures
to efficiently and accurately record transactions in books of account, which
will facilitate asset and cost control and the ready determination of results
of operations. The Company also seeks capital for its investees from other
potential investors and occasionally subordinates its own investment to those
of other investors. The Company may introduce its investees to potential
suppliers, customers and joint venture partners and assists its investees in
establishing relationships with commercial and investment bankers and other
professionals, including management consultants, recruiters, legal counsel
and independent accountants. The Company also assists with joint ventures,
acquisitions and mergers.
In connection with its managerial assistance, the Company may be
represented by one or more of its officers or directors on the board of
directors of an investee. As an investment matures and the investee
develops management depth and experience, the Company's role ordinarily will
4
become progressively less active. However, when the Company owns or acquires
a substantial proportion of a more mature investee company's equity, the
Company may remain active in and may initiate planning of major transactions
by the investee. The Company typically seeks to assist each investee
company in establishing its own independent and effective board of directors
and management.
Need for Follow-On Investments
Following its initial investment in investees, the Company has made and
anticipates that it will continue to make additional investments in such
investees as "follow-on" investments, in order to increase its investment in
an investee, and may exercise warrants, options or convertible securities
that were acquired in the original financing. Such follow-on investments
may be made for a variety of reasons including: 1) to increase the Company's
exposure to an investee, 2) to acquire securities issued as a result of
exercising convertible securities that were purchased in the original
financing, 3) to preserve the Company's proportionate ownership in a
subsequent financing, or 4) to attempt to preserve or enhance the value of
the Company's investment. There can be no assurance that the Company will
make follow-on investments or have sufficient funds to make such investments;
the Company has the discretion to make any follow-on investments as it
determines, subject to the availability of capital resources. The failure
to make such follow-on investments may, in certain circumstances, jeopardize
the continued viability of an investee and the Company's initial investment,
or may result in a missed opportunity for the Company to increase its
participation in a successful operation. Even if the Company has sufficient
capital to make a desired follow-on investment, the Company may under
certain circumstances be inhibited from doing so if such an investment would
result in non-compliance with BDC or RIC regulations.
Competition
Numerous companies and individuals are engaged in the venture capital
business and such business is intensely competitive. Most of the competitors
have significantly greater experience, resources and managerial capabilities
than the Company and are therefore in a better position than the Company to
obtain access to attractive venture capital investments.
Regulation
The Small Business Investment Incentive Act of 1980 added the provisions of
the 1940 Act applicable to BDC's, which are a special type of closed-end
investment company. After filing its election to be treated as a BDC, a
company may not withdraw its election without first obtaining the approval
of holders of a majority of its outstanding voting securities. The following
is a brief description of the 1940 Act provisions applicable to BDC's, and is
qualified in its entirety by reference to the full text of the 1940 Act and
the rules issued thereunder by the SEC.
Generally, to be eligible to elect BDC status, a company must primarily
engage in the business of furnishing capital and managerial expertise to
companies which do not have ready access to capital through conventional
financial channels. Such portfolio companies are termed "eligible portfolio
5
companies." In general, in order to qualify as a BDC, a company must (i) be
a domestic company; (ii) have registered a class of its securities pursuant
to Section 12 of the 1934 Act; (iii) operate for the purpose of investing in
the securities of certain types of portfolio companies, namely, immature or
emerging companies and businesses suffering or just recovering from financial
distress (see following paragraph); (iv) make available significant
managerial assistance to such portfolio companies; (v) have a majority of
"disinterested" directors (as defined in the 1940 Act); and (vi) file a
proper notice of election with the SEC.
An eligible portfolio company generally is a domestic company that is
not an investment company and that (i) does not have a class of equity
securities on which "margin" credit can be extended or (ii) is controlled
by a BDC (control under the 1940 Act is presumed to exist where a BDC owns
at least 25 percent of the outstanding voting securities of the investee).
The 1940 Act prohibits or restricts companies subject to the 1940 Act
from investing in certain types of companies, such as brokerage firms,
insurance companies, investment banking firms and investment companies.
Moreover, the 1940 Act requires that at least 70 percent of the value of
the Company's assets consist of qualifying assets. Qualifying assets
include: (i) securities of companies that were eligible portfolio companies
at the time the Company acquired their securities; (ii) securities of
bankrupt or insolvent companies that were eligible at the time of the
Company's initial investment in those companies; (iii) securities received
in exchange for or distributed in or with respect to any of the foregoing;
and (iv) cash items, government securities and high quality short-term
debt. The 1940 Act also places restrictions on the nature of the
transactions in which, and the persons from whom, securities can be
purchased in order for the securities to be considered qualifying assets.
The Company is permitted by the 1940 Act, under specified conditions, to
issue multiple classes of senior debt and a single class of preferred stock
if its asset coverage, as defined in the 1940 Act, is at least 200 percent
after the issuance of the debt or the preferred stock (i.e., such senior
securities may not be in excess of its net assets).
The Company may sell its securities at a price that is below the
prevailing net asset value per share only after a majority of its
disinterested directors has determined that such sale would be in the best
interest of the Company and its stockholders and upon the approval by the
holders of a majority of its outstanding voting securities, including a
majority of the voting securities held by non-affiliated persons. If the
offering of the securities is underwritten, a majority of the disinterested
directors must determine in good faith that the price of the securities
being sold is not less than a price which closely approximates market
value of the securities, less any distribution discount or commission. As
defined by the 1940 Act, the term "majority of the Company's outstanding
voting securities" means the vote of (i) 67 percent or more of the Company's
Common Stock present at the meeting, if the holders of more than 50 percent
of the outstanding Common Stock are present or represented by proxy or (ii)
more than 50 percent of the Company's outstanding Common Stock, whichever is
less.
6
Certain transactions involving certain closely related persons of the
Company, including its directors, officers and employees, may require the
prior approval of the SEC. However, the 1940 Act ordinarily does not restrict
transactions between the Company and investee companies.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. The Company was unable to satisfy the requirements for Sub-
Chapter M for the 1998 tax year. (See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Recent
Developments - Sub Chapter M Status.") There can be no assurance that the
Company will qualify for Sub-Chapter M treatment for 1999 or subsequent
years. In addition, under certain circumstances, even if the Company were
qualified for Sub-Chapter M treatment in 1999 and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than a RIC.
Employees
The Company currently employs four full-time employees.
Item 2. Properties
The Company maintains its offices at One Rockefeller Plaza, Suite 1430,
New York, New York 10020, where it leases approximately 4,700 square feet of
office space pursuant to a lease agreement expiring in 2003. A portion of
this space was sublet in 1997 and 1998 to an early-stage company in which
the Company had an equity interest. See "Note 7 to the Financial Statements"
and Schedules contained in "Item 8. Financial Statements and Supplementary
Data."
Item 3. Legal Proceedings
None.
Item 4. Submission of Matters to a Vote of Security Holders
The Company did not submit any matters to a vote of its shareholders
during the fourth quarter of the 1998 fiscal year.
7
PART II
Item 5. Market for Company's Common Equity and Related Stockholder Matters
Stock Transfer Agent
The Bank of New York, 101 Barclay Street, Suite 12W, New York, New York
10286 (Telephone 800-524-4458, Attention: Ms. Diane Ajjan) serves as transfer
agent for the Company's common stock. Certificates to be transferred should be
mailed directly to the transfer agent, preferably by registered mail.
Market Prices
The Company's common stock is traded on the Nasdaq National Market under
the symbol "HHGP." The following table sets forth the range of the high and
low selling price of the Company's shares during each quarter of the last
two years, as reported by the National Association of Securities Dealers,
Inc. The quarterly stock prices quoted represent interdealer quotations and
do not include markups, markdowns or commissions.
1998 Quarter Ending Low High
March 31 $2.1875 $3.4375
June 30 $2.2500 $3.6875
September 30 $1.2500 $2.3750
December 31 $1.1250 $1.5938
1997 Quarter Ending Low High
March 31 $3.3750 $5.1250
June 30 $3.5000 $4.8125
September 30 $2.5000 $3.7500
December 31 $2.5000 $4.0000
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. To initially qualify as a RIC, the Company had, among other
things, to pay a dividend to shareholders equal to the Company's cumulative
realized earnings and profits ("E&P") from its pre-RIC taxable years. The
Company paid a $0.75 dividend on May 12, 1998 to shareholders of record on
April 27, 1998. (See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Recent Developments -
Sub-Chapter M Status" and "Note 6 of Notes to Financial Statements"
contained in "Item 8. Financial Statements and Supplementary Data".)
On February 22, 1999, NBX Corporation announced that it had agreed to be
acquired by 3Com Corporation for approximately $90 million in cash plus
additional consideration for employees of NBX. This transaction was
effective on March 5, 1999 and closed on March 8, 1999. On closing, the
Company received a total of $12,432,940 in cash, of which $1,475,276 was
placed in a one-year escrow. On February 23, 1999, the Board of Directors
of the Company declared a cash dividend of $0.35 per share (approximately
$3.7 million) to shareholders of record on March 19, 1999, payable on March
25, 1999. Prior to 1998, the Company had not paid dividends since 1991.
8
Recent Sales of Unregistered Securities
The Company has not sold unregistered shares for the years ended December
31, 1998 and 1997 other than the restricted common stock shares sold to
Directors as part of their compensation program. In 1997, the Board of
Directors approved that effective January 1, 1998, 50 percent of all
Director fees be used to purchase Company common stock directly from the
Company. During 1998, the Directors have purchased a total of 24,491 shares.
(See "Note 4 of Notes To Financial Statements" contained in "Item 8.
Financial Statements and Supplementary Data.") On March 1, 1999, the
Directors voted to purchase their shares in the open market rather than
directly from the Company.
Shareholders
As of February 26, 1999, there were approximately 164 holders of record
of the Company's common stock which, the Company has been informed, hold the
Company's common stock for approximately 2,000 beneficial owners.
Item 6. Selected Financial Data
The following tables should be read in conjunction with the Financial
Statements and Schedules included in Item 8 of this Form 10-K.
BALANCE SHEET DATA
Financial Position as of December 31:
1998 1997 1996 1995 1994
Total assets $25,358,859 $39,273,784 $38,555,290 $37,524,555 $32,044,073
Total
liabilities $ 2,802,150 $ 5,618,850 $ 2,622,687 $ 962,646 $ 733,271
Net asset
value $22,556,709 $33,654,934 $35,932,603 $36,561,909 $31,310,802
Net asset
value per
share $ 2.13 $ 3.15 $ 3.44 $ 3.54 $ 3.43
Shares
outstanding 10,591,232 10,692,971 10,442,682 10,333,902 9,136,747
Operating Data for year ended December 31:
1998 1997 1996 1995 1994
Investment
income $ 635,486 $ 614,046 $ 1,013,417 $ 1,109,517 $ 820,276
Net operating
loss (2,765,112) (1,498,141) (1,291,065) (1,099,409) (2,278,882)
Net realized
(loss) gain on
investments (1,768,528) (2,079,677) (2,465,175) 1,371,349 96,856
Net realized
(loss) income (4,533,640) (3,577,818) (3,756,240) 271,940 (2,182,026)
Net increase
(decrease) in
unrealized
appreciation
on investments 1,655,830 969,243 2,967,248 158,219 (886,040)
Net (decrease)
increase in
net assets
resulting from
operations (2,877,810) (2,608,575) (788,992) 430,159 (3,068,066)
(Decrease)
increase in net
assets resulting
from operations
per outstanding
share $ (0.27) $ (0.24) $ (0.08) $ 0.04 $ (0.34)
9
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Statement of Operations
The Company accounts for its operations under Generally Accepted Accounting
Principles for investment companies. On this basis, the principal measure of
its financial performance is captioned "Net (decrease) increase in net assets
resulting from operations," which is the sum of three elements. The first
element is "Net operating loss," which is the difference between the
Company's income from interest, dividends, fees and other income and its
operating expenses, net of applicable income tax benefit (provision). The
second element is "Net realized loss on investments," which is the difference
between the proceeds received from dispositions of portfolio securities and
their stated cost, net of applicable income tax (benefits) provisions. These
two elements are combined in the Company's financial statements and reported
as "Net realized loss." The third element, "Net increase in unrealized
appreciation on investments," is the net change in the fair value of the
Company's investment portfolio, net of increase (decrease) in deferred
income taxes that would become payable if the unrealized appreciation were
realized through the sale or other disposition of the investment portfolio.
"Net realized loss on investments" and "Net increase in unrealized
appreciation on investments" are directly related. When a security is sold
to realize a (loss) gain, net unrealized appreciation (increases) decreases
and net realized gain (decreases) increases.
Financial Condition
The Company's total assets and net assets were $25,358,859 and
$22,556,709 at December 31, 1998, respectively, versus $39,273,784 and
$33,654,934 at December 31, 1997, respectively. The decrease is primarily
owing to: 1) the payment of a one-time cash dividend of $8,019,728 to meet
one of the Company's requirements for qualification for Sub-Chapter M
treatment; 2) the payment of the Company's outstanding balance on the Demand
Promissory Note of $4,000,000, which reduced the Company's total assets in
1998; and 3) the decrease of $2,877,810 as a result of operations. (See
"Statement of Operations" contained in "Item 8. Financial Statements and
Supplementary Data".)
Net asset value per share ("NAV") was $2.13 at December 31, 1998, versus
$3.15 at December 31, 1997. NAV was reduced $0.75 by the cash dividend paid
by the Company in 1998.
The Company's shares outstanding as of December 31, 1998 were 10,591,232,
versus 10,692,971 at December 31, 1997. The Company's outstanding shares were
reduced as a result of its repurchase in the open market of a total of 126,230
shares as of December 31, 1998. However, the treasury shares were then
decreased by purchases of Company stock by directors with 50 percent of
their director compensation. (See "Note 4 of Notes to Financial Statements"
contained in "Item 8. Financial Statements and Supplementary Data".)
10
The Company's financial condition is dependent on the success of its
investments. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack management
depth or have no history of operations. At December 31, 1998, $19,562,386 or
77 percent of the Company's total assets consisted of investments at fair
value in private businesses, of which net unrealized appreciation was
$10,250,204 before taxes. At December 31, 1997, $13,222,857 or 34 percent
of the Company's total assets consisted of investments at fair value in
private businesses, of which net unrealized appreciation was $2,464,795
before taxes. The increase in the percentage of private investments from
34 percent in 1997 to 77 percent in 1998 is primarily owing to 1) an
increase in the value of several private investments; 2) the payment of the
Company's outstanding balance on the Demand Promissory Note of
$4,000,000, which reduced the Company's total assets in 1998; 3) the decrease
of $2,877,810 as a result of operations (See "Statement of Operations"
contained in "Item 8. Financial Statements and Supplementary Data"); and
4) the payment of a one-time cash dividend of $8,019,728 to meet one of the
Company's requirements for qualification for Sub-Chapter M treatment.
A summary of the Company's investment portfolio is as follows:
December 31, 1998 December 31, 1997
Investments, at cost $14,124,643 $30,500,498
Unrealized appreciation 10,407,548 8,158,732
----------- -----------
Investments, at fair value $24,532,191 $38,659,230
__________________ =========== ===========
The accumulated unrealized appreciation on investments net of deferred taxes
is $6,996,664 at December 31, 1998, versus $5,340,834 at December 31, 1997.
Following an initial investment in a private company, the Company may
make additional investments in such investee in order to: (1) increase its
ownership percentage; (2) exercise warrants or options that were acquired
in a prior financing; (3) preserve the Company's proportionate ownership in
a subsequent financing; or (4) attempt to preserve or enhance the value of
the Company's investment. Such additional investments are referred to as
"follow-on" investments. There can be no assurance that the Company will
make follow-on investments or have sufficient funds to make additional
investments. The failure to make such follow-on investments could jeopardize
the viability of the investee company and the Company's investment or could
result in a missed opportunity for the Company to participate to a greater
extent in an investee's successful operations. The Company attempts to
maintain adequate liquid capital to make follow-on investments in its private
investee portfolio companies. The Company may elect not to make a
follow-on investment either because it does not want to increase its
concentration of risk, because it prefers other opportunities, or because it
is inhibited by compliance with BDC or RIC requirements, even though the
follow-on investment opportunity appears attractive.
11
The following table is a summary of the cash investments made by the
Company in its private placement portfolio during the year ended December
31, 1998:
New Investments: Amount
InSite Marketing Technology, Inc. $ 500,000
Follow-on Investments:
MultiTarget, Inc. $ 51,802
Loans:
BioSupplyNet, Inc. (SciQuest,Inc.) $ 250,000
NBX Corporation 10,000
-----------
Sub-total $ 260,000
Interest on Loans*:
NeuroMetrix, Inc. $ 48,100
Voice Control Systems, Inc. 17,453
------------
Sub-total $ 65,553
Exercise of Warrants Held:
Voice Control Systems, Inc. $ 82,953
------------
Total $ 960,308
============
*The Company received additional shares in NeuroMetrix, Inc. and Voice
Control Systems, Inc. in exchange for the accrued interest on its loans.
Results of Operations
Investment Income and Expenses:
The Company had a net operating loss of $2,765,112 in 1998, $1,498,141 in
1997 and $1,291,065 in 1996. The Company's investment objective is to achieve
long-term capital appreciation rather than current income from its investments.
Therefore, a significant portion of the investment portfolio is structured to
maximize the potential for capital appreciation and provides little or no
current yield in the form of dividends or interest. The Company does earn
interest income from fixed-income securities, including U.S. Government
Obligations. The amount of interest income earned varies based upon the
average balance of the Company's fixed-income portfolio and the total
average yield on this portfolio.
The Company had total investment income of $635,486 in 1998, $614,046 in
1997 and $1,013,417 in 1996. The Company had interest income from fixed-
income securities of $355,591 in 1998, $490,807 in 1997 and $803,819 in 1996.
The decrease from 1997 to 1998 of $135,216 or 27.5 percent is a result of a
decline in the balance of the Company's fixed-income portfolio as a result
of the dividend, operating expenses and additional investments in non-income
producing private portfolio investments. The decrease from 1996 to 1997 of
$313,012 or 38.9 percent is a result of the decline of the Company's fixed-
income portfolio as a result of operating expenses and additional investments
in non-income producing private portfolio investments. The Company also
received consulting and administrative fees which totaled $29,870 in 1997
and $68,185 in 1996. The Company did not receive any consulting or
administrative fees in 1998.
12
The Company had interest income from affiliated companies of $124,877 in
1998, $40,000 in 1997 and $40,779 in 1996. The increase from 1997 to 1998 of
$84,877 or 212.2 percent is owing to the receipt of interest income (either in
funds or additional shares) on loans to investee companies and the increase in
loans and outstanding lines of credit to investee companies, principally
NeuroMetrix, Inc. and BioSupplyNet, Inc. (which in 1998 was merged with
SciQuest,Inc.).
The Company had other income of $102,468 in 1998, $869 in 1997 and
$92,610 in 1996. The increase of $101,599 or 116.9 percent from 1997 to
1998 is a result of the receipt of $88,000 from BioSupplyNet to reimburse
the Company for consulting fees paid and expensed by the Company in 1996 as
part of the investment costs of BioSupplyNet.
Also in 1998 and 1997, the Company received or accrued dividends of
$50,000 and $52,500 from its investment in PHZ Capital Partners, L.P.
Operating expenses were $3,634,786 in 1998, $3,045,290 in 1997 and
$2,985,316 in 1996. The increase from 1997 to 1998 of $589,496 or 19.4% is
primarily owing to: an increase in accrual for the Company's profit-sharing
plan of $899,751 or 112.3% over the prior year (See "Note 3 of Notes to
Financial Statements" contained in "Item 8. Financial Statements and
Supplementary Data"); the final payment on the Harris & Harris Group Senior
Professorship Pledge to the Massachusetts Institute of Technology of
$728,862; mitigated by a decrease in salaries and benefits of $676,136 or
44.9%. To date, no actual payments have been made under the Company's
profit-sharing plan.
The increase from 1996 to 1997 of $59,974 or 2.0% is primarily owing
to: the accrual of $423,808 for the Company's profit-sharing plan;
restructuring expenses of $100,000 incurred by the Company as a result of
researching the conversion to RIC status; mitigated by a decrease in overall
expenses as a result of the Company's effort to cut expenses. Most of the
Company's operating expenses were related to employee and director
compensation, office and rent expenses and consulting and professional fees
(primarily legal and accounting fees). To date, no actual payments have
been made under the Company's profit-sharing plan.
The Company has in the past relied, and continues to rely to a large
extent, upon proceeds from sales of investments, rather than investment
income, to defray a significant portion of its operating expenses. Because
such sales cannot be predicted with certainty, the Company attempts to
maintain adequate working capital to provide for fiscal periods when there
are no such sales.
Realized Gains and Losses on Sales of Portfolio Securities:
During the three years ended December 31, 1998, 1997 and 1996, the Company
sold various investments, realizing a net loss of $1,768,528, $3,199,502 and
$3,792,576, respectively. During 1998, the Company realized losses on: the
sale of its privately held investment in MultiTarget, Inc. of $209,999;
publicly-held investments that were once privately held, including CORDEX
Petroleums, Inc. in the amount of $357,736; Nanophase Technologies
Corporation of $329,055 (common stock shares purchased in the open market);
Princeton Video Image, Inc. of $288,369; and Voice Control Systems, Inc.
13
(which purchased the Company's investee company, PureSpeech, Inc.) of
$724,826. These losses were offset by a realized net gain of $141,457 in
various publicly traded securities. Net losses of $1,171,496 had been
recognized in prior years and realized in 1998. Realizing losses and gains
from prior years increases (for losses) or decreases (for gains) the
Unrealized Appreciation on Investments.
During 1997, the Company realized losses on the sale of its investments
in: nFX Corporation in the amount of $2,631,720; Harber Brothers Productions,
Inc. of $1,205,000; Gel Sciences, Inc. of $633,028; Dynecology, Inc. of
$99,900; and Micracor Corporation of $66,444. These losses were offset by
gains on the sales of Highline Capital Partners of $750,000 and of various
publicly traded securities of $686,590.
During 1996, the Company realized a loss on the sale of its equity
interest in Sonex International Corporation of $2,579,000. However, because
the investment had been written off in 1994, the loss did not affect
earnings in 1996. Also during 1996, the Company sold and realized a loss on
the sale of its equity interest in Micracor Corporation of $999,993 and net
losses on sales of various publicly held securities of $213,583.
Unrealized Appreciation and Depreciation of Portfolio Securities:
The Board of Directors values the portfolio securities on a quarterly
basis pursuant to the Company's Asset Valuation guidelines in accordance
with the 1940 Act. (See "Footnote to Schedule of Investments" contained in
"Item 8. Financial Statements and Supplementary Data".)
Net unrealized appreciation on investments before taxes increased by
$2,248,816 or 27.6% during the year ended December 31, 1998, from $8,158,732
to $10,407,548. The most significant increases in valuations during 1998
were in NBX Corporation, $1,865,766; NeuroMetrix, Inc., $4,400,125; and PHZ
Capital Partners, L.P., $443,432. The most significant decrease during 1998
was Nanophase Technologies Corporation, $5,508,466. Other changes included
an increased valuation of Genomica Corporation, offset primarily by
decreased valuations in MedLogic Global Corporation and Princeton Video
Image, Inc.
Net unrealized appreciation on investments before taxes increased by
$1,491,143 or 22.4% during the year ended December 31, 1997, from $6,667,589
to $8,158,732. The most significant increases in valuations during 1997 were in
Nanophase Corporation, $3,775,701; NBX Corporation, $2,850,296; and PHZ
Capital Partners, L.P., $405,622. The most significant decreases were in
Princeton Video Image, Inc., $1,563,605 and PureSpeech, Inc., $1,243,977
(which was subsequently acquired by Voice Control Systems, Inc.).
Net unrealized appreciation on investments before taxes increased by
$4,564,996 or 217.1% during the year ended December 31, 1996, from $2,102,593
to $6,667,589. The most significant increases in valuations during 1996
were in Gel Sciences, Inc., $1,127,500; Nanophase Technologies Corporation,
$1,452,755; and Princeton Video Image, Inc., $751,000. The most significant
decrease was in the valuation of nFX Corporation, $1,892,240.
14
Liquidity and Capital Resources
The Company reported total cash, receivables and marketable securities
(the primary measure of liquidity) at December 31, 1998 of $5,547,984 versus
$21,693,067 (net of $4,000,000 drawn from the J.P. Morgan line of credit) at
December 31, 1997 and $19,296,591 at December 31, 1996.
The decrease in cash, receivables and marketable securities from December
31, 1997 to December 31, 1998 is mainly owing to: 1) the payment on May 12,
1998 of a one-time cash dividend of $0.75 per share for a total of
$8,019,728; 2) the decline in value of the Company's investment in Nanophase
Technologies Corporation of approximately $5.5 million and 3) the use of
funds for 1998 cash operating expenses and realized losses.
Included in marketable securities as of December 31, 1998 were the
Company's holdings in Nanophase Technologies Corporation of $1,211,249 and
other publicly-held securities of $359,393. Included in marketable
securities as of December 31, 1997 were the Company's holdings in Nanophase
Technologies Corporation of $6,854,660 and Princeton Video Image, Inc. of
$1,064,895. At December 31, 1997, both holdings were subject to lock-up
agreements and were valued at discounts from market value: a 26 percent
discount in the case of Nanophase Technologies Corporation and a 24 percent
discount in the case of Princeton Video Image, Inc.
From 1997 to 1998, receivables from brokers increased by $380,707 or 100
percent, owing to transactions that settled in January 1999. Note receivables
increased by $32,663 or 100 percent, as a result of the Company receipt of a
note from the sale of its investment in one of its investee companies. The
Company's liabilities of accrued bonus and deferred income tax liability
increased significantly during 1998. Accrued bonus increased by $899,751 or
112.3 percent to $1,323,559 as a result of the increase in the appreciation
of investments. The accrued bonus will not be paid out until the gains are
realized. Therefore, no bonuses were paid in 1998. The deferred tax
liability is also based on unrealized appreciation, and taxes will not be
paid until the gains are realized.
As of December 31, 1998, the Company had a $6,000,000 line of credit in
place with J.P. Morgan, on which the Company had no outstanding balance.
Management believes that its cash, receivables and marketable securities
provide the Company with sufficient liquidity for its operations over the
next 12 months.
On February 22, 1999, NBX Corporation announced that it had agreed to be
acquired by 3Com Corporation for approximately $90 million in cash plus
additional consideration for employees of NBX. This transaction was
effective on March 5, 1999 and closed on March 8, 1999. On closing, the
Company received a total of $12,432,940 in cash, of which $1,475,276 was
placed in a one-year escrow. On February 23, 1999, the Board of Directors
of the Company declared a cash dividend of $0.35 per share (approximately
$3.7 million) to shareholders of record on March 19, 1999, payable on March
25, 1999. (See "Note 8 of Notes to Financial Statements" contained in "Item
8. Financial Statements and Supplementary Data".)
15
Recent Developments -- Sub-Chapter M Status
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. In order to qualify as a RIC, the Company must, in general (1)
annually derive at least 90 percent of its gross income from dividends,
interest and gains from the sale of securities; (2) quarterly meet certain
investment diversification requirements; and (3) annually distribute at
least 90 percent of its investment company taxable income as a dividend.
In addition to the requirement that the Company must annually distribute at
least 90 percent of its investment company taxable income, the Company may
either distribute or retain its taxable net capital gains from investments,
but any net capital gains not distributed could be subject to corporate
level tax. Further, the Company could be subject to a four percent
excise tax (and in some cases, corporate level income tax) if it fails to
distribute 98 percent of its annual taxable income.
Because of the specialized nature of its investment portfolio, the
Company could satisfy the diversification requirements under Sub-Chapter M
of the Code only if it received a certification from the SEC that it is
"principally engaged in the furnishing of capital to other corporations
which are principally engaged in the development or exploitation of
inventions, technological improvements, new processes, or products not
previously generally available."
On April 8, 1998, the Company announced that it had received such a
certification from the SEC for 1997. Pursuant to the Company's receipt of
the certification, the Company's Board of Directors declared and paid a one-
time cash dividend of $0.75 per share to meet one of the Company's
requirements for qualification for Sub-Chapter M tax treatment. On
February 17, 1999, the Company received rulings from the IRS regarding other
issues relevant to the Company's tax status as a RIC. (See "Note 6 of Notes
to Financial Statements" contained in "Item 8. Financial Statements and
Supplementary Data".) Although the SEC certification for 1997 was issued,
there can be no assurance that the Company will receive such certification
for 1998 or subsequent years (to the extent it needs additional
certification as a result of changes in its portfolio) or that it will
qualify as a RIC in 1999 or that, if it does qualify in 1999, it will
continue to qualify in subsequent years.
The qualification of the Company as a RIC under Sub-Chapter M of the Code
depends on it satisfying certain technical requirements regarding its income,
investment portfolio, and distributions. The Company was unable to satisfy
these requirements for the 1998 tax year owing to the nature of the Company's
ownership interest in one of its investee companies. In addition, because
it realized taxable losses in 1998, it was not strategically advantageous
for the Company to elect Sub-Chapter M tax status for 1998.
The Company changed the nature of its ownership interest in the non-
qualifying investee company effective January 1, 1999 in order to meet the
Sub-Chapter M requirements. However, there can be no assurance that the
Company will qualify for Sub-Chapter M treatment for 1999 or subsequent
years. In addition, under certain circumstances, even if the Company were
qualified for Sub-Chapter M treatment in 1999 and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than a RIC.
16
The Company incurred ordinary and capital losses during its C Corporation
taxable years that remain available for use and may be carried forward to its
1999 and subsequent taxable years. Ordinarily, a corporation that elects to
qualify as a RIC may not use its ordinary loss carryforwards from C
Corporation taxable years to offset RIC investment company taxable income,
although a RIC may in certain cases use capital loss carryforwards to reduce
net capital gains. In addition, a C Corporation that elects to qualify as a
RIC and that makes an appropriate election continues to be taxable as a C
Corporation on any gains realized within 10 years of its qualification as a
RIC from sales of assets that were held by the corporation on the effective
date of the election ("C Corporation Assets") to the extent of any gain
built into the assets on such date ("Built-In Gain").
On February 17, 1999, the Company received a ruling from the IRS concluding
that the Company can carry forward its C Corporation losses to offset any
Built-In Gains resulting from sales of its C Corporation Assets. That
ruling may enable the Company to retain some or all of the proceeds from
such sales without disqualifying itself as a RIC or incurring corporate
level income tax, depending on whether the Company's sale of C Corporation
Assets with Built-In Gains will generate C Corporation E&P. In general, a
RIC is not permitted to have, as of the close of any RIC taxable year, E&P
accumulated during any C Corporation taxable year. However, because the
realization of Built-In Gains will occur while the Company is a RIC, a
strong argument exists that, under current law and IRS pronouncements, the
sale of C Corporation Assets with Built-In Gains during RIC taxable years
will not generate C Corporation E&P. The Company intends to use the $7.1
million loss carryforward (which results in a tax credit of approximately
$2.5 million) to reduce the taxes due to Built-In Gains. The December 31,
1998 NAV includes the utilization of the ordinary and capital loss
carryforwards of approximately $0.23 per share. The IRS recently announced
an intention to issue formal guidance in 1999 concerning conversions of C
Corporation to RICs. Such guidance may include resolution of the E&P issue
described above and other issues relevant to the Company.
If necessary for liquidity purposes or to fund investment opportunities,
in lieu of distributing its taxable net capital gains, the Company may
retain such net capital gains and elect to be deemed to have made a
distribution of the gains, or part thereof, to the shareholders under the
"designated undistributed capital gain" rules of section 852(b)(3) of the
Code. In such a case, the Company would have to pay a 35 percent corporate
level income tax on such "designated undistributed capital gain," but it
would not have to distribute the excess of the retained "designated
undistributed capital gain" over the amount of tax thereon in order to
maintain its RIC status.
Tax Consequences of Net Capital Gains
The following simplified examples illustrate the tax treatment under Sub-
Chapter M of the Code for the Company and its shareholders with regard to
three possible alternatives, assuming a net long-term capital gain of $1.00
per share, consisting entirely of sales of non-real property assets held for
more than 12 months.
Under Alternative A: 100 percent of net capital gain declared as a dividend
and distributed to shareholders:
17
1. No taxation at the Company level.
2. Shareholders receive a $1.00 per share dividend and pay a
maximum tax of 20 percent* or $.20 per share, retaining $.80 per share.
Under Alternative B: 100 percent of net capital gain retained by the
Company and designated as "undistributed capital gain" dividend:
1. The Company pays a corporate level income tax of 35 percent on
the undistributed gain or $.35 per share and retains 65 percent of the gain
or $.65 per share.
2. Shareholders increase their cost basis in their stock by $.65
per share. They pay a 20 percent* capital gains tax on 100 percent of the
undistributed gain of $1.00 per share or $.20 per share in tax. Offsetting
this tax, shareholders receive a tax credit equal to 35 percent of the
undistributed gain or $.35 per share.
Under Alternative C: 100 percent of net capital gain retained by the
Company, with no designated undistributed capital gain dividend:
1. The Company pays a corporate level income tax of 35 percent on
the retained gain or $.35 per share plus an excise tax of 4 percent of $.98
per share, or about $.04 per share.
2. There is no tax consequence at the shareholder level.
*Assumes all capital gains qualify for long-term rates of 20 percent.
Risk Factors
Investment in Small, Private Companies
There are significant risks inherent in the Company's venture capital
business. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack
management depth and have not attained profitability or have no history of
operations. Because of the speculative nature and the lack of a public
market for these investments, there is significantly greater risk of loss
than is the case with traditional investment securities. The Company
expects that some of its venture capital investments will be a complete loss
or will be unprofitable and that some will appear to be likely to become
successful but never realize their potential. The Company has been risk
seeking rather than risk averse in its approach to venture capital and other
investments. Neither the Company's investments nor an investment in the
Company is intended to constitute a balanced investment program. The
Company has in the past relied and continues to rely to a large extent upon
proceeds from sales of investments rather than investment income to defray a
significant portion of its operating expenses.
18
Valuation of Portfolio Investments
There is typically no public market of equity securities of the small
private companies in which the Company invests. As a result, the valuation
of the equity securities in the Company's portfolio is subject to the good
faith estimate of the Company's Board of Directors. (See "Asset Valuation
Policy Guidelines" in "Footnote to Schedule of Investments.") In the
absence of a readily ascertainable market value, the estimated value of the
Company's portfolio of equity securities may differ significantly from the
values that would be placed on the portfolio if a ready market for the
equity securities existed. Any changes in estimated net asset value are
recorded in the Company's statement of operations as "Change in unrealized
appreciation on investments." (See "Management's Discussion and Analysis
of Financial Condition and Results of Operations.")
Illiquidity of Portfolio Investments
Most of the investments of the Company are or will be equity securities
acquired directly from small companies. The Company's portfolio of equity
securities are and will usually be subject to restrictions on resale or
otherwise have no established trading market. The illiquidity of most of
the Company's portfolio of equity securities may adversely affect the
ability of the company to dispose of such securities at times when it may be
advantageous for the Company to liquidate such investments.
Fluctuations of Quarterly Results
The Company's quarterly operating results could fluctuate as a result of
a number of factors. These include, among others, variations in and the
timing of the recognition of realized and unrealized gains or losses, the
degree to which the Company encounters competition in its markets and
general economic conditions. As a result of these factors, results for any
one quarter should not be relied upon as being indicative of performance in
future quarters. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Risk of Loss of Pass Through Tax Treatment
If the Company meets certain diversification and distribution requirements
under the Code, it may qualify as a RIC under the Code for pass-through tax
treatment. The Company would cease to qualify for pass-through tax treatment
if it were unable to comply with these requirements, or if it ceased to
qualify as a BDC under the 1940 Act. The Company also could be subject to
a four percent excise tax (and, in certain cases, corporate level income
tax) if it failed to make certain distributions. (See "Management's
Discussion and Analysis of Financial Condition -- Recent Developments -
Sub-Chapter M Status.") The lack of Sub-Chapter M taxtreatment could have
a material adverse effect on the total return, if any, obtainable from an
investment in the Company. If the Company fails to qualify as a RIC, the
Company would become subject to federal income tax as if it were an
ordinary C Corporation, which would result in a substantial reduction in the
Company's net assets and the amount of income available for distribution to
the Company's stockholders.
19
Risks Relating to the Year 2000 Issue
The "Year 2000" computer problem has arisen because many computer
applications worldwide will not properly recognize the date change from
December 31, 1999, to January 1, 2000. The computer applications may
revert to 1900 or some other date because of the way in which dates were
encoded and calculated, potentially causing production of erroneous data,
miscalculations, system failures and other operational problems.
The Company has undertaken the evaluation of the Year 2000 impact on its
critical computer hardware and software. The Company has not incurred, nor
does it anticipate that it will incur, any material cost in addressing its
Year 2000 problem. The Company is developing a strategic plan focusing on
achieving Year 2000 compliance. Certain systems are being replaced and or
modified to be Year 2000 compliant. At the present time, it is not possible
to determine whether any such events are likely to occur or to quantify any
potential negative impact they may have on the Company's future results of
operations and financial condition.
Ultimately, the potential impact of the Year 2000 issue will depend not
only on the success of the corrective measures undertaken by the Company,
but also on the way in which the Year 2000 issue is addressed by vendors,
service providers, counterparties, utilities, governmental agencies and
other entities with which the Company does business.
Forward-Looking Statements
The information contained herein contains certain forward-looking
statements. These statements include the plans and objectives of management
for future operations and financial objectives, portfolio growth and
availability of funds. These forward-looking statements are subject to the
inherent uncertainties in predicting future results and conditions. Certain
factors that could cause actual results and conditions to differ materially
from those projected in these forward-looking statements are set forth
herein. Other factors that could cause actual results to differ materially
include the uncertainties of economic, competitive and market conditions,
and future business decisions, all of which are difficult or impossible to
predict accurately and many of which are beyond the control of the Company.
Although the Company believes that the assumptions underlying the forward-
looking statements included herein are reasonable, any of the assumptions
could be inaccurate and therefore there can be no assurance that the forward-
looking statements included or incorporated by reference herein will prove to
be accurate. Therefore, the inclusion of such information should not be
regarded as a representation by the Company or any other person that the
objectives and plans of the Company will be achieved.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
The Company does not hold any derivatives.
20
Item 8. Financial Statements and Supplementary Data
HARRIS & HARRIS GROUP, INC.
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
The following reports and financial schedules of Harris & Harris Group,
Inc. are filed herewith and included in response to Item 8.
Documents Page
Report of Independent Public Accountants. . . . . . . . . . . 22
Financial Statements
Statements of Assets and Liabilities
as of December 31, 1998 and 1997 . . . . . . . . . . . . 23
Statements of Operations for the
years ended December 31, 1998, 1997 and 1996 . . . . . . 24
Statements of Cash Flows for the
years ended December 31, 1998, 1997 and 1996. . . . . . . 25
Statements of Changes in Net Assets for the
years ended December 31, 1998, 1997 and 1996. . . . . . . 26
Schedule of Investments as of December 31, 1998 . . . . . . . 27-30
Footnote to Schedule of Investments . . . . . . . . . . . . . 31-33
Notes to Financial Statements . . . . . . . . . . . . . . . . 34-40
Selected Per Share Data and Ratios for the
years ended December 31, 1998, 1997, 1996, 1995 and 1994. 41
Schedules other than those listed above have been omitted because they
are not applicable or the required information is presented in the financial
statements and/or related notes.
21
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Harris & Harris Group, Inc.:
We have audited the accompanying statements of assets and liabilities of
Harris & Harris Group, Inc. (a New York corporation) as of December 31, 1998
and 1997, including the schedule of investments as of December 31, 1998, and
the related statements of operations, cash flows and changes in net assets
for the three years ended December 31, 1998, and the selected per share data
and ratios for each of the five years ended December 31, 1998. These
financial statements and selected per share data and ratios are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and selected per share
data and ratios based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
selected per share data and ratios are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements. Our procedures included
confirmation of securities owned as of December 31, 1998 and 1997, by
correspondence with the custodian and brokers. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for
our opinion.
As explained in Note 2, the financial statements include securities
valued at $19,562,386 (86.7 percent of net assets), whose values have been
estimated by the Board of Directors in the absence of readily ascertainable
market values. However, because of the inherent uncertainty of valuation,
those estimated values may differ significantly from the values that would
have been used had a ready market for the securities existed, and the
differences could be material.
In our opinion, the financial statements and selected per share data and
ratios referred to above present fairly, in all material respects, the
financial position of Harris & Harris Group, Inc. as of December 31, 1998
and 1997, the results of its operations, its cash flows and the changes in
its net assets for the three years ended December 31, 1998, and the
selected per share data and ratios for each of the five years ended
December 31, 1998 in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
New York, New York
February 10, 1999
22
STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
December 31, 1998 December 31, 1997
Investments, at value (See accompanying schedule of
investments and notes). . . . . . . . . $ 24,532,191 $ 38,659,230
Cash and cash equivalents. . . . . . . . . 164,143 145,588
Receivable from brokers. . . . . . . . . . 380,707 0
Interest receivable. . . . . . . . . . . . 666 111,106
Prepaid expenses . . . . . . . . . . . . . 90,649 85,126
Note receivable. . . . . . . . . . . . . . 32,663 0
Other assets . . . . . . . . . . . . . . . 157,840 272,734
--------------- -------------
Total assets . . . . . . . . . . . . . . . $ 25,358,859 $ 39,273,784
=============== =============
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities $ 505,118 $ 475,683
Accrued bonus (Note 3) . . . . . . . . . . 1,323,559 423,808
Deferred rent. . . . . . . . . . . . . . . 42,409 51,662
Deferred income tax liability (Note 6) . . 931,064 667,697
Demand Promissory Note Payable (Note 7). . 0 4,000,000
-------------- ------------
Total liabilities. . . . . . . . . . . . . 2,802,150 5,618,850
-------------- ------------
Commitments and contingencies (Notes 7 and 8)
Net assets . . . . . . . . . . . . . . . . $ 22,556,709 $ 33,654,934
============== =============
Net assets are comprised of:
Preferred stock, $0.10 par value,
2,000,000 shares authorized;
none issued. . . . . . . . . . . . . . . $ 0 $ 0
Common stock, $0.01 par value, 25,000,000
shares authorized; 10,692,971 issued
at 12/31/98 and issued and outstanding
at 12/31/97 . . . . . . . . . . . . . . . 106,930 106,930
Additional paid in capital . . . . . . . . . 16,158,381 16,178,979
Accumulated net realized (loss) income . . . (525,177) 12,028,191
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $3,410,884 at 12/31/98
and $2,817,898 at 12/31/97 . . . . . . . . 6,996,664 5,340,834
Treasury stock, at cost (101,739 shares) . . (180,089) 0
------------- -------------
Net assets. . . . . . . . . . . . . . . . . .$ 22,556,709 $ 33,654,934
============= =============
Shares outstanding . . . . . . . . . . . . . 10,591,232 10,692,971
------------- -------------
Net asset value per outstanding share . . . .$ 2.13 $ 3.15
============= =============
The accompanying notes are an integral part of these financial statements.
23
STATEMENTS OF OPERATIONS
Year Ended Year Ended Year Ended
12/31/98 12/31/97 12/31/96
Investment income:
Interest from:
Fixed-income securities . . . . $ 355,591 $ 490,807 $ 803,819
Affiliated companies . . . . . . 124,877 40,000 40,779
Dividend income--
unaffiliated companies. . . . . 2,550 0 8,024
Dividend income--
affiliated companies. . . . . . 50,000 52,500 0
Consulting and
administrative fees . . . . . . 0 29,870 68,185
Other income . . . . . . . . . . 102,468 869 92,610
----------- ----------- ----------
Total investment income. . . . . 635,486 614,046 1,013,417
Expenses:
Salaries and benefits. . . . . . 831,121 1,507,257 1,524,826
Bonus accrual (Note 3) . . . . . 899,751 423,808 0
Administration and operations. . 330,879 392,114 474,537
Professional fees. . . . . . . . 411,480 327,038 675,241
Depreciation . . . . . . . . . . 47,936 48,968 57,426
Rent . . . . . . . . . . . . . . 159,515 130,092 160,601
Directors' fees and expenses . . 129,253 100,496 80,702
Custodian fees . . . . . . . . . 10,513 15,517 11,983
Restructuring charges. . . . . . 0 100,000 0
Other expense (Note 7) . . . . . 728,862 0 0
Interest expense . . . . . . . . 85,476 0 0
----------- ----------- -----------
Total expenses . . . . . . . . 3,634,786 3,045,290 2,985,316
----------- ----------- -----------
Operating loss
before income taxes . . . . . (2,999,300) (2,431,244) (1,971,899)
Income tax benefit (Note 6). . . 234,188 933,103 680,834
----------- ------------ -----------
Net operating loss . . . . . . . . (2,765,112) (1,498,141) (1,291,065)
Net realized loss on investments:
Realized loss on
sale of investments . . . . . (1,768,528) (3,199,502) (3,792,576)
----------- ----------- -----------
Total realized loss. . . . . . (1,768,528) (3,199,502) (3,792,576)
Income tax benefit (Note 6). . . 0 1,119,825 1,327,401
----------- ----------- -----------
Net realized loss on investments (1,768,528) (2,079,677) (2,465,175)
----------- ----------- -----------
Net realized loss. . . . . . . . . (4,533,640) (3,577,818) (3,756,240)
Net increase in unrealized
appreciation on investments:
Increase as a result of
investment sales . . . . . . . 2,135,176 93,999 2,525,548
Decrease as a result of
investment sales . . . . . . . (963,680) (2,892,408) 0
Increase on investments held . . 9,766,320 7,297,164 4,112,413
Decrease on investments held . . (8,689,000) (3,007,612) (2,072,965)
------------ ------------ -----------
Change in unrealized appreciation
on investments . . . . . . . . 2,248,816 1,491,143 4,564,996
Income tax provision (Note 6). . (592,986) (521,900) (1,597,748)
------------ ----------- -----------
Net increase in unrealized appreciation
on investments . . . . . . . . 1,655,830 969,243 2,967,248
------------ ----------- ----------
Net decrease in net assets
resulting from operations:
Total. . . . . . . . . . . . . . $(2,877,810) $(2,608,575) $ (788,992)
============ ============ ===========
Per outstanding share. . . . . . $ (0.27) $ (0.24) $ (0.08)
============ ============ ===========
The accompanying notes are an integral part of these financial statements.
24
STATEMENTS OF CASH FLOWS
Year Ended Year Ended Year Ended
12/31/98 12/31/97 12/31/96
Cash flows (used in) provided
by operating activities:
Net decrease in net assets
resulting from operations . . . $ (2,877,810) $ (2,608,575) $ (788,992)
Adjustments to reconcile net decrease in net assets
resulting from operations to net cash (used in)
provided by operating activities:
Net realized and unrealized (gain) loss
on investments. . . . . . . . (480,288) 1,708,359 (772,420)
Deferred income taxes . . . . . 263,367 (1,442,094) 1,636,817
Depreciation. . . . . . . . . . 47,936 48,968 57,426
Other . . . . . . . . . . . . . (2,927) 0 (10,144)
Changes in assets and liabilities:
Receivable from brokers . . . . (380,707) 0 205,789
Prepaid expenses. . . . . . . . (5,523) (3,625) 5,475
Interest receivable . . . . . . 110,440 87,236 102,376
Taxes receivable. . . . . . . . 0 2,119,492 (1,679,377)
Notes receivable. . . . . . . . (32,663) 0 0
Other assets. . . . . . . . . . 86,312 40,296 (103,981)
Accounts payable
and accrued liabilities. . . . 81,235 49,555 22,197
Accrued bonus . . . . . . . . . 899,751 423,808 0
Deferred rent . . . . . . . . . (9,253) (9,252) 10,279
Collection on notes receivable. 800,000 0 0
Purchase of fixed assets. . . . (16,426) (10,169) (35,777)
----------- ----------- -----------
Net cash (used in) provided
by operating activities. . . . (1,516,556) 403,999 (1,350,332)
Cash provided by (used in) investing activities:
Net sale (purchase) of short-term
investments and
marketable securities. . . . . 14,715,834 (155,667) 6,035,532
Investment in
private placements and loans . (960,308) (4,511,434) (4,981,614)
----------- ----------- -----------
Net cash provided by
(used in) investing activities 13,755,526 (4,667,101) 1,053,918
Cash flows (used in) provided
by financing activities:
Payment of dividend . . . . . . (8,019,728) 0 0
Purchase of treasury stock (Note 4) (254,786) 0 0
Proceeds from exercise
of stock options (Note 3). . . 0 253,250 87,500
Proceeds (payment of)
from note payable (Note 7) . . (4,000,000) 4,000,000 0
Proceeds from sale of
stock (Note 4) . . . . . . . . 54,099 0 0
------------ ----------- -----------
Net cash (used in) provided
by financing activities. . . . (12,220,415) 4,253,250 87,500
Net increase (decrease)
in cash and cash equivalents:
Cash and cash equivalents
at beginning of the year. . . . 145,588 155,440 364,354
Cash and cash equivalents
at end of the year. . . . . . . 164,143 145,588 155,440
------------ ------------ ----------
Net increase (decrease) in cash and
cash equivalents . . . . . . . . $ 18,555 $ (9,852) $ (208,914)
============ =========== ===========
Supplemental disclosures of cash flow information:
Income taxes paid. . . . . . . . $ 372 $ 5,909 $ 57,234
Interest paid. . . . . . . . . . $ 85,378 $ 0 $ 0
The accompanying notes are an integral part of these financial statements.
25
STATEMENTS OF CHANGES IN NET ASSETS
Year Ended Year Ended Year Ended
12/31/98 12/31/97 12/31/96
Changes in net assets from operations:
Net operating loss. . . . . . . .$(2,765,112) $(1,498,141) $(1,291,065)
Net realized loss on investments. (1,768,528) (2,079,677) (2,465,175)
Net increase (decrease) in unrealized
appreciation on investments
as a result of sales . . . . . 1,171,496 (1,818,966) 1,641,606
Net increase in unrealized
appreciation on
investments held . . . . . . . 484,334 2,788,209 1,325,642
------------ ------------ ------------
Net decrease in net assets
resulting from operations . . . (2,877,810) (2,608,575) (788,992)
Changes in net assets from
capital stock transactions:
Payment of dividend. . . . . . . (8,019,728) 0 0
Purchase of treasury stock . . . (254,786) 0 0
Proceeds from exercise of
stock options and warrants . . 0 253,250 87,500
Proceeds from sale of stock. . . 54,099 0 0
Tax benefit of
restricted stock award
and common stock transactions . 0 77,656 72,186
------------ ---------- -----------
Net (decrease) increase in
net assets resulting from
capital stock transactions . . (8,220,415) 330,906 159,686
------------ ---------- -----------
Net decrease in net assets . . . .(11,098,225) (2,277,669) (629,306)
Net assets:
Beginning of the year . . . . . . 33,654,934 35,932,603 36,561,909
----------- ----------- -----------
End of the year . . . . . . . . .$22,556,709 $33,654,934 $35,932,603
=========== =========== ===========
The accompanying notes are an integral part of these financial statements.
26
SCHEDULE OF INVESTMENTS DECEMBER 31, 1998
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (10)(11)(12) --
12.0% of total investments
Publicly Traded Portfolio (Common stock unless noted otherwise) --
6.4% of total investments
Somnus Medical Technology, Inc. (1)(4) --
Biotechnology and Healthcare related . .(C) 47,200 $ 141,600
Nanophase Technologies Corporation (1)(6) --
Manufactures and markets inorganic crystals of
nanometric dimensions --
4.59% of fully diluted equity
Common Stock . . . . . . . . . . . . . .(C) 672,916 1,211,249
Princeton Video Image, Inc. (1) -- Real time
sports and entertainment advertising --
0.59% of fully diluted equity . . . . .(C) 62,600 178,410
Voice Control Systems, Inc. (1)(2) -- Supplier
of speech recognition and
related speech input technology . . . .(C) 22,964 39,383
----------
Total Publicly Traded Portfolio (cost: $1,414,202). . . . . . . $1,570,642
----------
Private Placement Portfolio (Illiquid) -- 5.6% of total investments
Exponential Business Development Company (1)(2)(5) --
Venture capital partnership focused on early stage companies
Limited partnership interest . . . . . .(A) -- $ 25,000
MedLogic Global Corporation (1)(2) -- Medical cyanoacrylate
adhesive -- 0.40% of fully diluted equity
Series B Convertible Preferred Stock . .(B) 60,319
Common Stock . . . . . . . . . . . . . .(B) 25,798 565,978
SciQuest, Inc. (1)(2)(6)(9) -- Internet e-commerce source for
scientific products -- 3.61% of fully diluted equity
Series C Convertible Preferred Stock . .(A) 277,163
Warrants at $2.7962 expiring 6/30/07 . .(A) 26,822 775,000
----------
Total Private Placement Portfolio (cost: $1,833,774). . . . . . $1,365,978
----------
Total Investments in
Unaffiliated Companies (cost: $3,247,976) . . . . . . . . . . $2,936,620
----------
The accompanying notes are an integral part of this schedule.
27
SCHEDULE OF INVESTMENTS DECEMBER 31, 1998
Method of Shares/
Valuation(3) Principal Value
Private Placement Portfolio (Illiquid) in Non-Controlled
Affiliates (10)(12) -- 49.9% of total investments
Genomica Corporation (1)(2)(6)(7) -- Develops software
that enables the study of complex genetic diseases --
7.05% of fully diluted equity
Common Stock . . . . . . . . . . . . . (B) 199,800
Series A Voting
Convertible Preferred Stock . . . . . (B) 1,660,200 $1,209,730
InSite Marketing Technology, Inc. (1)(2)(4) -- Integrates
marketing science and sales strategy into e-commerce
-- 7.12% of fully diluted equity
Common Stock . . . . . . . . . . . . . (A) 1,351,351 500,000
NBX Corporation (1)(2)(6) -- Exploits innovative
distributed computing technology for use in small business
telephone systems -- 13.95% of fully diluted equity
Promissory Note --
8% due March 16, 2001 . . . . . . . . (A) $ 10,000
Series A Convertible Preferred Stock . (B) 500,000
Series C Convertible Preferred Stock . (B) 240,793
Series D Convertible Preferred Stock . (B) 59,965 6,416,064
PHZ Capital Partners Limited Partnership (2) -- Organizes
and manages investment partnerships -- 20.0% of fully
diluted equity
Limited partnership interest . . . . . (D) -- 1,849,054
Questech Corporation (1)(2)(6) -- Manufactures and
markets proprietary decorative tiles and signs -- 12.40% of
fully diluted equity
Common Stock . . . . . . . . . . . . .(D) 565,792 2,263,168
Warrants at $4.00 expiring 11/28/01 . .(A) 166,667 167
-----------
Private Placement Portfolio
in Non-Controlled Affiliates (cost: $5,920,308) . . . . . . $12,238,183
-----------
The accompanying notes are an integral part of this schedule.
28
SCHEDULE OF INVESTMENTS DECEMBER 31, 1998
Method of Shares/
Valuation (3) Principal Value
Private Placement Portfolio in Controlled Affiliates (10)(12)
(Illiquid) -- 24.3% of total investments
NeuroMetrix, Inc. (1)(2)(6)(8) -- Developing devices for: 1) diabetics
to monitor their blood glucose and 2) detection of carpal tunnel
syndrome -- 27.67% of fully diluted equity
Series A Convertible Preferred Stock . . .(B) 175,000
Series B Convertible Preferred Stock . . .(B) 125,000
Series C-2 Convertible Preferred Stock . .(B) 229,620 $ 5,958,225
-----------
Total Private Placement Portfolio
in Controlled Affiliates (cost: $1,558,100). . . . . . . . . . $ 5,958,225
-----------
U.S. Government Obligations -- 13.8% of total investments
U.S. Treasury Bill dated 02/05/98 due date
02/04/99 -- 4.4% yield . . . . . . . . . .(K) $ 300,000 $ 298,878
U.S. Treasury Bill dated 02/05/98 due date
02/04/99 -- 4.4% yield . . . . . . . . . .(K) $ 600,000 597,756
U.S. Treasury Bill dated 08/13/98 due date
02/11/99 -- 4.3% yield . . . . . . . . . .(K) $ 400,000 398,160
U.S. Treasury Bill dated 03/05/98 due date
03/04/99 -- 4.3% yield . . . . . . . . . .(K) $ 1,550,000 1,538,902
U.S. Treasury Bill dated 11/19/98 due date
05/20/99 -- 4.5% yield . . . . . . . . . .(K) $ 575,000 565,467
-------------
Total Investments in U.S. Government Obligations
(cost: $3,398,259). . . . . . . . . . . . . . . . . . . . . $ 3,399,163
-------------
Total Investments -- 100% (cost: $14,124,643). . . . . . . . $ 24,532,191
=============
The accompanying notes are an integral part of this schedule.
29
SCHEDULE OF INVESTMENTS DECEMBER 31, 1998
Notes to Schedule of Investments
(1) Represents a non-income producing security. Equity investments that have
not paid dividends within the last twelve 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 Method
of Valuation A to L.
(4) These investments were made during 1998. Accordingly, the amounts shown
on the schedule represent the gross additions in 1998.
(5) No changes in valuation occurred in these investments during the year
ended December 31, 1998.
(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 has not yet commenced
its planned principal operations or has commenced such operations but has
not realized significant revenue from them.
(7) Genomica Corporation was cofounded by the Company, Cold Spring Harbor
Laboratory and Falcon Technology Partners, LP. Mr. G. Morgan Browne
serves on the Board of Directors of the Company and is Administrative
Director of Cold Spring Harbor Laboratory.
(8) The percentage owned by the Company proforma for the January 21, 1999
financing is 18.04%.
(9) SciQuest, Inc. acquired BioSupplyNet, Inc.
(10)Investments in unaffiliated companies consist of investments where Harris &
Harris Group, Inc. (the "Company") owns less than 5 percent of the
investee company. Investments in non-controlled affiliated companies
consist of investments where the Company owns more than 5 percent but
less than 25 percent of the investee company. Investments in controlled
affiliated companies consist of investments where the Company owns more
than 25 percent of the investee company.
(11)The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $3,247,976. The gross unrealized appreciation
based on tax cost for these securities is $156,440. The gross unrealized
depreciation on the cost for these securities is $467,796.
(12)The percentage ownership of each investee disclosed in the Schedule of
Investments expresses the potential common equity interest in each such
investee. The calculated percentage represents the amount of issuer's
common stock the Company owns or can acquire as a percentage of the
issuer's total outstanding common stock plus common shares reserved for
issued and outstanding warrants, convertible securities and
stock options.
The accompanying notes are an integral part of this schedule.
30
FOOTNOTE TO SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
The Company's investments can be classified into five broad categories for
valuation purposes:
1) EQUITY-RELATED SECURITIES
2) INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND
DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
3) LONG-TERM FIXED-INCOME SECURITIES
4) SHORT-TERM FIXED-INCOME INVESTMENTS
5) ALL OTHER INVESTMENTS
The Investment Company Act of 1940 (the "1940 Act") requires periodic
valuation of each investment in the Company's portfolio to determine net asset
value. Under the 1940 Act, unrestricted securities with readily available
market quotations are to be valued at the current market value; all other
assets must be valued at "fair value" as determined in good faith by or
under the direction of the Board of Directors.
The Company's Board of Directors is responsible for 1) determining overall
valuation guidelines and 2) ensuring the valuation of investments within the
prescribed guidelines.
The Company's Investment and Valuation Committee, comprised of at least
three or more Board members, is responsible for reviewing and approving the
valuation of the Company's assets within the guidelines established by the
Board of Directors.
Fair value is generally defined as the amount that an investment could
be sold for in an orderly disposition over a reasonable time. Generally, to
increase objectivity in valuing the assets of the Company, external measures
of value, such as public markets or third-party transactions, are utilized
whenever possible. Valuation is not based on long-term work-out value, nor
immediate liquidation value, nor incremental value for potential changes
that may take place in the future.
Valuation assumes that, in the ordinary course of its business, the
Company will eventually sell its investment.
The Company's valuation policy with respect to the five broad investment
categories is as follows:
EQUITY-RELATED SECURITIES
Equity-related securities are carried at fair value using one or more of
the following basic methods of valuation:
A. Cost: The cost method is based on the original cost to the Company.
This method is generally used in the early stages of a company's development
until significant positive or negative events occur subsequent to the date
of the original investment that dictate a change to another valuation
method. Some examples of such events are: 1) a major recapitalization; 2)
a major refinancing; 3) a significant third-party transaction; 4) the
development of a meaningful public market for the company's common stock;
5) significant positive or negative changes in the company's business.
31
B. Private Market: The private market method uses actual third-party
transactions in the company's securities as a basis for valuation, using actual,
executed, historical transactions in the company's securities by responsible
third parties. The private market method may also use, where applicable,
unconditional firm offers by responsible third parties as a basis for valuation.
C. Public Market: The public market method is used when there is an
established public market for the class of the company's securities held by
the Company. The Company discounts market value for securities that are
subject to significant legal, contractual or practical restrictions,
including large blocks in relation to trading volume. Other securities, for
which market quotations are readily available, are carried at market value
as of the time of valuation.
Market value for securities traded on securities exchanges or on the
Nasdaq National Market is the last reported sales price on the day of
valuation. For other securities traded in the over-the-counter market and
listed securities for which no sale was reported on that day, market value
is the mean of the closing bid price and asked price on that day.
This method is the preferred method of valuation when there is an
established public market for a company's securities, as that market
provides the most objective basis for valuation.
D. Analytical Method: The analytical method is generally used to value
an investment position when there is no established public or private market
in the company's securities or when the factual information available to the
Company dictates that an investment should no longer be valued under either
the cost or private market method. This valuation method is inherently
imprecise and ultimately the result of reconciling the judgments of the
Company's Investment and Valuation Committee members, based on the data
available to them. The resulting valuation, although stated as a precise
number, is necessarily within a range of values that vary depending upon
the significance attributed to the various factors being considered. Some
of the factors considered may include the financial condition and operating
results of the company, the long-term potential of the business of the
company, the values of similar securities issued by companies in similar
businesses, the proportion of the company's securities owned by the Company
and the nature of any rights to require the company to register restricted
securities under applicable securities laws.
INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND DEVELOPMENT
IN TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the following basic methods
of valuation:
E. Cost: The cost method is based on the original cost to the Company.
Such method is generally used in the early stages of commercializing or
developing intellectual property or patents or research and development in
technology or product development until significant positive or adverse
events occur subsequent to the date of the original investment that dictate
a change to another valuation method.
F. Private Market: The private market method uses actual third-party
investments in intellectual property or patents or research and development
in technology or product development as a basis for valuation, using actual
executed historical transactions by responsible third parties. The private
market method may also use, where applicable, unconditional firm offers by
responsible third parties as a basis for valuation.
32
G. Analytical Method: The analytical method is used to value an investment
after analysis of the best available outside information where the factual
information available to the Company dictates that an investment should no
longer be valued under either the cost or private market method. This
valuation method is inherently imprecise and ultimately the result of
reconciling the judgments of the Company's Investment and Valuation
Committee members. The resulting valuation, although stated as a precise
number, is necessarily within a range of values that vary depending upon
the significance attributed to the various factors being considered. Some
of the factors considered may include the results of research and
development, product development progress, commercial prospects, term of
patent and projected markets.
LONG-TERM FIXED-INCOME SECURITIES
H. Fixed-Income Securities for which market quotations are readily
available are carried at market value as of the time of valuation using the
most recent bid quotations when available.
Securities for which market quotations are not readily available are carried
at fair value using one or more of the following basic methods of valuation:
I. Fixed-Income Securities are valued by independent pricing services
that provide market quotations based primarily on quotations from dealers
and brokers, market transactions, and other sources.
J. Other Fixed-Income Securities that are not readily marketable are valued
at fair value by the Investment and Valuation Committee.
SHORT-TERM FIXED-INCOME INVESTMENTS
K. Short-Term Fixed-Income Investments are valued at market value at the
time of valuation. Short-term debt with remaining maturity of 60 days or
less is valued at amortized cost.
ALL OTHER INVESTMENTS
L. All Other Investments are reported at fair value as determined in good
faith by the Investment and Valuation Committee.
The reported values of securities for which market quotations are not
readily available and for other assets reflect the Investment and Valuation
Committee's judgment of fair values as of the valuation date using the
outlined basic methods of valuation. They do not necessarily represent an
amount of money that would be realized if the securities had to be sold in
an immediate liquidation. The Company makes many of its portfolio
investments with the view of holding them for a number of years, and the
reported value of such investments may be considered in terms of disposition
over a period of time. Thus valuations as of any particular date are not
necessarily indicative of amounts that may ultimately be realized as a
result of future sales or other dispositions of investments held.
33
NOTES TO FINANCIAL STATEMENTS
NOTE 1. THE COMPANY
Harris & Harris Group, Inc. (the "Company") is a venture capital
investment company operating as a business development company ("BDC") under
the Investment Company Act of 1940 ("1940 Act"). A BDC is a specialized
type of investment company under the 1940 Act. The Company operates as an
internally managed investment company whereby its officers and employees,
under the general supervision of its Board of Directors, conduct its
operations.
The Company elected to become a BDC on July 26, 1995, after receiving the
necessary approvals. From September 30, 1992 until the election of BDC
status, the Company operated as a closed-end, non-diversified, investment
company under the 1940 Act. Upon commencement of operations as an investment
company, the Company revalued all of its assets and liabilities at fair value
as defined in the 1940 Act. Prior to such time, the Company was registered
and filed under the reporting requirements of the Securities and Exchange
Act of 1934 as an operating company and, while an operating company, operated
directly and through subsidiaries.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification as a Regulated Investment Company ("RIC")
under Sub-Chapter M of the Internal Revenue Code. As a RIC, the Company
must, among other things, distribute at least 90 percent of its taxable net
income and may either distribute or retain its taxable net realized capital
gains on investments. (See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations - Recent Developments.")
There can be no assurance that the Company will qualify as a RIC or that if
it does qualify, it will continue to qualify. In addition, even if the
Company were to qualify as a RIC, and elected Sub-Chapter M treatment for
that year, the Company might take action in a subsequent year to ensure that
it would be taxed in that subsequent year as a C Corporation, rather than
a RIC.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies followed
in the preparation of the financial statements:
Cash and Cash Equivalents. Cash and cash equivalents include money
market instruments with maturities of less than three months.
Portfolio Investment Valuations. Investments are stated at "fair value"
as defined in the 1940 Act and in the applicable regulations of the
Securities and Exchange Commission. All assets are valued at fair value as
determined in good faith by, or under the direction of, the Board of
Directors. See the Asset Valuation Policy Guidelines in the Footnote to
Schedule of Investments.
Securities Transactions. Securities transactions are accounted for on
the date the securities are purchased or sold (trade date); dividend income
is recorded on the ex-dividend date; and interest income is accrued as
earned. Realized gains and losses on investment transactions are determined
on the first-in, first-out basis for financial reporting and tax reporting
or purposes.
Income Taxes. Prior to January 1, 1998, the Company recorded income
taxes using the liability method in accordance with the provision of
Statement of Financial Accounting Standards No. 109. Accordingly, deferred
tax liabilities had been established to reflect temporary differences
between the recognition of income and expenses for financial reporting and
tax purposes, the most significant difference of which relates to the
Company's unrealized appreciation on investments.
34
The December 31, 1998 financial statements include a provision for
deferred taxes on the net unrealized gains as of December 31, 1998, net of
the operating and capital loss carryforwards incurred by the Company
through December 31, 1998. (See Note 6. Income Taxes.)
Reclassifications. Certain reclassifications have been made to the
December 31, 1996 and December 31, 1997 financial statements to conform to
the December 31, 1998 presentation.
Estimates by Management. The preparation of the financial statements in
conformity with Generally Accepted Accounting Principles requires management
to make estimates and assumptions that affect the reported amounts of assets
and liabilities as of December 31,1998 and 1997, and the reported amounts of
revenues and expenses for the three years ended December 31, 1998. Actual
results could differ from these estimates.
NOTE 3. STOCK OPTION PLAN AND WARRANTS OUTSTANDING
On August 3, 1989, the shareholders of the Company approved the 1988
Long Term Incentive Compensation Plan. On June 30, 1994, the shareholders
of the Company approved various amendments to the 1988 Long Term Incentive
Compensation Plan: 1) to conform to the provisions of the BDC regulations
under the 1940 Act, which allow for the issuance of stock options to
qualified participants; 2) to increase the reserved shares under the amended
plan; 3) to call the plan the 1988 Stock Option Plan, as Amended and
Restated (the "1988 Plan"); and 4) to make various other amendments. On
October 20, 1995, the shareholders of the Company approved an amendment to
the 1988 Plan authorizing automatic 20,000 share grants of non-qualified
stock options to newly elected non-employee directors of the Company. The
Company's 1988 Plan was cancelled as of December 31, 1997, canceling all
outstanding stock options and eliminating all potential stock option grants.
As a substitution for the 1988 Stock Option Plan, the Company adopted an
employee profit-sharing plan.
The Company accounted for the 1988 Plan under APB Opinion No. 25, under
which no compensation cost has been recognized. Had compensation cost for
the 1988 Plan been determined consistent with the fair value method required
by FASB Statement No. 123 ("FASB No. 123"), the Company's net realized loss
and net asset value per share would have been reduced to the following pro-
forma amounts:
1998 1997 1996
Net Realized Loss:
As Reported N/A $(3,577,818) $ (3,756,240)
Pro Forma N/A $(3,921,583) $ (4,197,096)
Net Asset Value per share:
As Reported N/A $3.15 $3.44
Pro Forma N/A $3.12 $3.40
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option pricing model with the following weighted
average assumptions:
1998 1997 1996
Stock volatility N/A 0.60 0.60
Risk-free interest rate N/A 6.3% 6.8%
Option term in years N/A 7 7
Stock dividend yield N/A - - - -
35
A summary of the status of the Company's 1988 Plan at December 31, 1997
and 1996 and changes during the years then ended is presented in the table
and narrative below:
December 31, 1997 December 31, 1996
------------------- -------------------
Shares Weighted Shares Weighted
Average Average
--------- -------- --------- --------
Exercise Exercise
Price Price
-------- --------
Outstanding at beginning of year 1,080,000 $4.584 1,050,000 $4.445
Granted 300,000 $3.875 160,000 $5.008
Exercised 158,000 $1.603 50,000 $1.750
Forfeited 397,000 $5.267 80,000 $5.375
Expired - - - - - - - -
Canceled 825,000 $4.569 - - - -
Outstanding at end of year 0 0 1,080,000 $4.584
Exercisable at end of year 0 0 390,000 $3.334
Weighted average fair value
of options granted $2.50 - - $3.222 - -
During 1997, the Chairman of the Company exercised a warrant to purchase
237,605 shares of common stock at a price of $2.0641.
As of January 1, 1998, the Company began implementing the Harris &
Harris Group, Inc. Employee Profit Sharing Plan (the "Plan") that provides
for profit sharing equal to 20 percent of the net realized income of the
Company as reflected on the statement of operations of the Company for such
year, less the nonqualifying gain, if any. Under the Plan, net realized
income of the Company includes investment income, realized gains and losses,
and operating expenses (including taxes paid or payable by the Company), but
it will be 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 will be considered nonqualifying gain, which will reduce "Qualifying
Income."
As soon as practicable following year end, the Board of Directors will
determine whether, and if so how much, "Qualifying Income" exists for a plan
year, and 90 percent of the Qualifying Income will be paid out to Plan
participants pursuant to the distribution percentages set forth in the Plan.
The remaining 10 percent will be paid out after the Company has filed its
federal tax return for that year in which "Qualifying Income" exists. The
distribution amounts for each officer and employee is as follows: Charles
E. Harris, 13.790%; Mel P. Melsheimer, 4.233%; Rachel M. Pernia, 1.524%; and
Jacqueline M. Matthews, 0.453%. If a participant leaves the Company for
other than cause, the amount earned will be accrued and paid to such
participant, and the remaining amount allocable under the Plan will be
redistributed by the Compensation Committee and paid to the other
participants.
36
Notwithstanding any provisions of the Plan, in no event may the
aggregate amount of all awards payable for any Plan year during which the
Company remains a "business development company" within the meaning of the
Investment Company Act of 1940, as amended (the "1940 Act"), be greater than
20 percent of the Company's "net income after taxes" within the meaning of
Section 57(n)(1)(B) of the 1940 Act. In the event the awards exceed such
amount, the awards will be reduced pro rata.
The Plan may be modified, amended or terminated by the Company's Board
of Directors at any time; provided however, no such modification, amendment
or termination may adversely affect any participant that has not consented
to such modification, amendment or termination.
The Company calculates the Plan accrual at each quarter end based on
the unrealized gains at that date, net of operating expenses for the year.
Any adjustments to the Plan accrual are then reflected in the Statement of
Operations for the quarter. The Plan accrual is not paid out until the
gains are realized. During 1998, the Company accrued bonus expense of
$899,751, bringing the cumulative accrual under the Plan to $1,323,559 at
December 31, 1998.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that effective January 1,
1998, 50 percent of all Director fees be used to purchase Company common
stock from the Company. However, effective on March 1, 1999, the Directors
may purchase the Company's common stock in the market, rather than from the
Company. During 1998, the directors bought a total of 24,491 shares.
On April 15, 1998, the Company announced that the Board of Directors
had approved the purchase of up to 700,000 shares of Company stock in the
open market. As of December 31, 1998, the Company had purchased a total of
126,230 shares for a total of $254,786 or an average of $2.02 per share.
However, the treasury shares purchased were decreased by the director
purchases of a total of 24,491 shares of Company stock.
NOTE 5. EMPLOYEE BENEFITS
The Company has an employment and severance contract ("Employment
Contract") with its Chairman, Charles E. Harris, pursuant to which he is to
receive compensation in the form of salary and other benefits. On January 1,
1998, Mr. Harris's Employment Contract was amended to reduce his salary to
$200,000 and to allow him to participate in other business opportunities and
investments. The term of the contract expires on December 31, 1999. Base
salary is to be increased annually to reflect inflation and in addition may be
increased by such amount as the Compensation Committee of the Board of
Directors of the Company deems appropriate. In addition, Mr. Harris would be
entitled, under certain circumstances, to receive severance pay under the
employment and severance contracts.
As of January 1, 1989, the Company adopted an employee benefits program
covering substantially all employees of the Company under a 401(k) Plan and
Trust Agreement. During 1998, contributions to the plan that have been charged
to operations totaled approximately $37,000.
On June 30, 1994, the Company adopted a plan to provide medical and
health insurance for retirees, their spouses and dependents who, at the time of
their retirement, have ten years of service with the Company and have attained
50 years of age or have attained 45 years of age and have 15 years of service
with the Company. On February 10, 1997, the Company amended this plan to
include employees who "have seven full years of service and have attained 58
years of age." The coverage is secondary to any government provided or
37
subsequent employer provided health insurance plans. Based upon actuarial
estimates, the Company provided an original reserve of $176,520 that was
charged to operations for the period ending June 30, 1994. As of December 31,
1998 the Company had a reserve of $283,305 for the plan.
NOTE 6. INCOME TAXES
As of December 31, 1998, the Company had not elected tax treatment
available to RICs under Sub-Chapter M of the Code. Accordingly, for federal
and state income tax purposes, the Company is taxed at statutory corporate
rates on its income, which enables the Company to offset any future net
operating losses against prior years' net income. The Company may carry back
operating losses against net income two years and carryforward such losses 15
years.
For the years ended December 31, 1998, 1997 and 1996, the Company's
income tax (benefit) provision was allocated as follows:
1998 1997 1996
Investment operations $(234,188) $ (933,103) $ (680,834)
Realized loss on investments 0 (1,119,825) (1,327,401)
Increase in unrealized
appreciation on investments 592,986 521,900 1,597,748
Total income tax (benefit) ---------- ------------ ------------
provision $ 358,798 $(1,531,028) $ (410,487)
========== ============ ============
The above tax (benefit) provision consists of the following:
Current -- Federal $ 95,430 $ 0 $(2,047,304)
Deferred -- Federal 263,368 (1,531,028) 1,636,817
Total income tax (benefit) --------- ------------ ------------
provision $ 358,798 $(1,531,028) $ (410,487)
========= ============ ============
The Company's net deferred tax liability at December 31, 1998 and
1997 consists of the following:
1998 1997
Unrealized appreciation on investments $ 3,410,885 $ 2,817,898
Net operating and capital loss carryforward (2,479,821) (1,856,989)
Medical retirement benefits - - (81,345)
Other - - (211,867)
------------ ------------
Net deferred income tax liability $ 931,064 $ 667,697
============ ============
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification as a RIC under Sub-Chapter M of the Code. As
a RIC, the Company annually must distribute at least 90 percent of its
investment company taxable income as a dividend and may either distribute or
retain its taxable net capital gains from investments. To initially qualify
as a RIC, among other requirements, the Company had to pay a dividend to
shareholders equal to the Company's cumulative realized earnings and profits
("E&P"). On April 9, 1998, the Company declared a one-time cash dividend
of $0.75 per share to meet this requirement (for a total of $8,019,728).
The cash dividend was paid on May 12, 1998. Continued qualification as a
RIC requires the Company to satisfy certain portfolio diversification
requirements in future years. The Company's ability to satisfy those
requirements may not be controllable by the Company. (See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operation - Recent Developments - Sub-Chapter M Status.")
38
The Company incurred net ordinary and capital losses for a total of
approximately $7.1 million (which results in a tax credit of approximately
$2.5 million) during its C Corporation taxable years that remain available
for use and may be carried forward to its 1999 and subsequent taxable years.
Ordinarily, a corporation that elects to qualify as a RIC may not use its loss
carryforwards from C Corporation taxable years to offset RIC investment
company taxable income or net capital gains. In addition, a corporation
that elects to qualify as a RIC continues to be taxable as a C Corporation
on any gains realized within 10 years of its qualification as a RIC from
sales of assets that were held by the corporation on the effective date of
the election ("C Corporation Assets") to the extent of any gain built into
the assets on such date ("Built-In Gain"). On February 17, 1999, the
Company received a ruling from the IRS concluding that the Company can
carry forward its C Corporation losses to offset any Built-In Gains
resulting from sales of its C Corporation Assets. That ruling may enable
the Company to retain some or all of the proceeds from such sales without
disqualifying itself as a RIC or incurring corporate level income tax,
depending on whether the Company's sale of C Corporation Assets with Built-
In Gains will generate C Corporation E&P. In general, a RIC is not
permitted to have, as of the close of any RIC taxable year, E&P accumulated
during any C Corporation taxable year. However, because the realization of
Built-In Gains will occur while the Company is a RIC, a strong argument
exists that, under current law and IRS pronouncements, the sale of C
Corporation Assets with Built-In Gains during RIC taxable years will not
generate C Corporation E&P. The Company intends to use the $7.1 million loss
carryforward (which results in a tax credit of approximately $2.5 million) to
reduce its taxes which are due to Built-In Gains. The December 31, 1998 NAV
includes the utilization of ordinary and capital loss carryforwards of
approximately $0.23 per share. The IRS recently announced an intention to
issue formal guidance in 1999 concerning conversions of C Corporations to RICs.
Such guidance may include resolution of the E&P issue described above and
other issues relevant to the Company.
There can be no assurance that the Company will qualify as a RIC or
that, if it does qualify, it will elect RIC status.
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a ten-year lease with sublet
provisions for office space. In 1995, this lease was amended to include
additional office space. Rent expense under this lease for the year ended
December 31, 1998, was $159,515. Future minimum lease payments in each of
the following years are: 1999 -- $176,030; 2000 -- $178,561; 2001 --
$178,561; 2002 -- $178,561; 2003 -- $101,946.
In December 1993, the Company and MIT announced the establishment
by the Company of the Harris & Harris Group Senior Professorship at MIT.
Prior to the arrangement for the establishment of this Professorship, the
Company had made gifts of stock in start-up companies to MIT. These gifts,
together with the contribution of $700,000 in cash in 1993, which was
expensed by the Company in 1993, were used to establish this named chair.
During 1993, 1994 and 1995, the Company contributed to MIT securities which
were applied to the MIT Pledge at their market value at the time the shares
became publicly traded or otherwise monetized in a commercial transaction
and were free from restriction as to sale by MIT. On December 31, 1998,
the Company finalized the establishment of the Harris & Harris Group Senior
Professorship by making the final payment of $728,862 due on the pledge.
39
In June 1997, the Company agreed to provide one of its investee
companies with a $450,000 revolving line of credit, of which $50,000 had
been used through December 31, 1997. During 1998, through September 30,
1998, the investee company borrowed an additional $250,000 which was repaid
in the fourth quarter of 1998.
In December 1997, the Company signed a Demand Promissory Note for a
$4,000,000 line of credit with J.P. Morgan collateralized by the Company's U.S.
Treasury obligations. In March 1998, the line of credit was increased to
$6,000,000. As of December 31, 1997, the Company had borrowed $4,000,000
against the line of credit. From December 31, 1997 to January 2, 1998, the
rate on the line of credit was prime (8.5 percent). From January 2, 1998 to
April 2, 1998, the interest rate on the line of credit was LIBOR plus 1.5
percent (7.3125 percent). In March 1998, the Company paid down $2,500,000;
in April 1998, the Company paid the remaining balance and did not draw
against the line for the remainder of the year.
NOTE 8. SUBSEQUENT EVENTS
On February 22, 1999, NBX Corporation announced that it had agreed
to be acquired by 3Com Corporation for approximately $90 million in cash plus
additional consideration for employees of NBX. This transaction was effective
on March 5, 1999 and closed on March 8, 1999. On closing, the Company received
a total of $12,432,940 in cash, of which $1,475,276 was placed in a one-year
escrow.
On February 23, 1999, the Board of Directors of the Company declared a
cash dividend of $0.35 per share (approximately $3.7 million) to shareholders
of record on March 19, 1999, payable on March 25, 1999.
On March 18, 1999, the Company invested $1,000,000 in the equity of
a privately held medical device company with a patented product addressing a
very large potential market. At this writing, the Company is still under
non-disclosure with respect to the identity of this company. But this
investment is the Company's first private equity commitment of part of the
proceeds from the capital gains generated by the sale of NBX.
40
SELECTED PER SHARE DATA AND RATIOS
Per share operating performance:
Year Ended Year Ended Year Ended Year Ended Year Ended
December December December December December
31, 1998 31, 1997 31, 1996 31, 1995 31, 1994
Net asset value,
beginning of period $ 3.15 $ 3.44 $ 3.54 $ 3.43 $ 3.66
Net operating
loss (0.26) (0.14) (0.12) (0.11) (0.25)
Net realized
(loss) gain on
investments (0.16) (0.19) (0.24) 0.14 0.01
Net increase
(decrease) in
unrealized
appreciation
as a result of
sales 0.11 (0.17) 0.16 (0.01) (0.11)
Net increase in
unrealized
appreciation on
investments held 0.05 0.26 0.13 0.03 0.01
Net decrease as
a result of
dividend (0.75) -- -- -- --
Net (decrease)
increase from
capital stock
transactions (0.01) (0.05) (0.03) 0.06 0.11
----------- ------------ ---------- ----------- ---------
Net asset value,
end of period $ 2.13 $ 3.15 $ 3.44 $ 3.54 $ 3.43
=========== =========== ========== ========== =========
Market value per
share, end of
period* $ 1.50 $ 3.50 $ 3.75 $ 7.875 $ 6.375
Deferred income
tax per share $ 0.09 $ 0.06 $ 0.21 $ 0.050 $ 0.030
Ratio of expenses
to average net
assets 10.9% 9.1% 8.1% 8.3% 13.6%
Ratio of net
operating loss to
average net assets (10.4)% (4.5)% (3.5)% (3.2)% (7.1)%
Investment return
based on:
Stock price (45.5)% (6.7)% (52.4)% 23.5% (22.7)%
Net asset value (11.3)% (8.4)% (2.8)% 3.2% (6.3)%
Portfolio turnover 19.71% 77.2% 51.3% 51.2% 136.4%
Net assets, end of
period $22,556,709 $33,654,934 $35,932,603 $36,561,909 $31,310,802
Number of shares
outstanding 10,591,232 10,692,971 10,442,682 10,333,902 9,136,747
*The market value as of December 31, 1998 reflects the decline in market
price as a result of the $0.75 dividend paid on May 12, 1998.
The accompanying notes are an integral part of this schedule.
41
Item 9. Disagreements on Accounting and Financial Disclosure
None.
PART III
Item 10. Directors and Executive Officers of the Company
The information set forth under the captions "Election of Directors"
on page 2, "Executive Officers" on page 8 and "Section 16(a) Beneficial
Ownership Reporting Compliance" on page 13 in the Company's Proxy Statement
for Annual Meeting of Shareholders to be held April 28, 1999, filed pursuant
to Regulation 14A under the Securities Exchange Act of 1934 on or about
March 24, 1999 (the "1999 Proxy Statement") is herein incorporated by
reference.
Item 11. Executive Compensation
The information set forth under the captions "Summary Compensation
Table" on pages 9 and 10 and "Compensation of Directors" on page 12 in the
1999 Proxy Statement is herein incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information set forth under the caption "Security Ownership of
Directors and Executive Officers and other principal holders of the
Company's voting securities" on page 7 in the 1999 Proxy Statement is
herein incorporated by reference.
Item 13. Certain Relationships and Related Transactions
There were no relationships or transactions within the meaning of this
item during the year ended December 31, 1998.
42
PART IV
Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K
(a) The following documents are filed as a part of this report:
(1) The following Financial Statements of the Company are set forth
under Item 8:
Statements of Assets and Liabilities as of December 31, 1998 and
1997
Statements of Operations for the years ended December 31, 1998,
1997 and 1996
Statements of Cash Flows for the years ended December 31, 1998,
1997 and 1996
Statements of Changes in Net Assets for the years ended
December 31, 1998, 1997 and 1996
Schedule of Investments as of December 31, 1998
Footnote to Schedule of Investments
Notes to Financial Statements
Selected Per Share Data and Ratios for the years ended December
31, 1998, 1997, 1996, 1995 and 1994
(2) Report of Independent Public Accountants.
(3) The following exhibits are filed with this report or are
incorporated herein by reference to a prior filing, in
accordance with Rule 12b-32 under the Securities Exchange Act
of 1934. (Asterisk denotes exhibits filed with this report.)
3.1(a) Restated Certificate of Incorporation of the Company, as
amended, incorporated by reference to Exhibit 3.1 (a) to
the Company's Form 10-K for the year ended December 31, 1995.
3.1(b) Restated By-laws of the Company, incorporated by reference to
Exhibit 3.1(b) to the Company's Form 10-K for the year ended
December 31, 1995 and the Company's Form 10-Q for the quarter
ended September 30, 1998.
4.1 Specimen certificate of common stock certificate,
incorporated by reference to Exhibit 4 to Company's
Registration Statement on Form N-2 filed October 29, 1992.
9.1 Harris & Harris Group, Inc. Custodian Agreement with JP Morgan,
incorporated by reference to Exhibit 9.1 to the Company's Form
10-K for the year ended December 31, 1995.
10.1 Amended and Restated Employment Agreement between Harris &
Harris Group, Inc. and Charles E. Harris dated January 1, 1998.
10.5 Severance Compensation Agreement by and between the Company
and Charles E. Harris dated August 15, 1990, incorporated by
reference to exhibit 10(s) to the Company's Annual Report on
Form 10-K for the year ended December 31, 1990.
10.13 Stock Purchase Agreement, Standstill Agreement and
Termination and Release by and among Harris & Harris Group,
Inc. and American Bankers Life Assurance Company of Florida
dated May 18, 1995, incorporated by reference to Exhibit
10.13 to the Company's Form 10-K for the year ended December
31, 1995.
10.14 Form of Indemnification Agreement which has been established
with all directors and executive officers of the Company,
incorporated by reference to Exhibit 10.14 to the Company's
Form 10-K for the year ended December 31, 1995.
10.16 Demand Promissory Note, Corporate Certificate-Borrowing,
Statement of Purpose for an Extension of Credit Secured by
Margin Stock by and among Harris & Harris Group, Inc. and
J.P. Morgan.
10.17 Harris & Harris Group, Inc. Employee Profit Sharing Plan,
incorporated by reference as Exhibit (c) to the Company's
Form 8-K filed June 15, 1998.
11.0* Computation of Per Share Earnings is set forth under Item 8.
23* Consent of Arthur Andersen LLP.
27.0* Financial Data Schedule.
(b) Reports on Form 8-K. The Company did not file any reports on Form
8-K during the last quarter of 1998.
44
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
HARRIS & HARRIS GROUP, INC.
Date: March 19, 1999 By:/s/
------------------------
Charles E. Harris
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Company and in the capacities and on the dates indicated.
Signatures Title Date
/s/ Chairman of the Board, March 19, 1999
- ----------------------- Chief Compliance Officer and
Charles E. Harris Chief Executive Officer
/s/ President, Chief Operating March 19, 1999
- ----------------------- Officer and Chief Financial
Mel P. Melsheimer Officer
/s/ Vice President, Controller, March 19, 1999
- ----------------------- Treasurer and Principal
Rachel M. Pernia Accounting Officer
45
/s/ Director March 20, 1999
- -----------------------
C. Wayne Bardin
/s/ Director March 18, 1999
- -----------------------
Phillip A. Bauman
/s/ Director March 18, 1999
- -----------------------
G. Morgan Browne
/s/ Director March 19, 1999
- -----------------------
Harry E. Ekblom
/s/ Director March 19, 1999
- -----------------------
Dugald A. Fletcher
/s/ Director March 18, 1999
- -----------------------
Glenn E. Mayer
/s/ Director March 19, 1999
- -----------------------
William R. Polk
/s/ Director March 18, 1999
- -----------------------
James E. Roberts
46
EXHIBIT INDEX
The following exhibits are filed with this report in accordance with Rule
12b-32 under the Securities Exchange Act of 1934.
Exhibit No. Description
11.0 Computation of Per Share Earnings is set forth under Item 8.
23 Consent of Arthur Andersen LLP.
27.0 Financial Data Schedule.
47