10-Q: Quarterly report [Sections 13 or 15(d)]
Published on May 15, 2002
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For quarterly period ended March 31, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to _____________
Commission File Number: 0-11576
HARRIS & HARRIS GROUP, INC.
- --------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
New York 13-3119827
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(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
- --------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
(212) 332-3600
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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 the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
Class Outstanding at May 4, 2002
- -----------------------------------------------------------------------
Common Stock, $0.01 par value per share 8,864,231 shares
Harris & Harris Group, Inc.
Form 10-Q, March 31, 2002
TABLE OF CONTENTS
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements.................... 1
Consolidated Statements of Assets and Liabilities............. 2
Consolidated Statements of Operations......................... 3
Consolidated Statements of Cash Flows......................... 4
Consolidated Statements of Changes in Net Assets.............. 5
Consolidated Schedule of Investments.......................... 6
Notes to Consolidated Financial Statements.................... 13
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................. 20
Financial Condition........................................... 21
Results of Operations......................................... 22
Liquidity and Capital Resources............................... 23
Risk Factors.................................................. 24
Item 3. Quantitative and Qualitative Disclosures About
Market Risk.......................................... 30
PART II OTHER INFORMATION
Item 1. Legal Proceedings..................................... 32
Item 2. Changes in Securities and Use of Proceeds............. 32
Item 3. Defaults Upon Senior Securities....................... 32
Item 4. Submission of Matters to a Vote of Security Holders... 32
Item 5. Other Information..................................... 32
Item 6. Exhibits and Reports on Form 8-K...................... 33
Exhibit Index................................................. 34
Signature..................................................... 34
Harris & Harris Group, Inc.
Form 10-Q, March 31, 2002
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated
financial statements reflect all adjustments that are, in the
opinion of management, necessary for a fair presentation of the
results for the interim period presented.
On June 30, 1994, shareholders of Harris & Harris Group,
Inc. (the "Company") approved a proposal to allow the Company
to make an election to become a Business Development Company
("BDC") under the amended Investment Company Act of 1940. The
Company made such election on July 26, 1995. Certain information
and disclosures normally included in the consolidated financial
statements in accordance with Generally Accepted Accounting
Principles have been condensed or omitted as permitted by
Regulation S-X and Regulation S-K. It is suggested that the
accompanying consolidated financial statements be read in
conjunction with the audited consolidated financial statements
and notes thereto for the year ended December 31, 2001 contained
in the Company's 2001 Annual Report.
On September 25, 1997, the Company's Board of Directors
approved a proposal to seek qualification of the Company as a
Regulated Investment Company ("RIC") under Sub-Chapter M of the
Internal Revenue Code (the "Code"). At that time, the Company
was taxable under Sub-Chapter C of the Code (a "C Corporation").
In order to qualify as a RIC, the Company must, in general (1)
annually derive at least 90 percent of its gross income from
dividends, interest and gains from the sale of securities; (2)
quarterly meet certain investment diversification requirements;
and (3) annually distribute at least 90 percent of its investment
company taxable income as a dividend. In addition to the
requirement that the Company must annually distribute at least 90
percent of its investment company taxable income, the Company may
either distribute or retain its taxable net capital gains from
investments, but any net capital gains not distributed could be
subject to corporate level tax. Further, the Company could be
subject to a four percent excise tax if it fails to distribute 98
percent of its annual taxable income and would be subject to
income tax if it fails to distribute 100 percent of its taxable
income.
Because of the specialized nature of its investment
portfolio, the Company could satisfy the diversification
requirements under Sub-Chapter M of the Code only if it received
a certification from the Securities and Exchange Commission
("SEC") that it is "principally engaged in the furnishing of
capital to other corporations which are principally engaged in
the development or exploitation of inventions, technological
improvements, new processes, or products not previously generally
available."
On March 7, 2002, the Company received SEC certification and
qualified for RIC treatment for 2001 (as it had for 2000 and
1999). Although the SEC certification for 2001 was issued, there
can be no assurance that the Company will receive such
certification for subsequent years (to the extent it needs
additional certification as a result of changes in its portfolio)
or that it will actually qualify for Sub-Chapter M treatment in
subsequent years. In addition, under certain circumstances, even
if the Company qualified for Sub-Chapter M treatment in a given
year, the Company might take action in a subsequent year to
ensure that it would be taxed in that subsequent year as a C
Corporation, rather than as a RIC.
1
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
March 31, 2002 December 31, 2001
(Unaudited) (Audited)
Investments, at value (Cost:
$33,316,719 at 3/31/02,
$37,714,285 at 12/31/01)..........$ 33,975,983 $ 38,930,705
Cash and cash equivalents........... 312,025 135,135
Restricted funds (Note 5)........... 554,967 482,020
Interest receivable................. 0 82
Note receivable ($10,487, net of
reserve of $10,487)............... 0 10,487
Prepaid expenses.................... 71,117 14,833
Other assets........................ 91,478 109,105
------------ ------------
Total assets........................$ 35,005,570 $ 39,682,367
============ ============
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities.......................$ 1,029,753 $ 1,039,350
Bank loan payable (Note 8).......... 8,996,740 12,495,777
Accrued profit sharing (Note 3)..... 306,241 178,282
Deferred rent....................... 12,337 14,650
Current income tax receivable
(Note 6).......................... (1,807) 255,068
Deferred income tax liability
(Note 6).......................... 1,364,470 1,364,470
------------ ------------
Total liabilities................... 11,707,734 11,509,948
------------ ------------
Commitments and contingencies (Note 7)
Net assets..........................$ 23,297,836 $ 24,334,770
============ ============
Net assets are comprised of:
Preferred stock, $0.10 par value,
2,000,000 shares authorized;
none issued.......................$ 0 $ 0
Common stock, $0.01 par value,
25,000,000 shares authorized;
10,692,971 issued at 3/31/02
and 12/31/01...................... 106,930 106,930
Additional paid in capital (Note 4). 27,228,748 27,228,748
Additional paid in capital -
common stock warrants............. 109,641 109,641
Accumulated net realized gain
(loss)............................ 138,829 618,606
Accumulated unrealized appreciation
of investments, net of deferred
tax liability of $1,540,044 at
3/31/02 and 12/31/01.............. (880,781) (323,624)
Treasury stock at cost (1,828,740
shares at 3/31/02 and 12/31/01)... (3,405,531) (3,405,531)
------------ ------------
Net assets..........................$ 23,297,836 $ 24,334,770
============ ============
Shares outstanding.................. 8,864,231 8,864,231
============ ============
Net asset value per outstanding
share.............................$ 2.63 $ 2.75
============ ============
The accompanying notes are an integral part of
these consolidated financial statements.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2002 March 31, 2001
Investment income:
Interest from:
Unaffiliated issuers.............$ 54,136 $ 152,530
Affiliated companies............. 0 9,617
Other income....................... 5,326 29,812
------------ ------------
Total investment income.......... 59,462 191,959
Expenses:
Profit-sharing accrual (reversal)
(Note 3)......................... 127,959 (846,290)
Salaries and benefits.............. 255,376 299,704
Administration and operations...... 87,902 93,256
Professional fees.................. 43,095 59,203
Rent............................... 42,724 42,073
Directors' fees and expenses....... 41,076 22,990
Depreciation....................... 5,948 7,500
Custodian fees..................... 3,839 3,646
Interest expense (Note 4).......... 7,776 0
------------ ------------
Total expenses................... 615,695 (317,918)
------------ ------------
Operating (loss) income before
income taxes..................... (556,233) 509,877
Income tax provision (Note 6)...... 0 0
------------ ------------
Net operating (loss) income......... (556,233) 509,877
Net realized gain (loss) on investments:
Realized gain (loss) on
investments...................... 110,679 (1,194,652)
------------ ------------
Total realized gain (loss)....... 110,679 (1,194,652)
Income tax provision (Note 6)...... (34,223) (29,634)
------------ ------------
Net realized gain (loss) on
investments...................... 76,456 (1,224,286)
------------ ------------
Net realized loss................... (479,777) (714,409)
Net decrease in unrealized appreciation on investments:
Decrease as a result of
investment sales................. 0 0
Increase as a result of
investment sales................. 0 1,528,082
Increase on investments held....... 45,006 0
Decrease on investments held....... (602,163) (4,611,013)
------------ -----------
Change in unrealized appreciation
on investments................. (557,157) (3,082,931)
Income tax provision (Note 6)...... 0 0
------------ -----------
Net decrease in unrealized
appreciation on investments...... (557,157) (3,082,931)
------------ -----------
Net decrease in net assets resulting from operations:
Total.............................$ (1,036,934) $(3,797,340)
============ ===========
Per outstanding share.............$ (0.12) $ (0.42)
============ ===========
The accompanying notes are an integral part of
these consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2002 March 31, 2001
Cash flows from operating activities:
Net decrease in net assets
resulting from operations...........$(1,036,934) $(3,797,340)
Adjustments to reconcile net
decrease in net assets resulting
from operations to net cash used
in operating activities:
Net realized and unrealized loss
on investments................. 442,349 4,277,583
Depreciation..................... 5,948 7,500
Changes in assets and liabilities:
Restricted funds.................... (72,947) (65,919)
Interest receivable................. 82 30,000
Note receivable..................... 10,487 0
Prepaid expenses.................... (56,284) 20,371
Other assets........................ 17,627 (18,417)
Accounts payable and accrued
liabilities....................... (9,597) 6,670
Payable to broker for unsettled
trade............................. 0 (115,005)
Accrued profit sharing.............. 127,959 (2,938,855)
Current income tax liability........ (256,875) (5,682,250)
Deferred rent....................... (2,313) (2,313)
---------- -----------
Net cash used in operating
activities........................ (830,498) (8,277,975)
Cash flows from investing activities:
Net (purchase) sale of short-term
investments and marketable
securities....................... 6,753,035 8,895,704
Proceeds from investments........... 180,211 0
Investment in private placements
and loans......................... (2,425,000) (750,000)
Purchase of fixed assets............ (1,821) (2,609)
----------- -----------
Net cash provided by investing
activities........................ 4,506,425 8,143,095
Cash flows from financing activities:
Payment of bank loan payable........ (3,499,037) 0
----------- -----------
Net cash used in financing
activities......................... (3,499,037) 0
Net increase (decrease) in cash and cash equivalents:
Cash and cash equivalents at
beginning of the period........... 135,135 253,324
Cash and cash equivalents at
end of the period................. 312,025 118,444
----------- -----------
Net increase (decrease) in cash
and cash equivalents..............$ 176,890 $ (134,880)
=========== ===========
Supplemental disclosures of cash flow information:
Income taxes paid...................$ 290,748 $ 5,711,884
Interest paid.......................$ 11,108 $ 0
The accompanying notes are an integral part of
these consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Three Months Ended
March 31, 2002 March 31, 2001
Changes in net assets from operations:
Net operating (loss) income.........$ (556,233) $ 509,877
Net realized gain (loss) on
investments....................... 76,456 (1,224,286)
Net increase in unrealized
appreciation on investments as
a result of sales................. 0 1,528,082
Net decrease in unrealized
appreciation on investments held.. (557,157) (4,611,013)
----------- -------------
Net decrease in net assets
resulting from operations......... (1,036,934) (3,797,340)
Net decrease in net assets............ (1,036,934) (3,797,340)
----------- -------------
Net assets:
Beginning of the period............. 24,334,770 31,833,475
----------- -------------
End of the period...................$23,297,836 $ 28,036,135
=========== =============
The accompanying notes are an integral part of
these consolidated financial statements.
5
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (10)(11)(12) --
9.7% of total investments
Private Placement Portfolio (Illiquid) - 9.7% of total investments
AlphaSimplex Group, LLC (2) --
Investment advisory firm headed
by Dr. Andrew W. Lo, holder of
the Harris & Harris Group
Chair at MIT........................(D) -- $ 4,763
Exponential Business Development
Company (1)(2)(5) -- Venture
capital partnership focused on
early stage companies
Limited
partnership interest................(A) -- 25,000
Informio, Inc. (1)(2)(5)(6)(7) --
Develops audio web portal
technology -- 0.86% of fully
diluted equity
Series A Convertible
Preferred Stock.....................(D) 229,364 151,380
Kriton Medical, Inc. (1)(2)(5)(6) --
Develops ventricular assist
devices -- 1.83% of fully diluted
equity
Series B Convertible
Preferred Stock.....................(A) 476,191 1,000,001
NanoOpto Corporation (1)(2)(4)(6) --
Develops and manufactures high
performance, integrated optical
communication sub-components on a
chip -- 1.45% of fully diluted
equity
Series A-1 Convertible
Preferred Stock.....................(A) 267,857 625,000
Nantero, Inc. (1)(2)(5)(6) --
Develops a high density nonvolatile
random access memory chip using
nanotechnology -- 4.18% of fully
diluted equity
Series A Convertible
Preferred Stock.....................(A) 345,070 489,999
NeoPhotonics Corporation (1)(2)(4)(6)
-- Develops and manufactures planar
optical devices and components
using nanomaterials deposition
technology -- 2.27% of fully
diluted equity
Series D Convertible
Preferred Stock.....................(A) 1,478,197 1,000,000
----------
Total Private Placement Portfolio (cost: $3,648,509).........$3,296,143
----------
Total Investments in Unaffiliated Companies
(cost: $3,648,509)...........................................$3,296,143
----------
The accompanying notes are an integral part
of this consolidated schedule.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated Companies (10)(11)(13)
- -- 34.2% of total investments
Private Placement Portfolio (Illiquid) - 34.2% of total investments
Experion Systems, Inc. (1)(2)(6)(8)
-- Develops and sells software
to credit unions -- 10.86% of
fully diluted equity
Series A Convertible
Preferred Stock......................(D) 187,500
Series B Convertible
Preferred Stock......................(D) 22,500 $ 600,000
Nanopharma Corp. (1)(2)(4)(6) --
Develops advanced drug delivery
systems - 14.69% of fully
diluted equity
Series A Convertible
Preferred Stock......................(A) 684,516 700,000
NeuroMetrix, Inc. (1)(2)(5)(6) --
Develops and sells medical devices
for monitoring neuromuscular
disorders -- 13.40% of fully
diluted equity
Series A Convertible
Preferred Stock......................(D) 875,000
Series B Convertible
Preferred Stock......................(D) 625,000
Series C-2 Convertible
Preferred Stock......................(D) 1,148,100
Series E Convertible Preferred.......(D) 266,665 6,708,225
PHZ Capital Partners Limited
Partnership (2)(9) -- Organizes and
manages investment partnerships
utilizing its proprietary
algorithms -- 20.0% of fully
diluted equity
Limited partnership interest.........(D) -- 2,892,498
Questech Corporation (1)(2)(5)(6) --
Manufactures and markets proprietary
metal decorative tiles - 6.89% of
fully diluted equity
Common Stock.........................(B) 646,954
Warrants at $5.00 expiring 11/15/04..(B) 1,965
Warrants at $1.50 expiring 11/16/05..(B) 1,250 724,588
Schwoo, Inc. (1)(2)(5)(6) -- Develops
software that automatically manages
e-commerce security infrastructure
-- 14.88% of fully diluted equity
Series B Convertible Stock...........(D) 2,306,194
Convertible Bridge Loans.............(D) $360,250
Series B Convertible
Preferred Warrants...................(D) 934,985 0
-----------
Total Private Placement Portfolio (cost: $10,612,494).........$11,625,311
-----------
Total Investments in Non-Controlled Affiliated
Companies (cost: $10,612,494).................................$11,625,311
-----------
The accompanying notes are an integral part
of this consolidated schedule.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2002
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
U.S. Government and Agency Obligations - 56.1% of total investments
U.S. Treasury Bills --
due date 04/04/02..................(K) $9,000,000 $ 8,998,740
U.S. Treasury Bills --
due date 04/11/02..................(K) $2,000,000 $ 1,999,060
U.S. Treasury Bills --
due date 04/18/02..................(K) $1,400,000 $ 1,398,866
U.S. Treasury Bills --
due date 05/09/02..................(K) $2,875,000 $ 2,869,825
U.S. Treasury Bills --
due date 05/23/02..................(K) $2,000,000 $ 1,995,040
U.S. Treasury Bills --
due date 06/20/02..................(K) $1,800,000 $ 1,792,998
----------
Total Investments in U.S. Government (cost: $19,055,716).....$19,054,529
-----------
Total Investments -- 100% (cost: $33,316,719)................$33,975,983
===========
The accompanying notes are an integral part
of this consolidated schedule.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF MARCH 31, 2002
(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 Methods of Valuation A to L.
(4) Initial investment was made during 2002. The amounts shown on
the schedule as cost represent the gross additions in 2002.
(5) No changes in valuation occurred in these investments during
the three months ended March 31, 2002.
(6) These investments are development stage companies. A
development stage company is defined as a company that is
devoting substantially all of its efforts to establishing a new
business, and either it has not yet commenced its planned
principal operations or it has commenced such operations but
has not realized significant revenue from them.
(7) Previously named iPacer Corporation.
(8) Previously named MyPersonalAdvocate.com, Inc.
(9) Harris Partners I, L.P. owns a 20 percent limited partnership
interest in PHZ Capital Partners L.P. The partners of Harris
Partners I, L.P. are Harris & Harris Enterprises, Inc. (sole
general partner) and Harris & Harris Group, Inc. (sole limited
partner). Harris & Harris Enterprises, Inc. is a 100 percent
owned subsidiary of Harris & Harris Group, Inc.
(10) Investments in unaffiliated companies consist of investments
in which the Company owns less than five percent of the
portfolio company. Investments in non-controlled affiliated
companies consist of investments in which the Company owns more
than five percent but less than 25 percent of the portfolio
company. Investments in controlled affiliated companies
consist of investments in which the Company owns more than 25
percent of the portfolio company.
(11) The percentage ownership of each portfolio company disclosed
in the Consolidated Schedule of Investments expresses the
potential common equity interest in each such portfolio
company. The calculated percentage represents the amount of
the issuer's common stock the Company owns or can acquire as a
percentage of the issuer's total outstanding common stock plus
common shares reserved for issued and outstanding warrants,
convertible securities and stock options.
(12) The aggregate cost for federal income tax purposes of
investments in unaffiliated companies is $3,648,509. The gross
unrealized depreciation based on the tax cost for these
securities is $353,221. The gross unrealized appreciation
based on the tax cost for these securities is $855.
(13) The aggregate cost for federal income tax purposes of
investments in non-controlled affiliated companies is
$10,612,494. The gross unrealized depreciation based on the tax
cost for these securities is $4,767,268. The gross unrealized
appreciation based on the tax cost for these securities is
$3,754,451.
The accompanying notes are an integral part
of this consolidated schedule.
9
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
ASSET VALUATION POLICY GUIDELINES
The Company's investments can be classified into five broad
categories for valuation purposes:
1) EQUITY-RELATED SECURITIES
2) INVESTMENTS IN INTELLECTUAL PROPERTY OR
PATENTS OR RESEARCH AND DEVELOPMENT IN
TECHNOLOGY OR PRODUCT DEVELOPMENT
3) LONG-TERM FIXED-INCOME SECURITIES
4) SHORT-TERM FIXED-INCOME INVESTMENTS
5) ALL OTHER INVESTMENTS
The Investment Company Act of 1940 (the "1940 Act") requires
periodic valuation of each investment in the Company's portfolio
to determine net asset value. Under the 1940 Act, unrestricted
securities with readily available market quotations are to be
valued at the current market value; all other assets must be
valued at "fair value" as determined in good faith by or under
the direction of the Board of Directors.
The Company's Board of Directors is responsible for (1)
determining overall valuation guidelines and (2) ensuring the
valuation of investments within the prescribed guidelines.
The Company's Investment and Valuation Committee, comprised
of at least three or more outside Board members, is responsible
for reviewing and approving the valuation of the Company's assets
within the guidelines established by the Board of Directors.
Fair value is generally defined as the amount that an
investment could be sold for in an orderly disposition over a
reasonable time. Generally, to increase objectivity in valuing
the assets of the Company, external measures of value, such as
public markets or third-party transactions, are utilized whenever
possible. Valuation is not based on long-term work-out value, nor
immediate liquidation value, nor incremental value for potential
changes that may take place in the future.
Valuation assumes that, in the ordinary course of its
business, the Company will eventually sell its investment.
The Company's valuation policy with respect to the five
broad investment categories is as follows:
EQUITY-RELATED SECURITIES
Equity-related securities are carried at fair value using
one or more of the following basic methods of valuation:
A. Cost: The cost method is based on the original cost to
the Company. This method is generally used in the early stages
of a company's development until significant positive or negative
events occur subsequent to the date of the original investment
that dictate a change to another valuation method. Some examples
of such events are: (1) a major recapitalization; (2) a major
10
refinancing; (3) a significant third-party transaction; (4) the
development of a meaningful public market for the company's
common stock; and (5) significant positive or negative changes in
the company's business.
B. Private Market: The private market method uses actual
third-party transactions in the company's securities as a basis
for valuation, using actual, executed, historical transactions in
the company's securities by responsible third parties. The
private market method may also use, where applicable,
unconditional firm offers by responsible third parties as a basis
for valuation.
C. Public Market: The public market method is used when
there is an established public market for the class of the
company's securities held by the Company. The Company discounts
market value for securities that are subject to significant legal
and contractual restrictions. Other securities, for which market
quotations are readily available, are carried at market value as
of the time of valuation.
Market value for securities traded on securities exchanges
or on the Nasdaq National Market is the last reported sales price
on the day of valuation. For other securities traded in the
over-the-counter market and listed securities for which no sale
was reported on that day, market value is the mean of the closing
bid price and asked price on that day.
This method is the preferred method of valuation when there
is an established public market for a company's securities, as
that market provides the most objective basis for valuation.
D. Analytical Method: The analytical method is generally
used to value an investment position when there is no established
public or private market in the company's securities or when the
factual information available to the Company dictates that an
investment should no longer be valued under either the cost or
private market method. This valuation method is inherently
imprecise and ultimately the result of reconciling the judgments
of the Company's Investment and Valuation Committee members,
based on the data available to them. The resulting valuation,
although stated as a precise number, is necessarily within a
range of values that vary depending upon the significance
attributed to the various factors being considered. Some of the
factors considered may include the financial condition and
operating results of the company, the long-term potential of the
business of the company, the values of similar securities issued
by companies in similar businesses, the proportion of the
company's securities owned by the Company and the nature of any
rights to require the company to register restricted securities
under applicable securities laws.
INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND
DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the
following basic methods of valuation:
E. Cost: The cost method is based on the original cost to
the Company. Such method is generally used in the early stages of
commercializing or developing intellectual property or patents or
research and development in technology or product development
until significant positive or adverse events occur subsequent to
the date of the original investment that dictate a change to
another valuation method.
F. Private Market: The private market method uses actual
third-party investments in intellectual property or patents or
research and development in technology or product development as
a basis for valuation, using actual executed historical
transactions by responsible third parties.
11
The private market method may also use, where applicable,
unconditional firm offers by responsible third parties as a basis
for valuation.
G. Analytical Method: The analytical method is used to
value an investment after analysis of the best available outside
information where the factual information available to the
Company dictates that an investment should no longer be valued
under either the cost or private market method. This valuation
method is inherently imprecise and ultimately the result of
reconciling the judgments of the Company's Investment and
Valuation Committee members. The resulting valuation, although
stated as a precise number, is necessarily within a range of
values that vary depending upon the significance attributed to
the various factors being considered. Some of the factors
considered may include the results of research and development,
product development progress, commercial prospects, term of
patent and projected markets.
LONG-TERM FIXED-INCOME SECURITIES
H. Fixed-Income Securities for which market quotations are
readily available are carried at market value as of the time of
valuation using the most recent bid quotations when available.
Securities for which market quotations are not readily
available are carried at fair value using one or more of the
following basic methods of valuation:
I. Fixed-Income Securities are valued by independent
pricing services that provide market quotations based primarily
on quotations from dealers and brokers, market transactions, and
other sources.
J. Other Fixed-Income Securities that are not readily
marketable are valued at fair value by the Investment and
Valuation Committee.
SHORT-TERM FIXED-INCOME INVESTMENTS
K. Short-Term Fixed-Income Investments are valued at
market value at the time of valuation. Short-term debt with
remaining maturity of 60 days or less is valued at amortized
cost.
ALL OTHER INVESTMENTS
L. All Other Investments are reported at fair value as
determined in good faith by the Investment and Valuation
Committee.
The reported values of securities for which market
quotations are not readily available and for other assets
reflect the Investment and Valuation Committee's judgment of
fair values as of the valuation date using the outlined basic
methods of valuation. They do not necessarily represent an
amount of money that would be realized if the securities had to
be sold in an immediate liquidation. The Company makes many of
its portfolio investments with the view of holding them for a
number of years, and the reported value of such investments may
be considered in terms of disposition over a period of time.
Thus valuations as of any particular date are not necessarily
indicative of amounts that may ultimately be realized as a
result of future sales or other dispositions of investments
held.
12
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. THE COMPANY
Harris & Harris Group, Inc. (the "Company") is a venture
capital investment company operating as a business development
company ("BDC") under the Investment Company Act of 1940 ("1940
Act"). A BDC is a specialized type of investment company under
the 1940 Act. The Company operates as an internally managed
investment company whereby its officers and employees, under the
general supervision of its Board of Directors, conduct its
operations.
The Company elected to become a BDC on July 26, 1995, after
receiving the necessary approvals. From September 30, 1992 until
the election of BDC status, the Company operated as a closed-end,
non-diversified, investment company under the 1940 Act. Upon
commencement of operations as an investment company, the Company
revalued all of its assets and liabilities at fair value as
defined in the 1940 Act. Prior to such time, the Company was
registered and filed under the reporting requirements of the
Securities and Exchange Act of 1934 as an operating company and,
while an operating company, operated directly and through
subsidiaries.
Harris & Harris Enterprises, Inc. ("Enterprises") is a 100
percent wholly owned subsidiary of the Company. Enterprises
holds the lease for the office space, which it subleases to the
Company and an unaffiliated party; operates a financial relations
and consulting firm; is a partner in Harris Partners I, L.P. and
is taxed as a C corporation. Harris Partners I L.P. is a limited
partnership and owns a 20 percent limited partnership interest in
PHZ Capital Partners, L.P. The partners of Harris Partners I
L.P. are Enterprises (sole general partner) and the Company (sole
limited partner).
The Company qualified for 2001 as a Regulated Investment
Company ("RIC") under Sub-Chapter M of the Internal Revenue Code
of 1986 (the "Code"). There can be no assurance that the Company
will qualify as a RIC in 2002 or that, if it does qualify, it
will continue to qualify for subsequent years. In addition, even
if the Company were to qualify as a RIC for a given year, the
Company might take action in a subsequent year to ensure that it
would be taxed in that subsequent year as a C Corporation, rather
than a RIC. As a RIC, the Company must, among other things,
distribute at least 90 percent of its taxable net income and may
either distribute or retain its taxable net realized capital
gains on investments.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting
policies followed in the preparation of the consolidated
financial statements:
Principles of Consolidation. The consolidated financial
statements have been prepared in accordance with accounting
principles generally accepted in the United States for
investment companies and include the accounts of the Company
and its wholly owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in
consolidation.
Cash and Cash Equivalents. Cash and cash equivalents
include money market funds.
13
Portfolio Investment Valuations. Investments are stated
at "fair value" as defined in the 1940 Act and in the applicable
regulations of the Securities and Exchange Commission. All
assets are valued at fair value as determined in good faith by,
or under the direction of, the Board of Directors. (See the
"Asset Valuation Policy Guidelines" in the "Footnote to
Consolidated Schedule of Investments.")
Securities Transactions. Securities transactions are
accounted for on the date the securities are purchased or sold
(trade date); dividend income is recorded on the ex-dividend
date; and interest income is accrued as earned. Realized gains
and losses on investment transactions are determined on the
specific identification basis for financial reporting and tax
reporting.
Income Taxes. Prior to January 1, 1999, the Company
recorded income taxes using the liability method in accordance
with the provision of Statement of Financial Accounting Standards
No. 109. Accordingly, deferred tax liabilities had been
established to reflect temporary differences between the
recognition of income and expenses for financial reporting and
tax purposes, the most significant difference of which related to
the Company's unrealized appreciation on investments.
The March 31, 2002 consolidated financial statements include
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 the Company through
December 31, 1998.
The March 31, 2001 and December 31, 2001 consolidated
financial statements also reflect a tax provision on net realized
long-term capital gains which the Company retained for liquidity
and to fund investment opportunities, rather than distribute to
shareholders as a cash distribution. Accordingly, the Company
declared a designated undistributed capital gain dividend for the
year. (See "Note 6. Income Taxes" and Item 2. "Management's
Discussion and Analysis of Financial Condition and Results of
Operation -- Recent Developments -- Sub-Chapter M Status.")
The Company pays federal, state and local income taxes on
behalf of its wholly owned subsidiary, Harris & Harris
Enterprises, which is a C corporation. (See Note 6. Income
Taxes.)
Estimates by Management. The preparation of the
consolidated financial statements in conformity with accounting
principles generally accepted in the United States requires
management to make estimates and assumptions that affect the
reported amounts of assets and liabilities as of March 31, 2002
and December 31, 2001, and the reported amounts of revenues and
expenses for the three months ended March 31, 2002 and March 31,
2001. Actual results could differ from these estimates.
NOTE 3. EMPLOYEE PROFIT-SHARING PLAN
On August 3, 1989, the shareholders of the Company approved
the 1988 Long Term Incentive Compensation Plan (the "1988 Plan").
The Company's 1988 Plan was cancelled as of December 31, 1997,
canceling all outstanding stock options and eliminating all
potential stock option grants. As a substitution for the 1988
Plan, the Company adopted an employee profit-sharing plan.
As of January 1, 1998, the Company began implementing the
Harris & Harris Group, Inc. Employee Profit-Sharing Plan (the
"1998 Plan") that provides for profit sharing equal to 20 percent
of the net realized income of the Company as reflected on the
Consolidated Statements of Operations for such year, less the
nonqualifying gain, if any. The 1998 Plan was terminated by the
Company as of December 31, 1999, subject to the payment of any
amounts owed on the 1999 realized gains under the 1998 Plan.
14
In March 2000, the Company paid out 90 percent of the
profit sharing in the amount of $1,024,696 on the 1999 realized
gains; the remaining 10 percent or $113,855 was paid out in
September 2000, upon the completion and filing of the Company's
1999 federal tax return.
As of January 1, 2000, the Company implemented the Harris
& Harris Group, Inc. Employee Profit-Sharing Plan (the "Plan")
that provides for profit sharing equal to 20 percent of the net
realized income of the Company as reflected on the Consolidated
Statement of Operations of the Company for such year, less the
nonqualifying gain, if any.
Under the Plan, net realized income of the Company
includes investment income, realized gains and losses, and
operating expenses (including taxes paid or payable by the
Company), but is calculated without regard to dividends paid or
distributions made to shareholders, payments under the Plan,
unrealized gains and losses, and loss carryovers from other
years ("Qualifying Income"). The portion of net after-tax
realized gains attributable to asset values as of September 30,
1997 is considered nonqualifying gain, which reduces Qualifying
Income.
As soon as practicable following the year-end audit, the
Board of Directors will determine whether, and if so how much,
Qualifying Income exists for a plan year, and 90 percent of the
Qualifying Income will be paid out to Plan participants
pursuant to the distribution percentages set forth in the Plan.
The remaining 10 percent will be paid out after the Company
has filed its federal tax return for that year in which
Qualifying Income exists. Currently, the distribution amounts
for each officer and employee are as follows: Charles E.
Harris, 13.790 percent; Mel P. Melsheimer, 4.233 percent;
Helene B. Shavin, 1.524 percent; and Jacqueline M. Matthews,
0.453 percent. If a participant leaves the Company for other
than cause, the amount earned will be accrued and may
subsequently be paid to such participant.
Notwithstanding any provisions of the Plan, in no event
may the aggregate amount of all awards payable for any Plan
year during which the Company remains a "business development
company" within the meaning of 1940 Act be greater than 20
percent of the Company's "net income after taxes" within the
meaning of Section 57(n)(1)(B) of the 1940 Act. In the event
the awards exceed such amount, the awards will be reduced pro
rata.
The Plan may be modified, amended or terminated by the
Company's Board of Directors at any time with the stipulation
that no such modification, amendment or termination may
adversely affect any participant that has not consented to such
modification, amendment or termination. Nothing in this Plan
shall preclude the Board of Directors from, for any Plan Year
subsequent to the current Plan Year, naming additional
Participants in the Plan or changing the Award Percentage of
any Full Participant or New Participant (subject to the overall
percentage limitations contained herein).
The Company calculates the Plan accrual at each quarter
end based on the net realized and gross unrealized gains at
that date, net of operating expenses for the year. Any
adjustments to the Plan accrual are then reflected in the
Consolidated Statements of Operations for the quarter. The Plan
accrual is not paid out until the gains are realized. During
the first quarter of 2002, primarily as a result of an increase
in the net realized gains from investments which are included
in the bonus accrual calculation, the cumulative accrual was
increased by $127,959 to $306,241.
On April 26, 2000, the shareholders of the Company
approved the performance goals under the Plan in accordance
with Section 162(m) of the Code. The Code generally provides
that a public company such as the Company may not deduct
compensation paid to its chief executive officer or to any of
its four most highly compensated officers to the extent that
15
the compensation paid to any such officer/employee exceeds
$1 million in any tax year, unless the payment is made upon
the attainment of objective performance goals that are approved
by the Company's shareholders.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that, effective
January 1, 1998, 50 percent of all Directors' fees be used to
purchase Company common stock from the Company. However,
effective March 1, 1999, the directors may purchase the Company's
common stock in the open market, rather than from the Company.
During 1999, the Directors bought directly from the Company 5,816
shares.
On January 27, 2000, the Company placed privately, with an
unaffiliated investor, for $3 million in cash, a one-year, 12
percent note with one-year warrants to purchase 25,263 shares of
the Company's common stock at $11.8750 per share. Unless the
note was prepaid, six months after its issuance, the investor
would have received additional one-year warrants to purchase an
additional $300,000 worth of the Company's common stock at the
then-current market price. During March 2000, with part of the
proceeds from the sale of SciQuest.com stock, the Company prepaid
the Note. The Company incurred total interest costs of $146,141:
$36,500 in interest paid on the note and $109,641 on warrants.
The warrants expired unexercised.
On October 12, 2000, the Company announced that the Board of
Directors had authorized a repurchase program in the open market
of up to $2 million of the Company's stock, at the discretion of
management. As of March 31, 2002, the Company had repurchased a
total of 376,600 shares in the open market, at approximately
$2.30 per share, for a total of $868,051.
Since 1998, the Company has repurchased a total of 1,859,047
of its shares for a total of $3,496,388, including commissions
and expenses, at an average price of $1.88 per share. These
treasury shares were reduced by the purchases made by the
Directors.
On December 14, 2000, the Company declared a deemed dividend
of $1.78 per share for a total of $16,253,987, and in 2001, the
Company paid federal income taxes on behalf of shareholders of
$0.62 per share for a total of $5,688,896. The Company paid the
tax at the corporate rate on the distribution, and the
shareholders received a tax credit equal to their proportionate
share of the tax paid.
On January 22, 2002, the Company announced a deemed dividend
of $0.0875 per share for 2001 for a total of $775,620, and in
2002 the Company paid federal income taxes on behalf of
shareholders of $0.030625 per share for a total of $271,467. The
Company paid the tax at the corporate rate on the distribution,
and the shareholders received a tax credit equal to their
proportionate share of the tax paid.
The net of the total deemed dividends declared in 2000
($16,253,987) and 2001 ($775,620) and the taxes paid on behalf of
shareholders in 2000 ($5,688,896) and 2001 ($271,467) is
considered to be reinvested by the shareholders; therefore,
during 2000 and 2001, additional paid in capital has increased by
$10,565,091 and $504,153, respectively.
The tax character of the 2001 deemed dividend is long-term
capital gain.
As of December 31, 2001, there are no distributable
earnings. The difference between the book basis and tax basis
components of distributable earnings is attributed to Built-In
Gains generated at the time of the Company's qualification as a
RIC (see Note 6. "Income Taxes") and after tax earnings that
are not required to be distributed.
16
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment
Agreement with the Company (disclosed in a Form 8-K filed on
October 27, 1999) (the "Employment Agreement"), which superseded
an employment agreement that was about to expire on December 31,
1999. The Employment Agreement shall terminate on December 31,
2004 ("Term") subject to either an earlier termination or an
extension in accordance with the terms; on January 1, 2000 and on
each day thereafter, the Term extends automatically by one day
unless at any time the Company or Mr. Harris, by written notice,
decides not to extend the Term, in which case the Term will
expire five years from the date of the written notice.
During the period of employment, Mr. Harris shall serve as
the Chairman and Chief Executive Officer of the Company; be
responsible for the general management of the affairs of the
Company and all its subsidiaries, reporting directly to the Board
of Directors of the Company; serve as a member of the Board for
the period of which he is and shall from time to time be elected
or reelected; and serve, if elected, as President of the Company
and as an officer and director of any subsidiary or affiliate of
the Company.
Mr. Harris is to receive compensation under his Employment
Agreement in the form of base salary of $208,315 for 2000, with
automatic yearly adjustments to reflect inflation. In addition,
the Board may increase such salary, and consequently decrease it,
but not below the level provided for by the automatic adjustments
described above. Mr. Harris is also entitled to participate in
the Company's Profit-Sharing Plan as well as in all compensation
or employee benefit plans or programs, and to receive all
benefits, perquisites, and emoluments for which salaried
employees are eligible. Under the Employment Agreement, the
Company is to furnish Mr. Harris with certain perquisites which
include a company car, membership in certain clubs and up to a
$5,000 annual reimbursement for personal, financial or tax
advice.
The Employment Agreement provides Mr. Harris with life
insurance for the benefit of his designated beneficiaries in the
amount of $2,000,000; provides reimbursement for uninsured
medical expenses, not to exceed $10,000 per annum, adjusted for
inflation, over the period of the contract; provides Mr. Harris
and his spouse with long-term care insurance; and disability
insurance in the amount of 100 percent of his base salary. These
benefits are for the term of the Employment Agreement.
The Employment Agreement provides for the Company to adopt a
supplemental executive retirement plan (the "SERP") for the
benefit of Mr. Harris. Under the SERP, the Company will cause an
amount equal to one-twelfth of the Mr. Harris's current base
salary to be credited each month (a "Monthly Credit") to a
special account maintained for this purpose on the books of the
Company for the benefit of Mr. Harris (the "SERP Account"). The
amounts credited to the SERP Account will be deemed invested or
reinvested in such mutual funds or U.S. Government securities as
determined by Mr. Harris. The SERP Account will be credited and
debited to reflect the deemed investment returns, losses and
expenses attributed to such deemed investments and reinvestments.
Mr. Harris' benefit under the SERP will equal the balance in the
SERP Account and such benefit will always be 100 percent vested
(i.e., not forfeitable). Mr. Harris will determine the form and
timing of the distribution of the balance in the SERP Account;
provided, however, in the event of termination, the balance in
the SERP Account will be distributed to Mr. Harris or his
beneficiary, as the case may be, in a lump-sum payment within 30
days of such termination. The Company will establish a rabbi
trust for the purpose of accumulating funds to satisfy the
obligations incurred by the Company under the SERP. The
restricted funds for the SERP Plan total $554,967 as of March 31,
2002. Mr. Harris' rights to benefits pursuant to this SERP will
be no greater than those of a general creditor of the Company.
17
The Employment Agreement provides severance pay in the event
of termination without cause or by constructive discharge and
also provides for certain death benefits payable to the surviving
spouse equal to the executive's base salary for a period of two
years.
In addition, Mr. Harris is entitled to receive severance pay
pursuant to the severance compensation agreement that he entered
into with the Company, effective August 15, 1990. The severance
compensation agreement provides that if, following a change in
control of the Company, as defined in the agreement, such
individual's employment is terminated by the Company without
cause or by the executive within one year of such change in
control, the individual shall be entitled to receive compensation
in a lump sum payment equal to 2.99 times the individual's
average annualized compensation and payment of other welfare
benefits. If Mr. Harris' termination is without cause or is a
constructive discharge, the amount payable under the Employment
Agreement will be reduced by the amounts paid pursuant to the
severance compensation agreement.
As of January 1, 1989, the Company adopted an employee
benefits program covering substantially all employees of the
Company under a 401(k) Plan and Trust Agreement. As of January
1, 1999, the Company adopted the Harris & Harris Pension Plan and
Trust, a money purchase plan which would allow the Company to
stay compliant with the 401(k) top-heavy regulations and
deduction limitation regulations. In 2001, Congress enacted the
Economic Growth and Tax Relief Reconciliation Act of 2001 which
has increased the deduction limits for plans such as the 401(k)
Plan. This Act eliminates the need for the Company to maintain
two separate plans. Effective December 31, 2001, the Pension
Plan merged into the 401(k) Plan, with the 401(k) Plan being the
surviving plan. Contributions to the plan are at the discretion
of the Company.
On June 30, 1994, the Company adopted a plan to provide
medical and health insurance for retirees, their spouses and
dependents who, at the time of their retirement, have ten years
of service with the Company and have attained 50 years of age or
have attained 45 years of age and have 15 years of service with
the Company. On February 10, 1997, the Company amended this plan
to include employees who "have seven full years of service and
have attained 58 years of age." The coverage is secondary to any
government provided or subsequent employer provided health
insurance plans. Based upon actuarial estimates, the Company
provided an original reserve of $176,520 that was charged to
operations for the period ending June 30, 1994. As of March 31,
2002 the Company had a reserve of $385,935 for the plan.
NOTE 6. INCOME TAXES
On September 25, 1997, the Company's Board of Directors
approved a proposal to seek qualification as a RIC under Sub-
Chapter M of the Code. As a RIC, the Company annually must
distribute at least 90 percent of its investment company taxable
income as a dividend and may either distribute or retain its
realized net capital gains from investments. To initially
qualify as a RIC, among other requirements, the Company had to
pay a dividend to shareholders equal to the Company's cumulative
realized earnings and profits ("E&P"). On April 9, 1998, the
Company declared a one-time cash dividend of $0.75 per share to
meet this requirement (for a total of $8,019,728). The cash
dividend was paid on May 12, 1998.
The Company elected Sub-Chapter M status for the year ended
December 31, 1999. A corporation that elects to qualify as a RIC
continues to be taxable as a C Corporation on any gains realized
within 10 years of its qualification as a RIC from sales of
assets that were held by the corporation on the effective date of
the election ("C Corporation Assets") to the extent of any gain
built into the assets on such date ("Built-In Gain"). The
Company had Built-In Gains at the time of its qualification as a
RIC. Prior to 1999, the Company incurred ordinary and capital
losses from its operations. After the Company's election of RIC
18
status, those losses remained available to be carried forward to
subsequent taxable years. Recently issued Internal Revenue
Service regulations (issued in temporary and proposed form)
confirm that such losses may be used to offset realized Built-In
Gains and, to the extent so used, to eliminate C Corporation
taxation of such gains. Notwithstanding any such offset,
however, the new regulations also provide that all realized
Built-In Gains (calculated without regard to the offset, but net
of any C Corporation tax imposed on the Built-In Gains after
application of the offset) must be included in calculating a
RIC's investment company taxable income or net capital gains, as
the case may be, and therefore appear to require that such Built-
In Gains must be distributed to avoid Sub-Chapter M taxation of
such investment company taxable income or net capital gains (and,
in the case of any Built-In Gains that are includible in
investment company taxable income, possible loss of RIC status).
The Company has previously used loss carryforwards to offset
Built-In Gains. As of January 1, 2002, the Company had $501,640
of loss carryforwards remaining and $4,663,457 of unrealized
Built-In Gains. During the current period, the Company did not
realize any Built-In Gains.
Continued qualification as a RIC requires the Company to
satisfy certain portfolio diversification requirements in future
years. The Company's ability to satisfy those requirements may
not be controllable by the Company. (See Item 2. "Management's
Discussion and Analysis of Financial Condition and Results of
Operation -- Sub-Chapter M Status.") There can be no assurance
that the Company will qualify as a RIC in subsequent years.
During the three months ended March 31, 2002, the Company
accrued a net tax provision of $34,223. The Company pays
federal, state and local taxes on behalf of its wholly owned
subsidiary, Harris & Harris Enterprises, Inc., which is taxed as
a C Corporation.
For the three months ended March 31, 2002 and 2001, the
Company's income tax provision was allocated as follows:
Three Months Ended Three Months Ended
March 31, 2002 March 31, 2001
Investment operations $ 0 $ 0
Net realized gain on investments 34,223 29,634
Net decrease in unrealized
appreciation on investments 0 0
---------- ----------
Total income tax provision $ 34,223 $ 29,634
========== ==========
The above tax provision consists of the following:
Current $ 34,223 $ 29,634
Deferred -- Federal 0 0
---------- ----------
Total income tax provision $ 34,223 $ 29,634
========== ==========
The Company's net deferred tax liability at March 31, 2002
and December 31, 2001 consists of the following:
March 31, 2002 December 31, 2001
Tax on unrealized appreciation
on investments $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
========== ==========
19
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a ten-year lease with sublet
provisions for office space. In 1995, this lease was amended to
include additional office space. During 1999, the Company sublet
this space to an unaffiliated party. Rent expense under this
lease for the three months ended March 31, 2002 and March 31,
2001, was $42,724 and $41,475, respectively. Future minimum
lease payments in 2003 are $101,946.
On November 19, 2001, the Company established an asset
account line of credit of up to $12,700,000. The asset account
line of credit is secured by the Company's government agency
securities. Under the asset account line of credit, the Company
may borrow up to 95 percent of the current value of its
government agency securities. The Company's outstanding balance
under the asset line of credit at March 31, 2002 was $8,996,740.
The asset line of credit bears interest at a rate of the Broker
Call Rate plus 50 basis points. On April 4, 2002, the Company
repaid the entire outstanding balance under the asset line of
credit.
NOTE 8. SUBSEQUENT EVENTS
On April 26, 2002, the Company filed a registration
statement on Form N-2 with the SEC for the issuance of
transferable rights to its shareholders. The rights will allow
the Company's shareholders to subscribe for a maximum of
2,954,743 new shares of the Company's common stock. Upon
consummation of the offer, the Company intends to raise gross
proceeds of approximately $6,648,172, without exclusion of
expenses relating to the offer. The Company expects to invest,
directly or indirectly, the proceeds of the offer, excluding
expenses, in accordance with its investment objectives and
policies within 12 months after receipt of such proceeds,
depending on the available investment opportunities for the types
of investments in which the Company principally invests.
On May 6, 2002, the Company invested $750,000 in Series B
convertible preferred stock of privately held Nanotechnologies,
Inc. Nanotechnologies, Inc., which is based in Austin, Texas,
was founded to develop and commercialize a process for
synthesizing nanoscale materials by utilizing a proprietary
plasma-based technology to produce a wide variety of materials.
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
The Company accounts for its operations utilizing accounting
principles generally accepted in the United States for investment
companies. On this basis, the principal measure of its financial
performance is captioned "Net increase (decrease) in net assets
resulting from operations," which is the sum of three elements.
The first element is "Net operating income (loss)," which is the
difference between the Company's income from interest, dividends,
and fees and its operating expenses. The second element is "Net
realized (loss) gain on investments," which is the difference
between the proceeds received from dispositions of portfolio
securities and their stated cost, net of applicable income tax
provisions (benefits). These two elements are combined in the
Company's financial statements and reported as "Net realized
(loss) income." The third element, "Net increase (decrease) in
unrealized appreciation on investments," is the net change in the
fair value of the Company's investment portfolio.
20
"Net realized (loss) gain on investments" and "Net increase
(decrease) in unrealized appreciation on investments" are
directly related. When a security is sold to realize a (loss)
gain, net unrealized appreciation (increases) decreases and net
realized (loss) gain increases (decreases).
Financial Condition
The Company's total assets and net assets were,
respectively, $35,005,570 and $23,297,836 at March 31, 2002,
compared with $39,682,367 and $24,334,770 at December 31, 2001.
Among the significant changes in the first quarter of 2002
were: (1) the payment of $271,467 in federal income taxes as a
result of the Company's deemed dividend distribution; (2) decline
in the value of the Company's investment in Experion Systems,
Inc. of $600,000; (3) decrease in bank loan payable of
$3,499,037; and (4) establishment of a reserve against the note
receivable of $10,487.
Net asset value per share ("NAV") was $2.63 at March 31,
2002, versus $2.75 at December 31, 2001.
The Company's shares outstanding remained unchanged during
the three months ended March 31, 2002.
The Company's financial condition is dependent on the
success of its investments. The Company has invested a
substantial portion of its assets in private development stage or
start-up companies. These private businesses tend to be thinly
capitalized, unproven, small companies that lack management depth
and have little or no history of operations. At March 31, 2002,
$14,921,454 or 42.6 percent of the Company's total assets (64.0
percent of the Company's net assets) consisted of non-publicly
traded securities at fair value, of which net unrealized
appreciation was $660,451.
The increase in the value of the non-publicly traded
securities from $13,120,978 at December 31, 2001 to $14,921,454
at March 31, 2002 resulted primarily from the Company's new
investments in Nanopharma Corp., NanoOpto Corporation and
NeoPhotonics Corporation. The increase was partially offset by
the net effect of an additional investment and decrease in
valuation of the Company's holdings in Experion Systems, Inc.
A summary of the Company's investment portfolio is as
follows:
March 31, 2002 December 31, 2001
Investments, at cost $33,316,719 $37,714,285
Unrealized appreciation 659,264 1,216,420
----------- -----------
Investments, at fair value $33,975,983 $38,930,705
=========== ===========
The accumulated unrealized appreciation on investments net
of deferred taxes is ($705,206) at March 31, 2002, versus
($148,049) at December 31, 2001.
Following an initial investment in a private company, the
Company may make additional investments in such investee in order
to: (1) increase its ownership percentage; (2) exercise warrants,
options or convertible securities that were acquired in the
original or subsequent financing; (3) preserve the Company's
proportionate ownership in a subsequent financing; or (4) attempt
to preserve or enhance the value of the Company's investment.
There can be no assurance that the Company will make follow-on
investments or have sufficient funds to make additional
investments. The Company has the discretion to make follow-on
investments as it determines, subject to the availability of
capital resources. The failure to make such follow-on
investments may, in certain circumstances, jeopardize the
21
continued viability of the investee company and the Company's
initial investment or may result in a missed opportunity for the
Company to increase its participation in a successful operation.
Even if the Company has sufficient capital to make a desired
follow-on investment, it may elect not to make a follow-on
investment either because it does not want to increase its
concentration of risk, because it prefers other opportunities, or
because it is inhibited by compliance with BDC or RIC
requirements, even though the follow-on investment opportunity
appears attractive or would preserve rights pursuant to "pay to
play" provisions.
The following table is a summary of the cash investments
made by the Company in its private placement portfolio during the
three months ended March 31, 2002:
New Investments: Amount
Nanopharma Corp. $ 700,000
NanoOpto Corporation 625,000
NeoPhotonics Corporation 1,000,000
Additional Investments
Experion Systems, Inc. $ 100,000
----------
Total $2,425,000
==========
Results of Operations
Investment Income and Expenses:
The Company had net operating (loss) income of ($556,233)
and $509,877 for the three months ended March 31, 2002 and March
31, 2001, respectively. The Company's net operating (loss)
income reflected an increase to expenses of $127,959 in the three
months ended March 31, 2002 and a reduction to expenses of
$846,290 in the three months ended March 31, 2001 relating to
changes in the employee profit-sharing accrual.
The Company's principal objective is to achieve capital
appreciation. Therefore, a significant portion of the investment
portfolio is structured to maximize the potential for capital
appreciation and provides little or no current yield in the form
of dividends or interest. The Company does earn interest income
from fixed-income securities, including U.S. Government and
Agency Obligations. The amount of interest income earned varies
with the average balance of the Company's fixed-income portfolio
and the average yield on this portfolio.
The Company had interest income from fixed-income
securities of $54,136 and $152,530 for the three months ended
March 31, 2002 and March 31, 2001, respectively. The decrease of
$98,394 or 64.5 percent reflects the steep decline in interest
rates during the three months ended March 31, 2002 versus the
three months ended March 31, 2001.
The Company had interest income from affiliated companies of
$0 and $9,617 for the three months ended March 31, 2002 and March
31, 2001, respectively. The decrease of $9,617 is owing to the
decrease in the outstanding loans to investee companies since the
first quarter of 2001. The amount of outstanding loans to
investee companies varies.
The Company had other income of $5,326 and $29,812 for the
three months ended March 31, 2002 and March 31, 2001,
respectively. Other income primarily represents rental income
from subletting office space to an unaffiliated party. The
rental income was offset in the three months ended March 31, 2002
by a reserve against a note receivable and in the three months
ended March 31, 2001 by a gain on the sale of Company property.
22
Operating expenses were $615,695 and ($317,918) for the
three months ended March 31, 2002 and March 31, 2001,
respectively. The operating expenses of the first quarter of
2002 and 2001 reflect increases (decreases) in the employee
profit-sharing accrual of $127,959 and ($846,290), respectively,
owing primarily to decreases in the unrealized appreciation for
the respective three month periods offset by gain income.
Salaries and benefits decreased $44,328 or 14.8 percent primarily
as the result of no bonus payroll taxes in 2002. Professional
fees decreased $16,108 or 27.2 percent. Director's fees and
expenses increased $18,086 or 78.7 percent as a result of audit
committee meetings regarding the appointment of
PricewaterhouseCoopers LLP as independent public accountants for
the Company for the year ending December 31, 2002 and nominating
committee meetings resulting in the appointment of two additional
members of the Board of Directors.
The Company has in the past relied, and continues to rely to
a large extent, upon proceeds from sales of investments, rather
than investment income, to defray a significant portion of its
operating expenses. Because such sales cannot be predicted, the
Company attempts to maintain adequate working capital to provide
for fiscal periods when there are no such sales.
Realized Gains and Losses on Portfolio Securities:
During the three months ended March 31, 2002 and 2001, the
Company realized gains (losses) of $55,498 and ($1,194,652),
respectively. During the three months ended March 31, 2002, the
Company's realized gains of $55,498 consisted primarily of cash
received from the Nanophase Technologies Litigation Settlement
Fund.
During the three months ended March 31, 2001, the Company
realized losses of $1,194,652, primarily from the sale of 350,000
shares of SciQuest.com stock.
Unrealized Appreciation and Depreciation of Portfolio
Securities:
The Board of Directors values the portfolio securities on a
quarterly basis pursuant to the Company's Asset Valuation
guidelines in accordance with the 1940 Act. (See "Footnote to
Consolidated Schedule of Investments" contained in "Item 1.
Consolidated Financial Statements.")
Net unrealized appreciation on investments decreased by
$557,157 or 45.8 percent during the three months ended March 31,
2002, from $1,216,421 to $659,264, primarily as a result of the
decline in the value of the Company's holdings of Experion
Systems, Inc. of $600,000.
Net unrealized appreciation on investments decreased by
$3,082,931 or 34.4 percent during the three months ended March
31, 2001, from $8,947,928 to $5,864,997, primarily as a result of
the decline in the value of the Company's holdings of Nanophase
Technologies Corporation and Essential.com, Inc. of $2,287,914
and $2,187,413, respectively.
The changes in the values of Experion Systems, Inc. reflect
the extreme volatility of private and small capitalization, high
technology stocks, as well as the inherent risks at all times of
such investments (see "Risk Factors").
Liquidity and Capital Resources
The Company's primary sources of liquidity are cash,
receivables and freely tradable marketable securities. The
Company's secondary sources of liquidity are restricted
securities of companies that are publicly traded. At March 31,
2002 and December 31, 2001, respectively, the Company's total
primary liquidity was $10,369,814 and $13,459,654. On both of
the corresponding dates, the Company's total secondary liquidity
was $0 as the Company had no publicly traded securities. The
23
Company's tertiary source of liquidity is its holding of PHZ
Capital Partners, L.P., from which the Company received cash
distributions in the first quarter of 2002 of $140,352.
The decrease in the Company's primary source of liquidity
from December 31, 2001 to March 31, 2002 is primarily owing to
the: (1) payment of federal income taxes of $271,467; (2)
investment in Nanopharma Corp. of $700,000; (3) investment in
NanoOpto Corporation of $625,000; (4) investment in NeoPhotonics
Corporation of $1,000,000; (5) investment in Experion Systems,
Inc. of $100,000; and (6) use of funds for operating expenses.
From December 31, 2001 to March 31, 2002, the Company's
liabilities for accrued employee profit sharing increased by
$127,959 or 71.8 percent to $306,241 primarily as a result of an
increase in the realized gains from investments included in the
bonus accrual calculation.
The Company's total income tax liability decreased by
$256,875 or 15.9 percent to $1,362,663 primarily as a result of
the payment of taxes in connection with the deemed dividend
distribution.
Recent Developments -- Sub-Chapter M Status
On March 7, 2002, the Company received SEC certification and
qualified for RIC treatment for 2001. Although the SEC
certification for 1999, 2000 and 2001 was issued, there can be no
assurance that the Company will receive such certification for
subsequent years (to the extent it needs additional certification
as a result of changes in its portfolio) or that it will actually
qualify as a RIC for subsequent years. In addition, under certain
circumstances, even if the Company qualified for Sub-Chapter M
treatment in a given year, the Company might take action in a
subsequent year to ensure that it would be taxed in that
subsequent year as a C Corporation, rather than as a RIC.
On January 22, 2002, the Company announced that its Board of
Directors had declared a deemed dividend for 2001 of $0.0875 per
share for a total of $775,620 and paid corporate taxes on behalf
of shareholders of $0.030625 per share, for a total of $271,467.
Risk Factors
Investing in the Company's stock is highly speculative and the
investor could lose some or all of the amount invested.
The value of the Company's 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 the Company's
shares of 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 the Company's focus on the technology and very small
capitalization sectors and because it is a small capitalization
company, its 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, small technology, material
sciences and other high technology industries, will also affect
the Company's stock price. During the first quarter of 2002, the
Company decided to make all of its new private equity investments
in small technology, including nanotechnology, microsystems and
microelectromechanical systems (MEMS). Small technology
investments are new and especially risky, involving science and
technology risks as well as commercialization risks.
24
Investing in the Company's common stock may be inappropriate for
the investor's risk tolerance.
The Company's investments, in accordance with its investment
objective and principal strategies, result in a far above average
amount of risk and volatility and may well result in loss of
principal. The Company's investments in portfolio companies are
highly speculative and aggressive and, therefore, an investment
in its shares may not be suitable for investors for whom such
risk is inappropriate.
The market for venture capital investments, including small
technology investments, is highly competitive. In addition to
finding attractive investment opportunities, in some cases, the
Company's status as a regulated business development company may
hinder its ability to participate in investment opportunities or
to protect the value of existing investments because of "pay to
play" provisions in which preferred protections such as dilution
protection may be forfeited or preferred stock may be converted
to common stock by failure to invest in subsequent rounds of
financing.
The Company faces substantial competition in its investing
activities from private venture capital funds, investment
affiliates of large industrial, technology, service and financial
companies, small business investment companies, wealthy
individuals and foreign investors. As a result, the sources of
funding are many, but attractive investment opportunities are too
few. Hence, we face substantial competition in sourcing good
investment opportunities on terms of investment that are
commercially attractive. Further, as a regulated business
development company, the Company is required to disclose
quarterly the name and business description of portfolio
companies and value of any portfolio securities. Most of the
Company's competitors are not subject to such disclosure
requirements. The Company's obligation to disclose such
information could hinder its ability to invest in certain
portfolio companies. Additionally, other regulations, current
and future, may make the Company less attractive as a potential
investor to a given portfolio company than a private venture
capital fund not subject to the same regulations. Also,
compliance with certain regulations applicable to the Company's
business may prevent the Company from making follow-on
investments that would be in the Company's and its investors'
best interest.
The Company operates in a regulated environment.
The Company is subject to substantive SEC regulations as a
BDC. Securities and tax laws and regulations governing the
Company's activities may change in ways adverse to the Company's
and its shareholders' interests and interpretations of such laws
and regulations may change with unpredictable consequences. Any
change in the law or regulations that govern the Company's
business could have an adverse impact on the Company or its
operations. Also, as business and financial practices continue
to evolve, they may render the regulations under which the
Company operates less appropriate and more burdensome than they
were when originally imposed.
The Company is dependent upon key management personnel for
future success.
The Company is dependent for the selection, structuring,
closing and monitoring of its investments on the diligence and
skill of its senior management and other management members.
The Company utilizes outside consultants and lawyers, including
its two newest Directors, Dr. Kelly S. Kirkpatrick and Lori D.
Pressman, to assist the Company in conducting due diligence when
evaluating potential investments. The future success of the
Company depends to a significant extent on the continued service
and coordination of its senior management team, particularly
Charles E. Harris, the Company's Chairman and Chief Executive
25
Officer. The departure of any of the executive officers or key
employees could materially adversely affect the Company's ability
to implement its business strategy. The Company does not maintain
for its benefit any key man life insurance on any of its officers
or employees.
Investing in small, private companies involves a high degree of
risk and is highly speculative.
There are significant risks inherent in the Company's
venture capital business. The Company has invested a substantial
portion of its assets in privately held development stage or
start-up companies. These privately held businesses tend to be
thinly capitalized, unproven, small companies with risky
technologies that lack management depth and have not attained
profitability or have no history of operations. Because of the
speculative nature and the lack of a public market for these
investments, there is significantly greater risk of loss than is
the case with traditional investment securities. The Company
expects that some of its venture capital investments will be a
complete loss or will be unprofitable and that some will appear
to be likely to become successful but never realize their
potential. The Company has been risk seeking rather than risk
averse in its approach to venture capital and other investments.
Neither the Company's investments nor an investment in the
Company is intended to constitute a balanced investment program.
Small technology companies in particular are unproven, with
significant science and technology risks as well as
commercialization risks. The Company has in the past relied, and
continues to rely to a large extent, upon proceeds from sales of
investments rather than investment income to defray a significant
portion of its operating expenses. Such sales are unpredictable
and may not occur.
The Company invests in securities that are illiquid and may not
be able to dispose of such securities when it is advantageous to
do so.
Most of the investments of the Company are or will be equity
securities acquired directly from small companies. The Company's
portfolio of equity securities are and will usually be subject to
restrictions on resale or otherwise have no established trading
market. The illiquidity of most of the Company's portfolio of
equity securities may adversely affect the ability of the Company
to dispose of such securities at times when it may be
advantageous for the Company to liquidate such investments.
The inability of the Company's portfolio companies to market
successfully their products would have a negative impact on its
investment returns.
Even if the Company's 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 the Company's portfolio companies may not be
successful.
Because there is generally no established market in which to
value the Company's investments, the Company's Investment and
Valuation Committee's determination of their values may differ
materially from the values that a ready market or third party
would attribute to these investments.
There is typically no public market for equity securities of
the small privately held companies in which the Company invests.
As a result, the valuation of most of the equity securities in
the Company's portfolio is subject to the good faith estimate of
the Company's Board of Directors. (See "Asset Valuation Policy
Guidelines" in "Footnote to Consolidated Schedule of Investments"
contained in Item 1. "Consolidated Financial Statements.") In
the absence of a readily ascertainable market value, the
estimated value of the Company's portfolio of equity securities
may differ significantly from the values that would be placed on
the portfolio if a ready market for the equity securities
existed. The Company adjusts quarterly the valuation of its
26
portfolio to reflect the Investment and Valuation Committee's
estimate of the current fair value of each investment in its
portfolio. Any changes in estimated fair value are recorded in
the Company's consolidated statements of operations as a change
in the "Net (decrease) increase in unrealized appreciation on
investments." (See Item 2. "Management's Discussion and
Analysis of Financial Condition and Results of Operations.")
Quarterly results may fluctuate and are not indicative of future
quarterly performance.
The Company's quarterly operating results could 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 the
Company and its portfolio companies encounter competition in
their markets and general economic and market conditions. As a
result of these factors, results for any one quarter should not
be relied upon as being indicative of performance in future
quarters. (See Item 2. "Management's Discussion and Analysis of
Financial Condition and Results of Operations.")
Loss of pass-through tax treatment would substantially reduce
net assets and income available for dividends.
The Company currently qualifies as a RIC under the Code for
pass-through treatment because it meets certain diversification
and distribution requirements under the Code. The Company would
cease to qualify for pass-through tax treatment if it were
unable to comply with these requirements. The Company also
could be subject to a four percent excise tax (and, in certain
cases, corporate level income tax) if it failed to make certain
gain or income distributions. (See Item 2. "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Recent Developments -- Sub-Chapter M Status.")
The lack of pass-through tax treatment could have a material
adverse effect on the total return, if any, obtainable from an
investment in the Company. If the Company fails to qualify as a
RIC, the Company would become subject to Federal income tax as
if it were an ordinary C Corporation, which tax would result in
a corresponding reduction in the Company's net assets and the
amount of income available for distribution to the Company's
stockholders.
During some periods, there are few opportunities to take early
stage companies public or sell them to established companies.
During some periods, there may be few opportunities to gain
liquidity or realize a gain on an otherwise successful
investment, as the market for initial public offerings may be
moribund, particularly for early stage, high technology
companies. During such periods or other periods, it may also be
difficult to sell such companies to established companies. The
lack of exit strategies during such periods also tends to have
an adverse effect on the ability of private equity companies to
raise capital privately.
Because the Company must distribute income, the Company will
continue to need additional capital to fund its investments and
operating expenses.
The Company will continue to need capital to fund
investments and to pay for operating expenses. Unless the
Company elects to pay a Federal income tax and retain the after-
tax income, the Company must distribute at least 90 percent of
its investment company taxable income to its stockholders to
maintain its RIC status. As a result, such earnings will not be
available to fund investments. If the Company fails to generate
net realized long-term capital gains or to obtain funds from
outside sources, it could have a material adverse effect on the
Company's financial condition and results as well as its ability
to make follow-on and new investments. The Company does not
27
normally establish reserves for taxes on unrealized capital
gains. In addition, as a BDC, the Company is generally required
to maintain a ratio of at least 200 percent of total assets to
total borrowings, which may restrict its ability to borrow in
certain circumstances.
Loss of status as a RIC would reduce the Company's net asset
value by forcing it to establish currently unestablished
reserves for taxes.
As a RIC, the Company does not have to pay Federal income
taxes on its income that is distributed to its shareholders.
Accordingly, it does not establish reserves for taxes on its
unrealized capital gains. If the Company failed to qualify for
RIC status, it would have to establish such reserves for taxes,
which would reduce its net asset value, net of a reduction in the
reserve for employee profit sharing, accordingly. To the extent
that the Company, as a RIC, were to decide to make a deemed
distribution of net realized capital gains and were to retain
such net realized capital gains, it would have to establish
appropriate reserves for taxes upon making such a decision.
Leveraging by the Company could result in making the Company's
total return to common shareholders more volatile.
Leverage entails two primary risks. The first risk is that
the use of leverage magnifies the impact on the common
shareholders of changes in net asset value. For example, a fund
that uses 33% leverage (that is, $50 of leverage per $100 of
common equity) will show a 1.5% increase or decline in net asset
value for each 1% increase or decline in the value of its total
assets. The second risk is that the cost of leverage will exceed
the return on the securities acquired with the proceeds of
leverage, thereby diminishing rather than enhancing the return to
common shareholders. If the Company were to utilize leverage,
these two risks would generally make its total return to common
shareholders more volatile. In addition, the Company might be
required to sell investments in order to meet dividend or
interest payments on the debt or preferred stock when it may be
disadvantageous to do so.
As provided in the 1940 Act and subject to certain
exceptions, the Company can issue debt or preferred stock so long
as its total assets immediately after such issuance, less certain
ordinary course liabilities, exceed 200% of the amount of the
debt outstanding and exceed 200% of the sum of the amount of the
preferred stock and debt outstanding. Such debt or preferred
stock may be convertible in accordance with SEC guidelines which
may permit the Company to obtain leverage at attractive rates. A
leveraged capital structure creates certain special risks and
potential benefits not associated with unleveraged funds having
similar investment objectives and policies. Any investment
income or gains from the capital represented by preferred shares
or debt which is in excess of the dividends payable thereon will
cause the total return of the common shares to be higher than
would otherwise be the case. Conversely, if the investment
performance of the capital represented by preferred shares or
debt fails to cover the dividends payable thereon, the total
return of the common shares would be less or, in the case of
negative returns, would result in higher negative returns to a
greater extent than would otherwise be the case. The requirement
under the 1940 Act to pay in full dividends on preferred shares
or interest on debt before any dividends may be paid on the
common shares means that dividends on the common shares from
earnings may be reduced or eliminated. Although an inability to
pay dividends on the common shares could conceivably result in
the Company ceasing to qualify as a regulated investment company
under the Code, which would be materially adverse to the holders
of the common shares, such inability can be avoided through the
use of mandatory redemption requirements designed to ensure that
the Company maintains the necessary asset coverage.
The class voting rights of preferred shares could make it
more difficult for the Company to take certain actions that may,
in the future, be proposed by the Board and/or the holders of
28
common stock, such as a merger, exchange of securities,
liquidation or alteration of the rights of a class of the
Company's securities if such action would be adverse to the
preferred shares.
Preferred shares will be issued only if the Company's Board
of Directors determines in light of all relevant circumstances
known to the Board that to do so would be in the Company's best
interest and in the best interest of the Company's common
shareholders. The circumstances that the Board will consider
before issuing preferred shares include not only the dividend
rate on the preferred shares in comparison to the Company's
historical performance but also such matters as the terms on
which the Company can call the preferred shares and the Company's
ability to meet the asset coverage tests and other requirements
imposed by the rating agencies for such preferred shares.
The issuance of preferred shares convertible into shares of
common stock might also reduce the net income and net asset value
per share of the common shares upon conversion. Such income
dilution would occur if the Company could, from the investments
made with the proceeds of the preferred shares, earn an amount
per common share issuable upon conversion greater than the
dividend required to be paid on the amount of preferred stock
convertible into one share of common stock. Such net asset value
dilution would occur if preferred shares were converted at a time
when the net asset value per common share was greater than the
conversion price.
Unfavorable economic conditions could result in financial losses
for the Company as well as impair its ability to engage in
liquidity events.
Most of the companies in which the Company has made or will
make investments are susceptible to economic slowdowns or
recessions. An economic slowdown, capital markets conditions or
credit squeeze may affect the ability of a company to raise
additional capital from venture capital or other private equity
sources or to engage in a liquidity event such as an initial
public offering or merger. These conditions could lead to
financial losses in the Company's portfolio. Unfavorable
economic conditions also could increase the Company's cost of
capital.
On September 11, 2001, the World Trade Center in New York
City and the Pentagon near Washington, DC were targets of
terrorists attacks. As a result of these events and other
general economic conditions, it was especially difficult for
small companies to sell new products and services or to raise new
capital, and the United States equity markets experienced
declines. For the quarter ended September 30, 2001, the Nasdaq
Composite Index declined 31%.
The Company's business of making private equity investments
and positioning them for liquidity events also may be adversely
affected by current and future market and economic conditions.
Significant changes in the public equity markets could have an
effect on the valuations of privately held companies and on the
potential for liquidity events involving such companies, and this
could adversely affect the amount and timing of gains that may be
realized on the Company's investments.
The Company invests in privately held companies that may complete
initial public offerings. These types of companies can be highly
volatile and have uncertain liquidity.
When companies in which the Company has invested as private
entities complete initial public offerings, they are by
definition unseasoned issues. Typically, they have relatively
small capitalizations. Thus, they can be expected to be highly
volatile and of uncertain liquidity. If they are perceived as
suffering from adverse news or developments and/or the capital
markets are in a negative phase, not only their market prices,
but also their liquidity can be expected to be affected
negatively. Historically, the Company has also invested in
unseasoned publicly traded companies with similar characteristics
and thus with similar exposure to potential negative volatility
29
and illiquidity. The decimalization of the stock markets,
particularly Nasdaq, may decrease liquidity of stocks in general
and small capitalization issues in particular. In addition, the
imposition of decimalization on the stock exchanges, particularly
Nasdaq, may reduce liquidity and increase volatility and
riskiness of small, thinly traded public companies because it may
create a disincentive for dealers to market and make markets in
smaller issues.
Forward-Looking Statements
The information contained herein contains certain forward-
looking statements. These statements include the plans and
objectives of management for future operations and financial
objectives, portfolio growth and availability of funds. These
forward-looking statements are subject to the inherent
uncertainties in predicting future results and conditions.
Certain factors that could cause actual results and conditions to
differ materially from those projected in these forward-looking
statements are set forth herein. Other factors that could cause
actual results to differ materially include the uncertainties of
economic, competitive and market conditions, and future business
decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the
Company. Although the Company believes that the assumptions
underlying the forward-looking statements included herein are
reasonable, any of the assumptions could be inaccurate and
therefore there can be no assurance that the forward-looking
statements included or incorporated by reference herein will
prove to be accurate. Therefore, the inclusion of such
information should not be regarded as a representation by the
Company or any other person that the objectives and plans of the
Company will be achieved.
Item 3. Quantitative and Qualitative Disclosures About Market
Risk
The Company's business activities contain elements of risk.
The Company considers a principal type of market risk to be
valuation risk. Investments are stated at "fair value" as
defined in the 1940 Act and in the applicable regulations of the
SEC. All assets are valued at fair value as determined in good
faith by, or under the direction of, the Board of Directors.
(See the "Asset Valuation Policy Guidelines" in the "Footnote to
Consolidated Schedule of Investments contained in "Item 1.
Consolidated Financial Statements.")
Neither the Company's investments nor an investment in the
Company is intended to constitute a balanced investment program.
The Company has exposure to public-market price fluctuations to
the extent of its publicly traded portfolio, which portfolio may
be composed primarily or entirely of highly risky, volatile
securities.
The Company has invested a substantial portion of its
assets in private development stage or start-up companies. These
private businesses tend to be thinly capitalized, unproven, small
companies that lack management depth and have not attained
profitability or have no history of operations. Because of the
speculative nature and the lack of a public market for these
investments, there is significantly greater risk of loss than is
the case with traditional investment securities. The Company
expects that some of its venture capital investments will be a
complete loss or will be unprofitable and that some will appear
to be likely to become successful but never realize their
potential. Even when the Company's private equity investments
complete initial public offerings (IPOs), the Company is normally
subject to lock-up agreements for a period of time.
Because there is typically no public market for the equity
interests of the small privately held companies in which the
Company invests, the valuation of the equity interests in the
Company's portfolio is subject to the estimate of the Company's
Board of Directors in accordance with the Company's Asset
Valuation Policy Guidelines. In the absence of a readily
ascertainable market value, the estimated value of the Company's
portfolio of equity interests may differ significantly from the
values that would be placed on the portfolio if a ready market
30
for the equity interests existed. Any changes in valuation are
recorded in the Company's consolidated statements of operations
as "Net increase (decrease) in unrealized appreciation on
investments."
31
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Not Applicable
Item 2. Changes in Securities and Use of Proceeds
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. Other Information
Changes in and Disagreements With Accountants on
Accounting and Financial Disclosure
On February 26, 2002, the Company appointed the accounting
firm of PricewaterhouseCoopers LLP as independent public
accountants for the Company for the fiscal year ending
December 31, 2002. Arthur Andersen LLP was dismissed upon
completion of the December 31, 2001 audit. The decision to
change accountants was approved by the Company's Audit
Committee and is subject to ratification by its
stockholders.
In connection with its audits for the two most recent
fiscal years, (1) there were no disagreements with Arthur
Andersen on any matter of accounting principle or practice,
financial statement disclosure, auditing scope or
procedure, whereby such disagreements, if not resolved to
the satisfaction of Arthur Andersen, would have caused them
to make reference thereto in their report on the financial
statements for such years; and (2) there have been no
reportable events (as defined in Item 304(a)(1)(v) of
Regulation S-K).
The reports of Arthur Andersen on the financial statements
of the Company for the past two years contained no adverse
opinion or disclaimer of opinion and were not qualified or
modified as to uncertainty, audit scope or accounting
principle.
The Company has not consulted with PricewaterhouseCoopers
LLP during the last two years or subsequent interim periods
on either the application of accounting principles to a
specified transaction either completed or proposed or the
type of audit opinion PricewaterhouseCoopers LLP might
issue on the Company's financial statements.
The Company requested that Arthur Andersen furnish a letter
addressed to the SEC stating whether or not Arthur Andersen
agrees with the above statements. A copy of such letter to
the SEC, dated March 1, 2002, was filed as Exhibit 16.1 to
the Form 8-K filed with the SEC on March 1, 2002.
32
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3.1(a) Restated Certificate of Incorporation of the
Company, as amended, incorporated by reference to
Exhibit 3.1(a) to the Company's Form 10-K for the
year ended December 31, 1995.
3.1(b) Restated By-laws of the Company, incorporated by
reference to Exhibit 3.1(b) to the Company's Form
10K for the year ended December 31, 1995.
4.1 Specimen Certificate of Common Stock, incorporated
by reference to Exhibit 4 to Company's Registration
Statement on Form N-2 filed October 29, 1992.
10.22 Harris & Harris Group, Inc. Employee Profit-Sharing
Plan, incorporated by reference as Exhibit 10.22 to
the Company's Form 10K for the year ended December
31, 1999.
11.0* Computation of per share earnings. See Consolidated
Statements of Operations.
(b) Reports on Form 8-K
On March 1, 2002, the Company filed a Form 8-K stating
that on February 26, 2002, the Company appointed the
accounting firm of PricewaterhouseCoopers LLP as
independent accountants for the fiscal year ending
December 31, 2002. Arthur Andersen was dismissed upon
completion of the December 31, 2001 audit.
33
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
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.
Harris & Harris Group, Inc.
/s/ Helene B. Shavin
---------------------------
By: Helene B. Shavin,
Vice President and
Controller
Date: May 15, 2002
34