UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For quarterly period ended September 30, 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 October 18, 1999
- --------------------------------------- ----------------------------------
Common Stock, $0.01 par value per share 9,240,831 shares
Harris & Harris Group, Inc.
Form 10-Q, September 30, 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 . . . . . . . . 16
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
Financial Condition. . . . . . . . . . . . . . . . . . . . 23
Results of Operations. . . . . . . . . . . . . . . . . . . 25
Liquidity and Capital Resources. . . . . . . . . . . . . . 28
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . 31
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 33
PART II OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . 35
Item 2. Changes in Securities and Use of Proceeds . . . . 35
Item 3. Defaults Upon Senior Securities . . . . . . . . . 35
Item 4. Submission of Matters to a Vote of Security
Holders . . . . . . . . . . . . . . . . . . . . . 35
Item 5. Other Information . . . . . . . . . . . . . . . . 35
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . 35
Exhibit Index. . . . . . . . . . . . . . . . . . . . . . . 35
Signature . . . . . . . . . . . . . . . . . . . . . . . . 36
Harris & Harris Group, Inc.
Form 10-Q, September 30, 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 1997. Although the SEC certification for 1997 was issued, there
can be no assurance that the Company will receive such certification for
1999 or subsequent years (to the extend 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.
Pursuant to the Company's receipt of the section 851(e) certification and
its intention to qualify as a RIC, in 1998 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 it did not
1
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 approximately $7 million. The Company intends to use
the $7 million tax loss carryforward to offset the long-term capital gain
realized when the Company sold its interest in NBX Corporation in 1999. 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 (under the RIC regulations) 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 1999, 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>
September 30, 1999 December 31, 1998
(Unaudited) (Audited)
Investments, at value (See
accompanying schedule of
investments and notes). . . . . $ 26,578,612 $ 24,532,191
Cash and cash equivalents . . . . 216,054 164,143
Funds in escrow (Note 7). . . . . 1,327,748 0
Receivable from brokers . . . . . 0 380,707
Interest receivable . . . . . . . 63,176 666
Note receivable . . . . . . . . . 32,663 32,663
Prepaid expenses. . . . . . . . . 31,622 90,649
Other assets. . . . . . . . . . . 146,419 157,840
--------------- -----------------
Total assets. . . . . . . . . . . $ 28,396,294 $ 25,358,859
=============== =================
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities . . . . . . . . . . $ 433,910 $ 505,118
Accrued profit sharing (Note 5) . 2,747,383 1,323,559
Deferred rent . . . . . . . . . . 35,469 42,409
Deferred income tax liability
(Note 6). . . . . . . . . . . . 1,705,509 931,064
--------------- ----------------
Total liabilities . . . . . . . . 4,922,271 2,802,150
--------------- ----------------
Commitments and contingencies (Note 7)
Net assets. . . . . . . . . . . . $ 23,474,023 $ 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 9/30/99
and 12/31/98. . . . . . . . . . 106,930 106,930
Additional paid in capital. . . . 16,159,504 16,158,381
Accumulated net realized income
(deficit) . . . . . . . . . . . 1,897,300 (525,177)
Accumulated unrealized appreciation
of investments, net of deferred
tax liability of $1,705,509 at
9/30/99 and $3,410,884 at
12/31/98. . . . . . . . . . . . 7,847,769 6,996,664
Treasury stock at cost, 1,452,140
shares at 9/30/99 and 101,739
shares at 12/31/98 (Note 4) . . (2,537,480) (180,089)
---------------- ----------------
Net assets. . . . . . . . . . . . $ 23,474,023 $ 22,556,709
---------------- ----------------
Total net assets and liabilities. $ 28,396,294 $ 25,358,859
================ ================
Shares outstanding. . . . . . . . 9,240,831 10,591,232
---------------- ----------------
Net asset value per
outstanding share . . . . . . . $ 2.54 $ 2.13
=============== ================
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
3
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Nine Months Ended
<S> <C> <C> <C> <C>
Sept. Sept. Sept. Sept.
30, 1999 30, 1998 30, 1999 30, 1998
Investment income:
Interest from:
Fixed-income securities.$ 64,349 $ 46,571 $ 185,557 $ 314,237
Affiliated companies . . 19,196 22,649 28,513 109,133
Other income . . . . . . . 3,722 135,680 4,022 143,028
----------- ----------- ---------- ----------
Total investment income. 87,267 204,900 218,092 566,398
Expenses:
Salaries and benefits. . . 182,130 182,136 574,463 646,284
Profit-sharing accrual
(reversal) (Note 5) . . . 5,254 0 1,423,824 (423,808)
Administration and
operations. . . . . . . . 53,542 74,346 241,421 272,294
Professional fees. . . . . 95,013 66,767 219,003 246,866
Rent . . . . . . . . . . . 39,799 40,522 122,555 118,137
Directors' fees and
expenses. . . . . . . . . 19,500 31,252 82,616 101,385
Depreciation . . . . . . . 12,500 12,500 37,500 37,500
Custodian fees . . . . . . 3,713 2,253 6,996 8,451
Interest expense (Note 7). 0 11,963 0 85,378
----------- ----------- ---------- -----------
Total expenses . . . . . 411,451 421,739 2,708,378 1,092,487
----------- ----------- ---------- -----------
Operating loss before
income taxes. . . . . . . (324,184) (216,839) (2,490,286) (526,089)
Income tax (provision)
(Note 6). . . . . . . . . 0 (743,949) 0 (1,137,192)
------------ ------------ ----------- ------------
Net operating loss . . . . . (324,184) (960,788) (2,490,286) (1,663,281)
Net realized (loss) gain on sale of investments:
Realized (loss) gain on
investments . . . . . . . (86,217) (787,873) 11,039,600 (200,696)
------------ ----------- ---------- ------------
Total realized (loss)
gain. . . . . . . . . (86,217) (787,873) 11,039,600 (200,696)
Income tax (provision)
(Note 6). . . . . . . . . 0 0 (2,479,820) 0
------------ ----------- ----------- ------------
Net realized (loss) gain
on sale of investments . (86,217) (787,873) 8,559,780 (200,696)
------------ ---------- ---------- -----------
Net realized (loss) income . (410,401) (1,748,661) 6,069,494 (1,863,977)
Net increase (decrease) in unrealized appreciation on investments:
Increase as a result of
investment sales . . . . 73,446 554,687 559,352 665,312
Decrease as a result of
investment sales. . . . . (98,895) (170,468) (4,939,595) (963,680)
Increase on investments
held. . . . . . . . . . . 1,803,900 2,262 4,859,080 3,779,954
Decrease on investments
held. . . . . . . . . . . (357,853) (2,271,010) (1,333,107) (8,687,643)
----------- ------------- ------------ -----------
Change in unrealized appreciation
on investments . . . . . 1,420,598 (1,884,529) (854,270) (5,206,057)
Income tax benefit
(Note 6). . . . . . . . . 29,096 743,949 1,705,375 1,704,889
----------- ------------- ------------ -----------
Net increase (decrease) in
unrealized appreciation
on investments . . . . . 1,449,694 (1,140,580) 851,105 (3,501,168)
---------- ------------ ---------- ------------
Net increase (decrease) in net assets from operations:
Total. . . . . . . . . . . $1,039,293 $(2,889,241) $6,920,599 $(5,365,145)
========== ============ ========== ============
Per outstanding share. . . $ 0.11 $ (0.27) $ 0.75 $ (0.51)
========== ============ ========== ============
The accompanying notes are an integral part of these consolidated
financial statements.
</TABLE>
4
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<S> <C> <C>
Nine Months Ended Nine Months Ended
September 30, 1999 September 30, 1998
Cash flows from operating activities:
Net increase (decrease) in net
assets resulting from operations. $ 6,920,599 $ (5,365,145)
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 . . . (10,185,330) 5,406,753
Deferred income taxes. . . . . . . 774,445 (667,697)
Depreciation . . . . . . . . . . . 37,500 37,500
Changes in assets and liabilities:
Funds in escrow (Note 7) . . . . . (1,327,748) 0
Receivable from brokers. . . . . . 380,707 0
Interest receivable. . . . . . . . (62,510) 78,457
Collection on notes receivable . . 10,000 0
Prepaid expenses . . . . . . . . . 59,027 35,702
Other assets . . . . . . . . . . . (18,326) (4,855)
Accounts payable and accrued
liabilities. . . . . . . . . . . (71,208) (316,227)
Accrued profit sharing (Note 5). . 1,423,824 0
Deferred rent. . . . . . . . . . . (6,940 (6,940)
Purchase of fixed assets . . . . . (7,754) (8,300)
-------------- -------------
Net cash used in operating
activities. . . . . . . . . . . . (2,073,714) (810,752)
Cash flows from investing activities:
Net (purchase) sale of short-term
investments and marketable
securities . . . . . . . . . . . (1,368,720) 13,934,302
Proceeds from sale of private
placement investment . . . . . . 12,274,631 0
Investment in private placements
and loans. . . . . . . . . . . . (2,777,001) (960,308)
------------- ---------------
Net cash provided by investing
activities. . . . . . . . . . . . 8,128,910 12,973,994
Cash flows from financing activities:
Payment of dividend . . . . . . . . (3,647,017) (8,019,728)
Payment of note payable (Note 7). . 0 (4,000,000)
Proceeds from sale of treasury
stock (Note 4). . . . . . . . . . 17,283 40,604
Purchase of treasury stock
(Note 4). . . . . . . . . . . . . (2,373,551) (199,802)
------------- ---------------
Net cash used in financing
activities . . . . . . . . . . . . (6,003,285) (12,178,926)
Net increase (decrease) 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 . . . . . . . . . . 216,054 129,904
------------- ---------------
Net increase (decrease) in cash
and cash equivalents . . . . . . . $ 51,911 $ (15,684)
============ ===============
Supplemental disclosures of cash flow information:
Income taxes paid . . . . . . . . . $ 1,407 $ 372
Interest paid . . . . . . . . . . . $ 0 $ 85,378
</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> <C> <C>
Three Months Ended Nine Months Ended
Sept. Sept. Sept. Sept.
30, 1999 30, 1998 30, 1999 30, 1998
Changes in net assets from operations:
Net operating loss. . . . $(324,184) $ (960,788) $(2,490,286) $(1,663,281)
Net realized (loss) gain
on investments . . . . . (86,217) (787,873) 8,559,780 (200,696)
Net (decrease) increase in
unrealized appreciation
on investments as a result
of sales . . . . . . . . (25,449) 384,219 (4,380,243) (298,368)
Net increase (decrease)
in unrealized appreciation
on investments held. . . 1,475,143 (1,524,799) 5,231,348 (3,202,800)
----------- ------------ ------------ -----------
Net increase (decrease) in
net assets resulting
from operations . . . . 1,039,293 (2,889,241) 6,920,599 (5,365,145)
Changes in net assets from capital
stock transactions:
Payment of dividends. . . 0 0 (3,647,017) (8,019,728)
Proceeds from sale of
treasury stock (Note 4). 0 10,877 17,283 40,604
Purchase of treasury stock
(Note 4) . . . . . . . (1,832,831) (34,088) (2,373,551) (199,802)
----------- ---------- ----------- -----------
Net decrease in net assets
resulting from capital
stock transactions . . (1,832,831) (23,211) (6,003,285) (8,178,926)
----------- ---------- ----------- -----------
Net (decrease) increase in
net assets. . . . . . . . (793,538) (2,912,452) 917,314 (13,544,071)
Net assets:
Beginning of the period. 24,267,561 23,023,315 22,556,709 33,654,934
----------- ----------- ----------- -----------
End of the period. . . . $23,474,023 $20,110,863 $23,474,023 $20,110,863
=========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
6
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS SEPTEMBER 30, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (11)(12) --
41.4% of total investments
Publicly Traded Portfolio (Common stock unless noted otherwise) --
6.3% of total investments
ATG, Inc. (1)(4) --
Radioactive and hazardous
waste management services . . . (C) 20,000 $ 100,000
Nanophase Technologies
Corporation (1)(6)(13) --
Manufactures and markets
inorganic crystals of
nanometric dimensions --
4.60% of fully diluted equity. (C) 672,916 1,059,870
Somnus Medical Technology, Inc. (1) --
Biotechnology and
healthcare related . . . . . . .(C) 200,000 512,500
------------
Total Publicly Traded Portfolio (cost: $1,920,153). . . $1,672,370
</TABLE>
The accompanying notes are an integral part of this
consolidated schedule.
7
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS SEPTEMBER 30, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
Private Placement Portfolio (Illiquid) (11)(12)(13)
-- 35.1% of total investments
Alliance Pharmaceutical Corp.(1)(2)(4) --
Research and development of
pharmaceutical products -- $1,200,000
subordinated 6% notes due 5/20/02
convertible into 600,000 common shares
@ $2.00 per share . . . . . . . . (C) $1,200,000
Warrants convertible into
200,000 common shares @ $2.45
expiring 5/20/04. . . . . . . . . (C) 200,000 $ 3,329,750
Exponential Business Development Company (1)(2)(5) --
Venture capital partnership
focused on early stage companies
Limited partnership interest. . . (A) -- 25,000
Genomica Corporation (1)(2)(5)(6)(8) --
Develops software that enables the
study of complex genetic diseases --
4.97% of fully diluted equity
Common Stock. . . . . . . . . . . (B) 199,800
Series A Voting
Convertible Preferred Stock . . . (B) 1,660,200 1,209,730
Kriton Medical, Inc. (1)(2)(4)(5) --
Research and development of
medical devices -- 1.88% of fully
diluted equity
Series B Convertible
Preferred Stock . . . . . . . . . (A) 476,191 1,000,001
MedLogic Global Corporation (1)(2)(5) --
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)(7) --
Internet e-commerce source for
scientific products -- 2.30% of
fully diluted equity
Series C Convertible
Preferred Stock . . . . . . . . . (B) 277,163
Common Stock. . . . . . . . . . . (B) 26,822 3,200,962
-----------
Total Private
Placement Portfolio (cost: $5,111,080) . . . . . . . $ 9,331,420
-----------
Total Investments
in Unaffiliated Companies (cost: $7,031,233) . . . .. $11,003,790
</TABLE>
The accompanying notes are an integral part of this consolidated schedule.
8
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS SEPTEMBER 30, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
Private Placement Portfolio in
Non-Controlled Affiliates (11)(13) (Illiquid)
-- 40.9% of total investments
InSite Marketing Technology, Inc. (1)(2)(5)(9)
-- Integrates marketing science and
sales strategy into e-commerce
-- 6.92% of fully diluted equity
Common Stock . . . . . . . . . . (A) 1,351,351 $ 500,000
NeuroMetrix, Inc. (1)(2)(6)
-- Medical devices for monitoring
neuromuscular disorders -- 16.23%
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)(10) -- Organizes
and manages investment partnerships
-- 20.0% of fully diluted equity
Limited partnership interest . . (D) -- 1,637,112
Questech Corporation (1)(2)(5)(6)
-- Manufactures and markets
proprietary decorative tiles
and signs -- 12.38% of fully diluted
equity
Common Stock . . . . . . . . . . (D) 565,792 2,263,168
Warrants at $4.00
expiring 11/28/01. . . . . . . . (A) 166,667 167
Sundial Marketplace Corporation
(1)(2)(4)(5)(6) -- Internet retailer
offering telecommunications products
and services -- 20% of fully diluted equity
Series A Convertible
Preferred Stock . . . . . . . . (A) 2,000,000 500,000
-----------
Total Private Placement Portfolio
in Non-Controlled Affiliates (cost: $5,278,102). . . . . $10,858,672
</TABLE>
The accompanying notes are an integral part of this consolidated schedule.
9
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS SEPTEMBER 30, 1999
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
U.S. Government Obligations -- 17.7% of total investments
U.S. Treasury Bill dated 2/25/99 due date
10/7/99 -- 4.6% yield. . . . . .(K) $ 550,000 $ 549,582
U.S. Treasury Bill dated 3/4/99 due date
11/12/99 -- 4.5% yield . . . . (K) $ 1,000,000 994,800
U.S. Treasury Bill dated 3/11/99 due date
11/26/99 -- 4.5% yield . . . . (K) $ 1,000,000 992,940
U.S. Treasury Bill dated 3/25/99 due date
12/30/99 -- 4.7% yield . . . . (K) $ 600,000 592,908
U.S. Treasury Bill dated 12/10/98 due date
12/9/99 -- 4.8% yield . . . . . (K) $ 1,600,000 1,585,920
----------
Total U.S. Government
Obligations (cost: $4,715,999) . . . . . . . . . . . . $ 4,716,150
-----------
Total Investments -- 100% (cost: $17,025,334). . . . . . . $26,578,612
===========
The accompanying notes are an integral part of this consolidated schedule.
</TABLE>
10
CONSOLIDATED SCHEDULE OF INVESTMENTS SEPTEMBER 30, 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-incomeproducing securities.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Consolidated Schedule of Investments for a description
of the Method of Valuation A to L under Asset Valuation Policy
Guidelines set forth below.
(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 nine
months ended September 30, 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) In September 1998, SciQuest.com, Inc. acquired BioSupplyNet, Inc. On
September 20, 1999, SciQuest.com, Inc. filed a Form S-1 Registration
Statement. See Note 8 of Notes to Consolidated Financial Statements.
(8) In 1996, Genomica Corporation was cofounded by the Company, Cold Spring
Harbor Laboratory ("CSHL"), a not-for-profit institution, 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 CEO of Harris & Harris
Group became a trustee of CSHL.
(9) On October 5, 1999, Silknet Software, Inc. acquired InSite Marketing
Technology, Inc. See Note 8 of Notes to Consolidated Financial
Statements.
(10) 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.
(11) Investments in unaffiliated companies consist of investments in which
Harris & Harris Group, Inc. (the "Company") owns less than five percent
of the investee company. Investments in non-controlled affiliated
companies consist of investments where the Company owns more than five
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.
(12) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $7,031,233. The gross unrealized
appreciation based on the tax cost for these securities is $4,688,138.
The gross unrealized depreciation based on the tax cost for these
securities is $715,581.
(13) The percentage ownership of each investee company disclosed in the
Consolidated 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.
11
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 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:
12
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; 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 portfolio company's securities
held by the Company. The Company discounts market value for securities that
are subject to significant legal, contractual or practical restrictions,
including large blocks in relation to trading volume. Other securities, for
which market quotations are readily available, are carried at market value as
of the time of valuation.
Market value for securities traded on securities exchanges or on the
Nasdaq National Market is the last reported sales price on the day of
valuation. For other securities traded in the over-the-counter market and
listed securities for which no sale was reported on that day, market value
is the mean of the closing bid price and asked price on that day.
This method is the preferred method of valuation when there is an
established public market for a company's securities, as that market provides
the most objective basis for valuation.
D. Analytical Method: The analytical method is generally used to value an
investment position when there is no established public or private market in
the company's securities or when the factual information available to the
Company dictates that an investment should no longer be valued under either
the cost or private market method. This valuation method is inherently
imprecise and ultimately the result of reconciling the judgments of the
Company's Investment and Valuation Committee members, based on the data
available to them. The resulting valuation, although stated as a precise
number, is necessarily within a range of values that vary depending upon the
significance attributed to the various factors being considered. Some of the
factors considered may include the financial condition and operating results
of the company, the long-term potential of the business of the company, the
values of similar securities issued by companies in similar businesses, the
13
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, and terms 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.
14
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.
15
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 net investment company
taxable income and may either distribute or retain its taxable net 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 during a year, 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 as 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 and include the accounts of the Company and its wholly
owned subsidiary. All significant intercompany accounts and transactions
have been eliminated in consolidation.
16
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 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
first-in, first-out basis or specific identification basis for financial
reporting and tax reporting.
Income Taxes. The September 30, 1999 consolidated financial statements
include a provision for deferred taxes on the net unrealized gains as of
December 31, 1998. (See Note 6. Income Taxes.) The consolidated financial
statements do not include a provision for deferred income taxes on the
increase in the unrealized appreciation during 1999.
Reclassifications. Certain reclassifications have been made to the
September 30, 1998 financial statements to conform to the September 30, 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 September 30, 1999 and December 31, 1998, and the
reported amounts of revenues and expenses for the three and nine months ended
September 30, 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 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
17
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. (See Note 5. Employee Benefits.)
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 directly from the Company.
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 September 30, 1999, the Company had purchased a total of
401,878 shares for a total of $795,509 at 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.
On July 14, 1999, the Company announced an offer to purchase up to
1,100,000 shares of its common stock for cash at a price equal to $1.63 per
share. A total of 1,080,569 shares were tendered for a total cost, including
related expenses of approximately $71,500, of $1,832,831. Of these shares,
1,075,269 were tendered by one shareholder, which tendered all of its
holdings.
In total, as a result of the shares purchased in the open market and
through the tender offer, the Company has purchased 1,482,447 shares for a
total of $2,628,340, including commissions and expenses, at an average price
of $1.77.
NOTE 5. EMPLOYEE BENEFITS
The Company has an employment and severance contract ("Employment
Contract") with its Chairman, Charles E. Harris, pursuant to which he is to
receive compensation in the form of salary and other benefits. On January 1,
1998 Mr. Harris's Employment Contract was amended to reduce his salary to
$200,000 and to allow him to participate in other business opportunities and
investments. The term of this contract was to expire on December 31, 1999.
Base salary was to be increased annually to reflect inflation and in addition
could be increased by such amount as the Compensation Committee of the Board
of Directors of the Company deems appropriate. In addition, Mr. Harris would
have been entitled, under certain circumstances, to receive severance pay
under the employment and severance contracts. On October 19, 1999, Mr.
Harris signed an Employment Agreement with the Company, disclosed in a
Form 8-K filed on October 27, 1999, replacing the employment agreement which
was to expire on December 31, 1999.
18
As of January 1, 1998, the Company cancelled its stock option plan and
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 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, 13.79 percent; Mel P. Melsheimer, 4.233 percent; Rachel M. Pernia,
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 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 BDC within the meaning of 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 who 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 third
quarter of 1999, the Company accrued profit-sharing expense of $5,254,
bringing the cumulative accrual under the Plan to $2,747,383 at September
30, 1999.
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.
19
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 10 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 September 30, 1999,
the Company had a reserve of $283,305 for the plan.
NOTE 6. INCOME TAXES
As of December 31, 1998, the Company had not elected tax treatment
available to 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' losses against 1998 income. Following that offset, the Company had
approximately a $7 million loss carryforward. The Company intends to use
the approximate $7 million loss carryforward (which it anticipates will
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 and nine months ended September 30, 1999 and 1998, the
Company's income tax (provision) benefit was allocated as follows:
<TABLE>
<S> <C> <C> <C> <C>
Three Months Three Months Nine Months Nine Months
Ended Ended Ended Ended
Sept. Sept. Sept. Sept.
30, 1999 30, 1998 30, 1999 30,1998
Investment operations. . $ 0 $ (743,949) $ 0 $(1,137,192)
Realized (loss) gain
on investments . . . . 0 0 (2,479,820) 0
Net increase (decrease) in
unrealized appreciation
on investments . . . . 29,096 743,949 1,705,375 1,704,889
------------ ------------ ------------ ----------
Total income tax
(provision) benefit. . $ 29,096 $ 0 $ (774,445) $ 567,697
============ ============ ============ ===========
The above tax (provision) benefit consists of the following:
Current -- Federal $ 0 $ 0 $ 0 $ (100,000)
Deferred -- Federal 29,096 0 (774,445) 667,697
------------ ------------ ------------ ------------
Total deferred income
tax (provision) benefit $ 29,096 $ 0 $ (774,445) $ 567,697
============ ============ ============ ===========
</TABLE>
The Company's net deferred income tax liability at September 30,
1999 and December 31, 1998 consists of the following:
<TABLE>
<S> <C> <C>
September 30, 1999 December 31, 1998
Tax on unrealized appreciation
on investments $ 1,705,509 $ 3,410,885
Net operating loss and capital
loss carryforward 0 (2,479,821)
----------- ------------
Net deferred income tax liability $ 1,705,509 $ 931,064
=========== ===========
</TABLE>
20
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. Any capital gains not
distributed could be subject to corporate level tax. To initially qualify
as a RIC, among other requirements, the Company had to pay a dividend to
shareholders equal to the Company's cumulative realized earnings and profits
("E&P"). On April 9, 1998, the Company declared a one-time cash dividend of
$0.75 per share to meet this requirement (for a total of $8,019,728). The
cash dividend was paid on May 12, 1998. Continued qualification as a RIC
requires the Company to satisfy certain portfolio diversification
requirements in future years. The Company's ability to satisfy those
requirements may not be controllable by the Company.
The Company incurred net ordinary and capital losses during the C
Corporation taxable years, of which approximately $7 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
approximate $7 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 has announced an intention to issue formal guidance in 1999
concerning conversions of C Corporations to RIC's. 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 10-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 September
30, 1999 and 1998, was $39,799 and $40,522 respectively and $122,555 and
$118,137 for the nine months ended September 30, 1999 and 1998, 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
21
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 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 September 20, 1999, SciQuest.com, Inc. filed a Form S-1 Registration
Statement. The Company anticipates receiving 461,036 (as adjusted for
stock split) shares for its investment in SciQuest.com, Inc.
On October 5, 1999, the Company's interest in InSite Marketing Technology,
Inc. was acquired by merger in a tax-free exchange by Silknet Software, Inc.
(NASDAQ: SILK). The Company received 40,864 restricted shares of Silknet.
On October 19, 1999, Mr. Charles E. Harris signed an Employment Agreement
with the Company, disclosed in a Form 8-K filed on October 27, 1999,
replacing the Employment Agreement which was to expire on December 31, 1999.
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, and
the reversal of previously recorded unrealized gain (loss) on investments
sold or realized during the period, 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.
22
Financial Condition
The Company's total assets and net assets were, respectively, $28,396,294
and $23,474,023 at September 30, 1999, compared with $25,358,859 and
$22,556,709 at December 31, 1998.
Net asset value per share ("NAV") was $2.54 at September 30, 1999 versus
$2.13 at December 31, 1998.
Among the significant changes which affected total assets, net assets
and NAV in the first nine months of 1999 were: 1) the acquisition of NBX
Corporation by 3Com Corporation, that increased Harris & Harris Group's net
assets by approximately $5,868,568; 2) an increase in the value of the
Company's holdings in SciQuest.com, Inc., that increased net assets by
approximately $2,350,962; 3) an increase in the value of the Company's
holdings in Alliance Pharmaceutical that increased net assets by
approximately $2,127,750; 4) the payment of a cash dividend of $0.35 per
share, that reduced net assets by approximately $3,647,017; 5) the
addition to a deferred income tax liability, that reduced net assets by
$774,445; 6) the purchase of 275,648 treasury shares in the open market for
a total of $540,720; and the completion of the tender offer of 1,080,569
shares for a total of $1,832,831; and 7) the operating loss that reduced net
assets by approximately $2,490,286. (See "Consolidated Statements of
Operations" contained in "Item 1. Consolidated Financial Statements.")
The Company's shares outstanding as of September 30, 1999 were 9,240,831
versus 10,591,232 at December 31, 1998. The Company's outstanding shares were
reduced as a result of its purchase in the open market of 243,523 shares in
the first quarter and 32,125 shares in the second quarter as well as the
tender offer the Company completed in the third quarter for 1,080,569
shares. However, the treasury shares were then decreased by purchases of a
total of 30,307 shares of treasury shares by directors. (See "Note 4 of
Notes to Consolidated Financial Statements.")
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 September 30,
1999, $20,190,092 or 71.1 percent of the Company's total assets consisted
of investments at fair value in private businesses, of which net unrealized
appreciation was $9,800,910 before taxes. At December 31, 1998, $19,562,386
or 77.1 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 77.1 percent at December 31, 1998 to 71.1 percent at
September 30, 1999 is primarily owing to the acquisition of NBX
Corporation by 3Com Corporation, offset by the additional investments in
private businesses.
23
A summary of the Company's investment portfolio is as follows:
<TABLE>
<S> <C> <C>
September 30, 1999 December 31, 1998
Investments, at cost $ 17,025,334 $ 14,124,642
Unrealized appreciation 9,553,278 10,407,549
------------- -------------
Investments, at fair value $ 26,578,612 $ 24,532,191
============= =============
</TABLE>
The accumulated unrealized appreciation on investments net of deferred
taxes is $7,847,769 at September 30, 1999, versus $6,996,664 at December
31, 1998.
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 nine months ended
September 30, 1999:
<TABLE>
<S> <C>
New Investments: Amount
Alliance Pharmaceutical Corp. $1,202,000
Kriton Medical, Inc. 1,000,001
Sundial Marketplace Corporation 500,000
----------
Sub-Total $2,702,001
Exercise of Warrants:
SciQuest.com, Inc. 75,000
----------
Total $2,777,001
==========
</TABLE>
24
Results of Operations
Investment Income and Expenses:
The Company realized a net operating loss of $2,490,286 and $1,663,281
for the nine months ended September 30, 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 $185,557
and $314,237 for the nine months ended September 30, 1999 and 1998,
respectively. The decrease of $128,680 or 40.9 percent is the result of a
decline in the balance of the Company's fixed income portfolio during the
nine months ended September 30, 1999 versus the nine months ended September
30, 1998. The Company had borrowed funds against the JP Morgan line of
credit during the nine months ended September 30, 1998, which were not
outstanding during the nine months ended September 30, 1999. Accordingly,
the Company had interest expense of $85,378 during the nine months ended
September 30, 1998 and did not have any interest expense for the nine
months ended September 30, 1999.
The Company had interest income from affiliated companies of $28,513 and
$109,133 for the nine months ended September 30, 1999 and 1998, respectively.
The decrease of $80,620 or 73.9 percent is owing to a reduced number of loans
outstanding to investee companies during the fourth quarter of 1999 as
compared to the fourth quarter of 1998. This reduction is primarily
attributable to repayments or conversion of the loans to stock of investee
companies during the fourth quarter of 1998.
The Company had other income of $4,022 and $143,028 for the nine months
ended September 30, 1999 and 1998, respectively. The other income in 1998
represents dividend income, rental income and repayment of expenses paid
by the Company on BioSupplyNet's behalf in 1996. The Company
did not have any rental income in 1999.
Operating expenses were $2,708,378 and $1,092,487 for the nine months
ended September 30, 1999 and 1998, respectively. The increase of $1,615,891
or 147.9 percent is primarily owing to the increase in the accrual for the
Company's profit-sharing plan of $1,423,824 as a result of the realized gain
on the sale of NBX Corporation and the increase in the unrealized
appreciation on investments. Also, the first nine months of 1998 included a
profit-sharing reversal of $423,808, which reduced the total expenses for
that period by such amount. 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).
25
Ninety percent of the profit-sharing amounts resulting from the realized
gains during 1999, net of operating expenses for the year, will be paid out
as soon as practicable following the 1999 year-end audit. The remaining 10
percent will be paid out after the Company has filed its federal tax return
for the year.
The Company had interest income from fixed-income securities of $64,349
and $46,571 for the three months ended September 30, 1999 and 1998,
respectively. The increase of $17,778 or 38.2 percent is a result of the
Company having more funds available to invest in the third quarter of 1999
as a result of the funds received from the sale of NBX Corporation.
The Company had interest income from affiliated companies of $19,196 and
$22,649 for the three months ended September 30, 1999 and 1998, respectively.
The decrease of $3,453 or 15.2 percent is owing to a lower amount of loans
outstanding to investee companies.
Operating expenses were $411,451 and $421,739 for three months ended
September 30, 1999 and 1998, respectively. The decrease of $10,288 or 2.4
percent is primarily owing to interquarter variances and the interest expense
the Company incurred in the third quarter of 1998 and not in 1999.
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:
"Net realized gain (loss) on investments" and "Net (decrease) increase
in unrealized appreciation on investments" are directly related. When an
investment is sold or realized, its previously recorded unrealized gain or
loss is reversed completely. Therefore a reversal of a previously recorded
loss would increase the unrealized appreciation on invesments and a reversal
of a previously recorded gain would decrease the unrealized appreciation on
investments.
During the nine months ended September 30, 1999 and 1998, the Company
realized gains and (losses) of $11,039,600 and ($200,696), respectively.
During the nine months ended September 30, 1999, the Company realized a gain
of approximately $10,584,630 on the acquisition of NBX Corporation by 3Com
Corporation; a gain of approximately $160,918 on its sale of Princeton Video
Image, Inc. stock; and received a cash distribution from PHZ Capital Partners
L.P. of approximately $612,170. The Company also incurred losses of
approximately $318,118 on the sale of various publicly traded investments.
As a result of the gains and losses realized in the nine months ended
September 30, 1999, unrealized appreciation decreased by $4,380,243.
26
During the nine months ended September 30, 1998, the Company sold various
publicly traded securities, realizing a net loss of $200,696. As a result
of the gains and losses realized in the nine months ended September 30,
1998, unrealized appreciation decreased by $298,368.
During the three months ended September 30, 1999 and 1998, the Company
realized losses of $86,217 and $787,873, respectively. During the three
months ended September 30, 1999, the Company sold various publicly traded
securities realizing a net loss of $112,077 and received a cash distribution
from PHZ Capital Partners L.P. of $25,860. As a result of the gains and
losses realized in the three months ended September 30, 1999, unrealized
appreciation decreased by $25,449.
During the three months ended September 30, 1998, the Company sold
various publicly traded securities realizing a net loss of $787,873. As a
result of the gains and losses realized in the three months ended September
30, 1998, unrealized appreciation increased by $384,219.
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
$854,270 or 8.2 percent during the nine months ended September 30, 1999,
from $10,407,549 to $9,553,279, primarily as a result of the reclassification
of the Company's holdings of NBX Corporation from unrealized to realized gain
of approximately $4,716,062, offset by the increase in value of the Company's
holdings of SciQuest.com, Inc. of approximately $2,350,962, and of Alliance
Pharmaceutical Corp. of approximately $2,127,750.
Net unrealized appreciation on investments before taxes decreased by
$5,206,057 or 63.8 percent during the nine months ended September 30, 1998,
from $8,158,732 to $2,952,675, primarily as a result of decreased valuations
in Nanophase Technologies Corporation, Princeton Video Image, Inc. and
MedLogic Global Corporation. These decreases were offset primarily by an
increased valuation in NeuroMetrix, Inc.
Net unrealized appreciation on investments before taxes increased by
$1,420,598 or 17.5 percent during the three months ended September 30, 1999,
from $8,132,681 to $9,553,279, primarily as a result of the increase in the
value of Alliance Pharmaceutical Corp. of approximately $1,803,750.
27
Net unrealized appreciation on investments before taxes decreased by
$1,884,529 or 39.0 percent during the three months ended September 30, 1998,
from $4,837,204 to $2,952,675, owing primarily to decreases in Nanophase
Technologies Corporation, MultiTarget, Inc., Somnus Corporation and Energy
Research Corporation.
Liquidity and Capital Resources
The Company held cash, receivables and marketable securities (the primary
measure of liquidity) at September 30, 1999 totaling $8,028,161, versus
$5,547,984 at December 31, 1998.
The increase in cash, receivables and marketable securities from December
31, 1998 to September 30, 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., $1,202,000 in Alliance Pharmaceutical
Corp., and $500,000 in Sundial Marketplace Corporation; and 3) the purchase
of treasury shares in the open market for a total of $540,720 and the
purchase of 1,080,569 shares tendered in the Company's tender offer for a
total of approximately $1,832,831 including approximately $71,500 of related
fees.
From December 31, 1998 to September 30, 1999, the amounts receivable from
brokers decreased by $380,707 or 100 percent, owing to a transaction that
settled in January 1999. Funds in escrow increased by $1,327,748 or 100
percent, owing to the escrowed funds net of reserve 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 September 30, 1999. Accrued profit-sharing increased by
$1,423,824 or 107.5 percent to $2,747,383 as a result of the gain on the sale
of NBX Corporation and the increase in the unrealized appreciation on
investments. Ninety percent of the profit-sharing amount attributable to
1999 net realized income will be paid out as soon as practicable following
the year-end audit. The remaining 10 percent will be paid out after the
Company has filed its federal tax return for the year. There was no profit-
sharing paid out during the nine months ended September 30, 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 and capital loss
carryforward to offset the long-term capital gain realized when the Company
sold its interest in NBX Corporation.
As of September 30, 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.
28
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 the sum of its annual
ordinary income and capital gain net income.
Because of the specialized nature of its investment portfolio, the
Company could satisfy the diversification requirements under Sub-Chapter M
of the Code only if it received a certification from the SEC that it is
"principally engaged in the furnishing of capital to other corporations
which are principally engaged in the development or exploitation of
inventions, technological improvements, new processes, or products not
previously generally available."
On April 8, 1998, the Company announced that it had received such a
certification from the SEC for 1997. Pursuant to the Company's receipt of
the certification, the Company's Board of Directors declared and paid a one-
time cash dividend of $0.75 per share to meet one of the Company's
requirements for qualification for Sub-Chapter M tax treatment. On February
17, 1999, the Company received rulings from the IRS regarding other issues
relevant to the Company's tax status as a RIC. (See "Note 6 " of "Notes to
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 1999 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 Company anticipates filing a request for SEC
certification for 1999 in the near future.
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 (under the RIC regulations) 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
29
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 approximately $7 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 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 approximate $7 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 has announced an intention to issue formal guidance in 1999
concerning conversions of C Corporation to RIC's. 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 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.
30
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 four percent of
$.98 per share, or about $.04 per share.
2. There is no tax consequence at the shareholder level.
*Assumes all capital gains qualify for long-term rates of 20 percent.
Risk Factors
Investment in Small, Private Companies
There are significant risks inherent in the Company's venture capital
business. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack management
depth and have not attained profitability or have no history of operations.
Because of the speculative nature and the lack of a public market for these
investments, there is significantly greater risk of loss than is the case
with traditional investment securities. The Company expects that some of
its venture capital investments will be a complete loss or will be
unprofitable and that some will appear to be likely to become successful but
never realize their potential. The Company has been risk-seeking rather than
risk-averse in its approach to venture capital and other investments.
Neither the Company's investments nor an investment in the Company is
intended to constitute a balanced investment program. The Company has in
the past relied and continues to rely to a large extent upon proceeds from
sales of investments rather than investment income to defray a significant
portion of its operating expenses. Accordingly, the inability to liquidate
assets could have an adverse effect on the Company's ability to meet its
operating expenses in the ordinary course.
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
31
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 consolidated statement of operations as "Change in
unrealized appreciation on investments." (See "Management's Discussion and
Analysis of Financial Condition and Results of Operations.")
Illiquidity of Portfolio Investments
Most of the investments of the Company are or will be equity securities
acquired directly from small companies. The Company's portfolio of equity
securities are and will usually be subject to restrictions on resale or
otherwise have no established trading market. The illiquidity of most of
the Company's portfolio of equity securities may adversely affect the
ability of the company to dispose of such securities at times when it may
be advantageous for the Company to liquidate such investments.
Fluctuations of Quarterly Results
The Company's quarterly operating results could fluctuate as a result
of a number of factors. These include, among others, variations in and the
timing of the recognition of realized and unrealized gains or losses, the
degree to which the Company encounters competition in its markets and
general economic conditions. As a result of these factors, results for any
one quarter should not be relied upon as being indicative of performance in
future quarters. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Risk of Loss of Pass Through Tax Treatment
If the Company meets certain diversification and distribution
requirements under the Code, it may qualify as a RIC under the Code for
pass-through tax treatment. The Company would cease to qualify for pass-
through tax treatment if it were unable to comply with these requirements,
or if it ceased to qualify as a BDC under the 1940 Act. The Company also
could be subject to a four percent excise tax (and, in certain cases,
corporate level income tax) if it failed to make certain distributions.
(See "Management's Discussion and Analysis of Financial Condition
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.
32
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 has developed a plan focusing on achieving
Year 2000 compliance. At the present time, it is not possible to determine
whether any such events are likely to occur or to quantify any potential
negative impact they may have on the Company's future results of operations
and financial condition.
Ultimately, the potential impact of the Year 2000 issue will depend not
only on the success of the corrective measures undertaken by the Company,
but also on the way in which the Year 2000 issue is addressed by vendors,
service providers, counterparties, utilities, governmental agencies and other
entities with which the Company does business.
Forward-Looking Statements
The information contained herein contains certain forward-looking
statements. These statements include the plans and objectives of management
for future operations and financial objectives, portfolio growth and
availability of funds. These forward-looking statements are subject to the
inherent uncertainties in predicting future results and conditions. Certain
factors that could cause actual results and conditions to differ materially
from those projected in these forward-looking statements are set forth
herein. Other factors that could cause actual results to differ materially
include the uncertainties of economic, competitive and market conditions,
and future business decisions, all of which are difficult or impossible to
predict accurately and many of which are beyond the control of the
Company. Although the Company believes that the assumptions underlying the
forward-looking statements included herein are reasonable, any of the
assumptions could be inaccurate and therefore there can be no assurance that
the forward-looking statements included or incorporated by reference herein
will prove to be accurate. Therefore, the inclusion of such information
should not be regarded as a representation by the Company or any other
person that the objectives and plans of the Company will be achieved.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company's business activities contain elements of risk. The Company
considers the 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 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 Guidelines
in the Footnote to Consolidated Schedule of Investments.
33
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 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 consolidated statements
of operations as "Net increase (decrease) in unrealized appreciation on
investments."
34
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
None
Item 5. Other Information
None
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.
10.1 Employment Agreement Between Harris & Harris Group, Inc. and
Charles E. Harris, dated October 19, 1999, incorporated by
reference to Exhibit 99 to the Company's Form 8-K filed on
October 27, 1999.
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 nine
months ended September 30, 1999. On October 27, 1999, the Company
filed a Form 8-K to disclose the Employment Agreement between
Charles E. Harris, Chief Executive Officer of Harris & Harris Group,
Inc. and Harris & Harris Group, Inc.
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
27. Financial Data Schedule
35
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: November 15, 1999
WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
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<NAME> HARRIS & HARRIS GROUP, INC.
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