UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For quarterly period ended September 30, 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 by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at November 4, 2005
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Common Stock, $0.01 par value per share 20,756,345 shares
Harris & Harris Group, Inc.
Form 10-Q, September 30, 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....................................15
Financial Highlights..........................................................21
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ...................................................22
Background and Overview ......................................................22
Results of Operations ........................................................23
Financial Condition...........................................................26
Liquidity.....................................................................28
Capital Resources.............................................................28
Risk Factors..................................................................29
Item 3. Quantitative and Qualitative Disclosures About Market Risk............41
Item 4. Controls and Procedures...............................................42
PART II OTHER INFORMATION
Item 6. Exhibits..............................................................44
Exhibit Index to Form 10-Q....................................................46
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.(R) (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. The accompanying consolidated financial statements
should be read in conjunction with the audited consolidated financial statements
and notes thereto for the year ended December 31, 2004, contained in our Annual
Report on Form 10-K for the year ended December 31, 2004.
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, 2005, we received SEC certification for 2004, permitting us to
qualify for RIC treatment for 2004 (as we had for the years 1999 through 2003).
Although the SEC certification for 2004 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
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HARRIS & HARRIS GROUP, INC.(R)
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
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ASSETS
September 30, 2005 December 31, 2004
(Unaudited)
Investments, at value (Cost: $109,470,584 at 9/30/05,
$77,442,110 at 12/31/04) .................................. $ 130,127,822 $ 76,244,682
Cash and cash equivalents ...................................... 221,374 650,332
Restricted funds ............................................... 1,653,040 1,591,971
Receivable from portfolio company .............................. 0 10,000
Interest receivable ............................................ 168,612 58,960
Income tax receivable .......................................... 11,016 2,480
Prepaid expenses ............................................... 105,069 542,489
Other assets, net of reserve of $255,486 at 12/31/04 (Note 9) .. 236,248 260,537
------------- -------------
Total assets ................................................... $ 132,523,181 $ 79,361,451
============= =============
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities ....................... $ 3,346,238 $ 2,905,658
Accrued profit sharing (Note 4) ................................ 4,405,953 311,594
Deferred rent .................................................. 29,828 34,930
Deferred income tax liability (Note 6) ......................... 1,364,470 1,364,470
------------- -------------
Total liabilities .............................................. 9,146,489 4,616,652
------------- -------------
Net assets ..................................................... $ 123,376,692 $ 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, 30,000,000 shares
authorized at 9/30/05 and 25,000,000 shares authorized
at 12/31/04; 22,585,085 issued at 9/30/05 and
19,077,585 issued at 12/31/04 ............................. 225,852 190,776
Additional paid in capital (Note 8) ............................ 122,149,641 85,658,150
Accumulated net realized loss .................................. (14,710,466) (4,961,123)
Accumulated unrealized appreciation (depreciation) of
investments, including deferred tax liability of $1,540,044
at 9/30/05 and at 12/31/04 (Note 6) ....................... 19,117,196 (2,737,473)
Treasury stock, at cost (1,828,740 shares at 9/30/05 and
12/31/04) ................................................. (3,405,531) (3,405,531)
------------- -------------
Net assets ..................................................... $ 123,376,692 $ 74,744,799
============= =============
Shares outstanding ............................................. 20,756,345 17,248,845
============= =============
Net asset value per outstanding share .......................... $ 5.94 $ 4.33
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
2
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
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Three Months Ended Sept. 30 Nine Months Ended Sept. 30
--------------------------- --------------------------
2005 2004 2005 2004
------------ ------------ ------------ ------------
Investment income:
Interest from:
Fixed-income securities .................. $ 315,089 $ 235,778 $ 743,571 $ 365,842
Portfolio companies ...................... 0 17,803 (9,780) 23,506
Other income ................................... 285 0 5,409 0
------------ ------------ ------------ ------------
Total investment income .................. 315,374 253,581 739,200 389,348
------------ ------------ ------------ ------------
Expenses:
Profit sharing ................................. 2,393,488 336,820 4,094,359 336,820
Salaries and benefits .......................... 673,064 419,384 1,855,365 1,384,566
Administration and operations .................. 264,130 129,649 1,076,335 475,724
Professional fees .............................. 124,767 231,144 615,355 389,083
Rent ........................................... 51,996 38,860 151,857 111,515
Directors' fees and expenses ................... 64,089 63,188 204,830 156,811
Depreciation ................................... 17,637 10,958 49,535 29,906
Bank custody fees .............................. 0 2,351 8,599 8,145
------------ ------------ ------------ ------------
Total expenses ........................... 3,589,171 1,232,354 8,056,235 2,892,570
------------ ------------ ------------ ------------
Net operating loss ................................ (3,273,797) (978,773) (7,317,035) (2,503,222)
------------ ------------ ------------ ------------
Net realized (loss) income on investments:
Realized (loss) income on investments .......... (240) 2,704 (2,427,469) 798,673
Income tax benefit (provision) (Note 6) ........ 13 1,482 (4,839) (6,426)
------------ ------------ ------------ ------------
Net realized (loss) income on
investments .............................. (227) 4,186 (2,432,308) 792,247
------------ ------------ ------------ ------------
Net realized loss ................................. (3,274,024) (974,587) (9,749,343) (1,710,975)
------------ ------------ ------------ ------------
Net increase in unrealized appreciation /
decrease in unrealized depreciation on investments:
Investment sales ............................... 0 0 2,956,491 915,118
Investments held ............................... 10,610,947 2,731,943 18,898,178 1,136,691
Income tax benefit (provision) (Note 6) ........ 0 (646,235) 0 (646,235)
------------ ------------ ------------ ------------
Net increase in unrealized
appreciation / decrease in unrealized
depreciation on investments ................... 10,610,947 2,085,708 21,854,669 1,405,574
------------ ------------ ------------ ------------
Net increase (decrease) in net assets
resulting from operations:
Total .......................................... $ 7,336,923 $ 1,111,121 $ 12,105,326 $ (305,401)
============ ============ ============ ============
Per average outstanding share .................. $ .40 $ .06 $ .68 $ (0.02)
============ ============ ============ ============
Average outstanding shares ..................... 18,593,166 17,023,845 17,701,876 14,881,692
============ ============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
3
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
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Nine Months Ended September 30
------------------------------
2005 2004
------------ ------------
Cash flows from operating activities:
Net increase (decrease) in net assets resulting from operations ........ $ 12,105,326 $ (305,401)
Adjustments to reconcile net increase (decrease) in net assets resulting
from operations to net cash used in operating activities:
Net realized and unrealized gain on investments .................... (19,427,200) (2,850,482)
Depreciation ....................................................... 49,535 29,906
Deferred income taxes .............................................. 0 646,235
Changes in assets and liabilities:
Accrued profit sharing ............................................. 4,094,359 336,820
Funds in escrow .................................................... 0 0
Restricted funds ................................................... (61,069) (181,015)
Receivable from portfolio company .................................. 10,000 0
Interest receivable ................................................ (109,652) (183,875)
Income tax receivable .............................................. (8,536) 7,843
Prepaid expenses ................................................... 437,420 (18,828)
Other assets ....................................................... 13,346 5,514
Accounts payable and accrued liabilities ........................... 440,580 (158,095)
Deferred rent ...................................................... (5,102) (4,726)
Broker payable ..................................................... 0 0
------------ ------------
Net cash used in operating activities .................................. (2,460,993) (2,676,104)
------------ ------------
Cash flows from investing activities:
Net purchase of short-term investments
and marketable securities .................................... (25,740,084) (24,578,644)
Proceeds from sale of investments .................................. 661,440 2,515,386
Investment in private placements and loans, net .................... (9,377,296) (11,473,651)
Purchase of fixed assets ........................................... (38,592) (49,595)
------------ ------------
Net cash used in investing activities .............................. (34,494,532) (33,586,504)
------------ ------------
Cash flows from financing activities:
Proceeds from public offering, net ................................. 36,526,567 36,127,675
Net decrease in cash and cash equivalents:
Cash and cash equivalents at beginning of the period ............... 650,332 425,574
Cash and cash equivalents at end of the period ..................... 221,374 290,641
------------ ------------
Net decrease in cash and cash equivalents .......................... $ (428,958) $ (134,933)
============ ============
Supplemental disclosures of cash flow information:
Income taxes paid .................................................. $ 0 $ 0
The accompanying notes are an integral part of these consolidated financial
statements.
4
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
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Nine Months Ended Year Ended
September 30, 2005 December 31, 2004
------------------ -----------------
(Unaudited)
Changes in net assets from operations:
Net operating loss ........................ $ (7,317,035) $ (3,408,779)
Net realized (loss) income on investments . (2,432,308) 858,503
Net increase in unrealized appreciation on
investments as a result of sales ....... 2,956,491 915,118
Net increase (decrease) in unrealized
appreciation on investments held ....... 18,898,178 (430,956)
------------- -------------
Net increase (decrease) in net assets
resulting from operations .............. 12,105,326 (2,066,114)
------------- -------------
Changes in net assets from capital
Stock transactions:
Net proceeds from sale of stock ........... 36,526,567 36,128,175
------------- -------------
Net increase in net assets resulting from
capital stock transactions ............. 36,526,567 36,128,175
------------- -------------
Net increase in net assets .................. 48,631,893 34,062,061
Net assets:
Beginning of the period ................... 74,744,799 40,682,738
------------- -------------
End of the period ......................... $ 123,376,692 $ 74,744,799
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
5
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2005
(Unaudited)
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Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (7)(8) - 9.6% of net assets
Private Placement Portfolio (Illiquid) - 9.6% 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
-----------
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
Series C Convertible Preferred Stock.........................................(A) 1,250,000 2,500,000
-----------
4,500,000
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) 716,195 67,736
Series 1 Convertible Preferred Stock..........................................(C) 1,831,256 2,014,677
Series 2 Convertible Preferred Stock..........................................(C) 741,898 878,120
Warrants at $0.15 expiring 01/26/10...........................................(C) 16,364 164
Warrants at $0.15 expiring 12/05/10...........................................(C) 14,063 140
-----------
2,960,837
===========
The accompanying notes are an integral part of these consolidated financial
statements.
6
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2005
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (7)(8) - 9.6% of net assets (cont.)
Private Placement Portfolio (Illiquid) - 9.6% of net assets (cont.)
Optiva, Inc. (1)(2) -- Developed nanomaterials for
display industry applications
Series C Convertible Preferred Stock.........................................(B) 1,249,999$ 0
Secured Convertible Bridge Note with 50% Preferred
Stock Warrant coverage.......................................................(B) $150,001 75,000
-----------
75,000
Polatis, Inc. (1)(2)(5) -- Develops optical networking components
by merging materials, MEMS and electronics technologies
Series A-1 Convertible Preferred Stock.......................................(B) 16,775 47,828
Series A-2 Convertible Preferred Stock.......................................(B) 71,611 204,172
-----------
252,000
Total Unaffiliated Private Placement Portfolio (cost: $13,869,543)........................................ $11,859,229
-----------
Total Investments in Unaffiliated Companies (cost: $13,869,543)........................................... $11,859,229
-----------
The accompanying notes are an integral part of these consolidated financial
statements.
7
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2005
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Non-Controlled Affiliated Companies (7)(9) - 38.9% of net assets
Publicly Traded Portfolio - 27.5% of net assets
NeuroMetrix, Inc. (1)(10) -- Develops and sells medical devices for
monitoring neuromuscular disorders
Common Stock.................................................................(D) 1,137,570 $33,865,459
-----------
Total Publicly Traded Portfolio (cost: $4,411,374).......................................................... $33,865,459
-----------
Private Placement Portfolio (Illiquid) - 11.4% 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 Stock.........................................(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
------------
eLite Optoelectronics Inc. (1)(2)(4)(5) - Develops high-power light
emitting diodes
Series B Convertible Preferred Stock.........................................(A) 1,861,504 1,000,000
------------
Experion Systems, Inc. (1)(2)(6) -- Develops and sells software to credit
unions
Series A Convertible Preferred Stock.........................................(B) 187,500 0
Series B Convertible Preferred Stock.........................................(B) 22,500 0
Series C Convertible Preferred Stock.........................................(B) 222,184 0
Series D Convertible Preferred Stock.........................................(B) 64,501 0
------------
0
Kereos, Inc. (1)(2)(4)(5) -- Develops molecular imaging agents
and targeted therapeutics to image and treat cancer and
cardiovascular disease
Series B Convertible Preferred Stock.........................................(A) 349,092 960,000
------------
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
------------
The accompanying notes are an integral part of these consolidated financial
statements.
8
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2005
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Private Placement Portfolio (Illiquid) - 11.4% of net assets (cont.)
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........................................(B) 267,857 32,490
Series B Convertible Preferred Stock..........................................(B) 3,819,935 1,110,073
Series C Convertible Preferred Stock..........................................(B) 1,932,789 842,503
Warrants at $0.4359 expiring 03/15/10.........................................(B) 193,279 0
--------------
1,985,066
Nanopharma Corp. (1)(2)(5) -- Develops advanced polymers for
drug delivery
Series A Convertible Preferred Stock..........................................(B) 684,516 $ 136,903
Secured Convertible Bridge Note with 25% Warrants.............................(B) $733,000 733,000
--------------
869,903
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..........................................(B) 1,250 0
Warrants at $1.50 expiring 08/03/06..........................................(B) 8,500 0
Warrants at $1.50 expiring 11/21/07..........................................(B) 3,750 0
Warrants at $1.50 expiring 11/19/08..........................................(B) 5,000 0
Warrants at $1.50 expiring 11/19/09..........................................(B) 5,000 0
--------------
724,588
Solazyme, Inc. (1)(2)(5) -- Harnesses energy-harvesting machinery
of photosynthetic microbes to produce industrial and pharmaceutical
molecules
Convertible Promissory Note..................................................(A) $310,000 310,000
--------------
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.........................................(B) 1,500,000 375,000
--------------
Total Non-Controlled Private Placement Portfolio (cost: $20,516,103)......................................... $ 14,075,977
--------------
Total Investments in Non-Controlled Affiliated Companies (cost: $24,927,477)................................. $ 47,941,436
--------------
The accompanying notes are an integral part of these consolidated financial
statements.
9
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2005
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
U.S. Government and Government Agency Securities - 57.0% of net assets
U.S. Treasury Bills -- due date 10/27/05 ....................................(J) 1,558,000 1,554,853
U.S. Treasury Bills -- due date 12/29/05 ....................................(J) 4,648,000 4,609,561
U.S. Treasury Notes -- due date 02/28/06, coupon 1.625% .....................(H) 2,000,000 1,981,960
U.S. Treasury Bills -- due date 03/02/06 ....................................(J) 32,845,000 32,334,260
U.S. Treasury Bills -- due date 03/16/06 ....................................(J) 4,750,000 4,669,013
U.S. Treasury Notes -- due date 03/31/06, coupon 1.5%........................(H) 4,616,000 4,561,716
U.S. Treasury Notes -- due date 06/30/06, coupon 2.75%.......................(H) 14,601,000 14,463,021
U.S. Treasury Notes -- due date 02/15/07, coupon 2.25%.......................(H) 2,000,000 1,949,300
U.S. Treasury Notes -- due date 05/15/08, coupon 2.625%......................(H) 1,999,000 1,922,318
U.S. Treasury Notes -- due date 03/15/09, coupon 2.625%......................(H) 2,402,000 2,281,155
------------
Total Investments in U.S. Government and Government Agency
Securities (cost: $70,673,564).................................................. $ 70,327,157
------------
Total Investments (cost: $109,470,584)....................................................................... $130,127,822
============
The accompanying notes are an integral part of these consolidated financial
statements.
10
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HARRIS & HARRIS GROUP, INC. (R)
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2005
(Unaudited)
--------------------------------------------------------------------------------
Notes to Consolidated Schedule of Investments
(1) Represents a non-income producing security. Equity investments that have
not paid dividends within the last 12 months are considered to be
non-income producing.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Schedule of Investments for a description of the 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 five percent or more, but less than 25 percent, of the
voting shares of the portfolio company or where we hold one or more seats
on the portfolio company's Board of Directors. Investments in controlled
affiliated companies consist of investments in which we own 25 percent or
more of the voting shares of the portfolio company.
(8) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $13,869,543. The gross unrealized appreciation
based on the tax cost for these securities is $970,766. The gross
unrealized depreciation based on the tax cost for these securities is
$2,981,080.
(9) The aggregate cost for federal income tax purposes of investments in
non-controlled affiliated companies is $24,927,477. The gross unrealized
appreciation based on the tax cost for these securities is $29,454,085.
The gross unrealized depreciation based on the tax cost for these
securities is $6,440,126.
(10) The lock-up period on the sale of these shares expired on January 18,
2005.
The accompanying notes are an integral part of this consolidated schedule.
11
--------------------------------------------------------------------------------
HARRIS & HARRIS GROUP, INC. (R)
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
--------------------------------------------------------------------------------
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; and
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:
12
A. Cost: The cost method is based on our original cost. This method is
generally used in the early stages of a company's development until significant
positive or negative events occur subsequent to the date of the original
investment that dictate a change to another valuation method. Some examples of
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.
13
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.
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.
14
--------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
--------------------------------------------------------------------------------
NOTE 1. THE COMPANY
Harris & Harris Group, Inc.(R) (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
governmental 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 in accordance with 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.SM ("Enterprises"), is a 100 percent
wholly owned subsidiary of the Company. Enterprises is a partner in Harris
Partners I, L.P.SM and is taxed under Subchapter C of the Code (a "C
Corporation"). Harris Partners I, L.PSM, is a limited partnership and owns our
interest in AlphaSimplex Group, LLC. The partners of Harris Partners I, L.P.SM,
are Enterprises (sole general partner) and Harris & Harris Group, Inc.(R) (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 2004. We intend to file for RIC certification under Section 851(e) of
the Code for 2005, however, there can be no assurance that we will qualify as a
RIC for 2005 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
things, 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
generally accepted accounting principles ("GAAP") for interim financial
information and pursuant to the requirements of reporting on Form 10-Q and
Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying
annual financial statements prepared in accordance with GAAP are omitted. 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,
as filed with the Securities and Exchange Commission.
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:
15
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 September 30, 2005, our financial statements included private
venture capital investments valued at $25,935,206, 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. The
Company ceases accruing interest when securities are determined to be non-income
producing and writes off any previously accrued interest. In 2005, the Company
wrote off $56,315 of previously accrued interest. 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 September 30, 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.")
Restricted Funds. The Company maintains a rabbi trust for the purposes of
accumulating funds to satisfy the obligations incurred by us for the
Supplemental Executive Retirement Plan ("SERP") under the employment agreement
with Charles E. Harris. As of September 30, 2005, the Company had restricted
funds of $1,653,040 and accrued liabilities of $1,653,040 for the SERP.
Use of Estimates. 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 September 30, 2005, and December 31, 2004, and the reported amounts of
revenues and expenses for the three month and nine month periods ended September
30, 2005, and September 30, 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.(R) Employee Profit-Sharing Plan, which we refer to as the
2002 Plan.
16
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
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 2002 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 the
Company may not deduct compensation paid to its chief executive officer or to
any of its four most highly compensated officers to the extent that the
compensation paid to 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") have been 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 are permanent. These reduced awards are herein
referred to as "grandfathered participations." The amount by which the awards
are reduced is 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 future awards, including the
grandfathered participations, will be immediately cancelled and forfeited. With
regard to new investments and follow-on investments made after January 1, 2003,
both current and new participants are 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 on a pro rata basis.
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 precludes
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).
17
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 is
available for allocation and reallocation from year to year. Currently, under
the 2002 Plan, the distribution amounts for non-grandfathered investments for
each officer and employee are: Charles E. Harris, 8.43 percent; Douglas W.
Jamison, 4.06 percent; Daniel V. Leff, 3.77 percent; Sandra M. Forman, 1.62
percent; Daniel B. Wolfe, 1.62 percent; and Jacqueline M. Matthews, 0.50
percent, which together equal 20 percent. In one case, for a former employee who
left on July 27, 2001, any amount earned will be accrued and may subsequently be
paid to the participant. 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 2002 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). Although the accrual will fluctuate as a result of changes in
qualifying income and changes in unrealized appreciation, payments are made only
to the extent that qualifying income exists. At December 31, 2004, we had
$311,594 accrued for profit sharing. At September 30, 2005, we had $4,405,953
accrued for profit sharing as a result of unrealized appreciation on investments
still held. No actual profit sharing payments were made in 2004. At September
30, 2005, there was no qualifying income and, therefore, no payments are due.
NOTE 5. DISTRIBUTABLE EARNINGS
As of December 31, 2004, and September 30, 2005, there were 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 Code or 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. The Company's capital loss carryforwards
expire in 2011. We have previously used loss carryforwards to offset Built-In
Gains. As of December 31, 2004, and September 30, 2005, we had $501,640 of
pre-1999 loss carryforwards remaining and $4,663,457 of unrealized Built-In
Gains remaining. For the three and nine month periods ending September 30, 2004,
the company incurred deferred income tax expense of $646,235 related to the
increase in unrealized appreciation on investments.
18
Our net deferred tax liability at September 30, 2005, and December 31,
2004, consisted of the following:
September 30, 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
on behalf of shareholders, 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 September 30, 2005, and 2004, our income
tax (benefit) provision was ($13) and $1,482, respectively. For the nine months
ended September 30, 2005, and 2004, our income tax provision was $4,839 and
$6,426, 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. The asset account
line of credit bears interest at the Broker Call Rate, which is the interest
rate that banks charge to brokers to finance margin loans to investors, plus 50
basis points. Our outstanding balance under the asset account line of credit at
both September 30, 2005, and December 31, 2004, was $0. On November 1, 2005, we
terminated this asset line of credit.
NOTE 8. CAPITAL TRANSACTIONS
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. In July of
2004, we sold 3,450,000 common shares for gross proceeds of $36,501,000; net
proceeds of the offering, after offering costs of $372,825, were $36,128,175. In
September of 2005, we completed the sale of an additional 3,507,500 shares for
gross proceeds of $37,091,813; net proceeds of the offering, after offering
costs of $565,246, were $36,526,567.
19
NOTE 9. OTHER
At December 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 2004, we set up, by a charge to realized income from
investments, a reserve of 100 percent of the $255,486. On March 16, 2005, we
received the entire $255,486, released the reserve and realized the income.
NOTE 10. SUBSEQUENT EVENTS
On October 24, 2005, we made a $500,000 follow-on investment in a
privately held portfolio company.
On November 1, 2005, we terminated our $8,000,000 asset line of credit.
On November 4, 2005, we made a $3,000,000 initial investment in a
privately held company.
20
--------------------------------------------------------------------------------
HARRIS & HARRIS GROUP, INC.
FINANCIAL HIGHLIGHTS
(Unaudited)
--------------------------------------------------------------------------------
Three Months Ended Sept. 30 Nine Months Ended Sept. 30
------------------------------------- -------------------------------------
2005 2004 2005 2004
---------------- ---------------- ---------------- ----------------
Per Share Operating Performance
Net asset value per share, beginning
of period ............................... $ 4.61 $ 2.85 $ 4.33 $ 2.95
Net operating loss ................. (0.18) (0.05) (0.41) (0.17)
Net realized income (loss) income on
investments ..................... 0 0 (0.14) 0.05
Net increase in unrealized
appreciation on investments ..... 0.58 0.12 1.23 0.09
---------------- ---------------- ---------------- ----------------
Total from investment operations ... 0.40 0.07 0.68 (0.03)
---------------- ---------------- ---------------- ----------------
Net decrease as a result of deemed
dividend shareholder tax credit . 0 0 0 0
---------------- ---------------- ---------------- ----------------
Total distributions ................ 0 0 0 0
Net increase as a result of stock
offering ......................... 0.93 1.52 0.93 1.52
---------------- ---------------- ---------------- ----------------
Total increase from capital
stock transactions .............. 0.93 1.52 0.93 1.52
---------------- ---------------- ---------------- ----------------
Net asset value per share, end
of period .......................... $ 5.94 $ 4.44 $ 5.94 $ 4.44
================ ================ ================ ================
Stock price per share, end
of period .......................... $ 11.10 $ 10.34 $ 11.10 $ 10.34
Total return based on stock price (1) ... (6.8)% (15.5)% (32.2)% (10.3)%
Supplemental Data:
Net assets, end of period ............... $ 123,376,692 $ 39,266,216 $ 123,376,692 $ 39,266,216
Ratio of expenses to average
net assets (1) ..................... 3.5% 2.1% 9.2% 5.8%
Ratio of net operating loss to
average net assets (1) ............. (3.2)% (1.7)% (8.4)% (5.1)%
Cash dividends paid per share ........... $ 0 $ 0 $ 0 $ 0
Deemed dividend per share ............... $ 0 $ 0 $ 0 $ 0
Number of shares outstanding,
end of period ...................... 20,756,345 17,248,845 20,756,345 17,248,845
(1) Not annualized.
The accompanying notes are an integral part of this schedule.
21
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The information contained in this section should be read in conjunction
with our unaudited September 30, 2005, Consolidated Financial Statements, and
our audited 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, which
resulted in his 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. From August 2001 through September
2005, all 24 of our initial investments have been exclusively in tiny
technology.
Since our investment in Otisville in 1983, we have made a total of 66
venture capital investments, including four private placement investments in
securities of publicly traded companies. We have sold 40 of these 66
investments, realizing total proceeds of $108,496,803 on our invested capital of
$42,562,069. Seventeen of these 40 investments were profitable. As measured from
first dollar in to last dollar out, the average and median holding periods for
these 40 investments were 3.5 years and 3.2 years, respectively. As measured by
the 131 separate rounds of investment within these 40 investments, the average
and median holding periods for the 131 separate rounds of investment were 2.7
years and 2.4 years, respectively. At September 30, 2005, we valued the 26
venture capital investments remaining in our portfolio at $59,800,665, or 48.5
percent of our net assets, including net unrealized appreciation of $21,003,645.
At September 30, 2005, from first dollar in, the average and median holding
periods for these 26 venture capital investments were 3.1 years and 2.3 years,
respectively. As measured by the 69 separate rounds of investment within these
26 investments, the average and median holding periods for the 69 separate
rounds of investment were 2.7 years and 1.6 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 September 30, 2005, $25,935,206, or 21.0 percent, of
our net assets consisted of private venture capital investments at fair value,
net of unrealized depreciation of $8,450,440. At December 31, 2004, $18,508,138,
or 24.8 percent, of our net assets at fair value consisted of private venture
capital investments, net of unrealized depreciation of $9,577,094.
22
At September 30, 2005, $33,865,459, or 27.5 percent of our net assets,
consisted of common shares of NeuroMetrix, Inc., a publicly traded venture
capital investment, (Nasdaq: NURO), valued at market value, of which unrealized
appreciation was $29,454,085. Prior to January 18, 2005, our ownership interest
in NeuroMetrix, Inc., was not in freely tradable securities, and prior to March
31, 2005, the fair value of our investment in 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 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 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 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. Interest income is secondary to capital gains
and losses in 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, plus income
from interests in limited liability companies.
Net Increase / (Decrease) in Unrealized Appreciation or Depreciation on
Investments - the net unrealized change in the value of our investment
portfolio.
Owing to 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 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.
Results of Operations
Three months ended September 30, 2005, as compared with the three months ended
September 30, 2004
In the three months ended September 30, 2005, we had a net increase in net
assets resulting from operations of $7,336,923, as compared with a net increase
in net assets resulting from operations of $1,111,121 in the three months ended
September 30, 2004.
23
Investment Income and Expenses:
We had net operating losses of $3,273,797 and $978,773 for the three
months ended September 30, 2005, and September 30, 2004, respectively.
Operating expenses were $3,589,171 and $1,232,354 for the three months
ended September 30, 2005, and September 30, 2004, respectively. The increase in
expenses for the three months ended September 30, 2005, as compared with the
three months ended September 30, 2004, is primarily a result of the increase to
the profit sharing plan provision of $2,056,668 resulting from an increase of
$11,079,932 in the valuation of our investment in NeuroMetrix, Inc., during the
three months ended September 30, 2005. An increase in administrative and
operations expense of $134,481, or 103.7 percent, is primarily owing to the
increases in the cost of directors' and officers' liability insurance.
Realized Income and Losses on Investments:
During the three months ended September 30, 2005, we realized net losses
on investments of $240, and during the three months ended September 30, 2004, we
realized net income on investments of $2,704, before taxes.
Unrealized Appreciation or Depreciation on Investments:
During the three months ended September 30, 2005, net unrealized
appreciation on total investments increased by $10,610,947, or 105.6 percent,
from net unrealized appreciation of $10,046,292 at June 30, 2005. During the
three months ended September 30, 2004, net unrealized depreciation on total
investments decreased by $2,731,943, or 89.4 percent, from $3,056,850 at June
30, 2004, to $324,907 at September 30, 2004.
During the three months ended September 30, 2005, net unrealized
appreciation on our venture capital investments increased by $10,636,184, owing
to an increase in the valuation of our investment in NeuroMetrix, Inc., of
$11,079,932, and decreases in the valuations of Zia Laser, Inc., NeoPhotonics
Corporation and Polatis, Inc. of $375,000, $63,248, and $5,500, respectively.
During the three months ended September 30, 2004, we recorded a net
decrease of $2,678,872 in unrealized depreciation of our venture capital
investments. This net decrease in unrealized depreciation was primarily owing to
an increase in the valuation of our investment in NeuroMetrix, Inc., of
$3,172,686, partially offset by a decrease in the valuation of our investment in
Experion Systems, Inc., of $468,814.
Nine months ended September 30, 2005, as compared with the nine months ended
September 30, 2004
In the nine months ended September 30, 2005, we had a net increase in net
assets resulting from operations of $12,105,326, as compared with a net decrease
in net assets resulting from operations of $305,401 for the nine months ended
September 30, 2004.
Investment Income and Expenses:
For the nine months ended September 30, 2005, and September 30, 2004,
respectively, we had net operating losses of $7,317,035 and $2,503,222.
24
For the nine months ended September 30, 2005, and September 30, 2004,
respectively, operating expenses were $8,056,235 and $2,892,570. The increase in
expenses for the nine months ended September 30, 2005, as compared with the nine
months ended September 30, 2004, is primarily related to an increase of
$3,757,539 in the profit sharing expense resulting from an increase of
$20,751,637 in the valuation of our investment in NeuroMetrix, Inc., during the
first nine months of 2005. Salaries and benefits increased by $470,799, or 34.0
percent, primarily as a result of the addition of four full-time employees, and
secondarily to increases in salary and benefits for existing employees.
Administration and operations increased by $600,611, or 126.3 percent, as a
result of increased expenses owing to proxy solicitation for non-routine matters
($84,435) and increases in the cost of our directors' and officers' liability
insurance ($356,342). Professional fees increased by $226,272, or 58.2 percent,
owing to expenses associated with the implementation of the requirements of
Section 404 of the Sarbanes-Oxley Act of 2002.
Realized Income and Losses on Investments:
During the nine months ended September 30, 2005, we realized losses of
$2,427,469 as compared with realized income of $798,673 for the nine months
ended September 30, 2004, before taxes.
During the nine months ended September 30, 2005, we realized losses on the
sale of investments including $1,358,286 on Agile Materials & Technologies,
Inc., and $1,091,209 on Nanotechnologies, Inc. We also realized a loss of
$294,245 on our investment in Optiva, Inc. These realized losses were partially
offset by the realized gain of $255,486 on the sale of our investment in
NanoGram Devices Corporation.
During the nine months ended September 30, 2004, our realized net gains of
$798,673 consisted primarily of a realized gain of $1,681,259, resulting from
the sale of our investment in NanoGram Devices Corporation, offset by a realized
loss of $915,108 resulting from the sale of our shares of Series D Convertible
Preferred Stock in NeoPhotonics Corporation.
Unrealized Appreciation or Depreciation on Investments:
During the nine months ended September 30, 2005, net unrealized
appreciation on total investments increased by $21,854,669, from net unrealized
depreciation of $1,197,429 at December 31, 2004, to net unrealized appreciation
of $20,657,240 at September 30, 2005. During the nine months ended September 30,
2004, net unrealized depreciation on total investments decreased by $2,051,809,
or 86.3 percent, from $2,376,716 at December 31, 2003, to $324,907 at September
30, 2004.
During the nine months ended September 30, 2005, we recorded a net
increase of $21,878,292 in unrealized appreciation of our venture capital
investments, primarily as a result of an increase in unrealized appreciation of
NeuroMetrix, Inc., of $20,751,637. In addition, unrealized appreciation
increased primarily as a result of the realization of losses on the sale of our
investments in Agile Materials and Technologies, Inc., of $1,364,081,
Nanotechnologies, Inc., of $917,410 and on our investment in Optiva, Inc., of
$675,000. Changes in valuation resulted primarily in increased appreciation on
our investment in Nantero, Inc., of $813,771 and decreased appreciation on our
investments in Zia Laser, Inc., of $1,125,000 and in Nanopharma Corporation of
$563,097.
25
During the nine months ended September 30, 2004, we recorded a net
increase of $2,226,234 in unrealized depreciation of our venture capital
investments, primarily as a result of an increase in unrealized depreciation of
Nanotechnologies, Inc., of $638,840 and Optiva, Inc., of $625,000, offset by the
realization of the loss of $915,108 on the sale of our shares of Series D
Convertible Preferred stock in NeoPhotonics Corporation.
Financial Condition
As at September 30, 2005
At September 30, 2005, our total assets and net assets were $132,523,181
and $123,376,692, respectively, compared with $79,361,451 and $74,744,799 at
December 31, 2004, respectively.
At September 30, 2005, net asset value per share was $5.94, as compared
with $4.33 at December 31, 2004. At September 30, 2005, our shares outstanding
increased to 20,756,345 versus 17,248,845 at December 31, 2004.
Significant developments in the nine months ended September 30, 2005,
included the receipt of gross proceeds of $37,091,813, less costs of $565,246,
for a total of $36,526,567, pursuant to the issuance of 3,507,500 new shares of
our common stock; in addition, the value of our venture capital investments
increased by $28,178,705, from $31,621,960 at December 31, 2004, to $59,800,665
at September 30, 2005, primarily as a result of the increase in value of our
investment in NeuroMetrix, Inc., from $13,113,822 at December 31, 2004, to
$33,865,459 at September 30, 2005, and three new and nine follow-on investments.
The following table is a summary of additions to our portfolio of venture
capital investments during the nine months ended September 30, 2005:
New Investments Amount
--------------- -------------
eLite Optoelectronics, Inc. $ 1,000,000
Kereos, Inc. $ 800,000
Zia Laser, Inc. $ 1,500,000
Follow-on Investments
Cambrios, Inc. $ 511,006
Kereos, Inc. $ 160,000
Molecular Imprints, Inc. $ 2,500,000
Nanomix, Inc. $ 250,000
NanoOpto Corporation $ 411,741
Nanopharma Corp. $ 183,000
Nantero, Inc. $ 571,329
NeoPhotonics Corporation $ 999,999
Starfire Systems, Inc. $ 500,000
-----------
Total $ 9,387,075
===========
26
The following tables summarize the values of our portfolios of venture
capital investments and U.S. government and government agency securities, as
compared with their cost, at September 30, 2005 and December 31, 2004:
September 30, 2005 December 31, 2004
---------------- ----------------
Venture capital investments,
at cost .................. $ 38,797,020 $ 32,496,605
Unrealized appreciation
(depreciation)(1) ........ 21,003,645 (874,645)
---------------- ----------------
Venture capital investments,
at fair value ............ $ 59,800,665 $ 31,621,960
================ ================
September 30, 2005 December 31, 2004
---------------- ----------------
U.S. government and agency
obligations, at cost ..... $ 70,673,564 $ 44,945,505
Unrealized depreciation(1).. (346,407) (322,783)
---------------- ----------------
U.S. government and agency
obligations, at fair value $ 70,327,157 $ 44,622,722
================ ================
1)At September 30, 2005, the accumulated unrealized appreciation on investments,
net of deferred taxes, was $19,117,196. At December 31, 2004, the accumulated
unrealized depreciation on investments, including deferred taxes, was
$2,737,473.
The following table summarizes the value composition of our venture
capital investment portfolio at September 30, 2005 and December 31, 2004.
NeuroMetrix, Inc., accounted for 99.6 percent and 97.6 percent of the "Other
Venture Capital Investments" at September 30, 2005, and December 31, 2004,
respectively.
September 30, 2005 December 31, 2004
------------------ -----------------
Category
Tiny Technology 43.2% 57.5%
Other Venture Capital Investments 56.8% 42.5%
----- -------
Total Venture Capital Investments 100.0% 100.0%
====== ======
27
The following table summarizes the fair value composition of our venture
capital investment portfolio that was still privately held at September 30,
2005, and December 31, 2004. NeuroMetrix, Inc., became a publicly held company
in July 2004.
September 30, 2005 December 31, 2004
------------------ -----------------
Category
Tiny Technology 99.52% 98.2%
Other Privately Held Venture
Capital Investments .48% 1.8%
---- ------
Total Private Venture
Capital Investments 100.0% 100.0%
====== ======
Liquidity
Our primary sources of liquidity are cash and U.S. 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 September
30, 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. We intend to sell our shares in NeuroMetrix at any time in the
future, through one or more transactions.
At September 30, 2005, and December 31, 2004, our total net primary
liquidity was $104,593,618 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 September 30, 2005, is primarily owing to
the receipt of proceeds from our stock offering in 2005, reclassification of our
common shares of NeuroMetrix, Inc., from secondary liquidity to primary
liquidity, as they were no longer restricted at September 30, 2005, and an
increase in the market value of those shares. The increase in our total
liquidity is primarily owing to the proceeds from the stock offering, an
increase in the value of our investment in NeuroMetrix, Inc., offset by the
investments made in venture capital portfolio companies 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. In July
2004, we sold 3,450,000 common shares for gross proceeds of $36,501,000; net
proceeds of the offering, after offering costs of $372,825, were $36,128,175. In
September 2005, we completed the sale of 3,507,500 common shares, for total
gross proceeds of $37,091,813. Net proceeds, after offering costs of $565,246,
were $36,526,567. We intend to use, and have been using, the net proceeds of the
offering to make new investments in tiny technology as well as follow-on
investments in our existing venture capital investments, and for working
capital. Through September 30, 2005, we have used $17,351,279 for these
purposes.
28
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.
Recent Developments
On October 24, 2005, we made a $500,000 follow-on investment in a
privately held portfolio company.
On November 1, 2005, we terminated our $8,000,000 asset line of credit.
On November 4, 2005, we made a $3,000,000 initial investment in a
privately held company.
RISK FACTORS
Investing in our shares of common stock involves 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
shares of 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 shares of common stock could decline, and you could lose all or
part of your investment.
Risks related to the companies in our portfolio.
Investing in small, private companies involves a high degree of risk and
is highly speculative.
We have invested a substantial portion of our assets in privately held
development stage or start-up companies. These businesses tend to lack
management depth, to have limited or no history of operations and to have not
attained profitability. Tiny technology companies are especially risky,
involving scientific, technological and commercialization risks. Because of the
speculative nature of these investments, these securities have a significantly
greater risk of loss than traditional investment securities. Some of our venture
capital investments are likely to be complete losses or unprofitable, and some
will never realize their potential. We have been and will continue to be risk
seeking rather than risk averse in our approach to venture capital and other
investments. Neither our investments nor an investment in our shares of common
stock are intended to constitute a balanced investment program.
29
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.
Our portfolio companies may not successfully develop their products.
The technology of our portfolio companies is new and in many cases
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. If our portfolio companies are not able to
develop successful tiny technology-enabled products, they will be unable to
generate product revenue or build sustainable or profitable businesses.
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 effect on those companies' values.
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 in order to meet
commercial demand that are substantially larger than their current capabilities.
Our portfolio companies may not be able to develop commercial scale
manufacturing capabilities or produce products cost effectively. If our
portfolio companies are unable to manufacture economically or to produce their
products in commercial quantities that meet acceptable performance and quality
specifications, we could suffer financial losses in our portfolio.
Even if our portfolio companies develop commercially acceptable products,
they may not be able to manufacture their products in a profitable, cost
effective manner.
Even if the technology and products of our portfolio companies gain
commercial acceptance, they may not be able to manufacture their products in a
profitable manner. 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 manufacturing costs and royalty obligations are not
significantly less than the prices at which they can sell their products, it
would lead to financial losses in our portfolio.
30
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.
Our portfolio companies will need to achieve commercial acceptance of
their products to obtain product revenue and achieve profitability and may not
be able to do so.
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 initial 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 to achieve commercial
acceptance of their products in a cost-effective manner, the value of our
portfolio could be significantly adversely affected.
Unfavorable economic conditions could result in the inability of our
portfolio companies to access additional capital, leading to financial losses in
our portfolio.
Most of the companies in which we have made or will make investments are
susceptible to economic slowdowns or recessions. An economic slowdown or adverse
capital or credit market conditions may affect the ability of a company in our
portfolio to raise additional capital from venture capital or other sources or
to engage in a liquidity event such as an initial public offering or merger.
Adverse economic, capital or credit market conditions may lead to financial
losses in our portfolio.
The value of our portfolio 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, which could have
potential environmental and health impacts. Tiny technology in general and
nanotechnology in particular are currently the subject of health and
environmental impact research. If health or environmental concerns about tiny
technology or nanotechnology were to arise, whether or not they had any basis in
fact, our portfolio companies might incur additional research, legal and
regulatory expenses, might have difficulty raising capital or marketing their
products.
Public perception of ethical and social issues regarding nanotechnology
may limit or discourage the use of nanotechnology-enabled products, which could
reduce our portfolio companies' revenues and harm our business.
Nanotechnology has received both positive and negative publicity and is
the subject increasingly of public discussion and debate. Government authorities
could, for social or other purposes, prohibit or regulate the use of
nanotechnology. Ethical and emotional concerns about nanotechnology could
adversely affect acceptance of the potential products of our portfolio companies
or lead to new government regulation of nanotechnology-enabled products. For
example, debate regarding the production of materials that could cause harm to
the environment or the health of individuals could raise concerns in the
public's perception of nanotechnology, not all of which may be rational or
scientifically based.
31
Risks related to the illiquidity of our investments.
We invest in illiquid securities and may not be able to dispose of them
when it is advantageous to do so, or ever.
Most of our investments are or will be equity or equity-linked securities
acquired directly from small companies. These equity securities are generally
subject to restrictions on resale or otherwise have no established trading
market. The illiquidity of most of our portfolio of equity securities may
adversely affect our ability to dispose of these securities at times when it may
be advantageous for us to liquidate these investments. We may never be able to
dispose of these securities.
Unfavorable economic conditions and regulatory changes could impair our
ability to engage in liquidity events.
Our business of making private equity investments and positioning our
portfolio companies for liquidity events may be adversely affected by current
and future capital markets and economic conditions. The public equity markets
currently provide 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 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 a public company. Slowdowns in initial public offerings also
have an adverse effect on the frequency and prices of acquisitions of privately
held companies. The lack of merger and/or acquisition opportunities for
privately held companies also has an adverse effect on the ability of these
companies to raise capital from private sources. Public equity market response
to company offerings of nanotechnology-enabled products is uncertain. An
inability to engage in liquidity events could negatively affect our liquidity,
our reinvestment rate in new and follow-on investments and the value of our
portfolio.
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 investments 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.
32
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 Investment Company Act of 1940,
which we refer to as 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 an
efficient 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 value to undergo a
so-called "J-curve" valuation pattern. This means that when reflected on a
graph, the portfolio's valuation would appear in the shape of the letter "J,"
declining from the initial valuation prior to increasing in valuation. This
J-curve valuation pattern results from write-downs and write-offs of portfolio
investments that appear to be unsuccessful, prior to write-ups for portfolio
investments that prove to be successful. Even if our venture capital investments
prove to be profitable in the long run, such J-curve valuation patterns could
have a significant adverse effect on the value of our shares of common stock in
the interim. As we continue to make additional tiny technology investments, this
J-curve pattern may not be relevant for the portfolio as a whole because the
individual J-curves for each investment, or series of investments, may overlap
with previous investments at different stages of their J-curves.
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 our assets being invested 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 shares of common stock may
present greater risk to you than an investment in a diversified company.
We may be obligated to pay substantial amounts under our profit-sharing
plan.
Our employee profit-sharing plan requires us to distribute to our officers
and employees 20 percent of any net after-tax realized income as reflected on
our consolidated statements of operations for that year, less any non-qualifying
gain. Payments may be made under our profit-sharing plan in a particular year,
even if we have incurred losses in previous years. These distributions reduce
funds available for investment and 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.
33
Although we have specialized in tiny technology since 2001, as of
September 30, 2005, approximately 57 percent of the net asset value attributable
to our venture capital investment portfolio, or 27 percent of our net asset
value, is concentrated in one company, NeuroMetrix, Inc. We initially invested
in 1996 as a seed investor in NeuroMetrix, Inc., which is not a tiny technology
company.
At September 30, 2005, we valued our investment in NeuroMetrix, Inc.
("NeuroMetrix"), which had a historical cost to us of $4,411,374, at
$33,865,459, or 56.6 percent of the net asset value attributable to our venture
capital investment portfolio, or 27.5 percent of our net asset value.
NeuroMetrix, Inc. is a non-tiny technology company. We made our initial
investment as a seed investor in NeuroMetrix in 1996, prior to 2001 when we
began our focus on tiny technology. It is publicly traded on the Nasdaq National
Market and is often thinly traded. Any downturn in the market price of
NeuroMetrix's stock or its business outlook, in general, or any failure of its
products to receive widespread acceptance in the marketplace, would have a
significant effect on our specific investment in NeuroMetrix, Inc., and on the
overall value of our portfolio. We intend to sell our shares in NeuroMetrix
through one or more transactions at any time in the future.
All 24 of our initial investments from August 2001 through the present
have been in tiny technology companies, and we consider 21 of the companies in
our current venture capital investment portfolio to be tiny technology
companies. Nevertheless, at September 30, 2005, only 43.2 percent of the net
asset value attributable to our venture capital investment portfolio, or 20.8
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 and may
not be able to retain them.
We are dependent for the selection, structuring, closing and monitoring of
our investments on the diligence and skill of our senior management and other
key advisers. We utilize lawyers and outside consultants, including two of our
directors, Dr. Kelly S. Kirkpatrick and Lori D. Pressman, to assist us in
conducting due diligence when evaluating potential investments. There is
generally no publicly available information about the companies in which we
invest, and we rely significantly on the diligence of our employees and advisers
to obtain information in connection with our investment decisions. Our future
success to a significant extent depends on the continued service and
coordination of our senior management team, and particularly depends on our
Chairman and Chief Executive Officer, Charles E. Harris. The departure of any of
our executive officers, key employees or advisers could materially adversely
affect our ability to implement our business strategy. We do not maintain for
our benefit any key man life insurance on any of our officers or employees.
We will need to hire additional employees as the size of our portfolio
increases.
We anticipate that it will be necessary for us to add investment
professionals with expertise in venture capital and/or tiny technology and
administrative and support staff to accommodate the increasing size of our
portfolio. We may need to provide additional scientific, business, accounting,
legal or investment training for our hires. There is competition for highly
qualified personnel, and we may not be successful in our efforts to recruit and
retain highly qualified personnel.
34
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 such financings. 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. Recently, "pay to play" provisions have become common
in venture capital transactions. These provisions require proportionate
investment in subsequent rounds of financing in order to preserve preferred
rights such as anti-dilution protection or even to prevent preferred shares from
being converted to common shares.
We may elect not to make follow-on investments or otherwise lack
sufficient funds to make those investments. We have the discretion to make any
follow-on investments, subject to the availability of capital resources. The
failure to make follow-on investments may, in some circumstances, jeopardize the
continued viability of a portfolio company and our initial investment, or may
result in a missed opportunity for us to increase our participation in a
successful operation, or may cause us to lose some or all preferred rights
pursuant to "pay to play" provisions. Even if we have sufficient capital to make
a desired follow-on investment, we may elect not to make a follow-on investment
because we may not want to increase our concentration of risk, because we prefer
other opportunities or because we are inhibited by compliance with business
development company requirements or the desire to maintain our tax status.
35
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 is the risk of leverage, which is the use of debt to increase
the pool of capital available for investment purposes. 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. If we issue preferred
shares, the common shareholders would bear the cost of this leverage. 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 shares of common stock means that dividends on our shares of
common stock from earnings may be reduced or eliminated. An inability to pay
dividends on our shares of common stock could conceivably result in our ceasing
to qualify as a regulated investment company, or RIC, under the Code, which
would in most circumstances be materially adverse to the holders of our shares
of common stock. As of the date hereof, we do not have any debt or preferred
stock outstanding.
We are authorized to issue preferred stock, which would convey special
rights and privileges to its owners senior to those of common stock
shareholders.
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.
Loss of status as a RIC would reduce our net asset value and distributable
income.
We qualify as a RIC for 2004 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 2005 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. It is possible that establishing reserves for taxes could have a
material adverse effect on the value of our common stock.
36
We operate in a heavily regulated environment and changes to or
non-compliance with regulations and laws could harm our business.
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 additional expense and uncertainty
for publicly held companies in general, and for business development companies
in particular. These new or changed laws, regulations and standards are subject
to varying interpretations in many cases because of their lack of specificity,
and as a result, their application in practice may evolve over time, 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 and will 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 has
required the commitment of significant financial and managerial resources.
Moreover, even though BDCs are not mutual funds, they must comply with several
of the new regulations applicable to mutual funds, such as the requirement for
the implementation of a comprehensive compliance program and the appointment of
a Chief Compliance Officer. 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 the related expense, 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, 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. This increased regulatory burden 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.
If we are unable to remediate a material weakness previously identified in
our internal controls, or have other significant deficiencies or material
weaknesses, our ability to report our financial results on a timely and accurate
basis may be adversely affected.
Our management is responsible for establishing and maintaining adequate
internal control over financial reporting. Our internal control system is
designed to provide reasonable assurance to our management and Board of
Directors regarding the preparation and fair presentation of published financial
statements. Effective internal controls are necessary for us to provide reliable
financial reports.
We have in the past discovered, and may in the future discover, areas of
our internal controls that need improvement. 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. In addition, during the preparation and review of
the financial statements for the fiscal periods ended June 30, 2005, an error
was identified in the spreadsheet used to compute the line item referred to as
"Portfolio Turnover" in the Financial Highlights section, which existed at
December 31, 2004 and had not yet been addressed in the remediation process. The
error was corrected in the financial statements included in our Quarterly Report
on Form 10-Q for the quarter ended June 30, 2005 and did not have a material
impact on previously issued financial statements.
37
We have implemented the following changes to our internal control over
financial reporting during the first, second and third quarters of 2005:
1. We retained Anne M. Donoho, C.P.A., M.B.A., to serve as a temporary,
senior controller and consultant, from March 14, 2005 through August 2005.
2. We hired Patricia N. Egan, C.P.A, to serve as Chief Accounting Officer
and Senior Controller, effective June 13, 2005.
3. On March 5, 2005, we engaged an independent accounting and consulting
firm with investment company 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.
4. In March 2005, we revised the worksheet that we use for preparing our
Annual and Interim Reports to clarify how ratios in the Financial Highlights
section are calculated. In July 2005, we further revised this worksheet.
5. In March 2005, we 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.
6. We retained Robert D. Jenvey, C.P.A., to serve as a temporary
controller effective October 17, 2005.
We will continue to evaluate the effectiveness of internal controls and
procedures on an ongoing basis. A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Because of the inherent limitations in
all control systems, no evaluation of controls can provide absolute assurance
that all controls issues within the Company have been detected. These inherent
limitations include the realities that judgments in decision-making can be
faulty, and that breakdowns can occur because of simple error or mistake.
Additionally, controls can be circumvented. Because of the inherent limitations
in a cost-effective control system, misstatements due to error or fraud may
occur and not be detected.
If we are unable to remediate the identified material weakness in our
internal controls or if we have other significant deficiencies or material
weaknesses in our internal controls, our ability to report financial results on
a timely and accurate basis may be adversely affected.
38
We expect that the market price of our common stock will be volatile.
The price of the shares of our 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 may include 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.
To the extent that we do not realize income or retain after-tax realized
capital gains, we may have a greater need for additional capital to fund our
investments and operating expenses.
As a RIC, we must annually distribute at least 90 percent of our
investment company taxable income as a dividend and may either distribute or
retain our realized net capital gains from investments. As a result, 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 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 these requirements. Lack of capital could curtail our
investment activities or impair our working capital.
39
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.
Investing in our stock is highly speculative and an investor could lose
some or all of the amount invested.
Our investment objective and strategies result in a high degree of risk in
our investments and may result in losses in the value of our investment
portfolio. Our investments in portfolio companies are highly speculative and,
therefore, an investor in our common stock may lose his or her entire
investment. The value of the shares of our common stock may decline and may be
affected by numerous market conditions, which could result in the loss of some
or all of the amount invested in our common stock. The securities markets
frequently experience extreme price and volume fluctuations which affect market
prices for securities of companies generally, and technology and very small
capitalization companies in particular. Because of our focus on the technology
and very small capitalization sectors, and because we are a small capitalization
company ourselves, our stock price is especially likely to be affected by these
market conditions. General economic conditions, and general conditions in the
Internet and information technology, life sciences, nanotechnology, tiny
technology, materials science and other high technology industries, may also
affect the price of the shares of our common stock.
Our shares might trade at discounts from net asset value, or at premiums
that are unsustainable over the long term.
Shares of business development companies like us may, during some periods,
trade at prices higher than their net asset value and during other periods, as
frequently occurs with closed-end investment companies, trade at prices lower
than their net asset value. The possibility that our shares will trade at
discounts from net asset value or at premiums that are unsustainable over the
long term are risks separate and distinct from the risk that our net asset value
will decrease. The risk of purchasing shares of a business development company
that might trade at a discount or unsustainable premium is more pronounced for
investors who wish to sell their shares in a relatively short period of time
because, for those investors, realization of a gain or loss on their investments
is likely to be more dependent upon the existence of a premium or discount than
upon portfolio performance. Our shares of common stock may not trade at a price
higher than or equal to net asset value. On September 30, 2005, our stock closed
at $11.10 per share, a premium of $5.16 over our net asset value per share of
$5.94 as of September 30, 2005.
40
You have no right to require us to repurchase your shares.
You do not have the right to require us to repurchase your shares of
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.")
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, 57
percent of the value of our portfolio of venture capital investments consists of
the publicly traded common stock of one company, NeuroMetrix, Inc., which we
intend to sell through one or more transactions at any time in the future.
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."
41
We also invest in short-term money market instruments, and both short- and
long-term U.S. government and government agency securities. To the extent that
we invest in short- and long-term U.S. government and government agency
securities, 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 government agency securities at
September 30, 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
$177,223, $531,668 and $1,063,335, respectively.
While we invest in short-term money market and U.S. government and
government agency securities 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 our 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")). 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 of September 30, 2005, based upon the evaluation of our
disclosure controls and procedures and in light of the material weakness
described below, our chief executive officer and our chief financial officer
concluded that our disclosure controls and procedures were not effective.
However, in light of the material weakness described below, we performed
additional analysis and other post-closing procedures to ensure that our
financial statements are prepared in accordance with generally accepted
accounting principles.
(b) Changes in Internal Control Over Financial Reporting.
Remediation Update
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. In
addition, during the preparation and review of the financial statements for the
fiscal periods ended June 30, 2005, an error was identified in the spreadsheet
used to compute the line item referred to as "Portfolio Turnover" in the
Financial Highlights section, which existed at December 31, 2004 and had not yet
been addressed in the remediation process. The error was corrected in the
financial statements included in our Quarterly Report on Form 10-Q for the
quarter ended June 30, 2005, and did not have a material impact on previously
issued financial statements.
42
As a result of the above material weakness, we 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,
second and third quarters 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 retained Anne M. Donoho, C.P.A., M.B.A., to serve as a temporary,
senior controller and consultant, from March 14, 2005 through August 2005.
2. We hired Patricia N. Egan, C.P.A, to serve as Chief Accounting Officer
and Senior Controller, effective June 13, 2005.
3. On March 5, 2005, we engaged an independent accounting and consulting
firm with investment company 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.
4. In March and July 2005, we revised the worksheet that we use for
preparing our Annual and Interim Reports to clarify how ratios in the Financial
Highlights section are calculated.
5. In March 2005, we 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.
6. We retained Robert D. Jenvey, C.P.A., to serve as a temporary
controller effective October 17, 2005.
We have determined that before we consider the material weakness to be
remediated, additional testing of our procedures for preparing the Financial
Highlights ratios is prudent to ensure the new procedures are operating
effectively.
Other Changes
Other than as described above, we did not implement any further 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 third 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.
43
PART II. OTHER INFORMATION
Item 6. Exhibits
3.1(a) Restated Certificate of Incorporation, incorporated by
reference as Exhibit 99 to Form 8-K dated September 27, 2005.
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
44
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
/s/ Patricia N. Egan
-------------------------------------
By: Patricia N. Egan
Chief Accounting Officer and
Vice President
Date: November 4, 2005
45
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.
46