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, 1999
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to _______________
Commission File Number: 0-11576
HARRIS & HARRIS GROUP, INC.
- -----------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
New York 13-3119827
- ----------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
- -----------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
212/332-3600
- -----------------------------------------------------------------------------
(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 6, 1999
- --------------------------------------- --------------------------
Common Stock, $0.01 par value per share 10,321,400 shares
<PAGE>
Harris & Harris Group, Inc.
Form 10-Q, March 31, 1999
TABLE OF CONTENTS
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements . . . . . . . . . . . 1
Consolidated Statements of Assets and Liabilities. . . . . . . . 3
Consolidated Statements of Operations. . . . . . . . . . . . . . 4
Consolidated Statements of Cash Flows. . . . . . . . . . . . . . 5
Consolidated Statements of Changes in Net Assets . . . . . . . . 6
Consolidated Schedule of Investments . . . . . . . . . . . . . . 7
Notes to Consolidated Financial Statements . . . . . . . . . . . 15
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Financial Condition. . . . . . . . . . . . . . . . . . . . . . . 22
Results of Operations. . . . . . . . . . . . . . . . . . . . . . 24
Liquidity and Capital Resources. . . . . . . . . . . . . . . . . 25
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Item 3. Quantitative and Qualitative Disclosures About
Market Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 31
PART II OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . 33
Item 2. Changes in Securities . . . . . . . . . . . . . . . . . 33
Item 3. Defaults Upon Senior Securities . . . . . . . . . . . . 33
Item 4. Submission of Matters to a Vote of Security Holders . . 33
Item 5. Other Information . . . . . . . . . . . . . . . . . . . 33
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . 33
Exhibit Index. . . . . . . . . . . . . . . . . . . . . . . . . . 34
Signature. . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
<PAGE>
Harris & Harris Group, Inc.
Form 10-Q, March 31, 1999
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, the Company's shareholders approved a proposal to
allow the Company to make an election to become a Business Development
Company ("BDC") under the Investment Company Act of 1940, as amended. The
Company made such election on July 26, 1995. Certain information and
disclosures normally included in the 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 financial statements be read in conjunction with the audited
financial statements and notes thereto for the year ended December 31, 1998
contained in the Company's 1998 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"). On April 8, 1998, the Company announced that it
had received a certification from the Securities and Exchange Commission
("SEC") for 1997 relating to the Company's status under section 851(e) of
the Code. That certification was necessary for the Company to qualify as a
RIC for 1998 and subsequent taxable years.
Pursuant to the Company's receipt of the section 851(e) certification
and its intention to qualify as a RIC, the Company's Board of Directors
declared and paid a one-time cash dividend of $0.75 per share, for a total
of $8,019,728, to meet one of the Company's requirements for qualification
for Sub-Chapter M tax treatment. On February 17, 1999, the Company received
rulings from the Internal Revenue Service (the "IRS") regarding other issues
relevant to the Company's tax status as a RIC. (See "Note 6 of Notes to
Consolidated Financial Statements" contained in "Item 1. Consolidated
Financial Statements" & "Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Sub-Chapter M Status".)
The qualification of the Company as a RIC under Sub-Chapter M of the
Code depends on it satisfying certain technical requirements regarding its
income, investment portfolio, and distributions. The Company was unable to
satisfy these requirements for the 1998 tax year owing to the nature of the
Company's ownership interest in one of its investee companies, and therefore
1
it did not elect Sub-Chapter M status for 1998. In addition, because the
Company realized taxable losses in 1998, it was not strategically
advantageous for the Company to elect Sub-Chapter M tax status for 1998.
As of December 31, 1998, the Company had a net operating and capital loss
carryforward of $7.1 million. The Company intends to use the $7.1 million
tax loss carryforward to offset the long-term capital gain realized when
the Company sold its interest in NBX Corporation. The Company anticipates
realizing a tax benefit of approximately $2.5 million as a result of such
offset.
The Company changed the nature of its ownership interest in the
non-qualifying investee company effective January 1, 1999 in order to meet
the Sub-Chapter M requirements. However, there can be no assurance that the
Company will qualify for Sub-Chapter M treatment for 1999 or subsequent
years. In addition, under certain circumstances, even if the Company were
qualified for Sub-Chapter M treatment in 1999 and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than a RIC.
2
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
<S> <C> <C>
March 31, 1999 December 31, 1998
(Unaudited) (Audited)
Investments, at value (See accompanying
schedule of investments and notes). . .$ 24,438,036 $ 24,532,191
Cash and cash equivalents. . . . . . . . . 70,808 164,143
Funds in escrow (Note 7) . . . . . . . . . 1,327,748 0
Receivable from broker . . . . . . . . . . 0 380,707
Interest receivable. . . . . . . . . . . . 512 666
Note receivable. . . . . . . . . . . . . . 32,663 32,663
Prepaid expenses . . . . . . . . . . . . . 119,451 90,649
Other assets . . . . . . . . . . . . . . . 144,853 157,840
-------------- -----------------
Total assets . . . . . . . . . . . . . . .$ 26,134,071 $ 25,358,859
============== =================
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities .$ 399,691 $ 505,118
Payable to broker. . . . . . . . . . . . . 77,085 0
Accrued profit sharing (Note 3). . . . . . 2,224,900 1,323,559
Deferred rent. . . . . . . . . . . . . . . 40,096 42,409
Deferred income tax liability (Note 6) . . 1,705,509 931,064
-------------- -----------------
Total liabilities. . . . . . . . . . . . . 4,447,281 2,802,150
Commitments and contingencies (Note 7) -------------- -----------------
Net assets . . . . . . . . . . . . . . . .$ 21,686,790 $ 22,556,709
============== =================
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 3/31/99 and 12/31/98 . . . . . . . . 106,930 106,930
Additional paid in capital . . . . . . . . 16,158,400 16,158,381
Accumulated net realized income (deficit). 2,805,185 (525,177)
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $1,705,509 at 3/31/99
and $3,410,884 at 12/31/98. . . . . . . 3,257,549 6,996,664
Treasury stock at cost, 339,446 shares at
3/31/99 and 101,739 shares at 12/31/98. (641,274) (180,089)
--------------- ------------------
Net assets . . . . . . . . . . . . . . . .$ 21,686,790 $ 22,556,709
=============== ==================
Total net assets and liabilities . . . . .$ 26,134,071 $ 25,358,859
=============== ==================
Shares outstanding . . . . . . . . . . . . 10,353,525 10,591,232
=============== ==================
Net asset value per outstanding share. . .$ 2.09 $ 2.13
</TABLE> =============== ==================
The accompanying notes are an integral part of these consolidated
financial statements.
3
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 1999 March 31, 1998
Investment income:
Interest from:
Fixed-income securities. . . . $ 45,209 $ 192,291
Affiliated companies . . . . . 628 10,932
Other income . . . . . . . . . . 0 7,348
-------------- --------------
Total investment income. . . . 45,837 210,571
Expenses:
Salaries and benefits. . . . . . 207,078 236,611
Profit sharing accrual
(reversal) (Note 3). . . . . . 901,341 (198,763)
Administration and operations. . 72,725 88,204
Professional fees. . . . . . . . 61,017 89,026
Rent . . . . . . . . . . . . . . 41,378 38,808
Directors' fees and expenses . . 36,414 28,742
Depreciation . . . . . . . . . . 12,500 12,500
Custodian fees . . . . . . . . . 1,732 2,907
Interest expense (Note 7). . . . 0 73,415
-------------- --------------
Total expenses . . . . . . . . 1,334,185 371,450
-------------- --------------
Operating loss before income
taxes . . . . . . . . . . . . (1,288,348) (160,879)
Income tax provision (Note 6). . 0 (365,712)
-------------- --------------
Net operating loss . . . . . . . . (1,288,348) (526,591)
Net realized gain on investments:
Realized gain on sale of
investments. . . . . . . . . 10,745,548 78,661
-------------- -------------
Total realized gain. . . . . . 10,745,548 78,661
Income tax provision (Note 6). . (2,479,821) (27,531)
-------------- -------------
Net realized gain on
investments. . . . . . . . . . 8,265,727 51,130
-------------- -------------
Net realized income (loss) . . . . 6,977,379 (475,461)
Net (decrease) increase in unrealized
appreciation on investments:
Decrease as a result of
investment sales . . . . . . . (4,784,802) (87,898)
Increase on investments held . . 58,727 3,825,792
Decrease on investments held . . (718,416) (4,074,921)
-------------- -------------
Change in unrealized appreciation
on investments . . . . . . . . (5,444,491) (337,027)
Income tax benefit (Note 6). . . 1,705,376 808,957
-------------- -------------
Net (decrease) increase in unrealized
appreciation on investments. . (3,739,115) 471,930
-------------- -------------
Net increase (decrease) in net assets
from operations:
Total. . . . . . . . . . . . . . $ 3,238,264 $ (3,531)
============== ==============
Per outstanding share. . . . . . . $ 0.31 $ (0.00)
============== ==============
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
4
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 1999 March 31, 1998
Cash flows from operating activities:
Net increase (decrease) in
net assets resulting from
operations. . . . . . . . . . . $ 3,238,264 $ (3,531)
Adjustments to reconcile net
increase (decrease) in net assets
from operations to net cash used
in operating activities:
Net realized and unrealized
(gain) loss on investments. . (5,301,057) 258,366
Deferred income taxes . . . . . 774,445 (415,714)
Depreciation. . . . . . . . . . 12,500 12,500
Changes in assets and liabilities:
Receivable from brokers . . . . 380,707 0
Interest receivable . . . . . . 154 0
Prepaid expenses. . . . . . . . (28,802) (27,227)
Funds in escrow (Note 7). . . . (1,327,748) 0
Other assets. . . . . . . . . . 485 156,067
Accounts payable and accrued
liabilities. . . . . . . . . . (105,427) (16,956)
Payable to brokers. . . . . . . 77,085 0
Accrued profit sharing (Note 3) 901,341 (198,763)
Deferred rent . . . . . . . . . (2,313) (2,313)
Collection on notes receivable. 10,000 0
------------ --------------
Net cash used in operating
activities. . . . . . . . . . (1,370,366) (237,571)
Cash flows from investing activities:
Net purchase (sale) of short-term
investments and marketable
securities. . . . . . . . . . (5,889,416) 2,877,319
Proceeds from sale of private
placement investment. . . . . 12,274,631 0
Investment in private placements
and loans . . . . . . . . . . (1,000,001) (121,802)
------------- -----------
Net cash provided by
investing activities . . . . 5,385,214 2,755,517
Cash flows from financing activities:
Payment of dividend . . . . . . (3,647,017) 0
Payment of note payable (Note 7) 0 (2,500,000)
Proceeds from sale of stock . . 16,178 0
Purchase of stock (Note 4). . . (477,344) 0
----------- -----------
Net cash used in
financing activities . . . . (4,108,183) (2,500,000)
Net (decrease) increase
in cash and cash equivalents:
Cash and cash equivalents
at beginning of the period . . 164,143 145,588
Cash and cash equivalents
at end of the period . . . . . 70,808 163,534
-------------- -----------
Net (decrease) increase in
cash and cash equivalents. . . $ (93,335) $ 17,946
============== ===========
Supplemental disclosures of
cash flow information:
Income taxes paid . . . . . . . $ 797 $ 300
Interest paid . . . . . . . . . $ 0 $ 44,180
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
5
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 1999 March 31, 1998
Changes in net assets from operations:
Net operating loss. . . . . . . . $ (1,288,348) $ (526,591)
Net realized gain on investments. 8,265,727 51,130
Net decrease in unrealized
appreciation on investments
as a result of sales. . . . . . (3,079,426) (87,898)
Net (decrease) increase
in unrealized appreciation
on investments held . . . . . . (659,689) 559,828
---------------- --------------
Net increase (decrease) in net assets
resulting from operations . . . 3,238,264 (3,531)
Changes in net assets from capital
stock transactions:
Payment of dividend . . . . . . . (3,647,017) 0
Purchase of treasury stock. . . . (477,344) 0
Proceeds from sale of stock . . . 16,178 0
--------------- -------------
Net (decrease) increase in net assets
resulting from capital stock
transactions. . . . . . . . . . (4,108,183) 0
--------------- --------------
Net decrease in net assets . . . . . (869,919) (3,531)
Net assets:
Beginning of the period . . . . . 22,556,709 33,654,934
--------------- ----------------
End of the period . . . . . . . . $ 21,686,790 $ 33,651,403
=============== ================
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
6
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies
(10)(11)(12) -- 30.5% of total investments
Publicly Traded Portfolio (Common stock
unless noted otherwise) -- 20.8% of total
investments
ATG, Inc. (1)(4) --
Radioactive and hazardous
waste management services . . . . (C) 20,000 $ 128,750
3Com Corporation (1)(4) --
Computer network
technology related. . . . . . . . (C) 80,000 1,865,000
Fuisz Corporation (1)(4) --
Biotechnology and drug related . . (C) 35,000 229,688
Monsanto Corporation (1)(4) --
Life sciences and drug related . . (C) 10,000 459,375
Nanophase Technologies Corporation (1)(6) --
Manufactures and markets
inorganic crystals of nanometric
dimensions -- 4.59% of
fully diluted equity . . . . . . (C) 672,916 1,093,354
Network Event Theatre (1)(4) --
Internet and other services
to colleges . . . . . . . . . . . (C) 10,000 126,250
Somnus Medical Technology, Inc. (1) --
Biotechnology and
healthcare related. . . . . . . . (C) 130,000 341,250
Sterling Commerce (1)(4) --
Software technology for
business-to-business e-commerce . (C) 25,000 768,750
Voice Control Systems, Inc. (1)(2) --
Supplier of speech recognition and
related speech input technology. . (C) 22,964 73,198
----------
Total Publicly Traded Portfolio (cost: $5,664,623) . . . . . . $5,085,615
----------
</TABLE>
The accompanying notes are an integral part of this consolidated schedule.
7
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Private Placement Portfolio (Illiquid)
(10)(11)(12) -- 9.7% of total investments
Exponential Business Development Company (1)(2)(5) --
Venture capital partnership focused
on early stage companies
Limited partnership interest . . . . . . (A) -- $ 25,000
Kriton Medical, Inc. (1)(2)(4) -- Research
and development of medical devices
Series B Convertible Preferred Stock . . (A) -- 1,000,001
MedLogic Global Corporation (1)(2) --
Medical cyanoacrylate adhesive --
0.37% of fully diluted equity
Series B Convertible Preferred Stock . . (B) 54,287
Common Stock . . . . . . . . . . . . . . (B) 25,798 565,977
SciQuest.com, Inc. (1)(2)(8) -- Internet
e-commerce source for scientific products --
3.48% of fully diluted equity
Series C Convertible Preferred Stock . . (A) 277,163
Warrants at $2.7962 expiring 6/30/07 . . (A) 26,822 775,000
-----------
Total Private Placement Portfolio (cost: $2,833,776) . . . . . $ 2,365,978
-----------
Total Investments in
Unaffiliated Companies (cost: $8,498,399) . . . . . . . . . $ 7,451,593
-----------
</TABLE>
The accompanying notes are an integral part of this consolidated schedule.
8
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Private Placement Portfolio in
Non-Controlled Affiliates (10)(12) (Illiquid)
-- 48.2% of total investments
Genomica Corporation (1)(2)(5)(6)(7) --
Develops software that enables the
study of complex genetic diseases --
5.01% of fully diluted equity
Common Stock . . . . . . . . . . . . . . (B) 199,800
Series A Voting
Convertible Preferred Stock. . . . . . . (B) 1,660,200 $ 1,209,730
InSite Marketing Technology, Inc. (1)(2)(5)(6) --
Integrates marketing science
and sales strategy into e-commerce
-- 6.97% of fully diluted equity
Common Stock . . . . . . . . . . . . . . (A) 1,351,351 500,000
NeuroMetrix, Inc. (1)(2)(6) --
Medical devices for monitoring
neuromuscular disorders --
16.41% of fully diluted equity
Series A Convertible Preferred Stock . . (B) 175,000
Series B Convertible Preferred Stock . . (B) 125,000
Series C-2 Convertible Preferred Stock . (B) 229,620 5,958,225
PHZ Capital Partners Limited Partnership (2)(9)
-- Organizes and manages investment
partnerships -- 20.0% of fully diluted equity
Limited partnership interest . . . . . (D) -- 1,857,353
Questech Corporation (1)(2)(6) --
Manufactures and markets proprietary
decorative tiles and signs -- 12.40% of
fully diluted equity
Common Stock . . . . . . . . . . . . . (D) 565,792 2,263,168
Warrants at $4.00 expiring 11/28/01 . (A) 166,667 167
------------
Total Private Placement Portfolio
in Non-Controlled Affiliates (cost: $5,778,406). . . . . $11,788,643
------------
U.S. Government Obligations -- 21.3% of total investments
U.S. Treasury Bill dated 10/22/98 due date
4/22/99 -- 4.5% yield . . . . . . . .(K) $ 250,000 $ 249,298
U.S. Treasury Bill dated 11/12/98 due date
5/13/99 -- 4.5% yield . . . . . . . .(K) $ 4,400,000 4,376,988
U.S. Treasury Bill dated 11/19/98 due date
5/20/99 -- 4.5% yield . . . . . . . .(K) $ 575,000 571,514
------------
Total Investments in
U.S. Government Obligations (cost: $5,198,174). . . . . $ 5,197,800
------------
Total Investments -- 100% (cost: $19,474,979) . . . . . . $ 24,438,036
============
</TABLE>
The accompanying notes are an integral part of this consolidated schedule.
9
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 1999
(Unaudited)
Notes to Consolidated Schedule of Investments
(1) Represents a non-income producing security. Equity investments that
have not paid dividends within the last twelve months are considered
to be non-income producing.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Schedule of Investments for a description of the
Method of Valuation A to L.
(4) These investments were made during 1999. Accordingly, the amounts
shown on the schedule represent the gross additions in 1999.
(5) No changes in valuation occurred in these investments during the
three months ended March 31, 1999.
(6) These investments are development stage companies. A development stage
company is defined as a company that is devoting substantially all
of its efforts to establishing a new business, and either has not yet
commenced its planned principal operations or has commenced such
operations but has not realized significant revenue from them.
(7) Genomica Corporation was cofounded by the Company, Cold Spring Harbor
Laboratory ("CSHL") and Falcon Technology Partners, LP. Mr. G. Morgan
Browne serves on the Board of Directors of the Company and is
Administrative Director of CSHL. In late 1998, Mr. Charles E. Harris,
Chairman and C.E.O. of Harris & Harris Group became a trustee of CSHL.
(8) SciQuest.com, Inc. acquired BioSupplyNet, Inc.
(9) Harris Partners I L.P. owns a 20% 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% owned subsidiary of Harris & Harris
Group, Inc.
(10)Investments in unaffiliated companies consist of investments in
which Harris & Harris Group,Inc. (the "Company") owns less than
5 percent of the investee company. Investments in non-controlled
affiliated companies consist of investments where the Company
owns more than 5 percent but less than 25 percent of the investee
company. Investments in controlled affiliated companies consist
of investments where the Company owns more than 25 percent of the
investee company.
(11)The aggregate cost for federal income tax purposes of investments
in unaffiliated companies is $8,498,399. The gross unrealized
appreciation based on the tax cost for these securities is $55,897.
The gross unrealized depreciation based on the tax cost for these
securities is $1,102,703.
(12)The percentage ownership of each investee company disclosed in the
Schedule of Investments expresses the potential common equity
interest in each such investee. 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.
The accompanying notes are an integral part of this consolidated schedule.<PAGE>
10
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 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:
11
EQUITY-RELATED SECURITIES
Equity-related securities are carried at fair value using one or more
of the following basic methods of valuation:
A. Cost: The cost method is based on the original cost to the Company.
This method is generally used in the early stages of a company's development
until significant positive or negative events occur subsequent to the date
of the original investment that dictate a change to another valuation method.
Some examples of such events are: 1) a major recapitalization; 2) a major
refinancing; 3) a significant third-party transaction; 4) the development of
a meaningful public market for the company's common stock; 5) significant
positive or negative changes in the company's business.
B. Private Market: The private market method uses actual third-party
transactions in the company's securities as a basis for valuation, using
actual, executed, historical transactions in the company's securities by
responsible third parties. The private market method may also use, where
applicable, unconditional firm offers by responsible third parties as a
basis for valuation.
C. Public Market: The public market method is used when there is an
established public market for the class of the company's securities held
by the Company. The Company discounts market value for securities that
are subject to significant legal, contractual or practical restrictions,
including large blocks in relation to trading volume. Other securities,
for which market quotations are readily available, are carried at market
value as of the time of valuation.
Market value for securities traded on securities exchanges or on the
Nasdaq National Market is the last reported sales price on the day of
valuation. For other securities traded in the over-the-counter market
and listed securities for which no sale was reported on that day, market
value is the mean of the closing bid price and asked price on that day.
This method is the preferred method of valuation when there is an
established public market for a company's securities, as that market provides
the most objective basis for valuation.
D. Analytical Method: The analytical method is generally used to value
an investment position when there is no established public or private market
in the company's securities or when the factual information available to
the Company dictates that an investment should no longer be valued under
either the cost or private market method. This valuation method is
inherently imprecise and ultimately the result of reconciling the
judgments of the Company's Investment and Valuation Committee members,
based on the data available to them. The resulting valuation, although
stated as a precise number, is necessarily within a range of values that
vary depending upon the significance attributed to the various factors
being considered. Some of the factors considered may include the financial
condition and operating results of the company, the long-term potential of
the business of the company, the values of similar securities issued by <PAGE>
12
companies in similar businesses, the proportion of the company's
securities owned by the Company and the nature of any rights to require
the company to register restricted securities under applicable securities
laws.
INVESTMENTS IN INTELLECTUAL PROPERTY OR PATENTS OR RESEARCH AND DEVELOPMENT
IN TECHNOLOGY OR PRODUCT DEVELOPMENT
Such investments are carried at fair value using the following basic
methods of valuation:
E. Cost: The cost method is based on the original cost to the Company.
Such method is generally used in the early stages of commercializing or
developing intellectual property or patents or research and development
in technology or product development until significant positive or adverse
events occur subsequent to the date of the original investment that dictate
a change to another valuation method.
F. Private Market: The private market method uses actual third-party
investments in intellectual property or patents or research and development
in technology or product development as a basis for valuation, using actual
executed historical transactions by responsible third parties. The private
market method may also use, where applicable, unconditional firm offers by
responsible third parties as a basis for valuation.
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.
13
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.
14
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.
Harris & Harris Enterprises, Inc. is a 100 percent owned subsidiary
of the Company. Harris Partners I L.P. is a limited partnership. The
partners of Harris Partners I L.P. are Harris & Harris Enterprises, Inc.
(sole general partner) and Harris & Harris Group, Inc. (sole limited
partner).
The Company elected to become a BDC on July 26, 1995, after
receiving the necessary approvals. From September 30, 1992 until the
election of BDC status, the Company operated as a closed-end,
non-diversified, investment company under the 1940 Act. Upon commencement
of operations as an investment company, the Company revalued all of its
assets and liabilities at fair value as defined in the 1940 Act. Prior
to such time, the Company was registered and filed under the reporting
requirements of the Securities and Exchange Act of 1934 as an operating
company and, while an operating company, operated directly and through
subsidiaries.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification as a Regulated Investment Company ("RIC")
under Sub-Chapter M of the Internal Revenue Code. As a RIC, the Company
must, among other things, distribute at least 90 percent of its taxable
net income and may either distribute or retain its taxable net realized
capital gains on investments. (See "Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Sub-Chapter
M Tax Status.") There can be no assurance that the Company will qualify
as a RIC or that if it does qualify, it will continue to qualify. In
addition, even if the Company were to qualify as a RIC, and elected
Sub-Chapter M treatment for that year, the Company might take action in
a subsequent year to ensure that it would be taxed in that subsequent
year as a C Corporation, rather than a RIC.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies followed
in the preparation of the consolidated financial statements:
Principles of Consolidation. The consolidated financial statements
have been prepared in accordance with Generally Accepted Accounting
Principles for investment companies. All significant intercompany accounts
and transactions have been eliminated in consolidation.
15
Cash and Cash Equivalents. Cash and cash equivalents include money
market instruments with maturities of less than three months.
Portfolio Investment Valuations. Investments are stated at "fair value"
as defined in the 1940 Act and in the applicable regulations of the
Securities and Exchange Commission. All assets are valued at fair value
as determined in good faith by, or under the direction of, the Board of
Directors. See the Asset Valuation Policy Guidelines in the Footnote to
Schedule of Investments.
Securities Transactions. Securities transactions are accounted for
on the date the securities are purchased or sold (trade date); dividend
income is recorded on the ex-dividend date; and interest income is accrued
as earned. Realized gains and losses on investment transactions are
determined on the first-in, first-out basis or specific identification
basis for financial reporting and tax reporting.
Income Taxes. Prior to January 1, 1998, the Company recorded income
taxes using the liability method in accordance with the provision of
Statement of Financial Accounting Standards No. 109. Accordingly,
deferred tax liabilities had been established to reflect temporary
differences between the recognition of income and expenses for financial
reporting and tax purposes, the most significant difference of which
related to the Company's unrealized appreciation on investments.
The March 31, 1999 financial statements include a provision for
deferred taxes on the net unrealized gains as of December 31, 1998.
(See Note 6. Income Taxes.)
Reclassifications. Certain reclassifications have been made to the
March 31, 1998 financial statements to conform to the March 31, 1999
presentation.
Estimates by Management. The preparation of the consolidated financial
statements in conformity with Generally Accepted Accounting Principles
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities as of March 31, 1999 and
December 31, 1998, and the reported amounts of revenues and expenses for
the three months ended March 31, 1999 and 1998. Actual results could
differ from these estimates.
NOTE 3. STOCK OPTION PLAN AND WARRANTS OUTSTANDING
On August 3, 1989, the shareholders of the Company approved the 1988
Long Term Incentive Compensation Plan. On June 30, 1994, the shareholders
of the Company approved various amendments to the 1988 Long Term Incentive
Compensation Plan: 1) to conform to the provisions of the BDC regulations
under the 1940 Act, which allow for the issuance of stock options to
qualified participants; 2) to increase the reserved shares under the
amended plan; 3) to call the plan the 1988 Stock Option Plan, as Amended
and Restated (the "1988 Plan"); and 4) to make various other amendments.
On October 20, 1995, the shareholders of the Company approved an amendment
to the 1988 Plan authorizing automatic 20,000 share grants of non-qualified
16
stock options to newly elected non-employee directors of the Company.
The Company's 1988 Plan was cancelled as of December 31, 1997, canceling
all outstanding stock options and eliminating all potential stock option
grants. As a substitution for the 1988 Stock Option Plan, the Company
adopted an employee profit-sharing plan.
As of January 1, 1998, 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 statement of operations of the Company for
such year, less the nonqualifying gain, if any. Under the Plan, net
realized income of the Company includes investment income, realized
gains and losses, and operating expenses (including taxes paid or payable
by the Company), but it will be calculated without regard to dividends
paid or distributions made to shareholders, payments under the Plan,
unrealized gains and losses, and loss carry-overs from other years
("Qualifying Income"). The portion of net after-tax realized gains
attributable to asset values as of September 30, 1997 will be considered
nonqualifying gain, which will reduce Qualifying Income.
As soon as practicable following 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. The distribution amounts for each officer
and employee is as follows: Charles E. Harris, 13.790%;
Mel P. Melsheimer, 4.233%; Rachel M. Pernia, 1.524%; and
Jacqueline M. Matthews, 0.453%. If a participant leaves the Company
for other than cause, the amount earned will be accrued and paid to
such participant.
Notwithstanding any provisions of the Plan, in no event may the
aggregate amount of all awards payable for any Plan year during which
the Company remains a "business development company" within the meaning
of the Investment Company Act of 1940, as amended (the "1940 Act"), be
greater than 20 percent of the Company's "net income after taxes" within
the meaning of Section 57(n)(1)(B) of the 1940 Act. In the event the
awards exceed such amount, the awards will be reduced pro rata.
The Plan may be modified, amended or terminated by the Company's
Board of Directors at any time; provided however, no such modification,
amendment or termination may adversely affect any participant that has
not consented to such modification, amendment or termination.
The Company calculates the Plan accrual at each quarter end based
on the realized and 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. The Plan
profit-sharing resulting from the realized gains during 1999 net of
operating expenses for the year, will be paid out as soon as practicable
following year end. During the first quarter of 1999, the Company
accrued profit-sharing expense of $901,341, bringing the cumulative
accrual under the Plan to $2,224,900 at March 31, 1999.
17
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 on March 1, 1999, the directors may
purchase the Company's common stock in the open market, rather than directly
from the Company. During 1998 and 1999, the directors bought a total of
30,307 shares.
On April 15, 1998, the Company announced that the Board of Directors
had approved the purchase of up to 700,000 shares of Company stock in the
open market. As of March 31, 1999, the Company had purchased a total of
369,753 shares for a total of $732,131 or an average of $1.98 per share.
However, the treasury shares purchased were decreased by the directors'
purchases of a total of 30,307 shares of Company stock.
NOTE 5. EMPLOYEE BENEFITS
The Company has an employment and severance contract ("Employment
Contract") with its Chairman, Charles E. Harris, pursuant to which he
is to receive compensation in the form of salary and other benefits.
On January 1, 1998 Mr. Harris' Employment Contract was amended to reduce
his salary to $200,000 and to allow him to participate in other business
opportunities and investments. The term of the contract expires on
December 31, 1999. Base salary is to be increased annually to reflect
inflation and in addition may be increased by such amount as the
Compensation Committee of the Board of Directors of the Company deems
appropriate. In addition, Mr. Harris would be entitled, under certain
circumstances, to receive severance pay under the employment and severance
contracts.
As of January 1, 1989, the Company adopted an employee benefits
program covering substantially all employees of the Company under a
401(k) Plan and Trust Agreement. The Company's contribution to the
plan is determined by the Compensation Committee in the fourth quarter.
On June 30, 1994, the Company adopted a plan to provide medical and
health coverage 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, 1999, the Company
had a reserve of $283,305 for the plan.
18
NOTE 6. INCOME TAXES
As of December 31, 1998, the Company had not elected tax treatment
available to a RIC under Sub-Chapter M of the Code. Accordingly, for
federal and state income tax purposes, the Company was taxed at statutory
corporate rates on its income, which enabled the Company to offset any
prior years' net income against future net operating losses. The
Company intends to use the $7.1 million loss carryforward (which should
result in a tax credit of approximately $2.5 million) to offset the
long-term capital gain realized when the Company sold its interest in
NBX Corporation.
For the three months ended March 31, 1999 and 1998, the Company's
income tax provision (benefit) was allocated as follows:
<TABLE>
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 1999 March 31, 1998
Investment operations $ 0 $ 365,712
Realized (loss) gain on investments 2,479,821 27,531
Decrease in unrealized
appreciation on investments (1,705,376) (808,957)
------------- ------------
Total income tax provision (benefit) $ 774,445 $ (415,714)
============= ============
The above tax benefit consists of the following:
Current -- Federal $ 0 $ 100,000
Deferred -- Federal 774,445 (515,714)
------------- ------------
Total income tax provision (benefit) $ 774,445 $ (415,714)
============= ============
</TABLE>
The Company's net deferred tax liability at March 31, 1999 and
December 31, 1998 consists of the following:
<TABLE>
<S> <C> <C>
March 31, 1999 December 31, 1998
Tax on unrealized
appreciation on investments $ 1,705,509 $ 3,410,885
Net operating loss and
capital carryforward 0 (2,479,821)
------------- ---------------
Net deferred
income tax liability $ 1,705,509 $ 931,064
============= ===============
</TABLE>
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification as a RIC under Sub-Chapter M of the Code.
As a RIC, the Company annually must distribute at least 90 percent of its
investment company taxable income as a dividend and may either distribute
or retain its taxable net capital gains from investments. To initially
qualify as a RIC, among other requirements, the Company had to pay a
dividend to shareholders equal to the Company's cumulative realized
earnings and profits ("E&P"). On April 9, 1998, the Company declared
a one-time cash dividend of $0.75 per share to meet this requirement (for
a total of $8,019,728). The cash dividend was paid on May 12, 1998.
19
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.")
The Company incurred net ordinary and capital losses during the C
Corporation taxable years, of which $7.1 million will be eligible to be
carried forward to the Company's 1999 taxable year. Ordinarily, a
corporation that elects to qualify as a RIC may not use its ordinary
loss carryforwards from C Corporation taxable years to offset RIC
investment company taxable income, although a RIC in certain cases
may use ordinary and capital loss carryforwards to reduce net capital
gains. In addition, a corporation that elects to qualify as a RIC and
that makes an appropriate election continues to be taxable as a C
Corporation on any gains realized within 10 years of its qualification
as a RIC from sales of assets that were held by the corporation on the
effective date of the election ("C Corporation Assets") to the extent
of any gain built into the assets on such date ("Built-In Gain"). The
Company intends to use its $7.1 million loss carryforward to offset the
long term capital gain realized when the Company sold its interest
in NBX Corporation. The Company anticipates realizing a tax benefit of
approximately $2.5 million as a result of such offset.
The IRS recently announced an intention to issue formal guidance in
1999 concerning conversions of C Corporations to RICs. Such guidance may
include resolution of certain issues relevant to the conversion of the
Company from a C Corporation to a RIC.
There can be no assurance that the Company will qualify as a RIC or
that, if it does qualify, it will elect RIC status.
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a ten-year lease with sublet provisions
for office space. In 1995, this lease was amended to include additional
office space. Rent expense under this lease for the three months ended
March 31, 1999 and 1998, was $41,378 and $38,808 respectively. Future
minimum lease payments in each of the following years are: 2000 -- $178,561;
2001 -- $178,561; 2002 -- $178,561; 2003 -- $101,946.
In December 1997, the Company signed a Demand Promissory Note for a
$4,000,000 line of credit with J.P. Morgan collateralized by the Company's
U.S. Treasury obligations. In March 1998 the line of credit was increased
to $6,000,000. As of December 31, 1997, the Company had borrowed $4,000,000
against the line of credit. From December 31, 1997 to January 2, 1998, the
rate on the line of credit was prime (8.5 percent). From January 2, 1998
to April 2, 1998, the interest rate on the line of credit was libor plus
1.5 (7.3125 percent). In March 1998, the Company paid down $2,500,000;
in April 1998, the Company paid the remaining balance.
The Company has a total of $1,475,276 of funds in escrow as a result
of the acquisition of NBX Corporation by 3Com Corporation. The funds are
in a one year interest bearing escrow account for the benefit of the
20
Company, subject to any 3Com Corporation warranty claims associated
with its acquisition of NBX Corporation. The Company set up a reserve
of 10 percent for any potential claims, therefore the funds in escrow
reflect $1,327,748 net of the reserve of $147,528. At this time, the
Company does not anticipate any claims against the escrowed funds and
expects to receive these proceeds by March 8, 2000.
NOTE 8. SUBSEQUENT EVENTS
On April 19, 1999, Harris Partners I L.P. received a cash distribution
from its investment in PHZ Capital Partners, L.P. of $546,360. This
distribution was included in unrealized appreciation as of March 31, 1999
and will be included in realized gain for the three months ended
June 30, 1999.
21
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The Company accounts for its operations under Generally Accepted
Accounting Principles for investment companies. On this basis, the
principal measure of its financial performance is captioned "Net
increase (decrease) in net assets from operations," which is the
sum of three elements. The first element is "Net operating loss,"
which is the difference between the Company's income from interest,
dividends, and fees and its operating expenses, net of applicable
income tax benefit. The second element is "Net realized gain (loss)
on investments," which is the difference between the proceeds received
from dispositions of portfolio securities and their stated cost, net
of applicable income tax provisions (benefits). These two elements
are combined in the Company's financial statements and reported as
"Net realized income (loss)." The third element, "Net (decrease)
increase in unrealized appreciation on investments," is the net change
in the fair value of the Company's investment portfolio, net of decrease
in deferred income taxes that would become payable if the unrealized
appreciation were realized through the sale or other disposition of
the investment portfolio.
"Net realized gain (loss) on investments" and "Net (decrease) increase
in unrealized appreciation on investments" are directly related. When a
security is sold to realize a (loss) gain, net unrealized appreciation
(increases) decreases and net realized gain (decreases) increases.
Financial Condition
The Company's total assets and net assets were, respectively,
$26,134,071 and $21,686,790 at March 31, 1999, compared with $25,358,859
and $22,556,709 at December 31, 1998.
Among significant changes in the first quarter of 1999 were: 1) the
acquisition of NBX Corporation by 3Com Corporation, which increased
Harris & Harris Group's net assets by approximately $5,868,568; 2) the
payment of a cash dividend of $0.35 per share, which reduced net assets
by approximately $3,647,017; 3) the addition to a deferred income tax
liability, which reduced net assets by $774,445 and 4) the operating
loss and decrease in value in investments held which decreased net
assets by approximately $1,288,348 and $659,689, respectively. (See
"Consolidated Statements of Operations" contained in "Item 1. Consolidated
Financial Statements.")
Net asset value per share ("NAV") was $2.09 at March 31, 1999 versus
$2.13 at December 31, 1998. NAV was reduced by the $0.35 dividend declared
and paid in the first quarter of 1999.
The Company's shares outstanding as of March 31, 1999 were 10,353,525
versus 10,591,232 at December 31, 1998. The Company's outstanding shares
were reduced as a result of its repurchase in the open market of a total
of 369,753 shares as of March 31, 1999. However, the treasury shares
were then decreased by purchases of Company stock by directors with
50% of their director compensation. (See "Note 4 of Notes to Consolidated
Financial Statements.)
22
The Company's financial condition is dependent on the success of its
investments. The Company has invested a substantial portion of its assets
in private development stage or start-up companies. These private
businesses tend to be thinly capitalized, unproven, small companies that
lack management depth or have no history of operations. At March 31, 1999,
$14,154,621 or 54 percent of the Company's total assets consisted of
investments at fair value in private businesses, of which net unrealized
appreciation was $5,542,439 before taxes. At December 31, 1998, $19,562,386
or 77 percent of the Company's total assets consisted of investments at
fair value in private businesses, of which net unrealized appreciation
was $10,250,204 before taxes. The decrease in the percentage of private
investments from 77 percent at December 31, 1998 to 54 percent at
March 31, 1999 is primarily owing to the acquisition of NBX Corporation
by 3Com Corporation.
A summary of the Company's investment portfolio is as follows:
<TABLE>
<S> <C> <C>
March 31, 1999 December 31, 1998
Investments, at cost $ 19,474,979 $ 14,124,643
Unrealized appreciation 4,963,057 10,407,548
------------ ------------
Investments, at fair value $ 24,438,036 $ 24,532,191
============ ============
The accumulated unrealized appreciation on investments net of deferred
taxes is $3,257,549 at March 31, 1999, versus $6,996,664 at
December 31, 1998.
</TABLE>
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) to exercise warrants or options that were
acquired in a prior financing; (3) to preserve the Company's proportionate
ownership in a subsequent financing; or (4) attempt to preserve or enhance
the value of the Company's investment. Such additional investments are
referred to as "follow-on" investments. There can be no assurance that
the Company will make follow-on investments or have sufficient funds to
make additional investments. The failure to make such follow-on investments
could jeopardize the viability of the investee company and the Company's
investment or could result in a missed opportunity for the Company to
participate to a greater extent in an investee's successful operations.
The Company attempts to maintain adequate liquid capital to make
follow-on investments in its private investee portfolio companies.
The Company may elect not to make a follow-on investment either because
it does not want to increase its concentration of risk or because it
prefers other opportunities, even though the follow-on investment
opportunity appears attractive.
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, 1999:
<TABLE>
<S> <C>
New Investments: Amount
Kriton Medical, Inc. $ 1,000,001
-----------
Total $ 1,000,001
===========
</TABLE>
23
Results of Operations
Investment Income and Expenses:
The Company realized a net operating loss of $1,288,348 and $526,591 for
the three months ended March 31, 1999 and 1998 respectively. 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 Obligations.
The amount of interest income earned varies based upon 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 $45,209
and $192,291 for the three months ended March 31, 1999 and 1998,
respectively. The decrease of $147,082 or 76.5 percent is the result
of a decline in the balance of the Company's fixed income portfolio
during the three months ended March 31, 1999 versus the three months
ended March 31, 1998. The Company had borrowed funds against the JP Morgan
line of credit during the three months ended March 31, 1998, which were
not outstanding during the three months ended March 31, 1999.
Accordingly, the Company had interest expense of $73,415 during the three
months ended March 31, 1998 and did not have any interest expense for the
three months ended March 31, 1999.
The Company had interest income from affiliated companies of $628 and
$10,932 for the three months ended March 31, 1999 and 1998, respectively.
The decrease of $10,304 or 94.3 percent is owing to the repayment of the
majority of the outstanding loans by the investee companies during the
fourth quarter of 1998.
The Company had other income of $0 and $7,348 for the three months ended
March 31, 1999 and 1998, respectively. The other income in 1998 represents
rental income, the Company did not have any rental income in 1999.
Operating expenses were $1,334,185 and $371,450 for the three months
ended March 31, 1999 and 1998, respectively. The increase of $962,735 or
259.2 percent is primarily owing to the increase in the accrual for the
Company's profit-sharing plan of $901,341 as a result of the realized gain
on the sale of NBX Corporation. Also, the first quarter of 1998 included a
profit-sharing reversal of $198,763, which reduced the total expenses for
that period by $198,763. Most of the Company's operating expenses are
related to employee and director compensation, office and rent expenses and
consulting and professional fees (primarily legal and accounting fees).
The profit-sharing resulting from the realized gains during 1999, net of
operating expenses for the year, will be paid out as soon as practicable
following the year-end audit.
24
The Company has in the past relied, and continues to rely to a large
extent, upon proceeds from sales of investments, rather than investment
income, to defray a significant portion of its operating expenses. Because
such sales cannot be predicted with certainty, the Company attempts to
maintain adequate working capital to provide for fiscal periods when there
are no such sales.
Realized Gains and Losses on Sales of Portfolio Securities:
During the three months ended March 31, 1999 and 1998, the Company
realized gains of $10,745,548 and $78,661, respectively. During the three
months ended March 31, 1999, the Company realized a gain of approximately
$10,584,630 on the acquisition of NBX Corporation by 3Com Corporation. The
Company also realized a gain of $160,918 on its sale of Princeton Video
Image, Inc. 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 before taxes decreased by
$5,444,491 or 52.3 percent during the three months ended March 31, 1999,
from $10,407,548 to $4,963,057, primarily as a result of the
reclassification of the NBX Corporation unrealized gain of $4,716,062 to
realized and the decrease in value of publicly-held stocks that the Company
acquired during the three months ended March 31, 1999.
Net unrealized appreciation on investments before taxes decreased by
$337,027 or 4.1 percent during the three months ended March 31, 1998, from
$8,158,732 to $7,821,705, primarily as a result of increased valuations on
NeuroMetrix, Inc.; PureSpeech, Inc.; Energy Research Corporation and Fuisz
Technologies Corporation. These gains were offset primarily by decreased
valuations in Nanophase Technologies Corporation, Princeton Video Image, Inc.
and MedLogic Global Corporation.
Liquidity and Capital Resources
The Company reported total cash, receivables and marketable securities
(the primary measure of liquidity) at March 31, 1999 of $11,715,146 versus
$5,547,984 at December 31, 1998.
As of March 31, 1999, the Company had a $6,000,000 line of credit in
place with J.P. Morgan, of which the Company had no outstanding balance.
Management believes that its cash, receivables and marketable securities
provide the Company with sufficient liquidity for its operations over the
next 12 months.
25
The increase in cash, receivables and marketable securities from December
31, 1998 to March 31, 1999 is primarily owing to the receipt of total
proceeds of $12,422,159 in cash and funds in escrow ($1,475,276, against
which the Company recorded a 10 percent reserve); offset by the 1) payment
of a dividend of $0.35 per share for a total of $3,647,017; 2) the
investment of $1,000,001 in Kriton Medical, Inc.; and 3) the purchase of
treasury shares for a total of $477,344.
From December 31, 1998 to March 31, 1999, receivables from broker
decreased by $380,707 or 100 percent, owing to transactions that settled in
January 1999. Funds in escrow increased by $1,327,748 or 100 percent, owing
to the escrowed funds received by the Company on the sale of NBX Corporation.
The Company's liabilities of accrued profit-sharing and deferred income tax
liability increased significantly from December 31, 1998 to March 31, 1999.
Accrued profit-sharing increased by $901,341 or 68.1 percent to $2,224,900
as a result of the gain on the sale of NBX Corporation. The accrued profit-
sharing attributable to 1999 net realized income will be paid out as soon as
practicable following the year-end audit. There was no profit-sharing paid
out during the three months ended March 31, 1999.
The deferred income tax liability increased by $774,445 or 83.2 percent
to $1,705,509. The increase in the deferred tax liability reflects the
utilization of all of the Company's net operating loss carryforward to
offset the long-term capital gain realized when the Company sold its
interest in NBX Corporation.
Sub-Chapter M Status
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a RIC under Sub-Chapter M
of the Code. In order to qualify as a RIC, the Company must, in general (1)
annually derive at least 90 percent of its gross income from dividends,
interest and gains from the sale of securities; (2) quarterly meet certain
investment diversification requirements; and (3) annually distribute at
least 90 percent of its investment company taxable income as a dividend.
In addition to the requirement that the Company must annually distribute at
least 90 percent of its investment company taxable income, the Company may
either distribute or retain its taxable net capital gains from investments,
but any net capital gains not distributed could be subject to corporate
level tax. (Any undistributed investment company taxable income would also
be taxed.) Further, the Company could be subject to a four percent excise
tax if it fails to distribute at least 98 percent of its annual ordinary
income and net capital gain income.
Because of the specialized nature of its investment portfolio, the
Company could satisfy the diversification requirements under Sub-Chapter M
of the Code only if it received a certification from the SEC that it is
"principally engaged in the furnishing of capital to other corporations
which are principally engaged in the development or exploitation of
inventions, technological improvements, new processes, or products not
previously generally available."
On April 8, 1998, the Company announced that it had received such a
certification from the SEC for 1997. Pursuant to the Company's receipt of
the certification, the Company's Board of Directors declared and paid a one-
26
time cash dividend of $0.75 per share to meet one of the Company's
requirements for qualification for Sub-Chapter M tax treatment. On
February 17, 1999, the Company received rulings from the IRS regarding
other issues relevant to the Company's tax status as a RIC. (See "Note 6 of
Notes to Consolidated Financial Statements" contained in "Item 1.
Consolidated Financial Statements".) Although the SEC certification for
1997 was issued, there can be no assurance that the Company will receive
such certification for 1998 or subsequent years (to the extent it needs
additional certification as a result of changes in its portfolio) or that
it will qualify as a RIC in 1999 or that, if it does qualify in 1999, it
will continue to qualify in subsequent years.
The qualification of the Company as a RIC under Sub-Chapter M of the
Code depends on it satisfying certain technical requirements regarding its
income, investment portfolio, and distributions. The Company was unable to
satisfy these requirements for the 1998 tax year owing to the nature of the
Company's ownership interest in one of its investee companies. In addition,
because it realized taxable losses in 1998, it was not strategically
advantageous for the Company to elect Sub-Chapter M tax status for 1998.
The Company changed the nature of its ownership interest in the non-
qualifying investee company effective January 1, 1999 in order to meet the
Sub-Chapter M requirements. However, there can be no assurance that the
Company will qualify for Sub-Chapter M treatment for 1999 or subsequent
years. In addition, under certain circumstances, even if the Company were
qualified for Sub-Chapter M treatment in 1999 and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than a RIC.
The Company incurred ordinary and capital losses during its C Corporation
taxable years, of which $7.1 million will be eligible to be carried forward
to the Company's 1999 taxable years. Ordinarily, a corporation that elects
to qualify as a RIC may not use its ordinary loss carryforwards from C
Corporation taxable years to offset RIC investment company taxable income,
although a RIC may in certain cases use ordinary and capital loss
carryforwards to reduce net capital gains. In addition, a C Corporation
that elects to qualify as a RIC and that makes an appropriate election
continues to be taxable as a C Corporation on any gains realized within 10
years of its qualification as a RIC from sales of assets that were held by
the corporation on the effective date of the election ("C Corporation
Assets") to the extent of any gain built into the assets on such date
("Built-In Gain").
The Company intends to use its $7.1 million loss carryforward to offset
the long term capital gain realized when the Company sold its interest in
NBX Corporation. The Company anticipates realizing a tax benefit of
approximately $2.5 million as a result of such offset.
The IRS recently announced an intention to issue formal guidance in 1999
concerning conversions of C Corporation to RICs. Such guidance may include
resolution of certain issues relevant to the conversion of the Company from a
C Corporation to a RIC.
If necessary for liquidity purposes or to fund investment opportunities,
in lieu of distributing its taxable net capital gains, the Company may
27
retain such net capital gains and elect to be deemed to have made a
distribution of the gains, or part thereof, to the shareholders under the
"designated undistributed capital gain" rules of section 852(b)(3) of the
Code. In such a case, the Company would have to pay a 35 percent corporate
level income tax on such "designated undistributed capital gain," but it
would not have to distribute the excess of the retained "designated
undistributed capital gain" over the amount of tax thereon in order to
maintain its RIC status.
Tax Consequences of Net Capital Gains
The following simplified examples illustrate the tax treatment under
Sub-Chapter M of the Code for the Company and its shareholders with regard
to three possible alternatives, assuming a net long-term capital gain of
$1.00 per share, consisting entirely of sales of non-real property assets
held for more than 12 months.
Under Alternative A: 100 percent of net capital gain declared as a
dividend and distributed to shareholders:
1. No taxation at the Company level.
2. Shareholders receive a $1.00 per share dividend and pay a
maximum tax of 20 percent* or $.20 per share, retaining $.80 per share.
Under Alternative B: 100 percent of net capital gain retained by the
Company and designated as "undistributed capital gain" dividend:
1. The Company pays a corporate level income tax of 35 percent on
the undistributed gain or $.35 per share and retains 65 percent of the gain
or $.65 per share.
2. Shareholders increase their cost basis in their stock by $.65
per share. They pay a 20 percent* capital gains tax on 100 percent of the
undistributed gain of $1.00 per share or $.20 per share in tax. Offsetting
this tax, shareholders receive a tax credit equal to 35 percent of the
undistributed gain or $.35 per share.
Under Alternative C: 100 percent of net capital gain retained by the
Company, with no designated undistributed capital gain dividend:
1. The Company pays a corporate level income tax of 35 percent on
the retained gain or $.35 per share plus an excise tax of 4 percent of $.98
per share, or about $.04 per share.
2. There is no tax consequence at the shareholder level.
*Assumes all capital gains qualify for long-term rates of 20 percent.
28
Risk Factors
Investment in Small, Private Companies
There are significant risks inherent in the Company's venture capital
business. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack
management depth and have not attained profitability or have no history
of operations. Because of the speculative nature and the lack of a public
market for these investments, there is significantly greater risk of loss
than is the case with traditional investment securities. The Company
expects that some of its venture capital investments will be a complete
loss or will be unprofitable and that some will appear to be likely to
become successful but never realize their potential. The Company has been
risk seeking rather than risk averse in its approach to venture capital and
other investments. Neither the Company's investments nor an investment in
the Company is intended to constitute a balanced investment program. The
Company has in the past relied and continues to rely to a large extent upon
proceeds from sales of investments rather than investment income to defray
a significant portion of its operating expenses.
Valuation of Portfolio Investments
There is typically no public market of equity securities of the small
private companies in which the Company invests. As a result, the valuation
of the equity securities in the Company's portfolio is subject to the good
faith estimate of the Company's Board of Directors. (See "Asset Valuation
Policy Guidelines" in "Footnote to Consolidated Schedule of Investments.")
In the absence of a readily ascertainable market value, the estimated value
of the Company's portfolio of equity securities may differ significantly
from the values that would be placed on the portfolio if a ready market for
the equity securities existed. Any changes in estimated net asset value
are recorded in the Company's statement of operations as "Change in
unrealized appreciation on investments." (See "Management's Discussion
and Analysis of Financial Condition and Results of Operations.")
Illiquidity of Portfolio Investments
Most of the investments of the Company are or will be equity securities
acquired directly from small companies. The Company's portfolio of equity
securities are and will usually be subject to restrictions on resale or
otherwise have no established trading market. The illiquidity of most of
the Company's portfolio of equity securities may adversely affect the
ability of the company to dispose of such securities at times when it may be
advantageous for the Company to liquidate such investments.
29
Fluctuations of Quarterly Results
The Company's quarterly operating results could fluctuate as a result
of a number of factors. These include, among others, variations in and
the timing of the recognition of realized and unrealized gains or losses,
the degree to which the Company encounters competition in its markets and
general economic conditions. As a result of these factors, results for any
one quarter should not be relied upon as being indicative of performance in
future quarters. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Risk of Loss of Pass Through Tax Treatment
If the Company meets certain diversification and distribution
requirements under the Code, it may qualify as a RIC under the Code for
pass-through tax treatment. The Company would cease to qualify for pass-
through tax treatment if it were unable to comply with these requirements,
or if it ceased to qualify as a BDC under the 1940 Act. The Company also
could be subject to a four percent excise tax (and, in certain cases,
corporate level income tax) if it failed to make certain distributions.
(See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Sub-Chapter M Status.") The lack of Sub-Chapter
M 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 would result in a
substantial reduction in the Company's net assets and the amount of income
available for distribution to the Company's stockholders.
Risks Relating to the Year 2000 Issue
The "Year 2000" computer problem has arisen because many computer
applications worldwide will not properly recognize the date change from
December 31, 1999, to January 1, 2000. The computer applications may
revert to 1900 or some other date because of the way in which dates were
encoded and calculated, potentially causing production of erroneous data,
miscalculations, system failures and other operational problems.
The Company has undertaken the evaluation of the Year 2000 impact on
its critical computer hardware and software. The Company has not incurred,
nor does it anticipate that it will incur, any material cost in addressing
its Year 2000 problem. The Company is developing a strategic plan focusing
on achieving Year 2000 compliance. Certain systems are being replaced and
or modified to be Year 2000 compliant. At the present time, it is not
possible to determine whether any such events are likely to occur or to
quantify any potential negative impact they may have on the Company's
future results of operations and financial condition.
Ultimately, the potential impact of the Year 2000 issue will depend
not only on the success of the corrective measures undertaken by the
Company, but also on the way in which the Year 2000 issue is addressed by
vendors, service providers, counterparties, utilities, governmental
agencies and other entities with which the Company does business.
30
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. Investments
are stated at "fair value" as defined in the 1940 Act and in the applicable
regulations of the Securities and Exchange Commission. All assets are
valued at fair value as determined in good faith by, or under the direction
of, the Board of Directors. See the Asset Valuation Policy Guidelines in
the Footnote to Schedule of Investments.
The Company considers the principal type of market risk to be valuation
risk. The Company considers the management of risk essential to conducting
its businesses and to maintaining profitability. Accordingly, the Company's
risk management systems and procedures are designed to identify and analyze
the Company's risks, to set appropriate policies and limits and to
continually monitor these risks and limits by means of reliable
administrative and information systems and other policies and programs.
The Company manages its market risk by maintaining a portfolio of
equity interests that is diverse by industry, geographic area, property
type, size of individual investment and borrower. However, neither the
Company's investments nor an investment in the Company is intended to
constitute a balanced investment program. The Company does have
exposure to public market price fluctuations to the extent of its publicly
traded portfolio.
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.
Since there is typically no public market for the equity interests of
the small 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 for the equity interests existed. Any
changes in valuation are recorded in the Company's statement of
operations as "Net (decrease) increase 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
Recent Sales of Unregistered Securities
During three months ended March 31, 1999, the Directors purchased
a total of 5,816 shares of restricted common shares as part of
their compensation program.
Item 6. Exhibits and Reports on Form 8-K
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.
11.0* Computation of per share earnings. See Consolidated
Statements of Operations.
27.0* Financial Data Schedule.
(b) The Company did not file any reports on Form 8-K during the first
quarter of 1999.
32
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
27. Financial Data Schedule
33
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.
By: /s/ Rachel M. Pernia
-----------------------------------
Rachel M. Pernia, Vice President
Treasurer, Controller and Principal
Accounting Officer
Date: May 14, 1999
34
WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
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