UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For quarterly period ended March 31, 2000
[ ] 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 (IRS Employer Identification No.)
incorporation or organization)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
- ------------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
212/332-3600
- ------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at May 5, 2000
- --------------------------------------- ---------------------------
Common Stock, $0.01 par value per share 9,240,831 shares
Harris & Harris Group, Inc.
Form 10-Q, March 31, 2000
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. . . . . . . . . . . . . . . . . . . 24
Financial Condition. . . . . . . . . . . . . . . . . . . . . . 24
Results of Operations. . . . . . . . . . . . . . . . . . . . . 27
Liquidity and Capital Resources. . . . . . . . . . . . . . . . 28
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . 32
Item 3. Quantitative and Qualitative Disclosures
About Market Risk . . . . . . . . . . . . . . . . . . 37
PART II OTHER INFORMATION
Item 1. Legal Proceedings. . . . . . . . . . . . . . . . . . . 38
Item 2. Changes in Securities and Use of Proceeds. . . . . . . 38
Item 3. Defaults Upon Senior Securities. . . . . . . . . . . . 38
Item 4. Submission of Matters to a Vote of Security Holders. . 38
Item 5. Other Information. . . . . . . . . . . . . . . . . . . 39
Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . 39
Exhibit Index. . . . . . . . . . . . . . . . . . . . . . . . . 40
Signature. . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Harris & Harris Group, Inc.
Form 10-Q, March 31, 2000
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 amended Investment Company Act of 1940. The
Company made such election on July 26, 1995. Certain information and
disclosures normally included in the consolidated financial statements in
accordance with Generally Accepted Accounting Principles have been condensed
or omitted as permitted by Regulation S-X and Regulation S-K. It is
suggested that the accompanying consolidated financial statements be read in
conjunction with the audited consolidated financial statements and notes
thereto for the year ended December 31, 1999 contained in the Company's 1999
Annual Report.
On September 25, 1997, the Company's Board of Directors approved a
proposal to seek qualification of the Company as a Regulated Investment
Company ("RIC") under Sub-Chapter M of the Internal Revenue Code (the
"Code"). At that time, the Company was taxable under Sub-Chapter C of the
Code (a "C Corporation"). On April 8, 1998, the Company announced that it
had received a certification from the Securities and Exchange Commission
("SEC") for 1997 relating to the Company's status under section 851(e) of
the Code. That certification was necessary for the Company to qualify as a
RIC for 1998 and subsequent taxable years.
In 1999, because of changes in its investment portfolio, the Company
requested recertification from the SEC relating to the Company's status under
section 851(e) of the Code. On February 24, 2000, the Company received the
certification, and the Company plans to elect Sub-Chapter M tax treatment for
1999. However, there can be no assurance that the Company will qualify for
Sub-Chapter M treatment in subsequent years. In addition, under certain
circumstances, even if the Company qualified for Sub-Chapter M treatment in a
given year 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. 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.")
1
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
elect Sub-Chapter M status for 1998. The Company changed the nature of its
ownership interest in the non-qualifying investee company effective January
1, 1999 in order to meet the Sub-Chapter M requirements. 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.
Moreover, the Company received a tax opinion in 1998 that the Company
interprets to mean that its tax-loss carryforward at December 31, 1998 of
approximately $7.0 million (resulting in a tax credit of approximately $2.5
million) would be applicable as a qualifying RIC offset the Company's
unrealized gains as of December 31, 1998. That opinion was confirmed in
one of the rulings received from the IRS in February 1999.
2
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
<S> <C> <C>
March 31, 2000 December 31, 1999
(Unaudited) (Audited)
Investments, at value (See accompanying
schedule of investments and notes). . . $ 56,305,870 $ 63,535,651
Cash and cash equivalents. . . . . . . . . 230,998 133,256
Restricted funds (Note 5). . . . . . . . . 76,698 0
Funds in escrow (Note 7) . . . . . . . . . 0 1,327,748
Interest receivable. . . . . . . . . . . . 10,528 44,189
Note receivable. . . . . . . . . . . . . . 32,663 32,663
Prepaid expenses . . . . . . . . . . . . . 65,724 74,328
Other assets . . . . . . . . . . . . . . . 151,219 172,933
--------------- ----------------
Total assets . . . . . . . . . . . . . . . $ 56,873,700 $ 65,320,768
=============== ================
LIABILITIES & NET ASSETS
Accounts payable and accrued liabilities . $ 564,112 $ 700,566
Accrued profit sharing (Note 3). . . . . . 6,758,435 9,434,467
Income tax liability (Note 6). . . . . . . 1,183,618 0
Deferred rent. . . . . . . . . . . . . . . 30,844 33,156
Deferred income tax liability (Note 6) . . 1,364,470 1,517,774
--------------- ----------------
Total liabilities. . . . . . . . . . . . . 9,901,479 11,685,963
Commitments and contingencies (Note 7) --------------- ----------------
Net assets . . . . . . . . . . . . . . . . $ 46,972,221 $ 53,634,805
=============== ================
Net assets are comprised of:
Preferred stock, $0.10 par value,
2,000,000 shares authorized; none issued.$ 0 $ 0
Common stock, $0.01 par value, 25,000,000
shares authorized;10,692,971 issued at
3/31/00 and 12/31/99. . . . . . . . . . 106,930 106,930
Additional paid in capital . . . . . . . . 16,159,504 16,159,504
Additional paid in capital - common
stock warrants. . . . . . . . . . . . . 109,641 0
Accumulated net realized deficit . . . . . (1,518,133) (5,192,860)
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $1,630,506 at 3/31/00
and $1,783,810 at 12/31/99. . . . . . . 34,651,759 45,098,711
Treasury stock at cost, 1,452,140 shares
at 3/31/00 and 12/31/99 . . . . . . . . (2,537,480) (2,537,480)
--------------- -----------------
Net assets . . . . . . . . . . . . . . . . $ 46,972,221 $ 53,634,805
============== =================
Total net assets and liabilities . . . . . $ 56,873,700 $ 65,320,768
============== =================
Shares outstanding . . . . . . . . . . . . 9,240,831 9,240,831
Net asset value per outstanding share. . . $ 5.08 $ 5.80
============== =================
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
3
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 2000 March 31, 1999
Investment income:
Interest from:
Fixed-income securities . . . . $ 83,954 $ 45,209
Affiliated companies . . . . . . 21,682 628
Other income . . . . . . . . . . . 15,812 0
-------------- --------------
Total investment income. . . . . 121,448 45,837
Expenses:
Profit sharing accrual
(reversal) (Note 3). . . . . . . (1,651,336) 901,341
Salaries and benefits. . . . . . . 277,546 207,078
Administration and operations. . . 92,574 72,725
Professional fees. . . . . . . . . 85,307 61,017
Rent . . . . . . . . . . . . . . . 41,475 41,378
Directors' fees and expenses . . . 21,132 36,414
Depreciation . . . . . . . . . . . 10,000 12,500
Custodian fees . . . . . . . . . . 3,536 1,732
Interest expense (Note 4). . . . . 146,141 0
-------------- ---------------
Total expenses . . . . . . . . . (973,625) 1,334,185
-------------- ---------------
Operating income (loss) before
income taxes . . . . . . . . . . 1,095,073 (1,288,348)
Income tax provision (Note 6). . . 0 0
-------------- ---------------
Net operating income (loss). . . . . 1,095,073 (1,288,348)
Net realized gain on investments:
Realized gain on sale of
investments. . . . . . . . . . . 3,763,272 10,745,548
-------------- ----------------
Total realized gain. . . . . . . 3,763,272 10,745,548
Income tax provision (Note 6). . . (1,183,618) (2,479,821)
-------------- ----------------
Net realized gain on investments . 2,579,654 8,265,727
-------------- ----------------
Net realized income. . . . . . . . . 3,674,727 6,977,379
Net decrease in unrealized
appreciation on investments:
Decrease as a result of
investment sales . . . . . . . . (3,204,990) (4,784,802)
Increase on investments held . . . 14,338,573 58,727
Decrease on investments held . . . (21,733,839) (718,416)
------------- ----------------
Change in unrealized appreciation
on investments . . . . . . . . . (10,600,256) (5,444,491)
Income tax benefit (Note 6). . . . 153,304 1,705,376
------------- -----------------
Net decrease in unrealized appreciation
on investments . . . . . . . . . (10,446,952) (3,739,115)
------------- -----------------
Net (decrease) increase in net assets from operations:
Total. . . . . . . . . . . . . . . $ (6,772,225) $ 3,238,264
============= =================
Per outstanding share. . . . . . . $ (0.73) $ 0.31
============= =================
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
4
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 2000 March 31, 1999
Cash flows from operating activities:
Net (decrease) increase in net
assets resulting from operations. .$ (6,772,225) $ 3,238,264
Adjustments to reconcile net
(decrease) increase in net assets
from operations to net cash used
in operating activities:
Net realized and unrealized
loss (gain) on investment . . . 6,836,984 (5,301,057)
Income taxes. . . . . . . . . . . 1,030,314 774,445
Depreciation. . . . . . . . . . . 10,000 12,500
Other . . . . . . . . . . . . . . 105,040 0
Changes in assets and liabilities:
Restricted funds. . . . . . . . . (76,698) 0
Receivable from brokers . . . . . 0 380,707
Interest receivable . . . . . . . 33,661 154
Prepaid expenses. . . . . . . . . 8,604 (28,802)
Funds in escrow (Note 7). . . . . 1,327,748 (1,327,748)
Other assets. . . . . . . . . . . 16,189 485
Accounts payable and accrued
liabilities . . . . . . . . . . (136,454) (105,427)
Payable to brokers. . . . . . . . 0 77,085
Accrued profit sharing (Note 3) . (2,676,032) 901,341
Deferred rent . . . . . . . . . . (2,312) (2,313)
Collection on notes receivable. . 0 10,000
-------------- -------------
Net cash used in operating
activities. . . . . . . . . . . . (295,181) (1,370,366)
Cash flows from investing activities:
Net purchase (sale) of short-term
investments and marketable
securities . . . . . . . . . . . (1,977,303) (5,889,416)
Proceeds from sale of investments. 5,014,702 12,274,631
Investment in private placements
and loans. . . . . . . . . . . . (2,640,000) (1,000,001)
Purchase of fixed assets . . . . . (4,476) 0
--------------- --------------
Net cash provided by investing
activities . . . . . . . . . . . 392,923 5,385,214
Cash flows from financing activities:
Payment of dividend. . . . . . . . 0 (3,647,017)
Proceeds from note payable . . . . 3,000,000 0
Payment of note payable (Note 7) . (3,000,000) 0
Proceeds from sale of stock. . . . 0 16,178
Purchase of stock (Note 4) . . . . 0 (477,344)
--------------- --------------
Net cash used in financing
activities . . . . . . . . . . . 0 (4,108,183)
Net increase (decrease) in cash and cash equivalents:
Cash and cash equivalents at
beginning of the period . . . . 133,256 164,143
Cash and cash equivalents at
end of the period . . . . . . . 230,998 70,808
---------------- --------------
Net increase (decrease) in cash
and cash equivalents. . . . . .$ 97,742 $ (93,335)
================ ==============
Supplemental disclosures of cash flow information:
Income taxes paid. . . . . . . . .$ 1,450 $ 797
Interest paid. . . . . . . . . . .$ 36,500 $ 0
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
5
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 2000 March 31, 1999
Changes in net assets from operations:
Net operating income (loss) . . . .$ 1,095,073 $ (1,288,348)
Net realized gain on investments. . 2,579,654 8,265,727
Net decrease in unrealized
appreciation on investments as
a result of sales . . . . . . . . (3,051,686) (3,079,426)
Net decrease in unrealized
appreciation on investments held. (7,395,266) (659,689)
--------------- ---------------
Net (decrease) increase in net assets
resulting from operations . . . . (6,772,225) 3,238,264
Changes in net assets from capital
stock transactions:
Additional paid in capital on
Common Stock Warrants issued. . . 109,641 0
Payment of dividend . . . . . . . . 0 (3,647,017)
Purchase of treasury stock. . . . . 0 (477,344)
Proceeds from sale of stock . . . . 0 16,178
--------------- ---------------
Net Increase (decrease) in net assets
resulting from capital stock
transactions. . . . . . . . . . . 109,641 (4,108,183)
--------------- ---------------
Net decrease in net assets . . . . . . (6,662,584) (869,919)
Net assets:
Beginning of the period . . . . . . 53,634,805 22,556,709
-------------- --------------
End of the period . . . . . . . . . $ 46,972,221 $ 21,686,790
============== ==============
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
6
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 2000
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (13)(14)(15)
-- 52.5% of total investments
Publicly Traded Portfolio (Common stock unless noted otherwise)
-- 44.2% of total investments
Alliance Pharmaceutical Corp. (2)(7)
-- Research and development of
pharmaceutical products -- 1.42% of
fully diluted equity . . . . . . . . (C) 800,000 $11,344,900
Silknet Software, Inc. (1)(2)(8)
-- Provides customer-centric
e-business applications and
systems -- 0.21% of fully
diluted equity . . . . . . . . . . . (C) 40,864 3,537,563
SciQuest.com, Inc. (1)(2)(9) --
Internet e-commerce source for
scientific products -- 1.07% of
fully diluted equity . . . . . . . . (C) 417,639 10,017,272
-----------
Total Publicly Traded Portfolio (cost: $2,961,985) . . . . . . . $24,899,735
Private Placement Portfolio (Illiquid) (13)(14)(15) -- 8.3% of total investments
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)(6)(10)
-- Develops software that enables
the study of complex genetic
diseases -- 4.09% of fully diluted equity
Common Stock . . . . . . . . . . . . (B) 199,800
Series A Voting Convertible
Preferred Stock. . . . . . . . . . (B) 1,660,200
Series C Convertible Preferred
Stock. . . . . . . . . . . . . . . (B) 333,333 3,040,250
iPacer Corporation (1)(2)(4)(6) --
Developing audio web portal
technology -- 0.86% of fully
diluted equity
Series A Voting Convertible
Preferred Stock. . . . . . . . . . (A) 229,364 504,601
Kriton Medical, Inc. (1)(2)(6) --
Research and development of
medical devices -- 1.86% of fully
diluted equity
Series B Convertible Preferred Stock. (A) 476,191 1,000,001
MedLogic Global Corporation (1)(2)(6)
-- Medical cyanoacrylate adhesive
-- 0.37% of fully diluted equity
Series B Convertible Preferred Stock. (D) 54,287
Common Stock. . . . . . . . . . . . . (D) 25,798 103,763
-----------
Total Private Placement Portfolio (cost: $4,063,681) . . . . . . $ 4,673,615
-----------
Total Investments in Unaffiliated Companies (cost: $7,025,666) . $29,573,350
-----------
</TABLE>
The accompanying notes are an integral part of
this consolidated schedule.
7
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 2000
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated Companies (13)(15) --
38.5% of total investments
Publicly Traded Portfolio -- 18.0% of total investments
Nanophase Technologies Corporation
(1)(11) -- Manufactures and
markets inorganic crystals of
nanometric dimensions --
4.47% of fully diluted equity. . (C) 672,916 $10,144,209
-----------
Total Publicly Traded Portfolio (cost: $1,162,204) . . . . . . $10,144,209
Private Placement Portfolio (Illiquid) (13)(15) -- 20.5% of total investments
MyPersonalAdvocate.com, Inc. (1)(2)(4)(6)
-- Business-to-business e-commerce
and e-services trust-based marketing
start-up -- 15.39% of fully diluted equity
Convertible Preferred Stock. . . (A) 125,000 $ 1,000,000
NeuroMetrix, Inc. (1)(2)(6) --
Medical devices for monitoring
neuromuscular disorders -- 16.24%
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)(12) -- Organizes
and manages investment partnerships
-- 20.0% of fully diluted equity
Limited partnership interest . . (D) -- 1,630,433
Questech Corporation (1)(2)(6) --
Manufactures and markets
proprietary decorative tiles
and signs -- 12.40% of fully
diluted equity
Common Stock . . . . . . . . . . (D) 580,037 2,035,930
Warrants at $5.00
expiring 11/15/09. . . . . . . (A) 1,965
Warrants at $4.00
expiring 11/28/01. . . . . . . (A) 152,422 167
Sundial Marketplace Corporation
(1)(2)(6) -- Business-to-
business e-commerce company
providing retail wireless
communications services -- 20%
of fully diluted equity
Series A Convertible
Preferred Stock. . . . . . . . (A) 2,000,000 500,000
12% Convertible Note . . . . . . (A) $ 400,000 400,000
-----------
Total Private Placement Portfolio (cost: $6,772,657). . . . . . $11,524,755
-----------
Total Investments in Non-Controlled Affiliates
(cost: $7,934,861). . . . . . . . . . . . . . . . . . . . . . $21,668,964
-----------
</TABLE>
The accompanying notes are an integral part of this
consolidated schedule.
8
<TABLE>
<CAPTION>
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 2000
(Unaudited)
<S> <C> <C> <C>
Method of Shares/
Valuation (3) Principal Value
U.S. Government Obligations -- 9.0% of total investments
U.S. Treasury Bill dated 10/7/99 due date
4/6/00 -- 5.2% yield. . . . . . . . (K) $1,500,000 $ 1,499,355
U.S. Treasury Bill dated 11/4/99 due date
5/4/00 -- 5.3% yield. . . . . . . . (K) $ 500,000 497,520
U.S. Treasury Bill dated 11/12/99 due date
5/11/00 -- 5.4% yield . . . . . . . (K) $ 800,000 795,144
U.S. Treasury Bill dated 12/9/99 due date
6/8/00 -- 5.5% yield. . . . . . . . (K) $1,500,000 1,484,265
U.S. Treasury Bill dated 1/13/00 due date
7/13/00 -- 5.6% yield . . . . . . . (K) $ 800,000 787,272
----------
Total Investments in U.S. Government Obligations
(cost: $5,063,078) . . . . . . . . . . . . . . . . . . . . . . $ 5,063,556
-----------
Total Investments -- 100% (cost: $20,023,605). . . . . . . . . . $56,305,870
===========
</TABLE>
The accompanying notes are an integral part of this
consolidated schedule.
9
CONSOLIDATED SCHEDULE OF INVESTMENTS MARCH 31, 2000
(Unaudited)
Notes to Consolidated Schedule of Investments
(1) Represents a non-income producing security. Equity investments that have
not paid dividends within the last twelve months are considered to be
non-income producing.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Schedule of Investments for a description of the Method
of Valuation A to L.
(4) These investments were made during 2000. Accordingly, the amounts shown on
the schedule represent the gross additions in 2000.
(5) No changes in valuation occurred in these investments during the three
months ended March 31, 2000.
(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) As of March 31, 2000, the market price per share of Alliance Pharmaceutical
Corp. (National Market Symbol: ALLP) was $14.9275. The Company's holding
in Alliance Pharmaceutical, before a discount for trading restrictions was
valued at $11,942,000. These shares are currently restricted under
Rule 144. On May 5, 2000, the market price per share of Alliance
Pharmaceutical Corp. was $11.3125.
(8) On October 5, 1999, Silknet Software, Inc. (National Market Symbol: SILK)
acquired InSite Marketing Technology, Inc. On April 19, 2000, Kana
Communications, Inc. (National Market Symbol: KANA) and Silknet Software
completed a merger, in which the Silknet Software shares were exchanged
tax free for 1.66 Kana Communications shares. Upon the completion of the
merger, 90 percent of the Silknet Software/Kana Communications shares
became freely tradeable, and the Company is subject to a lock-up
agreement on the remaining 10 percent of the stock which expires on
October 5, 2000. On March 31, 2000, the market price per share of
Silknet Software and Kana Communications was $104.00 and $68.00,
respectively. The Company's holding in Silknet Software/Kana
Communications before a discount for trading restrictions and a 10
percent escrow was valued at $3,537,563. On May 5, 2000, the market
price per share of Kana Communications was $55.34375.
The accompanying notes are an integral part of this consolidated schedule.
10
(9) The Company is subject to a lock-up agreement on the stock which expires
on May 18, 2000. On March 31, 2000, the market price per share of
SciQuest.com, Inc. (National Market Symbol: SQST) was $25.75. The
Company's holding in SciQuest.com before a discount for trading
restrictions was valued at $10,754,204. On May 5, 2000, the market
price per share of SciQuest.com, Inc. was $15.3125.
(10) 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, Charles E. Harris, Chairman and CEO of Harris & Harris Group,
became a trustee of CSHL.
(11) As of March 31, 2000, the market price per share of Nanophase Technologies
Corporation(National Market Symbol: NANX) was $16.75. The Company's
holding in Nanophase Technologies Corporation before a discount for
illiquidity was valued at $11,271,343. On May 5, 2000, the market price
per share of Nanophase Technologies Corporation was $8.5625.
(12) 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.
(13) Investments in unaffiliated companies consist of investments in which
Harris & Harris Group, Inc. (the "Company") owns less than 5 percent of
the investee company. Investments in non-controlled affiliated companies
consist of investments where the Company owns more than 5 percent but
less than 25 percent of the investee company. Investments in controlled
affiliated companies consist of investments where the Company owns more
than 25 percent of the investee company.
(14) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $7,025,666. The gross unrealized
appreciation based on the tax cost for these securities is $23,477,696.
The gross unrealized depreciation based on the tax cost for these
securities is $930,012.
(15) 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 or more Board members, is responsible for reviewing and approving the
valuation of the Company's assets within the guidelines established by the
Board of Directors.
Fair value is generally defined as the amount that an investment could be
sold for in an orderly disposition over a reasonable time. Generally, to
increase objectivity in valuing the assets of the Company, external measures
of value, such as public markets or third-party transactions, are utilized
whenever possible. Valuation is not based on long-term work-out value, nor
immediate liquidation value, nor incremental value for potential changes that
may take place in the future.
Valuation assumes that, in the ordinary course of its business, the
Company will eventually sell its investment.
The Company's valuation policy with respect to the five broad investment
categories is as follows:
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 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, term of patent and
projected markets.
LONG-TERM FIXED-INCOME SECURITIES
H. Fixed-Income Securities for which market quotations are readily
available are carried at market value as of the time of valuation using the
most recent bid quotations when available.
Securities for which market quotations are not readily available are
carried at fair value using one or more of the following basic methods of
valuation:
I. Fixed-Income Securities are valued by independent pricing services
that provide market quotations based primarily on quotations from dealers
and brokers, market transactions, and other sources.
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.
The Company elected to become a BDC on July 26, 1995, after receiving
the necessary approvals. From September 30, 1992 until the election of BDC
status, the Company operated as a closed-end, non-diversified, investment
company under the 1940 Act. Upon commencement of operations as an investment
company, the Company revalued all of its assets and liabilities at fair value
as defined in the 1940 Act. Prior to such time, the Company was registered
and filed under the reporting requirements of the Securities and Exchange Act
of 1934 as an operating company and, while an operating company, operated
directly and through subsidiaries.
Harris & Harris Enterprises, Inc. ("Enterprises") is a 100 percent wholly
owned subsidiary of the Company. Enterprises holds the lease for the office
space, which it subleases to the Company and an unaffiliated party; owns a
financial relations and consulting firm; is a partner in Harris Partners I,
L.P.; and is taxed as a C corporation. Harris Partners I L.P. is a limited
partnership and owns a 20 percent limited partnership interest in PHZ Capital
Partners, L.P. The partners of Harris Partners I L.P. are Enterprises (sole
general partner) and Harris & Harris Group, Inc. (sole limited partner).
The Company intends for 1999 to elect treatment as a RIC. As a RIC, the
Company must, among other requirements, distribute at least 90 percent of its
taxable net income and may either distribute or retain its taxable net
realized capital gains on investments. (See "Item 2. Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Sub-Chapter
M Status.") There can be no assurance that the Company will qualify as a
RIC or that if it does qualify, it will continue to qualify. In addition,
even if the Company were to qualify as a RIC, and elected Sub-Chapter M
treatment for that year, the Company might take action in a subsequent year
to ensure that it would be taxed in that subsequent year as a C Corporation,
rather than as a RIC.
16
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of significant accounting policies followed
in the preparation of the consolidated financial statements:
Principles of Consolidation. The consolidated financial statements have
been prepared in accordance with Generally Accepted Accounting Principles for
investment companies. All significant intercompany accounts and transactions
have been eliminated in consolidation.
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
specific identification basis for financial reporting and tax reporting.
Income Taxes. Prior to January 1, 1999, the Company recorded income
taxes using the liability method in accordance with the provision of
Statement of Financial Accounting Standards No. 109. Accordingly, deferred
tax liabilities had been established to reflect temporary differences between
the recognition of income and expenses for financial reporting and tax
purposes, the most significant difference of which related to the Company's
unrealized appreciation on investments.
The March 31, 2000 consolidated financial statements include a provision
for deferred taxes on the remaining net built-in gains as of December 31,
1998, net of the unutilized operating and capital loss carryforwards incurred
by the Company through December 31, 1998. These statements also include a
tax provision on realized gains which the Company retained to prepay its
indebtedness, rather than distribute to shareholders as a cash distribution.
The Company pays federal, state and local income taxes on behalf of its
wholly owned subsidiary, Harris & Harris Enterprises, which is a C corporation.
(See Note 6. Income Taxes.)
Reclassifications. Certain reclassifications have been made to the March
31, 1999 financial statements to conform to the March 31, 2000 presentation.
Estimates by Management. The preparation of the consolidated financial
statements in conformity with Generally Accepted Accounting Principles requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities as of March 31, 2000 and December 31, 1999, and
the reported amounts of revenues and expenses for the three months ended
17
March 31, 2000 and March 31, 1999. Actual results could differ from these
estimates.
NOTE 3. STOCK OPTION PLAN AND EMPLOYEE PROFIT-SHARING PLAN
On August 3, 1989, the shareholders of the Company approved the 1988 Long
Term Incentive Compensation Plan (the "1988 Plan"). The Company's 1988 Plan
was cancelled as of December 31, 1997, canceling all outstanding stock
options and eliminating all potential stock option grants. As a substitution
for the 1988 Plan, the Company adopted an employee profit-sharing plan.
As of January 1, 1998, the Company began implementing the Harris & Harris
Group, Inc. Employee Profit Sharing Plan (the "1998 Plan") that provides for
profit sharing equal to 20 percent of the net realized income. The 1998 Plan
was terminated by the Company as of December 31, 1999, subject to the payment
of any amounts owed on the 1999 realized gains under the 1998 Plan.
In March 2000, the Company paid out, under the 1998 Plan, 90 percent of
the profit sharing on the 1999 realized gains of approximately $1,024,696;
the remaining 10 percent or approximately $113,855 will be paid out upon the
completion and filing of the Company's 1999 federal tax return.
As of January 1, 2000, the Company implemented the Harris & Harris Group,
Inc. Employee Profit Sharing Plan (the "Plan") that provides for profit sharing
equal to 20 percent of the net realized income of the Company as reflected on
the Consolidated Statement of Operations of the Company for such year, less
the nonqualifying gain, if any.
Under the Plan, net realized income of the Company includes investment
income, realized gains and losses, and operating expenses (including taxes
paid or payable by the Company), but is calculated without regard to
dividends paid or distributions made to shareholders, payments under the
Plan, unrealized gains and losses, and loss carry-overs from other years
("Qualifying Income"). The portion of net after-tax realized gains
attributable to asset values as of September 30, 1997 is considered
nonqualifying gain, which reduces Qualifying Income.
As soon as practicable following the year-end audit, the Board of
Directors will determine whether, and if so how much, Qualifying Income
exists for a plan year, and 90 percent of the Qualifying Income will be paid
out to Plan participants pursuant to the distribution percentages set forth
in the Plan. The remaining 10 percent will be paid out after the Company has
filed its federal tax return for that year in which Qualifying Income exists.
Currently, the distribution amounts for each officer and employee are as
follows: Charles E. Harris, 13.790 percent; Mel P. Melsheimer, 4.233
percent; 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 may subsequently be paid to such
participant.
18
Notwithstanding any provisions of the Plan, in no event may the
aggregate amount of all awards payable for any Plan year during which the
Company remains a "business development company" within the meaning of 1940
Act be greater than 20 percent of the Company's "net income after taxes"
within the meaning of Section 57(n)(1)(B) of the 1940 Act. In the event the
awards exceed such amount, the awards will be reduced pro rata.
The Plan may be modified, amended or terminated by the Company's Board
of Directors at any time with the stipulation that no such modification,
amendment or termination may adversely affect any participant that has not
consented to such modification, amendment or termination.
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. During the first quarter of 2000,
the Company, as a result of a decrease in the net unrealized appreciation
reduced the profit-sharing accrual by $1,651,336, which decreased the
cumulative accrual under the Plan to $6,758,435 at March 31, 2000.
The amounts payable under the Plan for the year ending December 31, 2000
will be paid out as soon as practicable following year end.
On April 26, 2000 the shareholders of the Company approved the
performance goals under the Plan in accordance with Section 162(m) of the
Internal Revenue Code of 1986 ("Code"). The Code generally provides that a
public company such as the Company may not deduct compensation paid to its
chief executive officer or to any of its four most highly compensated
officers to the extent that the compensation paid to any such officer/
employee exceeds $1 million in any tax year, unless the payment is made upon
the attainment of objective performance goals that are approved by the
Company's shareholders.
NOTE 4. CAPITAL TRANSACTIONS
In 1998, the Board of Directors approved that, effective January 1,
1998, 50 percent of all directors' fees be used to purchase Company common
stock from the Company. However, effective on March 1, 1999, the directors
may purchase the Company's common stock in the market, rather than 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. The Company purchased a total of 401,878 shares in the open market
for a total of $795,529. On July 14, 1999, the Board of Directors announced
a tender 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.
19
Since 1998, as a result of the shares purchased in the open market and
through the tender offer in 1999, the Company has purchased a total of
1,482,447 shares for a total of $2,628,337, including commissions and
expenses, at an average price of $1.77 per share.
On January 27, 2000, the Company placed privately, with an unaffiliated
investor, for $3 million in cash, a one-year 12 percent note with one-year
warrants to purchase 25,263 shares of the Company's common stock at $11.8750
per share. The note may be prepaid at any time. Unless the note is prepaid,
six months after its issuance, the investor will receive additional one-year
warrants to purchase an additional $300,000 worth of the Company's common
stock at the then-current market price. During March 2000, with the proceeds
from the sale of SciQuest.com stock, the Company prepaid the Note. The
Company incurred total interest costs of $146,141, $36,500 on the note and
$109,641 on the warrants.
NOTE 5. EMPLOYEE BENEFITS
On October 19, 1999, Charles E. Harris signed an Employment Agreement
with the Company (disclosed in a Form 8-K filed on October 27, 1999) (the
"Employment Agreement"), which superseded an employment agreement that was
about to expire on December 31, 1999. The Employment Agreement shall
terminate on December 31, 2004 ("Term") subject to either an earlier
termination or an extension in accordance with the terms; on January 1, 2000
and on each day thereafter, the Term extends automatically by one day unless
at any time the Company or Mr. Harris, by written notice, decides not to
extend the Term, in which case the Term will expire five years from the date
of the written notice.
During the period of employment, Mr. Harris shall serve as the Chairman
and Chief Executive Officer of the Company. He shall be responsible for the
general management of the affairs of the Company and all its subsidiaries,
reporting directly to the Board of Directors of the Company. He shall serve
as a member of the Board for the period of which he is elected and shall from
time to time be reelected. If elected, he shall serve as President of the
Company and as an officer and director of any subsidiary or affiliate of the
Company.
Mr. Harris is to receive compensation under his Employment Agreement in
the form of base salary of $202,980, with automatic yearly adjustments to
reflect inflation. In addition, the Board may increase such salary, and
consequently decrease it, but not below the level provided for by the
automatic adjustments described above. Mr. Harris is also entitled to
participate in the Company's Profit-Sharing Plan as well as in all
compensation or employee benefit plans or programs, and to receive all
benefits, perquisites, and emoluments for which salaried employees are
eligible. Under the Employment Agreement, the Company is to furnish Mr.
Harris with certain perquisites which include a company car, membership in
certain clubs and up to a $5,000 annual reimbursement for personal, financial
or tax advice.
The Employment Agreement provides Mr. Harris with life insurance for the
benefit of his designated beneficiaries in the amount of $2,000,000; provides
reimbursement for uninsured medical expenses (not to exceed $10,000 per annum,
adjusted for inflation, over the period of the contract); disability
insurance in the amount of 100 percent of his base salary; and provides Mr.
Harris and his spouse with long-term care insurance. These benefits are for
the term of the contract.
20
The Employment Agreement provides for the Company to adopt a supplemental
executive retirement plan (the "SERP") for the benefit of Mr. Harris. Under
the SERP, the Company will cause an amount equal to one-twelfth of the Mr.
Harris's current base salary to be credited each month (a "Monthly Credit")
to a special account maintained for this purpose on the books of the Company
for the benefit of Mr. Harris (the "SERP Account"). The amounts credited to
the SERP Account will be deemed invested or reinvested in such mutual funds
or U.S. Government securities as determined by Mr. Harris. The SERP Account
will be credited and debited to reflect the deemed investment returns, losses
and expenses attributed to such deemed investments and reinvestments. Mr.
Harris's benefit under the SERP will equal the balance in the SERP Account
and such benefit will always be 100 percent vested (i.e., not forfeitable).
Mr. Harris will determine the form and timing of the distribution of the
balance in the SERP Account; provided, however, in the event of the
termination, the balance in the SERP Account will be distributed to Mr.
Harris or his beneficiary, as the case may be, in a lump-sum payment within
30 days of such termination. The Company established a rabbi trust for the
purpose of accumulating funds to satisfy the obligations incurred by the
Company under the SERP. The restricted funds for the SERP Plan total
$76,698 as of March 31, 2000. Mr. Harris's rights to benefits pursuant to
this SERP will be no greater than those of a general creditor of the Company.
The Employment Agreement provides severance pay in the event of
termination without cause or by constructive discharge and also provides for
certain death benefits payable to the surviving spouse equal to the
executive's base salary for a period of two years.
In addition, Mr. Harris is entitled to receive severance pay pursuant to
the severance compensation agreement that he entered into with the Company,
effective August 15, 1990. The severance compensation agreement provides
that if, following a change in control of the Company, as defined in the
agreement, such individual's employment is terminated by the Company without
cause or by the executive within one year of such change in control, the
individual shall be entitled to receive compensation in a lump sum payment
equal to 2.99 times the individual's average annualized compensation and
payment of other welfare benefits. If Mr. Harris's termination is without
cause or is a constructive discharge, the amount payable under the Employment
Agreement will be reduced by the amounts paid pursuant to the severance
compensation agreement.
As of January 1, 1989, the Company adopted an employee benefits program
covering substantially all employees of the Company under a 401(k) Plan and
Trust Agreement. As of January 1, 1999, the Company adopted the Harris &
Harris Pension Plan and Trust, a money purchase plan which would allow the
Company to stay compliant with the 401(k) top-heavy regulations and deduction
limitation regulations. Contributions to the plan are at the discretion of
the Company.
On June 30, 1994, the Company adopted a plan to provide medical and health
insurance for retirees, their spouses and dependents who, at the time of their
retirement, have ten years of service with the Company and have attained 50
years of age or have attained 45 years of age and have 15 years of service
21
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, as of March 31, 2000, the Company had a reserve of $317,600 for
the plan.
NOTE 6. INCOME TAXES
The Company intends to elect Sub-Chapter M status for the year ended
December 31, 1999. Accordingly, on February 23, 1999, the Company declared a
cash dividend of $0.35 per share (for a total of $3,647,017) as a result of
the long-term capital gain generated in 1999 by the acquisition of NBX
Corporation by 3Com Corporation. The Company utilized net operating loss
and capital loss carryforwards of approximately $6.3 million in order to
retain most of the remaining long-term capital gain to invest in new
opportunities. Approximately $300,000 of the long-term capital gain was not
distributed during 1999. Therefore for the year ended December 31, 1999, the
Company incurred approximately $26,044 in excise taxes.
The Company had incurred net ordinary and capital losses for a total of
approximately $7.0 million (which results in a tax credit of approximately
$2.5 million) during its C Corporation taxable years of which $0.8 million
still remains available for use. A corporation that elects to qualify as a
RIC continues to be taxable as a C Corporation on any gains realized within
10 years of its qualification as a RIC from sales of assets that were held
by the corporation on the effective date of the election ("C Corporation
Assets") to the extent of any gain built into the assets on such date
("Built-In Gain"). On February 17, 1999, the Company received a ruling from
the IRS concluding that the Company can carry forward its C Corporation
losses to offset any Built-In Gains resulting from sales of its C
Corporation Assets. That ruling may enable the Company to retain some or
all of the proceeds from such sales without disqualifying itself as a RIC or
incurring corporate level income tax, depending on whether the Company's
sale of C Corporation Assets with Built-In Gains will generate C Corporation
E&P. In general, a RIC is not permitted to have, as of the close of any RIC
taxable year, E&P accumulated during any C Corporation taxable year.
However, because the realization of Built-In Gains will occur while the
Company is a RIC, a strong argument exists that, under current law and
IRS pronouncements, the sale of C Corporation Assets with Built-In Gains
during RIC taxable years will not generate C Corporation E&P. The Company
intends to use the remaining $0.8 million loss carryforward (which results
in a tax credit of approximately $0.3 million) to reduce its taxes which are
the result of Built-In Gains.
Continued qualification as a RIC requires the Company to satisfy certain
portfolio diversification requirements in future years. The Company's
ability to satisfy those requirements may not be controllable by the Company.
(See "Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operation -- Sub-Chapter M Status.") There can be no assurance
that the Company will qualify as a RIC for 2000 or subsequent years or that,
if it does qualify, it will continue to elect RIC status.
22
During the three months ended March 31, 2000, the Company accrued a net
tax provision of $1,030,314 on the gains realized on the sale of the 43,400
shares of SciQuest.com. The Company plans to retain the proceeds rather
than distribute such funds to shareholders as a cash dividend.
For the three months ended March 31, 2000 and 1999, the Company's income
tax provision was allocated as follows:
<TABLE>
<S> <C> <C>
Three Months Ended Three Months Ended
March 31, 2000 March 31, 1999
Investment operations $ 0 $ 0
Realized gain on investments 1,183,618 2,479,821
Decrease in unrealized
appreciation on investments (153,304) (1,705,376)
-------------- ---------------
Total income tax provision $ 1,030,314 $ 774,445
============== ================
The above tax provision consists of the following:
Current -- Federal $ 1,183,618 $ 0
Deferred -- Federal (153,304) 774,445
-------------- --------------
Total income tax provision $ 1,030,314 $ 774,445
============== ==============
</TABLE>
The Company's net deferred tax liability at March 31, 2000 and
December 31, 1999 consists of the following:
<TABLE>
<S> <C> <C>
March 31, 2000 December 31, 1999
Tax on unrealized appreciation
on investments $ 1,630,506 $ 1,783,810
Net operating loss and
capital carryforward (266,036) (266,036)
-------------- ---------------
Net deferred income tax liability $ 1,364,470 $ 1,517,774
============== ===============
</TABLE>
NOTE 7. COMMITMENTS AND CONTINGENCIES
During 1993, the Company signed a ten-year lease with sublet provisions
for office space. In 1995, this lease was amended to include additional
office space. During 1999, the Company sublet this space to an unaffiliated
party. Rent expense under this lease for the three months ended March 31,
2000 and March 31, 1999, was $41,475 and $41,378, respectively. Future
minimum lease payments in each of the following years are: 2001 --
$178,561; 2002 -- $178,561; 2003 -- $101,946.
The Company had a total of $1,475,276 of funds in escrow as of
December 31, 1999 as a result of the acquisition of NBX Corporation by 3Com
Corporation. These funds were in a one-year interest-bearing escrow account
23
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 reflected $1,327,748 net of the reserve of $147,528. The Company
received the full escrow monies including interest for a total of $1,541,136
on March 6, 2000.
NOTE 8. SUBSEQUENT EVENTS
On April 11, 2000, the Company invested an additional $500,000 in
MyPersonalAdvocate.com, Inc.
On May 5, 2000, the Company invested an additional $427,500 in Sundial
Marketplace Corporation. Altogether, the Company has now invested in Sundial
Marketplace a total of $1,327,500, of which $927,500 is in the form of
convertible preferred stock and $400,000 is in the form of notes with equity
features. If the Company were to exercise all of its equity rights, it would
own approximately a fully diluted 28 percent interest, subject to adjustment,
in Sundial Marketplace.
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 income (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 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." The third element, "Net decrease in
unrealized appreciation on investments," is the net change in the fair value
of the Company's investment portfolio, net of decrease in deferred income
taxes that would become payable if the unrealized appreciation were realized
through the sale or other disposition of the investment portfolio.
"Net realized gain 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 increases.
Financial Condition
The Company's total assets and net assets were, respectively, $56,873,700
and $46,972,221 at March 31, 2000, compared with $65,320,768 and $53,634,805
at December 31, 1999.
Among the significant changes in the first quarter of 2000 were:
(1) declines in the values of the Company's holdings in SciQuest.com, and
Silknet Software of approximately $19,723,854 and $1,861,499, respectively;
(2) increases in the values of the Company's holdings in Nanophase
Technologies Corporation, Alliance Pharmaceutical Corp., and Genomica
Corporation of $7,191,790, $5,813,900 and $1,330,520, respectively;
24
(3) a decrease in the Company profit-sharing plan of approximately
$1,651,336 reflected in a credit to the profit-sharing accrual, which
generated an operating income for the quarter of $1,095,073. The changes
in the values of SciQuest.com, Silknet Software, Nanophase Technologies
and Alliance Pharmaceutical reflected the extreme volatility of publicly
traded, small capitalization, high-technology stocks during that period.
In addition, the Company increased its total tax liability by $1,030,314
as a result of the gains realized on the sale of the 43,400 shares of
SciQuest.com. The Company plans to retain the proceeds rather than distribute
the funds to shareholders as a cash dividend. (See "Consolidated Statements
of Operations" contained in "Item 1. Consolidated Financial Statements.")
Net asset value per share ("NAV") was $5.08 at March 31, 2000 versus
$5.80 at December 31, 1999.
The Company's shares outstanding remained unchanged during the three
months ended March 31, 2000.
The Company's financial condition is dependent on the success of its
investments. The Company has invested a substantial portion of its assets in
private development stage or start-up companies. These private businesses
tend to be thinly capitalized, unproven, small companies that lack management
depth or have no history of operations. At March 31, 2000, $35,043,944 or
61.6 percent of the Company's total assets consisted of investments at fair
value in publicly traded securities (three of the four investments were in
private equities at the time the Company made the investments) of which net
unrealized appreciation was $30,919,755; $16,198,370 or 28.5 percent of the
Company's total assets consisted of non-publicly traded securities at fair
value in private businesses, of which net unrealized appreciation was
$5,362,032.
At December 31, 1999, $41,556,607 or 63.6 percent of the Company's total
assets consisted of investments at fair value in publicly traded securities
(that were private businesses at the time the Company made the investments),
of which net unrealized appreciation was $38,864,873; $18,892,731 or 29.0
percent of the Company's total assets consisted of non-publicly traded
securities at fair value in private businesses and publicly traded companies,
of which net unrealized appreciation was $8,553,549.
The decrease in the value of publicly traded securities from $41,556,607
at December 31, 1999 to $35,043,944 at March 31, 2000 is primarily owing to
the decrease in the market value of SciQuest.com and the sale of 43,400
shares of SciQuest.com; the decrease in the value of
Silknet Software; offset by the increase from the reclassification of
Alliance Pharmaceutical through the conversion of the note and warrants to a
publicly-traded security and the increase in the market values of
Alliance Pharmaceutical and Nanophase Technologies. The changes in the values
of SciQuest.com, Silknet Software, Nanophase Technologies and Alliance
Pharmaceutical reflected the extreme volatility of publicly traded, small
capitalization, high technology stocks during this period. The volatility of
the overall market will continue to have an impact on the performance of the
Company's investments. The value of the Company's investments will vary on
a quarterly basis. (See "Risk Factors")
25
The decrease in the value of the non-publicly traded securities from
$18,892,731 at December 31, 1999 to $16,198,370 at March 31, 2000 resulted
from the reclassification of Alliance Pharmaceutical to a restricted publicly
traded security by the conversion of the note and the exercise of the warrant
and the dissolution and subsequent liquidation of Adaptive Web Technologies.
These decreases were offset by the additional investment in and the increase
in the value of Genomica Corporation as well as the Company's new investments
in MyPersonalAdvocate.com and iPacer Corporation.
A summary of the Company's investment portfolio is as follows:
<TABLE>
<S> <C> <C>
March 31, 2000 December 31, 1999
Investments, at cost $20,023,605 $16,653,130
Unrealized appreciation 36,282,265 46,882,521
----------- -----------
Investments, at fair value $56,305,870 $63,535,651
=========== ===========
</TABLE>
The accumulated unrealized appreciation on investments net of deferred taxes
is $34,651,759 at March 31, 2000, versus $45,098,711 at December 31, 1999.
Following an initial investment in a private company, the Company may
make additional investments in such investee in order to: (1) increase its
ownership percentage; (2) to exercise warrants or options that were acquired
in a prior financing; (3) to preserve the Company's proportionate ownership
in a subsequent financing; or (4) attempt to preserve or enhance the value
of the Company's investment. Such additional investments are referred to as
"follow-on" investments. There can be no assurance that the Company will
make follow-on investments or have sufficient funds to make additional
investments. The failure to make such follow-on investments could jeopardize
the viability of the investee company and the Company's investment or could
result in a missed opportunity for the Company to participate to a greater
extent in an investee's successful operations. The Company attempts to
maintain adequate liquid capital to make follow-on investments in its private
investee portfolio companies. The Company may elect not to make a follow-on
investment either because it does not want to increase its concentration of
risk or because it prefers other opportunities, even though the follow-on
investment opportunity appears attractive.
The following table is a summary of the cash investments made by the
Company in its private placement portfolio during the three months ended March
31, 2000:
<TABLE>
<S> <C>
New Investments: Amount
MyPersonalAdvocate.com, Inc. $ 1,000,000
iPacer Corporation 500,000
Additional Investments:
Genomica Corporation $ 500,000
Loans:
Sundial Marketplace Corporation $ 150,000
Exercise of Warrants Held:
Alliance Pharmaceutical Corp. $ 490,000
--------------
Total $ 2,640,000
==============
</TABLE>
26
Results of Operations
Investment Income and Expenses:
The Company realized a net operating income (loss) of $1,095,073 and
($1,288,348) for the three months ended March 31, 2000 and March 31, 1999,
respectively. The Company's net operating income in the three months ended
March 31, 2000 reflected a decrease in the employee profit-sharing accrual
that resulted in a credit to expenses of $1,651,336.
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 with the average
balance of the Company's fixed-income portfolio and the average yield on this
portfolio.
The Company had interest income from fixed-income securities of $83,954
and $45,209 for the three months ended March 31, 2000 and March 31, 1999,
respectively. The increase of $38,745 or 85.7 percent is the result of an
increase in the balance of the Company's fixed income portfolio during the
three months ended March 31, 2000 versus the three months ended March 31,
1999. During January 2000, the Company placed privately a $3,000,000 one-
year, 12 percent note. Accordingly, the Company had interest expense of
$146,141 during the three months ended March 31, 2000. The Company had no
interest expense for the three months ended March 31, 1999.
The Company had interest income from affiliated companies of $21,682 and
$628 for the three months ended March 31, 2000 and March 31, 1999,
respectively. The increase of $21,054 is owing to the increase in the
outstanding loans of investee companies during the first quarter of 2000.
The Company had other income of $15,812 and $0 for the three months ended
March 31, 2000 and March 31, 1999, respectively. The other income in 2000
represents rental income; in December of 1999, the Company started subleasing
office space to an unaffiliated party. The Company did not have any rental
income in the first quarter of 1999.
Operating expenses were ($973,625) and $1,334,185 for the three months
ended March 31, 2000 and March 31, 1999, respectively. The operating
expenses of the first quarter of 2000 reflect a decrease in the employee
profit-sharing accrual, owing to the decrease in the unrealized appreciation
for the three months ended March 31, 2000, resulting in a credit to expenses
of $1,651,336 that reduced the total expenses for that period by such amount.
Salaries and benefits increased $70,468 or 34 percent primarily as the result
of the Company's contribution to the Supplemental Executive Retirement Plan
or SERP which started January 1, 2000. The remaining expenses are related to
office and rent expenses and consulting, professional fees (primarily legal
and accounting fees) and director compensation.
27
The Company has in the past relied, and continues to rely to a large
extent, upon proceeds from sales of investments, rather than investment
income, to defray a significant portion of its operating expenses. Because
such sales cannot be predicted, the Company attempts to maintain adequate
working capital to provide for fiscal periods when there are no such sales.
Realized Gains and Losses on Sales of Portfolio Securities:
During the three months ended March 31, 2000 and 1999, the Company
realized gains of $3,763,272 and $10,745,548, respectively. During the
three months ended March 31, 2000, the Company realized a total gain of
$3,763,272, consisting primarily of a gain of: $3,264,989 on the sale of
SciQuest.com shares, $241,025 on the sale of Nanophase Technologies
Corporation shares and $147,528 on the realization of the reserve on the
NBX/3Com escrow (the Company received the full escrowed funds in March 2000).
During the three months ended March 31, 1999, the Company realized a gain of
approximately $10,584,630 on the acquisition of NBX Corporation by 3Com
Corporation and a gain of $160,918 on its sale of Princeton Video Image,
Inc. stock.
Unrealized Appreciation and Depreciation of Portfolio Securities:
The Board of Directors values the portfolio securities on a quarterly basis
pursuant to the Company's Asset Valuation guidelines in accordance with the
1940 Act. (See "Footnote to Consolidated Schedule of Investments" contained
in "Item 1. Consolidated Financial Statements.")
Net unrealized appreciation on investments decreased by $10,600,256 or
22.6 percent during the three months ended March 31, 2000, from $46,882,521 to
$36,282,265, primarily as a result of declines in the value of SciQuest.com
and Silknet Software of $19,723,854 and $1,861,499, respectively, offset by
increases in the value of Nanophase Technologies Corporation, Alliance
Pharmaceutical Corp. and Genomica Corporation of $7,191,790, $5,813,900 and
$1,330,520, respectively. The changes in the values of SciQuest.com, Silknet
Software, Nanophase Technologies and Alliance Pharmaceutical reflect the
extreme volatility of publicly traded, small capitalization, high technology
stocks during this period.
During the three months ended March 31, 1999, net unrealized appreciation
on investments before taxes decreased by $5,444,491 or 52.3 percent, from
$10,407,548 to $4,963,057, primarily as a result of the reclassification of
the NBX Corporation unrealized gain of $4,716,062 to realized and decreases
in value of publicly held stocks in the Company's portfolio.
Liquidity and Capital Resources
The Company's primary sources of liquidity are cash, receivables and
freely tradeable marketable securities. The Company's secondary sources of
liquidity are restricted securities of companies that are publicly traded.
At March 31, 2000 and December 31, 1999, respectively, the Company's total
primary liquidity was $15,481,954 and $6,622,216. On the corresponding
28
dates, the Company's total secondary liquidity was $24,899,735 and
$38,230,812, respectively. The Company's tertiary source of liquidity is
its holding of PHZ Capital Partners, L.P., from which the Company received
net after-tax distributions in the first quarter of 2000 of $75,000.
The increase in the Company's primary source of liquidity from December 31,
1999 to March 31, 2000 is primarily owing to the increase in the value of its
freely tradeable marketable security, Nanophase Technologies Corporation, of
approximately $7,191,790; proceeds from the sale of 43,400 of shares of
SciQuest.com stock of approximately $3,345,005; the receipt of escrowed funds
plus interest for a total of $1,541,136; and the receipt of the funds from the
dissolution and subsequent liquidation of Adaptive Web Technologies. These
increases were offset by the (1) payment of the 1999 employee profit sharing
of approximately $1,024,696; (2) the investments of $1,000,000 in
MyPersonalAdvocate.com, Inc., $500,000 in iPacer Corporation, $500,000 in
Genomica Corporation, $490,000 for the exercise of warrants to purchase common
stock in Alliance Pharmaceutical Corp., $150,000 in Sundial Marketplace
Corporation; and (3) the use of funds for operating expenses.
The decrease in the Company's secondary source of liquidity from December
31, 1999 to March 31, 2000 is primarily owing to the decrease in the market
value of SciQuest.com and the decrease owing to the sale of the 43,400 shares
of SciQuest.com; the decrease in the market value of Silknet Software,
offset by the conversion of the Alliance Pharmaceutical note and warrants to
restricted marketable stock as well as the increase in its market value.
The changes in the values of SciQuest.com, Silknet Software, Nanophase
Technologies and Alliance Pharmaceutical reflected the extreme stock market
volatility in the first quarter.
From December 31, 1999 to March 31, 2000, the Company's liabilities for
accrued employee profit sharing and deferred income tax liability changed
significantly. Accrued profit sharing decreased by $2,676,032 or 28.4
percent to $6,758,435 as a result of payment of approximately $1,024,696 of
the 1999 profit sharing and the decrease of $1,651,336 in the liability for
accrued employee profit sharing owing to the decrease in the unrealized
appreciation for the three months ended March 31, 2000.
The Company's total income tax liability increased by $1,030,314 or 67.8
percent to $2,548,088 as a result of a tax provision on realized gains on
which the Company currently plans to retain the proceeds rather than
distribute such funds to shareholders as a cash dividend.
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
29
either distribute or retain its taxable net capital gains from investments,
but any net capital gains not distributed could be subject to corporate level
tax. Further, the Company could be subject to a four percent excise tax if
it fails to distribute 98 percent of its annual taxable income and would be
subject to income tax if it fails to distribute 100 percent of its taxable
income.
Because of the specialized nature of its investment portfolio, the Company
could satisfy the diversification requirements under Sub-Chapter M of the Code
only if it received a certification from the 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.
The qualification of the Company as a RIC under Sub-Chapter M of the Code
depends on it satisfying certain technical requirements regarding its income,
investment portfolio and distributions. The Company was unable to satisfy
these requirements for the 1998 tax year owing to the nature of the Company's
ownership interest in one of its investee companies. In addition, because it
realized taxable losses in 1998, it was not strategically advantageous for
the Company to elect Sub-Chapter M tax status for 1998. The Company changed
the nature of its ownership interest in the non-qualifying investee company
effective January 1, 1999 in order to meet the Sub-Chapter M requirements.
In 1999, because of changes in its investment portfolio, the Company
requested recertification from the SEC relating to the Company's status under
section 851(e) of the Code. On February 24, 2000, the Company received the
certification, and the Company intends to elect Sub-Chapter M tax treatment
for 1999. Although the SEC certification for 1999 was issued, there can be no
assurance that the Company will receive such certification for 2000 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 2000
or that, if it does qualify in 2000, it will continue to qualify in
subsequent years. The Company plans to elect Sub-Chapter M tax treatment
for 1999. In addition, under certain circumstances, even if the Company were
qualified for Sub-Chapter M treatment in 2000 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.
The Company incurred ordinary and capital losses during its C Corporation
taxable years that remain available for use and may be carried forward to its
2000 and subsequent taxable years. 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").
30
On February 17, 1999, the Company received rulings from the IRS regarding
issues relevant to the Company's tax status as a RIC, including a ruling from
the IRS concluding that the Company can carry forward its C Corporation
losses to offset any Built-In Gains resulting from sales of its C Corporation
Assets. That ruling may enable the Company to retain some or all of the
proceeds from such sales without disqualifying itself as a RIC or incurring
corporate level income tax, depending on whether the Company's sale of C
Corporation Assets with Built-In Gains will generate C Corporation E&P. In
general, a RIC is not permitted to have, as of the close of any RIC taxable
year, E&P accumulated during any C Corporation taxable year. However, because
the realization of Built-In Gains will occur while the Company is a RIC, a
strong argument exists that, under current law and IRS pronouncements, the
sale of C Corporation Assets with Built-In Gains during RIC taxable years
will not generate C Corporation E&P. In 1999, the Company used $6.3 million
of its loss carryforward (which resulted in a tax credit of approximately
$2.2 million) to reduce the taxes resulting from Built-In Gains.
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 federal taxation at the Company level.
2. Taxable shareholders receive a $1.00 per share dividend and pay a
maximum federal tax of 20 percent* or $.20 per share, retaining $.80 per share.
*Assumes all capital gains qualify for long-term rates of 20 percent.
31
Under Alternative B: 100 percent of net capital gain retained by the
Company and designated as "undistributed capital gain" or deemed dividend:
1. The Company pays a corporate-level federal 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. Taxable shareholders increase their cost basis in their stock by
$.65 per share. They pay a 20 percent* federal 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 or deemed dividend:
1. The Company pays a corporate-level federal 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.
Risk Factors
Investing in the Company's Stock is Highly Speculative and You Could Lose
Some or All of the Amount You Invest
The value of the Company's common stock may decline and may be affected
by numerous market conditions, which could result in the loss of some or all
of your investment in the Company's shares. The securities markets
frequently experience extreme price and volume fluctuation which affect
market prices for securities of companies generally, and technology companies
in particular. Because of the Company's focus on the technology sector, its
stock price is likely to be impacted by these market conditions. General
economic conditions, and general conditions in the Internet and information
technology and life sciences and other high technology industries, will also
affect the Company's stock price.
Investing in the Company's Shares May be Inappropriate for Your Risk Tolerance
Investing in the Company's shares may be inappropriate for your risk
tolerance. The Company's investments in accordance with its investment
objective and principal strategies may result in an above average amount of
risk and volatility or loss of principal. The Company's investments in
portfolio companies are highly speculative and aggressive and, therefore, an
investment in its shares may not be suitable for you.
32
The Market for Venture Capital Investments is Highly Competitive. In Some
Cases, the Company's Status as a Regulated Business Development Company May
Hinder its Ability to Participate in Investment Opportunities.
The Company faces substantial competition in its investing activities
from private venture capital funds, investment affiliates of large industrial,
technology, service and financial companies, small business investment
companies, wealthy individuals and foreign investors. As a regulated
business development company, the Company is required to disclose quarterly
the name and business description of portfolio companies and value of any
portfolio securities. Most of the Company's competitors are not subject to
this disclosure requirement. The Company's obligation to disclose this
information could hinder its ability to invest in certain portfolio
companies. Additionally, other regulations, current and future, may make
the Company less attractive as a potential investor to a given portfolio
company than a private venture capital fund not subject to the same
regulations.
Regulatory Risks
Securities and tax laws and regulations governing the Company's activities
may change in ways negative to the Company's and its shareholders' interests
and interpretations of such laws and regulations may change with unpredictable
consequences.
The Company is Dependent Upon Key Management Personnel for Future Success
The Company is dependent for the selection, structuring, closing and
monitoring of its investments on the diligence and skill of its senior
management and other management members. The future success of the Company
depends to a significant extent on the continued service and coordination of
its senior management team, particularly the Chairman and Chief Executive
Officer. The departure of any of the executive officers or key employees
could materially adversely affect the Company's ability to implement its
business strategy. The Company does not maintain key man life insurance on
any of its officers or employees.
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 with risky
technologies that lack management depth and have not attained profitability
or have no history of operations. Because of the speculative nature and the
lack of a public market for these investments, there is significantly greater
risk of loss than is the case with traditional investment securities. The
Company expects that some of its venture capital investments will be a
complete loss or will be unprofitable and that some will appear to be likely
to become successful but never realize their potential. The Company has been
risk seeking rather than risk averse in its approach to venture capital and
other investments. Neither the Company's investments nor an investment in
the Company is intended to constitute a balanced investment program. 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.
33
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.
Volatility and Illiquidity of Publicly Traded Holdings
When companies in which the Company has invested as private entities
complete initial public offerings, they are by definition unseasoned issues.
Typically, they have relatively small capitalizations. Thus, they can be
expected to be highly volatile and of uncertain liquidity. If they are
perceived as suffering from adverse news or developments and/or the capital
markets are in a negative phase, not only their market prices, but also their
liquidity can be expected to be impacted negatively. Historically, the
Company has also invested in unseasoned publicly traded companies with
similar characteristics and thus with similar exposure to potential negative
volatility and illiquidity.
The Inability of the Company's Portfolio Companies to Successfully Market
Their Products Would Have a Negative Impact on its Investment Returns
Even if the Company's portfolio companies are able to develop commercially
viable products, the market for new products and services is highly competitive
and rapidly changing. Commercial success is difficult to predict and the
marketing efforts of the Company's portfolio companies may not be successful.
Valuation of Portfolio Investments
There is typically no public market of equity securities of the small
private companies in which the Company invests. As a result, the valuation of
the equity securities in the Company's portfolio is subject to the good faith
estimate of the Company's Board of Directors. (See "Asset Valuation Policy
Guidelines" in "Footnote to Consolidated Schedule of Investments.") In the
absence of a readily ascertainable market value, the estimated value of the
Company's portfolio of equity securities may differ significantly from the
values that would be placed on the portfolio if a ready market for the equity
securities existed. Any changes in estimated net asset value are recorded in
the Company's statement of operations as "Change in unrealized appreciation
on investments." (See "Management's Discussion and Analysis of Financial
Condition and Results of Operations.")
34
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 -- Recent Developments -- 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.
Because the Company Must Distribute Income, the Company Will Continue to Need
Additional Capital
The Company will continue to need capital to fund investments and to pay
for operating expenses. The Company must distribute at least 90 percent of
its net operating income other than net realized long-term capital gains to
its stockholders to maintain its RIC status. As a result such earnings will
not be available to fund investments. If the Company fails to generate net
realized long-term capital gains or to obtain funds from outside sources, it
could have a material adverse effect on the Company's financial condition and
results. The Company does not normally establish reserves for taxes on
unrealized capital gains. To the extent that the Company retains capital
gains, either as a C corporation or as a Sub-Chapter M corporation, it will
have to make provisions for federal taxes and possibly state and local taxes.
In addition, as a BDC, the Company is generally required to maintain a ratio
of at least 200 percent of total assets to total borrowings, which may
restrict its ability to borrow in certain circumstances.
Reserves for Taxes
As a Sub-Chapter M corporation, the Company does not have to pay federal
income taxes on realized capital gains to the extent that such gains are
distributed to shareholders. Accordingly, it does not establish reserves for
taxes on its unrealized capital gains. If the Company were not to qualify or
were to elect not to qualify for Sub- Chapter M tax status, it would have to
establish such reserves for taxes, which would reduce its net asset value,
net of a reduction in the reserve for employee profit sharing, accordingly.
To the extent that the Company as a Sub-Chapter M corporation were to make a
deemed distribution of net realized capital gains and were to retain such net
realized capital gains, it would have to establish appropriate reserves for
taxes upon making such a decision.
36
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 believe that the assumptions underlying the forward-
looking statements included herein are reasonable, any of the assumptions
could be inaccurate and therefore there can be no assurance that the forward-
looking statements included or incorporated by reference herein will prove to
be accurate. Therefore, the inclusion of such information should not be
regarded as a representation by the Company or any other person that the
objectives and plans of the Company will be achieved.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company's business activities contain elements of risk. The Company
considers a principal type of market risk to be valuation risk. Investments
are stated at "fair value" as defined in the 1940 Act and in the applicable
regulations of the 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.
Neither the Company's investments nor an investment in the Company is
intended to constitute a balanced investment program. The Company has exposure
to public-market price fluctuations to the extent of its publicly traded
portfolio.
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.
Because 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."
37
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
On Wednesday, April 26th, 2000, the Company held its Annual Meeting of
Shareholders for the following purposes: (1) to elect directors of the
Company; (2) to approve the performance goals under the Harris & Harris
Group, Inc. Employee Profit-Sharing Plan, effective as of January 1,
2000; and (3) to ratify, confirm and approve the Board of Directors'
selection of Arthur Andersen LLP as the Company's independent public
accountant for its fiscal year ending December 31, 2000. At the close
of business on the record date (March 22, 2000), an aggregate of
9,240,831 shares of common stock were issued and outstanding.
All of the nominees at the April 26, 2000 Annual Meeting were elected
directors:
Nominees For Withheld
Dr. C. Wayne Bardin 8,245,039 30,095
Dr. Phillip A. Bauman 8,244,634 30,500
G. Morgan Browne 8,244,334 30,800
Harry E. Ekblom 8,244,054 31,080
Dugald A. Fletcher 8,244,054 31,080
Charles E. Harris 8,234,134 41,000
Glenn E. Mayer 8,244,259 30,875
James E. Roberts 8,245,039 30,095
With respect to proposal number two, described as a proposal "to
approve the performance goals under the Harris & Harris Group, Inc.
Employee Profit-Sharing Plan, effective as of January 1, 2000," the
affirmative votes cast were 8,140,651, the negative votes cast were
27,256 and those abstaining were 107,227.
With respect to proposal number three, described as a proposal "to
ratify, confirm and approve the Board of Directors' selection of Arthur
Andersen LLP" as the Company's independent public accountant for its
fiscal year ending December 31, 2000, the affirmative votes cast were
8,255,442, the negative votes cast were 12,396 and those abstaining
were 7,296.
38
Item 5. Other Information
Recent Sales of Unregistered Securities
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.
10.22 Harris & Harris Group, Inc. Employee Profit-Sharing Plan,
incorporated by reference as Exhibit 10.22 to the Company's
Form 10K for the year ended December 31, 1999.
11.0* Computation of per share earnings. See Consolidated Statements
of Operations.
27.0* Financial Data Schedule.
(b) The Company did not file any reports on Form 8-K during the first
quarter of 2000
39
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
27. Financial Data Schedule
40
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Harris & Harris Group, Inc.
By: /s/ Rachel M. Pernia
-----------------------------
Rachel M. Pernia, Vice President
Treasurer, Controller and Principal
Accounting Officer
Date: May 15, 2000
41
WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
<TABLE> <S> <C>
<S> <C>
<PERIOD TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-2000
<PERIOD-END> MAR-31-2000
<INVESTMENTS-AT-COST> 20,023,605
<INVESTMENTS-AT-VALUE> 56,305,870
<RECEIVABLES> 43,191
<ASSETS-OTHER> 524,639
<OTHER-ITEMS-ASSETS> 0
<TOTAL-ASSETS> 56,873,700
<PAYABLE-FOR-SECURITIES> 0
<SENIOR-LONG-TERM-DEBT> 0
<OTHER-ITEMS-LIABILITIES> 9,901,479
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<SHARES-COMMON-PRIOR> 9,240,831
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<NET-ASSETS> 46,972,221
<DIVIDEND-INCOME> 0
<INTEREST-INCOME> 105,636
<OTHER-INCOME> 15,812
<EXPENSES-NET> (973,625)
<NET-INVESTMENT-INCOME> 1,095,073
<REALIZED-GAINS-CURRENT> 2,579,654
<APPREC-INCREASE-CURRENT> (10,446,952)
<NET-CHANGE-FROM-OPS> (6,772,225)
<EQUALIZATION> 0
<DISTRIBUTIONS-OF-INCOME> 0
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<NUMBER-OF-SHARES-SOLD> 0
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<NET-CHANGE-IN-ASSETS> (6,662,584)
<ACCUMULATED-NII-PRIOR> 0
<ACCUMULATED-GAINS-PRIOR> (5,192,860)
<OVERDISTRIB-NII-PRIOR> 0
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<GROSS-ADVISORY-FEES> 0
<INTEREST-EXPENSE> 146,141
<GROSS-EXPENSE> 0
<AVERAGE-NET-ASSETS> 50,303,513
<PER-SHARE-NAV-BEGIN> 5.80
<PER-SHARE-NII> 0.40
<PER-SHARE-GAIN-APPREC> (1.13)
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