UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For quarterly period ended March 31, 2005
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ____________ to _____________
Commission File Number: 0-11576
HARRIS & HARRIS GROUP, INC.
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(Exact name of registrant as specified in its charter)
New York 13-3119827
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(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
111 West 57th Street, New York, New York 10019
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(Address of Principal Executive Offices) (Zip Code)
(212) 582-0900
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
------ ------
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
------ ------
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at May 6, 2005
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Common Stock, $0.01 par value per share 17,248,845 shares
Harris & Harris Group, Inc.
Form 10-Q, March 31, 2005
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements..................................... 1
Consolidated Statements of Assets and Liabilities............................. 2
Consolidated Statements of Operations......................................... 3
Consolidated Statements of Cash Flows......................................... 4
Consolidated Statements of Changes in Net Assets.............................. 5
Consolidated Schedule of Investments.......................................... 6
Notes to Consolidated Financial Statements....................................14
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations ................................................................19
Background and Overview ......................................................19
Results of Operations ........................................................21
Financial Condition...........................................................22
Liquidity and Capital Resources...............................................24
Risk Factors..................................................................25
Item 3. Quantitative and Qualitative Disclosures About Market Risk............35
Item 4. Controls and Procedures...............................................36
PART II OTHER INFORMATION
Item 6. Exhibits..............................................................39
Signature ....................................................................40
Exhibit Index.................................................................41
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated financial
statements reflects all adjustments that are, in the opinion of management,
necessary for a fair statement of the results for the interim period presented.
Harris & Harris Group, Inc. (the "Company," "us," "our" and "we"), is an
internally managed venture capital company that has elected to be treated as a
business development company under the Investment Company Act of 1940 (the "1940
Act"). Certain information and disclosures normally included in the consolidated
financial statements in accordance with Generally Accepted Accounting Principles
have been condensed or omitted as permitted by Regulation S-X and Regulation
S-K. It is suggested that the accompanying consolidated financial statements be
read in conjunction with the audited consolidated financial statements and notes
thereto for the year ended December 31, 2004, contained in our 2004 Annual
Report.
On September 25, 1997, our Board of Directors approved a proposal to seek
qualification as a Regulated Investment Company ("RIC") under Subchapter M of
the Internal Revenue Code (the "Code"). At that time, we were taxable under
Subchapter C of the Code (a "C Corporation"). In order to qualify as a RIC, we
must, in general (1) annually derive at least 90 percent of our gross income
from dividends, interest, gains from the sale of securities and similar sources;
(2) quarterly meet certain investment diversification requirements; and (3)
annually distribute at least 90 percent of our investment company taxable income
as a dividend. In addition to the requirement that we must annually distribute
at least 90 percent of our investment company taxable income, we may either
distribute or retain our taxable net capital gains from investments, but any net
capital gains not distributed could be subject to corporate level tax. Further,
we could be subject to a four percent excise tax to the extent we fail to
distribute at least 98 percent of our annual investment company taxable income
and would be subject to income tax to the extent we fail to distribute 100
percent of our investment company taxable income.
Because of the specialized nature of our investment portfolio, we
generally can satisfy the diversification requirements under Subchapter M of the
Code only if we receive a certification from the Securities and Exchange
Commission ("SEC") that we are "principally engaged in the furnishing of capital
to other corporations which are principally engaged in the development or
exploitation of inventions, technological improvements, new processes, or
products not previously generally available."
On June 15, 2004, we received SEC certification for 2003, permitting us to
qualify for RIC treatment for 2003 (as we had for the years 1999 through 2002).
Although the SEC certification for 2003 was issued, there can be no assurance
that we will qualify for or receive such certification for subsequent years (to
the extent we need additional certification as a result of changes in our
portfolio) or that we will actually qualify for Subchapter M treatment in
subsequent years. In addition, under certain circumstances, even if we qualified
for Subchapter M treatment in a given year, we might take action in a subsequent
year to ensure that we would be taxed in that subsequent year as a C
Corporation, rather than as a RIC.
1
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
March 31, 2005 December 31, 2004
(Unaudited)
Investments, at value (Cost: $75,545,747 at 3/31/05,
$77,442,110 at 12/31/04) ............................... $ 73,900,723 $ 76,244,682
Cash and cash equivalents ................................... 411,956 650,332
Restricted funds ............................................ 1,598,985 1,591,971
Receivable from portfolio company ........................... 17,100 10,000
Interest receivable ......................................... 164,427 58,960
Income tax receivable ....................................... 2,469 2,480
Prepaid expenses ............................................ 421,347 542,489
Other assets, net of reserve of $255,486 at 12/31/04 (Note 9) 255,874 260,537
------------ ------------
Total assets ................................................ $ 76,772,881 $ 79,361,451
============ ============
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities .................... $ 2,863,830 $ 2,905,658
Accrued profit sharing (Note 4) ............................. 0 311,594
Deferred rent ............................................... 33,229 34,930
Deferred income tax liability (Note 6) ...................... 1,364,470 1,364,470
------------ ------------
Total liabilities ........................................... 4,261,529 4,616,652
------------ ------------
Net assets .................................................. $ 72,511,352 $ 74,744,799
============ ============
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;
19,077,585 issued at 3/31/05 and 12/31/04 .............. 190,776 190,776
Additional paid in capital .................................. 85,658,150 85,658,150
Accumulated net realized loss ............................... (6,746,974) (4,961,123)
Accumulated unrealized depreciation of investments, including
deferred tax liability of $1,540,045 at 3/31/05 and
at 12/31/04 (Note 6) ................................... (3,185,069) (2,737,473)
Treasury stock, at cost (1,828,740 shares at 3/31/05 and
12/31/04) .............................................. (3,405,531) (3,405,531)
------------ ------------
Net assets .................................................. $ 72,511,352 $ 74,744,799
============ ============
Shares outstanding .......................................... 17,248,845 17,248,845
============ ============
Net asset value per outstanding share ....................... $ 4.20 $ 4.33
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
2
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2005 March 31, 2004
Investment income:
Interest from:
Fixed income securities ................................ $ 221,498 $ 55,853
Portfolio companies .................................... 38,610 683
------------ ------------
Total investment income ................................ 260,108 56,536
------------ ------------
Expenses:
Profit-sharing provision (reversal) (Note 4) .............. (311,594) 0
Salaries and benefits ..................................... 567,691 470,075
Administration and operations ............................. 321,961 159,299
Professional fees ......................................... 272,465 79,061
Rent ...................................................... 48,682 33,737
Directors' fees and expenses .............................. 85,660 52,446
Depreciation .............................................. 15,269 9,283
Custodian fees ............................................ 5,564 2,500
------------ ------------
Total expenses ........................................ 1,005,698 806,401
------------ ------------
Net operating loss ............................................. (745,590) (749,865)
------------ ------------
Net realized (loss) income from investments:
Realized income (loss) from investments ................... (1,036,044) 793,389
Income tax provision (Note 6) ............................. (4,217) (6,796)
------------ ------------
Net realized (loss) income from investments ............... (1,040,261) 786,593
------------ ------------
Net realized (loss) income ..................................... (1,785,851) 36,728
------------ ------------
Net (increase) decrease in unrealized depreciation on:
Investment sales .......................................... 1,363,891 915,118
Investments held .......................................... (1,811,487) (131,331)
------------ ------------
Net (increase) decrease in unrealized
depreciation on investments ........................... (447,596) 783,787
------------ ------------
Net (decrease) increase in net assets resulting from operations:
Total ..................................................... $ (2,233,447) $ 820,515
============ ============
Per average outstanding share ............................. $ (0.13) $ 0.06
============ ============
Average outstanding shares ................................ 17,248,845 13,798,845
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
3
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2005 March 31, 2004
Cash flows from operating activities:
Net (decrease) increase in net assets
resulting from operations ............................ $ (2,233,447) $ 820,515
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 1,483,640 (1,577,176)
Depreciation ......................................... 15,269 9,283
Changes in assets and liabilities:
Restricted funds ..................................... (7,014) (118,567)
Receivable from portfolio company .................... (7,100) 0
Interest receivable .................................. (105,467) (20,115)
Income tax receivable ................................ 11 6,340
Prepaid expenses ..................................... 121,142 (72,324)
Other assets ......................................... 6,142 (3,212)
Accounts payable and accrued liabilities ............. (41,828) (411,567)
Payable to broker for unsettled trade ................ 0 10,583,080
Accrued profit sharing ............................... (311,594) 0
Deferred rent ........................................ (1,701) (1,575)
------------ ------------
Net cash (used in) provided by operating activities .. (1,081,947) 9,214,682
------------ ------------
Cash flows from investing activities:
Net (purchase) sale of short-term investments
and marketable securities ........................ 4,287,322 (4,520,645)
Investment in private placements and loans ........... (3,782,686) (7,223,662)
Proceeds from sale of investments .................... 355,684 2,506,588
Purchase of fixed assets ............................. (16,749) (12,726)
------------ ------------
Net cash provided by (used in) investing activities .. 843,571 (9,250,445)
------------ ------------
Net decrease in cash and cash equivalents:
Cash and cash equivalents at beginning of the year ... 650,332 425,574
Cash and cash equivalents at end of the year ......... 411,956 389,811
------------ ------------
Net decrease in cash and cash equivalents ............ $ (238,376) $ (35,763)
============ ============
Supplemental disclosures of cash flow information:
Income taxes paid .................................... $ 3,750 $ 0
The accompanying notes are an integral part of these consolidated financial
statements.
4
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2005 March 31, 2004
Changes in net assets from operations:
Net operating loss ....................... $ (745,590) $ (749,865)
Net realized (loss) income on investments (1,040,261) 786,593
Net decrease in unrealized depreciation
on investments as a result of sales .. 1,363,891 915,118
Net increase in unrealized depreciation on
investments held ..................... (1,811,487) (131,331)
------------ ------------
Net (decrease) increase in net assets ......... (2,233,447) 820,515
------------ ------------
Net assets:
Beginning of the period .................. 74,744,799 40,682,738
------------ ------------
End of the period ........................ $ 72,511,352 $ 41,503,253
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
5
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2005
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (7)(8)(9) - 12.1% of net assets
Private Placement Portfolio (Illiquid) - 12.1% of net assets
AlphaSimplex Group, LLC (2) -- Investment management company headed by
Dr. Andrew W. Lo, holder of the Harris & Harris Group Chair at MIT
Limited Liability Company Interest ............................... (C) -- $ 125,000
----------
Continuum Photonics, Inc. (1)(2)(5) -- Develops optical networking
components by merging materials, MEMS and
electronics technologies
Series B Convertible Preferred Stock ............................. (B) 2,000,000 147,724
Series C Convertible Preferred Stock ............................. (B) 2,689,103 159,691
----------
307,415
----------
Crystal IS, Inc. (1)(2)(5) - Develops a technology to grow
single-crystal boules of aluminum nitride for gallium nitride
electronics
Series A Convertible Preferred Stock ............................. (A) 274,100 199,983
----------
Exponential Business Development Company (1)(2) --
Venture capital partnership focused on early stage companies
Limited Partnership Interest ..................................... (B) -- 0
----------
Heartware, Inc. (1)(2)(5) -- Develops ventricular assist devices
Series A-2 Non-Voting Preferred Stock ............................ (B) 47,620 0
----------
Molecular Imprints, Inc. (1)(2) -- Develops nanoimprint lithography
capital equipment
Series B Convertible Preferred Stock ............................. (A) 1,333,333 2,000,000
----------
Nanosys, Inc. (1)(2)(5) -- Develops nanotechnology-enabled systems
incorporating zero and one-dimensional inorganic
nanometer-scale materials
Series C Convertible Preferred Stock ............................. (A) 803,428 1,500,000
----------
Nantero, Inc. (1)(2)(5) -- Develops a high-density, nonvolatile, random
access memory chip, using nanotechnology
Series A Convertible Preferred Stock ............................. (C) 345,070 1,046,908
Series B Convertible Preferred Stock ............................. (C) 207,051 628,172
Series C Convertible Preferred Stock ............................. (C) 188,315 571,329
----------
2,246,409
----------
NeoPhotonics Corporation (1)(2)(5) -- Develops and manufactures
planar optical devices and components
Common Stock ................................................. (C) 60,580 9,105
Series 1 Convertible Preferred Stock .............................. (A) 1,831,256 2,014,677
Warrants at $0.15 expiring 3/12/11 ................................ (C) 30,426 304
----------
2,024,086
----------
The accompanying notes are an integral part of these consolidated financial
statements.
6
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2005
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (7)(8)(9) - 12.1% of net assets (cont.)
Private Placement Portfolio (Illiquid) - 12.1% of net assets (cont.)
Optiva, Inc. (1)(2)(5) -- Develops and commercializes nanomaterials
for display industry applications
Series C Convertible Preferred Stock.........................................(B) 1,249,999 $ 0
Secured Convertible Bridge Note with 50% Preferred
Stock Warrant coverage.......................................................(B) $ 750,000 0
----------
0
----------
Solazyme, Inc. (1)(2)(5) -- Harnesses energy-harvesting machinery
of photosynthetic microbes to produce industrial and pharmaceutical
molecules
Convertible Promissory Note..................................................(A) $ 310,000 341,526
----------
Total Unaffiliated Private Placement Portfolio (cost: $11,311,070) ................................................$8,744,419
----------
Total Investments in Unaffiliated Companies (cost: $11,311,070) ...................................................$8,744,419
----------
The accompanying notes are an integral part of these consolidated financial
statements.
7
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2005
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Non-Controlled Affiliated Companies (7)(8)(10) - 34.4% of net assets
Publicly Traded Portfolio - 15.0% of net assets
NeuroMetrix, Inc. (1)(11) -- Develops and sells medical devices for
monitoring neuromuscular disorders
Common Stock .............................................................. (D) 1,137,570 $10,863,793
-----------
Total Publicly Traded Portfolio (cost: $4,411,373) ...................................................................$10,863,793
-----------
Private Placement Portfolio (Illiquid) - 19.4% of net assets
Cambrios Technologies Corporation (1)(2)(5) -- Develops commercially relevant
materials by evolving biomolecules to express control over nanostructure
synthesis
Series B Convertible Preferred ............................................ (A) 1,294,025 1,294,025
-----------
Chlorogen, Inc. (1)(2)(5) -- Develops patented chloroplast technology
to produce plant-made proteins
Series A Convertible Preferred Stock ...................................... (A) 4,478,038 785,000
-----------
CSwitch, Inc. (1)(2)(5) -- Develops next-generation, system-on-a-chip
solutions for communications-based platforms
Series A Convertible Preferred Stock ...................................... (A) 1,000,000 1,000,000
-----------
Experion Systems, Inc. (1)(2)(6) -- Develops and sells software to credit
unions
Series A Convertible Preferred Stock ...................................... (B) 294,118 0
Series B Convertible Preferred Stock ...................................... (B) 35,294 0
Series C Convertible Preferred Stock ...................................... (B) 222,184 0
Series D Convertible Preferred Stock ...................................... (B) 64,501 202,103
-----------
202,103
-----------
NanoGram Corporation (1)(2)(5) -- Develops a broad suite of intellectual
property utilizing nanotechnology
Series I Convertible Preferred Stock ...................................... (A) 63,210 21,672
Series II Convertible Preferred Stock ..................................... (A) 1,250,904 1,000,723
-----------
1,022,395
-----------
Nanomix, Inc. (1)(2)(5) -- Develops nanoelectronic sensors that
integrate carbon nanotube electronics with silicon microstructures
Series C Convertible Preferred Stock ....................................... (A) 9,779,181 2,500,000
-----------
NanoOpto Corporation (1)(2)(5) -- Develops discrete and integrated
optical communications sub-components on a chip by utilizing
nano-manufacturing technology
Series A-1 Convertible Preferred Stock ..................................... (C) 267,857 48,735
Series B Convertible Preferred Stock ....................................... (C) 3,819,935 1,665,111
Series C Convertible Preferred Stock ....................................... (C) 1,932,789 842,503
Warrants at $0.4359 expiring 03/15/10 ...................................... (C) 193,279 0
-----------
2,556,349
-----------
The accompanying notes are an integral part of these consolidated financial
statements.
8
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2005
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Private Placement Portfolio (Illiquid) - 19.4% of net assets (cont.)
Nanopharma Corp. (1)(2)(5) -- Develops advanced polymers for drug
delivery
Series A Convertible Preferred Stock ...................................... (A) 684,516 $ 700,000
Secured Convertible Bridge Note with 25% Warrants ......................... (A) $ 550,000 566,863
-----------
1,266,863
-----------
Nanotechnologies, Inc. (1)(2)(5) -- Develops and commercializes
nanoscale materials for industry
Series B Convertible Preferred Stock ...................................... (B) 1,538,837 0
Series C Convertible Preferred Stock ...................................... (B) 473,903 0
-----------
0
-----------
Nextreme Thermal Solutions, Inc. (1)(2)(5) -- Manufactures thin-film,
superlattice thermoelectric devices
Series A Convertible Preferred Stock ...................................... (A) 500,000 500,000
-----------
Questech Corporation (1)(2) -- Manufactures and markets proprietary
metal decorative tiles
Common Stock ............................................................. (C) 646,954 $ 724,588
Warrants at $1.50 expiring 11/16/05 ...................................... (C) 1,250 0
Warrants at $1.50 expiring 08/03/06 ...................................... (C) 8,500 0
Warrants at $1.50 expiring 11/21/07 ...................................... (C) 3,750 0
Warrants at $1.50 expiring 11/19/08 ...................................... (C) 5,000 0
Warrants at $1.50 expiring 11/19/09 ...................................... (C) 5,000 0
-----------
724,588
-----------
Starfire Systems, Inc. (1)(2)(5) -- Develops and produces ceramic-
forming polymers
Common Stock ............................................................. (A) 375,000 150,000
Series A-1 Convertible Preferred Stock ................................... (A) 600,000 600,000
-----------
750,000
-----------
Zia Laser, Inc. (1)(2)(4)(5) -- Manufactures quantum dot semiconductor
lasers
Series C Convertible Preferred Stock ..................................... (A) 1,500,000 1,500,000
-----------
Total Non-Controlled Private Placement Portfolio (cost: $19,171,176) .............................................$14,101,323
-----------
Total Investments in Non-Controlled Affiliated Companies (cost: $23,582,549) .....................................$24,965,116
-----------
U.S. Government and Agency Obligations - 55.4% of net assets
U.S. Treasury Notes -- due date 04/30/05, coupon 1.625% .................. (H) 767,000 766,279
U.S. Treasury Notes - due date 06/30/05, coupon 1.125% ................... (H) 21,500,000 21,415,935
U.S. Treasury Notes -- due date 02/28/06, coupon 1.625% .................. (H) 2,000,000 1,968,120
U.S. Treasury Notes - due date 06/30/06, coupon 2.75% .................... (H) 10,000,000 9,899,200
U.S. Treasury Notes -- due date 02/15/07, coupon 2.25% ................... (H) 2,000,000 1,945,460
U.S. Treasury Notes -- due date 05/15/08, coupon 2.625% .................. (H) 1,999,000 1,920,299
U.S. Treasury Notes -- due date 03/15/09, coupon 2.625% .................. (H) 2,402,000 2,275,895
-----------
Total Investments in U.S. Government and Agency Obligations (cost: $40,652,128)...................................$40,191,188
-----------
Total Investments (cost: $75,545,747) ............................................................................$73,900,723
===========
The accompanying notes are an integral part of these consolidated financial
statements.
9
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2005
Notes to Consolidated Schedule of Investments
(1) Represents a non-income producing security. Equity investments that have
not paid dividends within the last 12 months are considered to be
non-income producing.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Schedule of Investments for a description of the Valuation
Procedures.
(4) Initial investment was made during 2005.
(5) These investments are development stage companies. A development stage
company is defined as a company that is devoting substantially all of its
efforts to establishing a new business, and either it has not yet
commenced its planned principal operations, or it has commenced such
operations but has not realized significant revenue from them.
(6) Experion Systems, Inc., was previously named MyPersonalAdvocate.com, Inc.
(7) Investments in unaffiliated companies consist of investments in which we
own less than five percent of the voting shares of the portfolio company.
Investments in non-controlled affiliated companies consist of investments
in which we own more than five percent, but less than 25 percent, of the
voting shares of the portfolio company. Investments in controlled
affiliated companies consist of investments in which we own more than 25
percent of the voting shares of the portfolio company.
(8) The percentage ownership of each portfolio company disclosed in the
Consolidated Schedule of Investments expresses the potential equity
interest in each such portfolio company. The calculated percentage
represents the amount of the issuer's equity securities we own or can
acquire as a percentage of the issuer's total outstanding equity
securities plus equity securities reserved for issued and outstanding
warrants, convertible securities and all authorized stock options, both
granted and ungranted.
(9) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $11,311,070. The gross unrealized appreciation
based on the tax cost for these securities is $979,490. The gross
unrealized depreciation based on the tax cost for these securities is
$3,546,141.
(10) The aggregate cost for federal income tax purposes of investments in
non-controlled affiliated companies is $23,582,549. The gross unrealized
appreciation based on the tax cost for these securities is $6,452,420. The
gross unrealized depreciation based on the tax cost for these securities
is $5,069,853.
(11) The Company's 1,137,570 share holding in NeuroMetrix, Inc. (Nasdaq
National Market Symbol: NURO), at the March 31, 2005, market price per
share of $9.55, was $10,863,793. The lock-up period on the sale of these
shares expired on January 18, 2005. Charles E. Harris, our Chairman and
CEO, is a board member of NeuroMetrix, Inc.
The accompanying notes are an integral part of this consolidated schedule.
10
HARRIS & HARRIS GROUP, INC.
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
VALUATION PROCEDURES
Our investments can be classified into five broad categories for valuation
purposes:
1) EQUITY-RELATED SECURITIES
2) INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND
DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
3) LONG-TERM FIXED-INCOME SECURITIES
4) SHORT-TERM FIXED-INCOME INVESTMENTS
5) ALL OTHER INVESTMENTS
The 1940 Act requires periodic valuation of each investment in our
portfolio to determine our net asset value. Under the 1940 Act, unrestricted
securities with readily available market quotations are to be valued at the
current market value; all other assets must be valued at "fair value" as
determined in good faith by or under the direction of the Board of Directors.
Our Board of Directors is responsible for (1) determining overall
valuation guidelines and (2) ensuring that our investments are valued within the
prescribed guidelines.
Our Valuation Committee, comprised of three or more independent Board
members, is responsible for reviewing and approving the valuation of our assets
within the guidelines established by the Board of Directors. The Valuation
Committee receives information and recommendations from management.
Fair value is generally defined as the amount that an investment could be
sold for in an orderly disposition over a reasonable time. Generally, to
increase objectivity in valuing our assets, external measures of value, such as
public markets or third-party transactions, are utilized whenever possible.
Valuation is not based on long-term work-out value, nor immediate liquidation
value, nor incremental value for potential changes that may take place in the
future.
The values assigned to these investments are based on available
information and do not necessarily represent amounts that might ultimately be
realized, as such amounts depend on future circumstances and cannot reasonably
be determined until the individual investments are actually liquidated or become
readily marketable.
Our valuation policy with respect to the five broad investment categories
is as follows:
EQUITY-RELATED SECURITIES
Equity-related securities are valued using one or more of the following
basic methods of valuation:
A. Cost: The cost method is based on our original cost. This method is
generally used in the early stages of a company's development until significant
positive or negative events occur subsequent to the date of the original
investment that dictate a change to another valuation method.
11
Some examples of these 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 a company's common stock; and (5) significant
positive or negative changes in a company's business.
B. Analytical Method: The analytical method is generally used to value an
investment position when there is no established public or private market in the
company's securities or when the factual information available to us dictates
that an investment should no longer be valued under either the cost or private
market method. This valuation method is inherently imprecise and ultimately the
result of reconciling the judgments of our Valuation Committee members, based on
the data available to them. The resulting valuation, although stated as a
precise number, is necessarily within a range of values that vary depending upon
the significance attributed to the various factors being considered. Some of the
factors considered may include the financial condition and operating results of
the company, the long-term potential of the business of the company, the values
of similar securities issued by companies in similar businesses, the proportion
of the company's securities we own and the nature of any rights to require the
company to register restricted securities under applicable securities laws.
C. Private Market: The private market method uses actual, executed,
historical transactions in a company's securities by responsible third parties
as a basis for valuation. The private market method may also use, where
applicable, unconditional firm offers by responsible third parties as a basis
for valuation.
D. Public Market: The public market method is used when there is an
established public market for the class of a company's securities held by us or
into which our securities are convertible. Securities for which market
quotations are readily available, and which are not subject to substantial legal
or contractual and transfer restrictions, 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. If, for any reason, the Valuation Committee determines that market
quotations are not reliable, such securities shall be fair valued by the
Valuation Committee in accordance with these valuation procedures. We discount
market value for securities that are subject to significant legal or contractual
transfer restrictions.
INVESTMENTS IN INTELLECTUAL PROPERTY, PATENTS, RESEARCH AND DEVELOPMENT IN
TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the following basic
methods of valuation:
E. Cost: The cost method is based on our original cost. This 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. Analytical Method: The analytical method is used to value an investment
after analysis of the best available outside information where the factual
information available to us dictates that an investment should no longer be
valued under either the cost or private market method. This valuation method is
inherently imprecise and ultimately the result of reconciling the judgments of
our Valuation Committee members. The resulting valuation, although stated as a
precise number, is necessarily within a range of values that vary depending upon
the significance attributed to the various factors being considered. Some of the
factors considered may include the results of research and development, product
development progress, commercial prospects, term of patent, projected markets,
and other subjective factors.
12
G. Private Market: The private market method uses actual third-party
investments in the same or substantially similar 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.
LONG-TERM FIXED INCOME SECURITIES
H. Readily Marketable: Long-term fixed-income securities for which market
quotations are readily available are carried at market value as of the time of
valuation using the most recent bid quotations when available.
I. Not Readily Marketable: Long-term fixed-income securities for which
market quotations are not readily available are carried at fair value as
determined in good faith by the Valuation Committee on the basis of available
data, which may include credit quality, and interest rate analysis as well as
quotations from broker-dealers or, where such quotations are not available,
prices from independent pricing services that the Board believes are reasonably
reliable and based on reasonable price discovery procedures and data from other
sources.
SHORT-TERM FIXED-INCOME INVESTMENTS
J. Short-Term Fixed-Income Investments are valued in the same manner as
long-term fixed income securities until the remaining maturity is 60 days or
less, after which time such securities may be valued at amortized cost if there
is no concern over payment at maturity.
ALL OTHER INVESTMENTS
K. All Other Investments are reported at fair value as determined in good
faith by the Valuation Committee.
For all other investments, the reported values shall reflect the Valuation
Committee's judgment of fair values as of the valuation date using the outlined
basic methods of valuation or any other method of valuation within the
prescribed guidelines that the Valuation Committee determines after review and
analysis is more appropriate for the particular kind of investment. They do not
necessarily represent an amount of money that would be realized if we had to
sell such assets in an immediate liquidation. Thus, valuations as of any
particular date are not necessarily indicative of amounts that we may ultimately
realize as a result of future sales or other dispositions of investments we
hold.
13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. THE COMPANY
Harris & Harris Group, Inc. (the "Company," "us," "our" and "we"), is a
venture capital company operating as a business development company ("BDC")
under the Investment Company Act of 1940 ("1940 Act"). We operate as an
internally managed company whereby our officers and employees, under the general
supervision of our Board of Directors, conduct our operations.
We elected to become a BDC on July 26, 1995, after receiving the necessary
approvals. From September 30, 1992, until the election of BDC status, we
operated as a closed-end, non-diversified investment company under the 1940 Act.
Upon commencement of operations as an investment company, we revalued all of our
assets and liabilities at fair value as defined in the 1940 Act. Prior to
September 30, 1992, we were registered and filed under the reporting
requirements of the Securities and Exchange Act of 1934 as an operating company
and, while an operating company, operated directly and through subsidiaries.
Harris & Harris Enterprises, Inc. ("Enterprises"), is a 100 percent wholly
owned subsidiary of the Company. Enterprises is a partner in Harris Partners I,
L.P. and is taxed as a C corporation. Harris Partners I, L.P., is a limited
partnership and owns our interest in AlphaSimplex Group, LLC. The partners of
Harris Partners I, L.P., are Enterprises (sole general partner) and Harris &
Harris Group, Inc. (sole limited partner).
We filed for the 1999 tax year to elect treatment as a Regulated
Investment Company ("RIC") under Subchapter M of the Internal Revenue Code of
1986 (the "Code") and qualified for the same treatment for the years 2000
through 2003. There can be no assurance that we will qualify as a RIC for 2004
or subsequent years. In addition, under certain circumstances, even if we
qualified for Subchapter M treatment for a given year, we might take action in a
subsequent year to ensure that we would be taxed in that subsequent year as a C
Corporation, rather than as a RIC. As a RIC, we must, among other factors,
distribute at least 90 percent of our investment company taxable income and may
either distribute or retain our realized net capital gains on investments.
NOTE 2. INTERIM FINANCIAL STATEMENTS
Our interim financial statements have been prepared in accordance with the
instructions to Form 10-Q and Article 10 of Regulation S-X and in conformity
with generally accepted accounting principles applicable to interim financial
information. Accordingly, they do not include all information and disclosures
necessary for a presentation of our financial position, results of operations
and cash flows in conformity with generally accepted accounting principles in
the United States of America. In the opinion of management, these financial
statements reflect all adjustments, consisting only of normal recurring
accruals, necessary for a fair presentation of our financial position, results
of operations and cash flows for such periods. The results of operations for any
interim period are not necessarily indicative of the results for the full year.
These financial statements should be read in conjunction with the financial
statements and notes thereto contained in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2004.
NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies followed in
the preparation of the consolidated financial statements:
14
Principles of Consolidation. The consolidated financial statements have
been prepared in accordance with accounting principles generally accepted in the
United States of America for investment companies and include the accounts of
the Company and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.
Cash and Cash Equivalents. Cash and cash equivalents include money market
instruments with maturities of less than three months.
Portfolio Investment Valuations. Investments are stated at "value" as
defined in the 1940 Act and in the applicable regulations of the Securities and
Exchange Commission. Value, as defined in Section 2(a)(41) of the 1940 Act, is
(i) the market price for those securities for which a market quotation is
readily available and (ii) the fair value as determined in good faith by, or
under the direction of, the Board of Directors for all other assets. (See
"Valuation Procedures" in the "Footnote to Consolidated Schedule of
Investments.") At March 31, 2005, our financial statements include private
venture capital investments valued at $22,845,742, the fair values of which were
determined in good faith by, or under the direction, of the Board of Directors.
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 by specific
identification for financial reporting and tax reporting.
Income Taxes. Prior to January 1, 1999, we recorded income taxes using the
liability method in accordance with the provisions of Statement of Financial
Accounting Standards No. 109. Accordingly, deferred tax liabilities had been
established to reflect temporary differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases; the most significant such difference relates to our unrealized
appreciation on investments.
The March 31, 2005, consolidated statement of assets and liabilities
includes a liability for deferred taxes on the remaining net Built-In Gains as
of December 31, 1998, net of the unutilized operating and capital loss
carryforwards incurred by us through December 31, 1998.
We pay federal, state and local income taxes on behalf of our wholly owned
subsidiary, Harris & Harris Enterprises, which is a C corporation. (See "Note 6.
Income Taxes.")
Estimates by Management. The preparation of the consolidated financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and contingent assets
and liabilities as of March 31, 2005, and December 31, 2004, and the reported
amounts of revenues and expenses for the three months ended March 31, 2005, and
March 31, 2004. The most significant estimates relate to the fair valuations of
certain of our investments. Actual results could differ from these estimates.
NOTE 4. EMPLOYEE PROFIT SHARING PLAN
As of January 1, 2003, we implemented the Amended and Restated Harris &
Harris Group, Inc. Employee Profit-Sharing Plan, which we refer to as the 2002
Plan.
The 2002 Plan (and its predecessor) provides for profit sharing by our
officers and employees equal to 20 percent of our "qualifying income" for that
plan year (the "Payout Amount"). For the purposes of the 2002 Plan, qualifying
income is defined as net realized income as reflected on our consolidated
statements of operations for that year, less nonqualifying gains, if any.
For purposes of the 2002 Plan, our net realized income includes investment
income, realized gains and losses, and operating expenses (including taxes paid
or payable by us), but is calculated without including dividends paid or
distributions made to shareholders, payments under the Plan, unrealized gains
15
and losses, and loss carry-overs from other years, which we refer to as
qualifying income. The proportion of net after-tax realized gains attributable
to asset values as of September 30, 1997 is considered nonqualifying gain, which
reduces qualifying income. As soon as practicable following the year-end audit,
the Audit Committee will determine whether, and if so how much, qualifying
income exists for a plan year. Once determined, 90 percent of the Payout Amount
will be paid out to Plan participants pursuant to the distribution percentages
set forth in the Plan. The remaining 10 percent will be paid out after we have
filed our federal tax return for that plan year.
On October 15, 2002, our shareholders approved the performance goals under
the 2002 Plan in accordance with Section 162(m) of the Code, effective as of
January 1, 2003. The Code generally provides that a public company such as we
may not deduct compensation paid to its chief executive officer or to any of its
four most highly compensated officers to the extent that the compensation paid
to the officer/employee exceeds $1,000,000 in any tax year, unless payment is
made upon the attainment of objective performance goals that are approved by our
shareholders.
Under the 2002 Plan, awards previously granted to four current
Participants (Messrs. Harris and Melsheimer and Ms. Shavin and Ms. Matthews,
herein referred to as the "grandfathered participants") will be reduced by 10
percent with respect to "Non-Tiny Technology Investments" (as defined in the
2002 Plan) and by 25 percent with respect to "Tiny Technology Investments" (as
defined in the 2002 Plan) and will become permanent. These reduced awards are
herein referred to as "grandfathered participations." The amount by which the
awards are reduced will be allocable and reallocable each year by the
Compensation Committee among current and new participants as awards under the
2002 Plan. The grandfathered participations will be honored by us whether or not
the grandfathered participant is still employed by us or is still alive (in the
event of death, the grandfathered participations will be paid to the
grandfathered participant's estate), unless the grandfathered participant is
dismissed for cause, in which case all awards, including the grandfathered
participations, will be immediately cancelled and forfeited. With regard to new
investments and follow-on investments made after the date on which the first new
employee begins participating in the 2002 Plan, both current and new
participants will be required to be employed by us at the end of a plan year in
order to participate in profit-sharing on our investments with respect to that
year.
Notwithstanding any provisions of the 2002 Plan, in no event may the
aggregate amount of all awards payable for any Plan Year during which we remain
a "business development company" within the meaning of the 1940 Act be greater
than 20 percent of our "net income after taxes" within the meaning of Section
57(n)(1)(B) of the 1940 Act. In the event the awards as calculated exceed that
amount, the awards will be reduced pro rata.
The 2002 Plan may be modified, amended or terminated by the Compensation
Committee at any time. Notwithstanding the foregoing, the grandfathered
participations may not be further modified. Nothing in the 2002 Plan will
preclude the Compensation Committee from naming additional participants in the
2002 Plan or, except for grandfathered participations, changing the Award
Percentage of any Participant (subject to the overall percentage limitations
contained in the 2002 Plan). Currently, under the 2002 Plan, the distribution
amounts for non-grandfathered investments for each officer and employee are:
Charles E. Harris, 7.790 percent; Douglas W. Jamison, 3.75 percent; Daniel V.
Leff, 3.483 percent; Sandra M. Forman, 1.5 percent; Daniel B. Wolfe, 1.5
percent; Helene B. Shavin, 1.524 percent; and Jacqueline M. Matthews, 0.453
percent, which together equal 20 percent. In one case, for a former employee who
left other than due to termination for cause, any amount earned will be accrued
and may subsequently be paid to the participant.
16
The grandfathered participations are set forth below:
Grandfathered Participations
----------------------------
Name of Officer/Employee Non-Tiny Technology (%) Tiny Technology (%)
------------------------ ----------------------- -------------------
Charles E. Harris 12.41100 10.34250
Mel P. Melsheimer 3.80970 3.17475
Helene B. Shavin 1.37160 1.14300
Jacqueline M. Matthews 0.40770 0.33975
TOTAL 18.00000 15.00000
Accordingly, an additional 2 percent of qualifying income with respect to
grandfathered Non-Tiny Technology Investments, 5 percent of qualifying income
with respect to grandfathered Tiny Technology Investments and the full 20
percent of qualifying income with respect to non-grandfathered investments are
available for allocation and reallocation from year to year. Currently, Douglas
W. Jamison, Daniel V. Leff, Sandra M. Forman and Daniel B. Wolfe are allocated
0.7329229 percent, 0.6807388 percent, 0.2931692 percent and 0.2931692 percent,
respectively, of the Non-Tiny Technology Grandfathered Participations and
1.8323072 percent, 1.701847 percent, 0.7329229 percent and 0.7329229 percent,
respectively, of the Tiny Technology Grandfathered Participations.
We perform a calculation to determine the accrual for profit-sharing. We
calculate 20 percent of qualifying income pursuant to the terms of the plan and
estimate the effect on qualifying income of selling all the portfolio
investments that are valued above cost (i.e., are in an unrealized appreciation
position). While the accrual will fluctuate as a result of changes in qualifying
income and changes in unrealized appreciation, payments are only made to the
extent that qualifying income exists. During 2003, we made no accrual for profit
sharing. At December 31, 2004, we had $311,594 accrued for profit sharing. At
March 31, 2005, we have no accrual for profit sharing, and we reversed the
$311,594 that was accrued at December 31, 2004.
NOTE 5. DISTRIBUTABLE EARNINGS
As of December 31, 2004, and March 31, 2005, there are no distributable
earnings. The difference between the book basis and tax basis components of
distributable earnings is primarily attributed to Built-In Gains existing at the
time of our qualification as a RIC (see Note 6. "Income Taxes"), nondeductible
deferred compensation and net operating losses.
NOTE 6. INCOME TAXES
Provided that a proper election is made, a corporation taxable under
Subchapter C of the Internal Revenue Code (a "C Corporation") that elects to
qualify as a RIC continues to be taxable as a C Corporation on any gains
realized within 10 years of its qualification as a RIC (the "Inclusion Period")
from sales of assets that were held by the corporation on the effective date of
the RIC election ("C Corporation Assets"), to the extent of any gain built into
the assets on such date ("Built-In Gain"). (If the corporation fails to make a
proper election, it is taxable on its Built-In Gain as of the effective date of
its RIC election.) We had Built-In Gains at the time of our qualification as a
RIC and made the election to be taxed on any Built-In Gain realized during the
Inclusion Period. Prior to 1999, we incurred ordinary and capital losses from
operations. After our election of RIC status, those losses remained available to
be carried forward to subsequent taxable years. We have previously used loss
carryforwards to offset Built-In Gains. As of January 1, 2005, and March 31,
2005, we had $501,640 of pre-1999 loss carryforwards remaining and $4,663,457 of
unrealized Built-In Gains remaining.
17
Our net deferred tax liability at March 31, 2005, and December 31, 2004,
consists of the following:
March 31, 2005 December 31, 2004
Tax on unrealized Built-In Gains $ 1,540,044 $ 1,540,044
Net operating loss and capital carryforward (175,574) (175,574)
-------------- -----------------
Net deferred income tax liability $ 1,364,470 $ 1,364,470
============== =================
Continued qualification as a RIC requires us to satisfy certain investment
asset diversification requirements in future years. Our ability to satisfy those
requirements may not be controllable by us. There can be no assurance that we
will qualify as a RIC in subsequent years.
To the extent that we retain capital gains and declare a deemed dividend
to shareholders, the dividend is taxable to the shareholders. We would pay tax,
at the corporate rate, on the distribution, and the shareholders would receive a
tax credit equal to their proportionate share of the tax paid. We last took
advantage of this rule for 2001.
We pay federal, state and local taxes on behalf of our wholly owned
subsidiary, Harris & Harris Enterprises, Inc., which is taxed as a C
Corporation. For the three months ended March 31, 2005, and 2004, our income tax
provision was $4,217 and $6,796, respectively.
NOTE 7. ASSET ACCOUNT LINE OF CREDIT
On November 19, 2001, we established an asset account line of credit. Any
borrowings under the asset account line of credit will be secured by government
and government agency securities. Currently, under the asset account line of
credit, we may borrow up to $8,000,000. The asset account line of credit may be
increased to up to 95 percent of the current value of the government and
government agency securities with which we secure the line. Our outstanding
balance under the asset account line of credit at both March 31, 2005, and 2004,
was $0. The asset account line of credit bears interest at the Broker Call Rate
plus 50 basis points.
NOTE 8. SUBSEQUENT EVENTS
On April 14, 2005, we made a $100,000 follow-on investment in a privately
held portfolio company.
On April 27, 2005, we sold our investment in Nanotechnologies, Inc., to
Nanotechnologies, Inc., for $1 (one dollar).
NOTE 9. OTHER
At March 31, 2004 we had a total of $255,486 of funds in escrow as a
result of the merger of NanoGram Devices Corporation and a wholly owned
subsidiary of Wilson Greatbatch Technologies, Inc. The funds were held for one
year, until March 16, 2005, in an interest-bearing escrow account to secure the
indemnification obligations of the former stockholders of NanoGram Devices
Corporation. During the quarter ended March 31, 2004, we set up, by a charge to
realized income from investments, a reserve of 100 percent of the $255,486. Upon
receipt of the funds, on March 16, 2005, we released the reserve and realized
the income.
18
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The information contained in this section should be read in conjunction
with our March 31, 2005, Consolidated Financial Statements, and our December 31,
2004, Consolidated Financial Statements, and notes thereto.
Background and Overview
We incorporated under the laws of the state of New York in August 1981. In
1983, we completed an initial public offering and invested $406,936 in Otisville
BioTech, Inc., which also completed an initial public offering later that year.
In 1984, Charles E. Harris purchased a controlling interest in us, thereby also
becoming the control person in Otisville. We then divested our other assets and
became a financial services company, with the investment in Otisville as the
initial focus of our business activity. We hired new management for Otisville,
and Otisville acquired new technology targeting the development of a human blood
substitute.
By 1988, we operated two insurance brokerages and a trust company as
wholly-owned subsidiaries. In 1989, Otisville changed its name to Alliance
Pharmaceutical Corporation, and by 1990, we had completed selling our $406,936
investment in Alliance for total proceeds of $3,923,559.
In 1992, we sold our insurance brokerage and trust company subsidiaries to
their respective managements and registered as an investment company under the
1940 Act, commencing operations as a closed-end, non-diversified investment
company. In 1995, we elected to become a business development company subject to
the provisions of Sections 55 through 65 of the 1940 Act. Throughout our
corporate history, we have made early stage venture capital investments in a
variety of industries. We define venture capital investments as investments in
start-up firms and small businesses with exceptional growth potential. In 1994,
we made our first tiny technology investment. Since August 2001, we have made
initial investments exclusively in tiny technology, including our last 22
initial investments.
Since our investment in Otisville in 1983, we have made a total of 64
venture capital investments, including four investments, via private placements,
in securities of publicly traded companies. We have sold 39 of these 64
investments, realizing total proceeds of $108,180,940 on our invested capital of
$41,470,859. Seventeen of these 39 investments were profitable. As measured from
first dollar in to last dollar out, the average and median holding periods for
these 39 investments were 3.5 years and 3.2 years, respectively. As measured by
tranches of cash invested to tranches of cash received, the average and median
holding periods for the 128 separate investment tranches were 2.7 years and 2.4
years, respectively. At March 31, 2005, we valued the 25 venture capital
investments remaining in our portfolio at $33,709,535, or 46.5 percent of our
net assets, net of unrealized depreciation of $1,184,084. At March 31, 2005,
from first dollar in, the average and median holding periods for our 25 current
venture capital investments are 2.9 years and 2.0 years, respectively.
We have invested a substantial portion of our assets in venture capital
investments of private, development stage or start-up companies. These private
businesses tend to be thinly capitalized, unproven, small companies that lack
management depth, have little or no history of operations and are developing
unproven technologies. At March 31, 2005, $22,845,742, or 31.5 percent, of our
net assets, consisted of private venture capital investments at fair value, net
of unrealized depreciation of $7,636,504. At December 31, 2004, $18,508,138, or
24.8 percent, of our net assets, consisted of private venture capital
investments at fair value, net of unrealized depreciation of $9,577,094.
19
At March 31, 2005, $10,863,793, or 15.0 percent of our net assets,
consisted of common shares of NeuroMetrix, Inc., a publicly-traded venture
capital investment, valued at market value, of which unrealized appreciation was
$6,452,420. Prior to March 31, 2005, the fair value for NeuroMetrix, Inc. was
determined in good faith by our Valuation Committee within guidelines
established by our Board of Directors.
We value our private venture capital investments each quarter at fair
value as determined in good faith by our Valuation Committee within guidelines
established by our Board of Directors in accordance with the 1940 Act. (See
"Footnote to Consolidated Schedule of Investments" contained in "Consolidated
Financial Statements.")
We have broad discretion in the investment of our capital. However, we
invest primarily in illiquid equity securities of private companies. Generally,
these investments take the form of preferred stock, are subject to restrictions
on resale and have no established trading market. Our principal objective is to
achieve long-term capital appreciation. Therefore, a significant portion of our
investment portfolio provides little or no income in the form of dividends or
interest. We do earn interest income from fixed-income securities, including
U.S. government and government agency securities. The amount of interest income
we earn varies with the average balance of our fixed-income portfolio and the
average yield on this portfolio and is not expected to be material to our
results of operations.
We present the financial results of our operations utilizing accounting
principles generally accepted in the United States for investment companies. On
this basis, the principal measure of our financial performance during any period
is the net increase/(decrease) in our net assets resulting from our operating
activities, which is the sum of the following three elements:
Net Operating Income / (Loss) - the difference between our income from
interest, dividends, and fees and our operating expenses.
Net Realized Income / (Loss) on Investments - the difference between the
net proceeds of sales of portfolio securities and their stated cost, and income
from interests in limited liability companies.
Net Increase / (Decrease) in Unrealized Appreciation on Investments - the
net change in the fair value of our investment portfolio.
Because of the structure and objectives of our business, we generally
expect to experience net operating losses and seek to generate increases in our
net assets from operations through the long term appreciation of our venture
capital investments. We have in the past relied, and continue to rely, on
proceeds from sales of investments, rather than on investment income, to defray
a significant portion of our operating expenses. Because such sales are
unpredictable, we attempt to maintain adequate working capital to provide for
fiscal periods when there are no such sales.
20
Results of Operations
Three months ended March 31, 2005, as compared to the three months ended March
31, 2004
We had a net decrease in net assets resulting from operations of
$2,233,447 in the three months ended March 31, 2005, as compared with a net
increase in net assets resulting from operations of $820,515 in the three months
ended March 31, 2004.
Investment Income and Expenses:
We had net operating losses of $745,590 and $749,865 for the three months
ended March 31, 2005, and March 31, 2004, respectively.
Operating expenses were $1,005,698 and $806,401 for the three months ended
March 31, 2005, and March 31, 2004, respectively. During the three months ended
March 31, 2005, as compared with the three months ended March 31, 2004,
professional fees increased by $193,404, or 244.6 percent, primarily as a result
of the ongoing expense of the implementation of the Sarbanes-Oxley Act of 2002.
The increase in administration and operations of $162,662, or 102.1 percent, is
primarily associated with the increase in the number of employees from six at
March 31, 2004, to 10 at March 31, 2005, and an increase in directors and
officers liability insurance expense. These increases were offset by a
profit-sharing reversal of $311,594 during the three months ended March 31,
2005, versus no profit-sharing provision during the three months ended March 31,
2004.
Realized Income and Losses from Investments:
During the three months ended March 31, 2005, we realized net losses of
$1,036,044, and during the three months ended March 31, 2004, we realized gains
of $793,389.
During the three months ended March 31, 2005, we realized net losses of
$1,036,044, consisting primarily of a realized loss of $1,358,286 from the sale
of our investment in Agile Materials & Technologies, Inc., offset by a realized
gain of $255,486 resulting from the receipt of funds that were held in escrow
for one year from the March 2004 merger of NanoGram Devices Corporation and a
wholly owned subsidiary of Wilson Greatbatch Technologies, Inc. In March 2004,
we set up a reserve of $255,486, by a charge to realized income from
investments. On March 16, 2005, the funds were released to us, and we released
the reserve and recorded the realized income.
Unrealized Appreciation and Depreciation of Portfolio Securities:
Net unrealized depreciation on investments increased by $447,596, or 37.4
percent, during the three months ended March 31, 2005, from $1,197,428 at
December 31, 2004, to $1,645,024 at March 31, 2005.
During the three months ended March 31, 2005, net unrealized depreciation
on our venture capital investments increased by $309,439, from $874,645 to
$1,184,084 primarily owing to a decrease in the valuation of our investment in
NeuroMetrix, Inc., of $2,250,029, offset by an increase in the valuation of our
investment in Nantero, Inc., of $813,771. In addition, unrealized depreciation
decreased by $1,364,081 as a result of the loss realized on the sale of Agile
Materials & Technologies, Inc.
21
Financial Condition
Three Months ended March 31, 2005
Our total assets and net assets were $76,772,881 and $72,511,352,
respectively, at March 31, 2005, compared with $79,361,451 and $74,744,799 at
December 31, 2004.
Net asset value per share ("NAV") was $4.20 at March 31, 2005, versus
$4.33 at December 31, 2004. Our shares outstanding remained unchanged during the
three months ended March 31, 2005.
Significant developments in the three months ended March 31, 2005, were an
increase in the value of our venture capital investments of $2,087,575 and a
decrease in the value of our investment in U.S. government and agency
obligations of $4,431,534. The increase in the value of our venture capital
investments, from $31,621,960 at December 31, 2004, to $33,709,535 at March 31,
2005, resulted primarily from one new and five follow-on investments, partially
offset by a net decrease in the net value of our previous venture capital
investments. The decrease in the value of our U.S. government and agency
obligations, from $44,622,722 at December 31, 2004, to $40,191,188 at March 31,
2005, is primarily owing to the use of funds for investments and working
capital.
The following table is a summary of additions to our portfolio of venture
capital investments during the three months ended March 31, 2005:
New Investment Amount
-------------- -------------
Zia Laser, Inc. $ 1,500,000
Follow-on Investment
--------------------
Cambrios, Inc. $ 511,006
Nanomix, Inc. $ 250,000
NanoOpto Corporation $ 411,741
Nantero, Inc. $ 571,329
Starfire Systems, Inc. $ 500,000
-----------
Total $ 3,744,076
===========
22
The following tables summarize the values of our portfolios of venture
capital investments and U.S. government and agency obligations, as compared with
their cost, at March 31, 2005, December 31, 2004, and December 31, 2003:
March 31, December 31,
2005 2004 2003
------------- -------------------------------------------
Venture capital investments,
at cost $34,893,619 $32,496,605 $17,481,879
Unrealized depreciation(1) 1,184,084 874,645 2,375,303
----------- ----------- -----------
Venture capital investments,
at fair value $33,709,535 $31,621,960 $15,106,576
=========== =========== ===========
March 31, December 31,
2005 2004 2003
------------- -------------------------------------------
U.S. government and agency
obligations, at cost $40,652,128 $44,945,505 $27,121,899
Unrealized depreciation(1) 460,940 322,783 1,413
----------- ----------- -----------
U.S. government and agency
obligations, at fair value $40,191,188 $44,622,722 $27,120,486
=========== =========== ===========
(1)At March 31, 2005, December 31, 2004, and December 31, 2003, the accumulated
unrealized depreciation on investments, including deferred taxes, was
$3,185,069, $2,737,473 and $3,221,635, respectively.
The following table summarizes the value composition of our venture
capital investment portfolio at March 31, 2005, December 31, 2004, and December
31, 2003. NeuroMetrix, Inc., accounted for 97.1 percent, 97.6 percent and 85.6
percent of the "Other Venture Capital Investments," at March 31, 2005, December
31, 2004, and December 31, 2003, respectively.
March 31, December 31,
Category 2005 2004 2003
------------ --------------------- ----------------
Tiny Technology 66.8% 57.5% 60.7%
Other Venture Capital Investments 33.2% 42.5% 39.3%
------ ------ ------
Total Venture Capital Investments 100.0% 100.0% 100.0%
====== ====== ======
The following table summarizes the fair value composition of our
venture capital investment portfolio that was still privately held at March 31,
2005, December 31, 2004, and December 31, 2003. NeuroMetrix, Inc., became a
publicly held company in July 2004.
March 31, December 31,
Category 2005 2004 2003
------------ --------------------- ----------------
Tiny Technology 98.6% 98.2% 60.7%
Other Privately Held Venture
Capital Investments 1.4% 1.8% 39.3%
-------- ------ -----
Total Private Venture
Capital Investments 100.0% 100.0% 100.0%
====== ====== ======
23
Liquidity
Our primary sources of liquidity are cash and government and government
agency securities, receivables and freely marketable non-government securities,
net of short-term indebtedness. Our secondary sources of liquidity are
restricted securities of companies that are publicly traded. At March 31, 2005,
NeuroMetrix, Inc., is our only publicly traded, freely marketable non-government
security. NeuroMetrix became a publicly traded company in July 2004, and our
common shares of NeuroMetrix were contractually restricted until January 18,
2005.
Three Months ended March 31, 2005
At March 31, 2005, and December 31, 2004, our total net primary liquidity
was $51,650,933 and $45,353,691, respectively, and our secondary liquidity was
$0 and $13,133,822, respectively.
The increase in our primary liquidity and decrease in our secondary
liquidity from December 31, 2004, to March 31, 2005, is primarily owing to the
reclassification of our common shares of NeuroMetrix, Inc. from secondary
liquidity to primary liquidity, as they are no longer restricted at March 31,
2005. The decrease in our total liquidity is primarily owing to the investments
made in venture capital portfolio companies, a decrease in the value of our
investment in NeuroMetrix, Inc., and the use of funds for net operating
expenses. NeuroMetrix's common stock is thinly traded, which could negatively
impact our liquidity.
Capital Resources
In 2004, we registered with the Securities and Exchange Commission for the
sale of up to 7,000,000 shares of our common stock from time to time. On July 7,
2004, we sold 3,450,000 common shares for net proceeds of $36,501,000; net
proceeds of the offering, less offering costs of $372,825, were $36,128,175. We
intend to use, and have been using, the net proceeds of the offering, less
offering costs, to make new investments in tiny technology as well as follow-on
investments in our existing venture capital investments, and for working
capital. Through March 31, 2005, we have used $8,860,125 for these purposes. An
additional 3,550,000 shares of our common stock may be sold at prices and on
terms to be set forth in one or more supplements to the prospectus from time to
time.
Critical Accounting Policies
Critical accounting policies are those that are both important to the
presentation of our financial condition and results of operations and require
management's most difficult, complex or subjective judgments. Our critical
accounting policies are those applicable to the valuation of investments.
Valuation of Portfolio Investments
As a business development company, we invest primarily in illiquid
securities, including debt and equity securities of private companies. The
investments are generally subject to restrictions on resale and generally have
no established trading market. We value all of our private equity investments at
fair value as determined in good faith by our Valuation Committee. The Valuation
Committee, comprised of three or more independent Board members, reviews and
approves the valuation of our investments within the guidelines established by
the Board of Directors. Fair value is generally defined as the amount for which
an investment could be sold in an orderly disposition over a reasonable time.
Generally, to increase objectivity in valuing our assets, external measures of
value, such as public markets or third party transactions, are utilized whenever
possible. Valuation is not based on long-term work-out value, nor immediate
liquidation value, nor incremental value for potential changes that may take
place in the future.
24
Recent Developments
On April 14, 2005, we made a $100,000 follow-on investment in a privately
held portfolio company.
On April 27, 2005, we sold our investment in Nanotechnologies, Inc., to
Nanotechnologies, Inc., for $1 (one dollar).
RISK FACTORS
Investing in our common stock involves a number of significant risks
relating to our business and investment objective. You should carefully consider
the risks and uncertainties described below before you purchase any of our
common stock. These risks and uncertainties are not the only ones we face.
Unknown additional risks and uncertainties, or ones that we currently consider
immaterial, may also impair our business. If any of these risks or uncertainties
materialize, our business, financial condition or results of operations could be
materially adversely affected. In this event, the trading price of our common
stock could decline, and you could lose all or part of your investment.
Risks related to the companies in our portfolio.
Investing in small, private companies involves a high degree of risk and is
highly speculative.
We have invested a substantial portion of our assets in venture capital
investments in privately held development stage or start-up companies. These
businesses tend to lack management depth, to have limited or no history of
operations and to have not attained profitability. Tiny technology companies are
especially risky, involving scientific, technological and commercialization
risks. Because of the speculative nature of these investments, these securities
have a significantly greater risk of loss than traditional investment
securities. Some of our venture capital investments will be complete losses or
unprofitable, and some will never realize their potential. We have been and will
continue to be risk seeking rather than risk averse in our approach to venture
capital and other investments. Neither our investments nor an investment in our
common stock is intended to constitute a balanced investment program. Losses on
our investments could have a significant adverse effect on the value of our
common stock.
Our portfolio companies working with tiny technology may be particularly
susceptible to intellectual property litigation.
Research and commercialization efforts in tiny technology are being
undertaken by a wide variety of government, academic and private corporate
entities. As additional commercially viable applications of tiny technology
begin to emerge, ownership of intellectual property on which these products are
based may be contested. Any litigation over the ownership of, or rights to, any
of our portfolio companies' technologies or products would have a material
adverse affect on those companies' values and may have a significant adverse
effect on the value of our common stock.
Our portfolio companies may not successfully develop their products.
The technology of our portfolio companies is new and unproven. Their
potential products require significant and lengthy product development efforts.
To date, many of our portfolio companies have not developed any commercially
available products. During the product development process, our portfolio
companies may experience technological issues that they may be unable to
overcome. Because of these uncertainties, none of the potential products of our
portfolio companies may be successfully developed. If our portfolio companies
are not able to develop successful nanotechnology-enabled products, they will be
unable to generate product revenue or build a sustainable or profitable
business. The difficulties of commercialization could have a significant adverse
effect on the value of our common stock.
25
Many of our portfolio companies are dependent on collaborations.
To develop products for certain target markets, many of our portfolio
companies depend on entering into collaborations to offset cash used in
operating activities and leverage their partners' financial, research and
development, manufacturing, marketing and sales capabilities. These portfolio
companies may not be able to enter into new collaborations for their target
markets, which would limit their access to important financial, research and
development, marketing and sales resources. One partner may also react
negatively to the non-extension of the collaboration with another partner. Our
portfolio companies will need to convince their current and future partners of
the feasibility and benefits of using their tiny technology-enabled products as
part of their end user products, which may be time consuming. If our portfolio
companies are unable to persuade their partners to use their tiny
technology-enabled products, they may not be able to commercialize their
products or to generate revenues from product sales. To use our portfolio
companies' tiny technology-enabled products, their partners will be required to
integrate these products into their final products, and they may not do so
successfully. These conditions could lead to losses in our portfolio and have a
significant adverse effect on the value of our common stock.
Our portfolio companies may not currently have the ability to manufacture
nanotechnology-enabled products in volume and will not be able to sell products
without developing volume manufacturing capabilities.
The manufacture of our portfolio companies' potential
nanotechnology-enabled products is unproven and will require long lead times to
establish adequate facilities. Some of the potential products may require our
portfolio companies to manufacture large volumes of materials that are
substantially larger than their current capabilities in order to meet commercial
demand. Our portfolio companies may not be able to develop commercial scale
manufacturing capabilities or produce products cost effectively. If our
portfolio companies are able to manufacture economically or obtain their
products in commercial quantities that meet acceptable performance and quality
specifications, it could lead to financial losses in our portfolio and have a
significant adverse effect on the value of our common stock.
Our portfolio companies may not successfully market their products.
Even if our portfolio companies are able to develop commercially viable
products, the market for new products and services is highly competitive,
rapidly changing and especially sensitive to adverse general economic
conditions. Commercial success is difficult to predict, and the marketing
efforts of our portfolio companies may not be successful. Lack of marketing
success by our portfolio companies could have a significant adverse effect on
the value of our common stock.
We may invest in companies working with technologies or intellectual property
that currently have few or no proven commercial applications.
Nanotechnology, in particular, is a developing area of technology, of
which much of the future commercial value is unknown, difficult to estimate and
subject to widely varying interpretations. There are as of yet relatively few
nanotechnology products commercially available. The timing of additional future
commercially available nanotechnology products is highly uncertain. Long delays,
or failure, in commercialization of nanotechnology in our portfolio companies or
in general, could have a significant adverse effect on the value of our common
stock.
26
Our portfolio companies will need to achieve commercial acceptance of their
products to obtain product revenue and achieve profitability.
Even if the products of our portfolio companies are technologically
feasible, these early-stage companies may not successfully develop commercially
viable products on a timely basis, if at all. It could be at least several years
before many of our portfolio companies develop first products that are
commercially available and, during this period, superior competitive
technologies may be introduced or customer needs may change resulting in some
products being unsuitable for commercialization. The revenue growth and
achievement of profitability by our portfolio companies will depend
substantially on their ability to introduce new products into the marketplace
that are widely accepted by customers. If they are unable, cost effectively, to
achieve commercial acceptance of their products, the value of our portfolio
could be significantly, adversely affected, which could have a significant
adverse effect on the value of our common stock.
Some of our portfolio companies plan concurrently to develop a number of
products, and any one or all of these products may fail to achieve commercial
acceptance.
Some of our portfolio companies plan concurrently to develop a number of
potential products utilizing their technology and know how. We expect that some
or all of these potential products will not be technologically feasible or will
not achieve commercial acceptance, and we cannot predict which, if any, of these
products will be successfully developed or commercialized. Failure of products
of companies in our portfolio could have a significant adverse effect on the
value of our common stock.
Even if our portfolio companies develop commercially acceptable products, they
may not be able to manufacture their products in a cost effective manner or
achieve profitability.
Even if the technology and products of our portfolio companies gain
commercial acceptance, they may not be able to manufacture their products at a
cost that enables them to become and remain profitable. Even if our portfolio
companies are able to manufacture their products on a commercial scale, the cost
of manufacturing their products may be higher than they expect. If the costs
associated with that manufacturing, together with their royalty obligations, are
not significantly less than the prices at which they can sell their products, we
could experience financial losses in our portfolio, which could have a
significant adverse effect on the value of our common stock.
Unfavorable economic conditions could result in the inability of our portfolio
companies to access additional capital, leading to financial losses in our
portfolio.
Most of the companies in which we have made or will make investments are
susceptible to economic slowdowns or recessions. An economic slowdown or adverse
capital or credit market conditions may affect the ability of companies in our
portfolio to raise additional capital from venture capital or other sources or
to engage in a liquidity event such as an initial public offering or merger.
Adverse economic, capital or credit market conditions may lead to financial
losses in our portfolio, which could have a significant adverse effect on the
value of our common stock.
The value of our portfolio and the value of our common stock could be adversely
affected if the technologies utilized by our portfolio companies are found to
cause health or environmental risks.
Our portfolio companies work with new technologies that could have
potential environmental and health impacts. Tiny technology in general and
nanotechnology in particular are currently the subject of health and
environmental impact research. If health or environmental concerns about tiny
technology or nanotechnology were to arise, our portfolio companies might incur
additional research, legal and regulatory expenses, might have difficulty
27
raising capital or could be forced out of business. Such adverse health and
environmental effects would have an adverse effect on the value of our portfolio
and could have a significant adverse effect on the value of our common stock.
Public perception of ethical and social issues may limit or discourage the use
of nanotechnology-enabled products, which could reduce our portfolio companies'
revenues and harm our business.
The subject of nanotechnology has received negative as well as positive
publicity and has aroused public debate. Government authorities could, for
social or other purposes, prohibit or regulate the use of nanotechnology.
Ethical, emotional, rational and irrational and other concerns about
nanotechnology could adversely affect acceptance of the potential products of
our portfolio companies or lead to government regulation of
nanotechnology-enabled products, any of which could have a significant adverse
effect on the value of our common stock.
Risks related to the illiquidity of our investments.
We invest in illiquid securities and may not be able to dispose of them when it
is advantageous to do so, or ever.
Most of our investments are or will be equity or equity-linked securities
acquired directly from small companies. These equity securities are generally
subject to restrictions on resale or otherwise have no established trading
market. The illiquidity of most of our portfolio of equity securities may
adversely affect our ability to dispose of these securities at times when it may
be advantageous for us to liquidate these investments. We may never be able to
dispose of these securities. Illiquidity of our investments could impair our own
liquidity and could have a significant adverse effect on the value of our common
stock.
Unfavorable economic conditions and government reforms could impair our ability
to engage in liquidity events.
Our business of making venture capital investments and positioning our
portfolio companies for liquidity events may be adversely affected by current
and future capital markets and economic conditions. The public equity markets
currently provide less opportunity for liquidity events than at times in the
past when there was more robust demand for initial public offerings, even for
more mature technology companies than those in which we typically invest. The
potential for public market liquidity could further decrease and could lead to
an inability to realize potential gains or could lead to financial losses in our
portfolio and a decrease in our revenues, net income and assets. Recent
government reforms affecting publicly traded companies, stock markets,
investment banks and securities research practices may have made it more
difficult for privately held companies to complete successful initial public
offerings of their equity securities, and such reforms have increased the
expense and legal exposure of being publicly traded. Slowdowns in initial public
offerings may also have an adverse effect on the frequency and valuations of
acquisitions of privately held companies. The lack of opportunities to sell
investments in privately held companies also has an adverse effect on the
ability of these companies to raise capital from private sources. At this time,
it is not known how the public equity markets will respond to
nanotechnology-associated company offerings. Inability to engage in liquidity
events could negatively effect our liquidity, our reinvestment in new and
follow-on investments and could have a significant adverse effect on the value
of our common stock.
28
Even if our portfolio companies complete initial public offerings, the returns
on our investments may be uncertain.
When companies in which we have invested as private entities complete
initial public offerings of their securities, these newly issued securities are
by definition unseasoned issues. Unseasoned issues tend to be highly volatile
and have uncertain liquidity, which may negatively affect their price. In
addition, we are typically subject to lock-up provisions which prohibit us from
selling our investment into the public market for specified periods of time
after initial public offerings. The market price of securities that we hold may
decline substantially before we are able to sell these securities. Most initial
public offerings of technology companies are listed on the Nasdaq National
Market. Recent government reforms of the Nasdaq National Market have made market
making by broker-dealers less profitable, which has caused broker-dealers to
reduce their market-making activities, thereby making the market for unseasoned
stocks less liquid. Declines in value of companies in our portfolio after their
initial public offerings could have a significant adverse effect on the value of
our common stock.
Risks related to our company.
Because there is generally no established market in which to value our
investments, our Valuation Committee's value determinations may differ
materially from the values that a ready market or third party would attribute to
these investments.
There is generally no public market for the equity securities in which we
invest. Pursuant to the requirements of the 1940 Act, we value all of the
private equity securities in our portfolio at fair value as determined in good
faith by the Valuation Committee of our Board of Directors pursuant to Valuation
Procedures established by the Board of Directors. As a result, determining fair
value requires that judgment be applied to the specific facts and circumstances
of each portfolio investment pursuant to specified valuation principles and
processes. We are required by the 1940 Act to value specifically each individual
investment on a quarterly basis and record unrealized depreciation for an
investment that we believe has become impaired. Conversely, we must record
unrealized appreciation if we believe that the underlying portfolio company has
appreciated in value. Without a readily ascertainable market value and because
of the inherent uncertainty of valuation, the fair value that we assign to our
investments may differ from the values that would have been used had a ready
market existed for the investments, and the difference could be material. Any
changes in fair value are recorded in our consolidated statements of operations
as a change in the "Net (decrease) increase in unrealized appreciation on
investments."
In the venture capital industry, even when a portfolio of early stage,
high-technology venture capital investments proves to be profitable over the
portfolio's lifetime, it is common for the portfolio's fair value to undergo a
so-called "J-curve" valuation pattern. This not-atypical J-curve valuation
pattern results from write-downs and write-offs of portfolio investments that
reveal themselves as unsuccessful or that appear to be unsuccessful before the
write-downs and write-offs are offset by the portfolio investments, if any, that
prove to be successful. Even if our venture capital investments prove to be
profitable overall in the long run, such J-curve valuation patterns could have a
significant adverse effect on the value of our common stock in the interim.
29
Because we are a non-diversified company with a relatively concentrated
portfolio, the value of our business is subject to greater volatility than the
value of companies with more broadly diversified investments.
As a result of being able to invest all of our assets in the securities of
a small number of issuers, we are classified as a non-diversified company. We
may be more vulnerable to events affecting a single issuer or industry and
therefore subject to greater volatility than a company whose investments are
more broadly diversified. Accordingly, an investment in our common stock may
present greater risk to you than an investment in a more diversified company.
We may be obligated to pay substantial amounts under our profit sharing plan.
Our employee profit-sharing plan requires us to distribute to our officers
and employees 20 percent of any net after-tax realized income as reflected on
our consolidated statements of operations for that year, less any non-qualifying
gain. These distributions may have a significant effect on the amount of direct
distributions in the form of cash dividends, or indirect distributions in the
form of tax credits, if any, made to our shareholders.
Approximately 32 percent of the net asset value attributable to our venture
capital investment portfolio, or 15 percent of our net asset value, as of March
31, 2005, is concentrated in one company, NeuroMetrix, Inc., which is not a tiny
technology company.
At March 31, 2005, we valued our investment in NeuroMetrix, Inc., which
had an historical cost to us of $4,411,373 and is not a tiny technology company,
at $10,863,793, or 32.2 percent of the net asset value attributable to our
venture capital investment portfolio, or 15.0 percent of our net asset value.
NeuroMetrix is publicly traded on the Nasdaq National Market and is thinly
traded. Any downturn in the business outlook of NeuroMetrix or any failure of
the products of NeuroMetrix to receive widespread acceptance in the marketplace
would have a significant effect on our specific investment in NeuroMetrix and on
the overall value of our portfolio, and could have a significant adverse effect
on the value of our common stock.
Approximately 33 percent of the net asset value attributable to our venture
capital investment portfolio, or 15 percent of our net asset value, as of March
31, 2005, is not invested in tiny technology.
All 22 of our investments added since August 2001 have been in tiny
technology companies, and we consider 20 of the companies in our current venture
capital investment portfolio to be tiny technology companies. Nevertheless, at
March 31, 2005, only 66.8 percent of the net asset value attributable to our
venture capital investment portfolio, or 31.1 percent of our net asset value,
was invested in tiny technology companies, which may limit our ability to
achieve our investment objective.
We are dependent upon key management personnel for future success.
We are dependent for the selection, structuring, closing and monitoring of
our investments on the diligence and skill of our senior management and other
key advisers. We utilize lawyers and outside consultants, including two of our
directors, Kelly S. Kirkpatrick, Ph.D., and especially Lori D. Pressman, to
assist us in conducting due diligence when evaluating potential investments.
There is generally no publicly available information about the companies in
which we invest, and we rely significantly on the diligence of our employees and
advisers to obtain information in connection with our investment decisions. Our
future success to a significant extent depends on the continued service and
coordination of our senior management team, and particularly depends on our
Chairman and Chief Executive Officer, Charles E. Harris. The departure of any of
30
our executive officers, key employees or advisers could materially adversely
affect our ability to implement our business strategy. We do not maintain for
our benefit any key man life insurance on any of our officers or employees. On
January 1, 2005, Douglas W. Jamison assumed the roles of President, Chief
Operating Officer and Chief Financial Officer.
We will need to hire additional employees, especially as the size of our
portfolio increases.
We anticipate that it will be necessary for us to add investment
professionals with expertise in venture capital and/or tiny technology and
administrative and support staff to accommodate the increasing size of our
portfolio. We are currently actively seeking to hire a senior controller. We may
need to provide additional scientific, business, accounting, legal or investment
training for our new hires. There is competition for highly qualified personnel,
and we may not be successful in our efforts to recruit and retain highly
qualified personnel.
The market for venture capital investments, including tiny technology
investments, is highly competitive.
We face substantial competition in our investing activities from many
competitors, including but not limited to: private venture capital funds;
investment affiliates of large industrial, technology, service and financial
companies; small business investment companies; wealthy individuals; and foreign
investors. Our most significant competitors typically have significantly greater
financial resources than we do. Greater financial resources are particularly
advantageous in securing lead investor roles in venture capital syndicates. Lead
investors negotiate the terms and conditions of a round of financing. Many
sources of funding compete for a small number of attractive investment
opportunities. Hence, we face substantial competition in sourcing good
investment opportunities on terms of investment that are commercially
attractive.
In addition to the difficulty of finding attractive investment opportunities,
our status as a regulated business development company may hinder our ability to
participate in investment opportunities or to protect the value of existing
investments.
We are required to disclose on a quarterly basis the names and business
descriptions of our portfolio companies and the value of any portfolio
securities. Most of our competitors are not subject to these disclosure
requirements. Our obligation to disclose this information could hinder our
ability to invest in some portfolio companies. Additionally, other current and
future regulations may make us less attractive as a potential investor than a
competitor not subject to the same regulations.
Our failure to make follow-on investments in our portfolio companies could
impair the value of our portfolio.
Following an initial investment in a portfolio company, we may make
additional investments in that portfolio company as "follow-on" investments, in
order to: (1) increase or maintain in whole or in part our ownership percentage;
(2) exercise warrants, options or convertible securities that were acquired in
the original or subsequent financing; or (3) attempt to preserve or enhance the
value of our investment. "Pay to play" provisions have become common in venture
capital transactions. These provisions require proportionate investment in
subsequent rounds of financing in order to preserve preferred rights such as
anti-dilution protection or to prevent preferred shares from being converted to
common shares. Conversion of preferred shares in our portfolio to common shares
could have a significant adverse effect on the value of our portfolio and of our
common stock.
31
We may elect not to make follow-on investments or otherwise lack
sufficient funds to make those investments. We have the discretion to make any
follow-on investments, subject to the availability of capital resources. The
failure to make follow-on investments may, in some circumstances, jeopardize the
continued viability of a portfolio company and our initial investment, or may
result in a missed opportunity for us to increase our participation in a
successful operation, or may cause us to lose some or all preferred rights
pursuant to "pay to play" provisions. Even if we have sufficient capital to make
a desired follow-on investment, we may elect not to make a follow-on investment
because we may not want to increase our concentration of risk, because we prefer
other opportunities or because we are inhibited by compliance with business
development company requirements or the desire to maintain our tax status.
Bank borrowing or the issuance of debt securities or preferred stock by us to
fund investments in portfolio companies or to fund our operating expenses would
make our total return to common shareholders more volatile.
Use of debt or preferred stock as a source of capital entails two primary
risks. The first risk is that the use of debt leverages our available common
equity capital, magnifying the impact on net asset value of changes in the value
of our investment portfolio. For example, a business development company that
uses 33 percent leverage (that is, $50 of leverage per $100 of common equity)
will show a 1.5 percent increase or decline in net asset value for each 1
percent increase or decline in the value of its total assets. The second risk is
that the cost of debt or preferred stock financing may exceed the return on the
assets the proceeds are used to acquire, thereby diminishing rather than
enhancing the return to common shareholders. To the extent that we utilize debt
or preferred stock financing for any purpose, these two risks would likely make
our total return to common shareholders more volatile. In addition, we might be
required to sell investments, in order to meet dividend, interest or principal
payments, when it may be disadvantageous for us to do so.
As provided in the 1940 Act and subject to some exceptions, we can issue
debt or preferred stock so long as our total assets immediately after the
issuance, less some ordinary course liabilities, exceed 200 percent of the sum
of the debt and any preferred stock outstanding. The debt or preferred stock may
be convertible in accordance with SEC guidelines, which may permit us to obtain
leverage at more attractive rates. The requirement under the 1940 Act to pay, in
full, dividends on preferred shares or interest on debt before any dividends may
be paid on our common stock means that dividends on our common stock from
earnings may be reduced or eliminated. An inability to pay dividends on our
common stock could conceivably result in our ceasing to qualify as a regulated
investment company, or RIC, under the tax Code, which would in most
circumstances be materially adverse to the holders of our common shares. Loss of
RIC status could have a significant adverse effect on the value of our common
stock.
We are authorized to issue preferred stock, which would convey special rights
and privileges to its owners.
We are currently authorized to issue up to 2,000,000 shares of preferred
stock, under terms and conditions determined by our Board of Directors. These
shares would have a preference over our common stock with respect to dividends
and liquidation. The statutory class voting rights of any preferred shares we
would issue could make it more difficult for us to take some actions that may,
in the future, be proposed by the Board and/or holders of common stock, such as
a merger, exchange of securities, liquidation or alteration of the rights of a
class of our securities if these actions were perceived by the holders of the
preferred shares as not in their best interests. The issuance of preferred
shares convertible into shares of common stock might also reduce the net income
and net asset value per share of our common stock upon conversion. These
effects, among others, could have an adverse effect on your investment in our
common stock.
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Loss of status as a RIC would reduce our net asset value and distributable
income.
We currently qualify as a RIC for 2003 under the tax Code. As a RIC, we do
not have to pay federal income taxes on our income (including realized gains)
that is distributed to our shareholders. Accordingly, we are not permitted under
accounting rules to establish reserves for taxes on our unrealized capital
gains. If we failed to qualify for RIC status in 2004 or beyond, to the extent
that we had unrealized gains, we would have to establish reserves for taxes,
which would reduce our net asset value, net of a reduction in the reserve for
employee profit sharing, accordingly. To the extent that we, as a RIC, were to
decide to make a deemed distribution of net realized capital gains and retain
the net realized capital gains, we would have to establish appropriate reserves
for taxes upon making that decision. Loss of RIC status or establishing reserves
for taxes could have a material adverse effect on the value of our common stock.
We operate in a regulated environment.
We are subject to substantive SEC regulations as a business development
company. Securities and tax laws and regulations governing our activities may
change in ways adverse to our and our shareholders' interests, and
interpretations of these laws and regulations may change with unpredictable
consequences. Any change in the laws or regulations that govern our business
could have an adverse impact on us or on our operations. Changing laws,
regulations and standards relating to corporate governance and public
disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and
NASDAQ National Market rules, are creating expense and uncertainty for publicly
held companies in general, and business development companies in particular.
These new or changed laws, regulations and standards are subject to varying
interpretations in many cases owing to their lack of specificity, and their
application in practice may evolve over time as new guidance is provided by
regulatory and governing bodies, which may well result in continuing uncertainty
regarding compliance matters and higher costs necessitated by ongoing revisions
to disclosure and governance practices.
We are committed to maintaining high standards of corporate governance and
public disclosure. As a result, our efforts to comply with evolving laws,
regulations and standards have resulted in, and are likely to continue to result
in, increased general and administrative expenses and a diversion of management
time and attention from revenue-generating activities to compliance activities.
In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act
of 2002 and the related regulations regarding our required assessment of our
internal controls over financial reporting and our external auditors' audit of
that assessment have required the commitment of significant financial and
managerial resources. Moreover, even though BDCs are not mutual funds, they are
being required to comply with new regulations for mutual funds, such as Rule
38a-1 under the 1940 Act. Further, our board members, chief executive officer
and chief financial officer could face an increased risk of personal liability
in connection with the performance of their duties. As a result, we may have
difficulty attracting and retaining qualified board members and executive
officers, which could harm our business, and we have significantly increased
both our coverage under, and premiums for, directors' and officers' liability
insurance. If our efforts to comply with new or changed laws, regulations and
standards differ from the activities intended by regulatory or governing bodies
because of ambiguities related to practice, our reputation may be harmed. Also,
as business and financial practices continue to evolve, they may render the
regulations under which we operate less appropriate and more burdensome than
they were when originally imposed. While there are benefits associated with this
increased regulatory burden, it is causing us to incur significant additional
expenses and is time consuming for our management, which could have a material
adverse effect on our financial performance and a significant adverse effect on
the value of our common stock.
33
We expect that market prices of our common stock will be volatile.
Our common stock price may be volatile. The trading price of our common
stock may fluctuate substantially. The price of the common stock may be higher
or lower than the price you pay for your shares, depending on many factors, some
of which are beyond our control and may not be directly related to our operating
performance. These factors include the following:
o price and volume fluctuations in the overall stock market from time
to time;
o significant volatility in the market price and trading volume of
securities of business development companies or other financial
services companies;
o volatility resulting from trading in derivative securities related
to our common stock including puts, calls, long-term equity
anticipation securities, or LEAPs, or short trading positions;
o changes in regulatory policies or tax guidelines with respect to
business development companies or regulated investment companies;
o actual or anticipated changes in our net asset value or fluctuations
in our operating results or changes in the expectations of
securities analysts;
o announcements regarding any of our portfolio companies;
o announcements regarding developments in the nanotechnology field in
general;
o announcements regarding government funding and initiatives related
to the development of nanotechnology;
o general economic conditions and trends; and/or
o departures of key personnel.
We will not have control over many of these factors but expect that our
stock price may be influenced by them. As a result, our stock price may be
volatile and you may lose all or part of your investment.
Quarterly results fluctuate and are not indicative of future quarterly
performance.
Our quarterly operating results fluctuate as a result of a number of
factors. These factors include, among others, variations in and the timing of
the recognition of realized and unrealized gains or losses, the degree to which
we and our portfolio companies encounter competition in our markets and general
economic and capital markets conditions. As a result of these factors, results
for any one quarter should not be relied upon as being indicative of performance
in future quarters, and our common stock may be more volatile than it otherwise
would be.
To the extent that we do not realize income or retain after-tax realized capital
gains, we may have a greater need for additional capital to fund our investments
and operating expenses.
In order to maintain our status as a RIC, we must annually distribute at
least 90 percent of our investment company taxable income as a dividend and may
either distribute or retain our realized net capital gains from investments. As
a result, these earnings may not be available to fund investments. If we fail to
generate net realized capital gains or to obtain funds from outside sources, it
would have a material adverse effect on our financial condition and results of
operations as well as our ability to make follow-on and new investments. Because
34
of the structure and objectives of our business, we generally expect to
experience net operating losses and rely on proceeds from sales of investments,
rather than on investment income, to defray a significant portion of our
operating expenses. These sales are unpredictable and may not occur. In
addition, as a business development company, we are generally required to
maintain a ratio of at least 200 percent of total assets to total borrowings,
which may restrict our ability to borrow to fund such requirements. Lack of
capital could curtail our investment activities or impair our working capital,
which would have a significant adverse effect on the value of our common stock.
Investment in foreign securities could result in additional risks.
The Company may invest in foreign securities, although we currently have
no investments in foreign securities. If we invest in securities of foreign
issuers, we may be subject to risks not usually associated with owning
securities of U.S. issuers. These risks can include fluctuations in foreign
currencies, foreign currency exchange controls, social, political and economic
instability, differences in securities regulation and trading, expropriation or
nationalization of assets, and foreign taxation issues. In addition, changes in
government administrations or economic or monetary policies in the United States
or abroad could result in appreciation or depreciation of our securities and
could favorably or unfavorably affect our operations. It may also be more
difficult to obtain and enforce a judgment against a foreign issuer. Any foreign
investments made by us must be made in compliance with U.S. and foreign currency
restrictions and tax laws restricting the amounts and types of foreign
investments. Losses on investments in foreign securities could have a
significant adverse effect on the value of our common stock.
Forward-Looking Statements
The information contained herein contains certain forward-looking
statements. These statements include the plans and objectives of management for
future operations and financial objectives, portfolio growth and availability of
funds. These forward-looking statements are subject to the inherent
uncertainties in predicting future results and conditions. Certain factors that
could cause actual results and conditions to differ materially from those
projected in these forward-looking statements are set forth herein. Other
factors that could cause actual results to differ materially include the
uncertainties of economic, competitive and market conditions, and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond our control. Although we believe that
the assumptions underlying the forward-looking statements included herein are
reasonable, any of the assumptions could be inaccurate and therefore there can
be no assurance that the forward-looking statements included or incorporated by
reference herein will prove to be accurate. Therefore, the inclusion of such
information should not be regarded as a representation by us or any other person
that our plans will be achieved.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our business activities contain elements of risk. We consider the
principal types of market risk to be valuation risk and the risk associated with
fluctuations in interest rates. We consider the management of risk to be
essential to our business.
Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market
price for those securities for which a market quotation is readily available and
(ii) the fair value as determined in good faith by, or under the direction of,
the Board of Directors for all other assets . (See the "Valuation Procedures" in
the "Footnote to Consolidated Schedule of Investments" contained in "Item 1.
Consolidated Financial Statements.")
35
Neither our investments nor an investment in us is intended to constitute
a balanced investment program. We are exposed to public-market price
fluctuations as a result of our publicly traded portfolio, which may be composed
primarily or entirely of highly risky, volatile securities. Currently, 32
percent of the value of our portfolio of venture capital investments consists of
the publicly traded common stock of one company, NeuroMetrix, Inc.
We have invested a substantial portion of our assets in private
development stage or start-up companies. These private businesses tend to be
based on new technology and to be thinly capitalized, unproven, small companies
that lack management depth and have not attained profitability or have no
history of operations. Because of the speculative nature and the lack of a
public market for these investments, there is significantly greater risk of loss
than is the case with traditional investment securities. We expect that some of
our venture capital investments will be a complete loss or will be unprofitable
and that some will appear to be likely to become successful but never realize
their potential. Even when our private equity investments complete initial
public offerings (IPOs), we are normally subject to lock-up agreements for a
period of time, and thereafter, the market for the unseasoned publicly traded
securities may be relatively illiquid.
Because there is typically no public market for the equity interests of
many of the small privately held companies in which we invest, the valuation of
the equity interests in that portion of our portfolio is determined in good
faith by our Board of Directors in accordance with our Valuation Procedures. In
the absence of a readily ascertainable market value, the determined value of our
portfolio of equity interests may differ significantly from the values that
would be placed on the portfolio if a ready market for the equity interests
existed. Any changes in valuation are recorded in our consolidated statements of
operations as "Net increase (decrease) in unrealized appreciation on
investments."
We also invest in short-term money market instruments, and both short and
long-term U.S. government and agency obligations. To the extent that we invest
in short and long-term U.S. government and agency obligations, changes in
interest rates may result in changes in the value of these obligations which
would result in an increase or decrease of our net asset value. The level of
interest rate risk exposure at any given point in time depends on the market
environment and expectations of future price and market movements, and it will
vary from period to period. If the average interest rate on our portfolio of U.
S. government and agency obligations at March 31, 2005, were to increase by 25,
75 and 150 basis points, the value of the securities, and our net asset value,
would decrease by approximately $101,670, $305,010 and $610,020, respectively.
In addition, we may from time to time borrow amounts on a line of credit
that we maintain. We currently have no borrowings outstanding under our line of
credit. To the extent we opt to borrow money to make investments in the future,
our net investment income will be dependent upon the difference between the rate
at which we borrow funds and the rate at which we invest such funds. As a
result, there can be no assurance that a significant change in market interest
rates will not have a material adverse effect on our net investment income in
the event we choose to borrow funds for investing purposes.
While we invest in short-term money market and U.S. government and agency
obligations and may draw down on the asset line of credit, we do not consider a
change in interest rates to result in significant risks.
Item 4. Controls and Procedures
(a) Disclosure Controls and Procedures. As of the end of the period
covered by this report, our chief executive officer and chief financial officer
conducted an evaluation of our disclosure controls and procedures (as required
by Rules 13a-15 of the Securities Exchange Act of 1934 (the "1934 Act")).
36
Disclosure controls and procedures means controls and other procedures of an
issuer that are designed to ensure that information required to be disclosed by
the issuer in the reports that it files or submits under the 1934 Act is
recorded, processed, summarized and reported, within time periods specified in
the SEC's rules and forms. Disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information required
to be disclosed by an issuer in the reports that it files or submits under the
1934 Act is accumulated and communicated to the issuer's management as
appropriate to allow timely decisions regarding required disclosure. As
previously disclosed in our Form 10-K for the fiscal year ended December 31,
2004, and as described below, we determined that we had a material weakness with
respect to maintaining effective controls over the accuracy of the Financial
Highlights ratios. While we have completed most of the steps that we think are
necessary to remediate the material weakness, we commenced a search for, but
have not yet hired, a full-time, permanent senior controller. Therefore, as of
March 31, 2005, based upon the evaluation of our disclosure controls and
procedures, our chief executive officer and chief financial officer concluded
that our disclosure controls and procedures were not effective. In light of the
material weakness described below, we performed additional analysis and other
post-closing procedures to ensure our financial statements are prepared in
accordance with generally accepted accounting principles.
(b) Changes in Internal Control Over Financial Reporting. As noted in
Management's Report on Internal Control Over Financial Reporting included in the
Annual Report on Form 10-K for the fiscal year ended December 31, 2004, we
determined that we had a material weakness with respect to maintaining effective
controls over the accuracy of the Financial Highlights ratios based on an audit
adjustment to the line item referred to as "Total return based on: Net asset
value" in the Company's Financial Highlights section of the financial statements
for the year ended December 31, 2004. Specifically, our procedures for preparing
the Financial Highlights ratios were not sufficiently detailed to detect errors
in the underlying calculations. As a result of the above material weakness, we
have implemented the following changes to our internal control over financial
reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the
1934 Act) during the first quarter of 2005 to which this report relates that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting:
1. We have revised the worksheet that we use for preparing our annual
report on Form 10-K to clarify how ratios in the Financial Highlights section
are calculated.
2. On March 5, 2005, we engaged an independent accounting and consulting
firm with industry experience, Eisner LLP ("Eisner"), to read the financial
statements contained in the draft Annual Report and to provide financial
reporting and accounting advisory services to the Company. On April 4, 2005, we
engaged Eisner to provide financial reporting and accounting advisory services
to the Company on an ongoing basis, including reading and commenting on the
Company's quarterly and annual financial statements prior to submission to our
external auditors.
37
3. We have mapped out a detailed sequence of reviews of our Annual and
Interim Reports that must occur rather than merely stating that additional
reviews should occur as necessary.
4. On March 4, 2005, we commenced the search for a permanent senior
controller to stand between our CFO and our current controller. We have retained
Anne M. Donoho, C.P.A., M.B.A., to serve in this role as a temporary, senior
controller, effective March 14, 2005.
We believe that the above enhancements to our internal control over
financial reporting will better ensure the accuracy of our financial statements
and the quantitative disclosures in our periodic reports.
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PART II. OTHER INFORMATION
Item 6. Exhibits
3.1(a) Restated Certificate of Incorporation, incorporated by
reference as Exhibit 2.a to Pre-Effective Amendment No.
1 to the Registration Statement on Form N-2 dated March
22, 2004.
3.1(b) Restated By-Laws, incorporated by reference as Exhibit
2.b to Pre-Effective Amendment No. 1 to the Registration
Statement on Form N-2 dated March 22, 2004.
4.1 Form of Specimen certificate of common stock
certificate, incorporated by reference as Exhibit 2.d to
Pre-Effective Amendment No. 2 to the Registration
Statement on Form N-2 dated April 13, 2004.
11.0 Computation of Per Share Earnings, incorporated by
reference as "Consolidated Statements of Operations" in
Item 1 in this Quarterly Report on Form 10-Q.
31.01* Certification of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.02* Certification of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.01* Certification of CEO and CFO pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
*filed herewith
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized on behalf of the Registrant and as its chief
accounting officer.
Harris & Harris Group, Inc.
/s/ Douglas W. Jamison
-------------------------------------
By: Douglas W. Jamison, President
and Chief Financial Officer
Date: May 9, 2005
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EXHIBIT INDEX
Exhibit No. Description
31.01 Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.02 Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32.01 Certification of CEO and CFO pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
41