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 June 30, 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.
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(Exact name of registrant as specified in its charter)
New York 13-3119827
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(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
One Rockefeller Plaza, Rockefeller Center, New York, New York 10020
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(Address of Principal Executive Offices) (Zip Code)
212/332-3600
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90
days.
Yes X No
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
Class Outstanding at August 8, 2000
--------------------------------------- ------------------------------
Common Stock, $0.01 par value per share 9,240,831 shares
Harris & Harris Group, Inc.
Form 10-Q, June 30, 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. . . . . . . . . . . . . . 31
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . 34
Item 3. Quantitative and Qualitative Disclosures
About Market Risk. . . . . . . . . . . . . . . . . . . . . 38
PART II OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . 40
Item 2. Changes in Securities and Use of Proceeds . . . . 40
Item 3. Defaults Upon Senior Securities . . . . . . . . . 40
Item 4. Submission of Matters to a Vote of Security
Holders . . . . . . . . . . . . . . . . . . . . . 40
Item 5. Other Information . . . . . . . . . . . . . . . . 40
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . 40
Exhibit Index. . . . . . . . . . . . . . . . . . . . . . . 41
Signature. . . . . . . . . . . . . . . . . . . . . . . . . 42
Harris & Harris Group, Inc.
Form 10-Q, June 30, 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
intends to elect Sub-Chapter M tax treatment for 1999 and 2000.
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 to 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
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
June 30, 2000 December 31, 1999
(Unaudited) (Audited)
Investments, at value (See accompanying
schedule of investments and notes). . $ 44,236,607 $ 63,535,651
Cash and cash equivalents. . . . . . . . 231,944 133,256
Restricted funds (Note 5). . . . . . . . 147,656 0
Funds in escrow (Note 7) . . . . . . . . 0 1,327,748
Interest receivable. . . . . . . . . . . 218 44,189
Note receivable. . . . . . . . . . . . . 21,776 32,663
Prepaid expenses . . . . . . . . . . . . 35,681 74,328
Other assets . . . . . . . . . . . . . . 141,413 172,933
------------- --------------
Total assets . . . . . . . . . . . . . . $ 44,815,295 $ 65,320,768
============= ==============
LIABILITIES & NET ASSETS
Accounts payable and accrued
liabilities . . . . . . . . . . . . . $ 592,814 $ 700,566
Accrued profit sharing (Note 3). . . . . 4,293,344 9,434,467
Income tax liability (Note 6). . . . . . 2,672,413 0
Deferred income tax liability (Note 6) . 1,364,470 1,517,774
Deferred rent. . . . . . . . . . . . . . 28,529 33,156
------------- --------------
Total liabilities. . . . . . . . . . . . 8,951,570 11,685,963
Commitments and contingencies (Note 7) ------------- --------------
Net assets . . . . . . . . . . . . . . . $ 35,863,725 $ 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 6/30/00 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 income
(deficit) . . . . . . . . . . . . . . 3,309,454 (5,192,860)
Accumulated unrealized appreciation of
investments, net of deferred tax
liability of $1,630,506 at 6/30/00
and $1,783,810 at 12/31/99. . . . . . 18,715,676 45,098,711
Treasury stock, at cost, 1,452,140
shares at 6/30/00 and 12/31/99. . . . (2,537,480) (2,537,480)
------------- -------------
Net assets . . . . . . . . . . . . . . . $ 35,863,725 $ 53,634,805
============= =============
Total net assets and liabilities . . . . $ 44,815,295 $ 65,320,768
============= =============
Shares outstanding . . . . . . . . . . . 9,240,831 9,240,831
============= =============
Net asset value per outstanding share. . $ 3.88 $ 5.80
============= =============
The accompanying notes are an integral part of these
consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Six Months Ended
6/30/00 6/30/99 6/30/00 6/30/99
Investment income:
Interest from:
Fixed-income securities. $ 60,861 $ 75,999 $ 144,815 $ 121,208
Affiliated companies . . 12,376 8,689 34,058 9,317
Other income. . . . . . . 19,252 300 35,064 300
----------- ----------- ------------ ----------
Total investment income. 92,489 84,988 213,937 130,825
Expenses:
Profit-sharing (reversal)
accrual (Note 3) . . . . (2,465,091) 517,229 (4,116,427) 1,418,570
Salaries and benefits . . 244,740 185,255 522,286 392,333
Administration and
operations . . . . . . . 152,525 115,154 245,099 187,879
Professional fees . . . . 120,707 62,973 206,014 123,990
Rent. . . . . . . . . . . 41,634 41,378 83,109 82,756
Directors' fees and
expenses . . . . . . . . 34,278 26,702 55,410 63,116
Depreciation. . . . . . . 10,000 12,500 20,000 25,000
Custodian fees. . . . . . 1,064 1,551 4,600 3,283
Interest expense
(Note 4) . . . . . . . . 0 0 146,141 0
------------ ------------ ----------- ----------
Total expenses. . . . . (1,860,143) 962,742 (2,833,768) 2,296,927
------------ ------------ ----------- ----------
Operating income (loss)
before income taxes. . . 1,952,632 (877,754) 3,047,705 (2,166,102)
Income tax provision
(Note 6) . . . . . . . . 0 0 0 0
------------ ------------ ----------- ----------
Net operating income
(loss) . . . . . . . . . 1,952,632 (877,754) 3,047,705 (2,166,102)
Net realized gain on investments:
Realized gain on
investments. . . . . . . 4,332,410 380,270 8,095,682 11,125,818
------------ ------------ ----------- ----------
Total realized gain . . 4,332,410 380,270 8,095,682 11,125,818
Income tax provision
(Note 6) . . . . . . . . (1,457,455) 0 (2,641,073) (2,479,821)
------------ ------------ ----------- ----------
Net realized gain on
investments. . . . . . . 2,874,955 380,270 5,454,609 8,645,997
------------ ------------ ----------- ----------
Net realized income (loss). 4,827,587 (497,484) 8,502,314 6,479,895
Net (decrease) increase in
unrealized appreciation on
investments:
Increase as a result
of investment sales. . . 0 485,906 0 485,906
Decrease as a result of
investment sales . . . . (9,247,287) (55,898) (12,452,277) (4,840,700)
Increase on investments
held . . . . . . . . . . 1,094,989 2,996,453 15,433,562 3,055,180
Decrease on investments
held . . . . . . . . . . (7,783,785) (256,838) (29,517,624) (975,254)
------------ ------------ ---------- -----------
Change in unrealized
appreciation on
investments . . . . . . (15,936,083) 3,169,623 (26,536,339) (2,274,868)
Income tax (provision)
benefit (Note 6). . . . 0 (29,097) 153,304 1,676,279
------------ ------------- ---------- ---------
Net (decrease) increase
in unrealized appreciation
on investments. . . . . (15,936,083) 3,140,526 (26,383,035) (598,589)
------------ ------------ ----------- ----------
Net (decrease) increase
in net assets from operations:
Total . . . . . . . . . . $(11,108,496) $ 2,643,042 $(17,880,721) $ 5,881,306
============ ============ ============ ===========
Per outstanding share . . $ (1.20) $ 0.26 $ (1.93) $ 0.57
============ ============ ============ ===========
The accompanying notes are an integral part of these
consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended Six Months Ended
June 30, 2000 June 30, 1999
Cash flows from operating activities:
Net (decrease) increase in net
assets resulting from operations. . $(17,880,721) $ 5,881,306
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 investments. . . . 18,440,657 (8,850,950)
Depreciation . . . . . . . . . . . 20,000 25,000
Other. . . . . . . . . . . . . . . 83,007 0
Changes in assets and liabilities:
Receivable from brokers. . . . . . 0 (428,030)
Interest receivable. . . . . . . . 43,971 (27,522)
Prepaid expenses . . . . . . . . . 38,647 24,354
Funds in escrow (Note 7) . . . . . 1,327,748 (1,327,748)
Restricted funds (Note 5). . . . . (147,656) 0
Other assets . . . . . . . . . . . 18,489 3,650
Accounts payable and accrued
liabilities . . . . . . . . . . . (107,752) (105,315)
Accrued profit sharing (Note 3). . (5,141,123) 1,418,570
Income tax liability . . . . . . . 2,672,413 0
Deferred income tax liability. . . (153,304) 803,542
Deferred rent. . . . . . . . . . . (4,627) (4,627)
Collection on notes receivable . . 10,887 10,000
----------- -----------
Net cash used in operating
activities . . . . . . . . . . . . (779,364) (2,577,770)
Cash flows from investing activities:
Sales of short-term investments
and marketable securities . . . . (4,277,993) (3,208,695)
Proceeds from sale of investments. 9,580,519 12,274,631
Investment in private placements
and loans . . . . . . . . . . . . (4,417,500) (2,277,001)
Purchase of fixed assets . . . . . (6,974) 0
----------- -----------
Net cash provided by investing
activities. . . . . . . . . . . . 878,052 6,788,935
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 17,283
Purchase of stock (Note 4) . . . . 0 (540,720)
----------- -----------
Net cash used in financing
activities. . . . . . . . . . . . 0 (4,170,454)
Net increase 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 . . . . . . . . . . 231,944 204,854
----------- -----------
Net increase in cash and cash
equivalents. . . . . . . . . . . . $ 98,688 $ 40,711
=========== ============
Supplemental disclosures of cash flow information:
Income taxes paid . . . . . . . . . $ 600 $ 797
Interest paid . . . . . . . . . . . $ 36,500 $ 0
The accompanying notes are an integral part of these
consolidated financial statements.
5
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(Unaudited)
Three Months Ended Six Months Ended
6/30/00 6/30/99 6/30/00 6/30/99
Changes in net assets from operations:
Net operating income
(loss). . . . . . . . $ 1,952,632 $ (877,754) $ 3,047,705 $(2,166,102)
Net realized gain on
investments . . . . . 2,874,955 380,270 5,454,609 8,645,997
Net (decrease) increase
in unrealized appreciation
on investments as a
result of sales. . . (9,247,287) 430,008 (12,298,973) (1,874,973)
Net (decrease) increase
in unrealized appreciation
on investments held (6,688,796) 2,710,518 (14,084,062) 1,276,384
------------- ----------- ------------ -----------
Net (decrease) increase
in net assets resulting
from operations . . . (11,108,496) 2,643,042 (17,880,721) 5,881,306
Changes in net assets from capital
stock transactions:
Additional paid in
capital on Common Stock
Warrants issued . . . 0 0 109,641 0
Payment of dividends. 0 0 0 (3,647,017)
Proceeds from sale of
treasury stock
(Note 4) . . . . . . 0 1,105 0 17,283
Purchase of treasury
stock (Note 4) . . . 0 (63,376) 0 (540,720)
------------- ---------- ------------ -----------
Net increase (decrease)
in net assets resulting
from capital stock
transactions . . . . 0 (62,271) 109,641 (4,170,454)
Net (decrease) increase
in net assets. . . . . . (11,108,496) 2,580,771 (17,771,080) 1,710,852
------------ ---------- ------------ ------------
Net assets:
Beginning of the
period. . . . . . . . 46,972,221 21,686,790 53,634,805 22,556,709
----------- ----------- ----------- -----------
End of the period . . $35,863,725 $24,267,561 $35,863,725 $24,267,561
=========== =========== =========== ===========
The accompanying notes are an integral part of these
consolidated financial statements.
6
CONSOLIDATED SCHEDULE OF INVESTMENTS JUNE 30, 2000
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Unaffiliated Companies (15)(16)(17)
-- 43.4% of total investments
Publicly Traded Portfolio -- 27.8% of total investments
Alliance Pharmaceutical Corp. (7)
-- Research and development
of pharmaceutical products --
1.36% of fully diluted
equity . . . . . . . . . . . . (C) 800,000 $ 8,550,000
Kana Communications, Inc.
(1)(2)(8) -- Provides customer-
centric e-business applications
and systems -- 0.06% of fully
diluted equity . . . . . . . . (C) 67,834 3,777,035
------------
Total Publicly Traded Portfolio (cost: $2,192,000) . . . . . . $ 12,327,035
Private Placement Portfolio (Illiquid) -- 15.6% of total investments
Essential.com, Inc. (1)(2)(9) --
Online energy and communications
marketplace -- 0.73% of fully
diluted equity
Common stock. . . . . . . . . . (B) 169,185 $ 2,204,000
Exponential Business Development Company
-- (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 --
4.06% of fully diluted equity
Common Stock. . . . . . . . . . (B) 199,800
Series A Voting Convertible
Preferred Stock . . . . . . . (B) 1,660,200
Series C Convertible
Preferred Stock . . . . . . . (A) 333,333 3,040,250
Informio, Inc. (1)(2)(4)(6)(11)
-- Developing audio web portal
technology
Series A Voting Convertible
Preferred Stock . . . . . . . (A) -- 504,601
Kriton Medical, Inc. (1)(2)(6)
-- Research and development of
medical devices -- 1.87% 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: $5,413,214) . . . . . $ 6,877,615
------------
Total Investments in Unaffiliated Companies
(cost: $7,605,214) . . . . . . . . . . . . . . . . . . . . . . $ 19,204,650
------------
The accompanying notes are an integral part of this consolidated schedule.
7
CONSOLIDATED SCHEDULE OF INVESTMENTS JUNE 30, 2000
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
Investments in Non-Controlled Affiliated Companies (15)(17)
-- 39.0% of total investments
Publicly Traded Portfolio -- 14.3% of total investments
Nanophase Technologies Corporation
(1)(12) -- Manufactures and
markets inorganic crystals of
nanometric dimensions --
4.28% of fully diluted equity. . . (C) 672,916 $ 6,321,205
------------
Total Publicly Traded Portfolio (cost: $1,162,204) . . . . . . $ 6,321,205
Private Placement Portfolio (Illiquid) -- 24.7% of total investments
Experion Systems, Inc. (1)(2)(4)(6)(13)
-- Business-to-business e-commerce
and e-services trust-based
marketing start-up -- 15.23% of
fully diluted equity
Convertible Preferred Stock. . . . (A) 187,500 $ 1,500,000
NeuroMetrix, Inc. (1)(2)(6) --
Medical devices for monitoring
neuromuscular disorders --
15.91% 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
8% Convertible Note. . . . . . . . (A) 750,000 6,708,225
PHZ Capital Partners Limited
Partnership (2)(14) -- Organizes
and manages investment partnerships
-- 20.0% of fully diluted equity
Limited partnership interest . . . (D) -- 1,746,456
Questech Corporation (1)(2)(6) --
Manufactures and markets
proprietary decorative tiles
and signs -- 12.38% of fully
diluted equity
Common Stock . . . . . . . . . . . (D) 580,037
Warrants at $5.00 expiring
11/15/09 . . . . . . . . . . . . (A) 1,965
Warrants at $4.00 expiring
11/28/01 . . . . . . . . . . . . (A) 152,422
9% Demand Convertible Note . . . . (A) 100,000 970,218
-----------
Total Private Placement Portfolio (cost: $7,338,679) . . . . . . $10,924,899
-----------
Total Investments in Non-Controlled Affiliated
Companies (cost: $8,500,883) . . . . . . . . . . . . . . . . . $17,246,104
-----------
The accompanying notes are an integral part of this consolidated schedule.
8
CONSOLIDATED SCHEDULE OF INVESTMENTS JUNE 30, 2000
(Unaudited)
Method of Shares/
Valuation (3) Principal Value
U.S. Government Obligations -- 17.6% of total investments
U.S. Treasury Bill dated 1/13/00
due date 7/13/00 -- 4.0% yield. . . (K) $ 450,000 $ 449,366
U.S. Treasury Bill dated 2/3/00
due date 8/3/00 -- 5.1% yield . . . (K) $ 910,000 905,641
U.S. Treasury Bill dated 2/10/00
due date 8/10/00 -- 5.3% yield. . . (K) $1,600,000 1,590,496
U.S. Treasury Bill dated 8/19/99
due date 8/17/00 -- 5.4% yield. . . (K) $ 400,000 397,160
U.S. Treasury Bill dated 3/9/00
due date 9/7/00 -- 5.5% yield . . . (K) $2,000,000 1,979,140
U.S. Treasury Bill dated 9/16/99
due date 9/14/00 -- 5.5% yield. . . (K) $ 500,000 494,230
U.S. Treasury Bill dated 4/6/00
due date 10/5/00 -- 5.7% yield. . . (K) $2,000,000 1,969,820
-----------
Total Investments in U.S. Government Obligations
(cost: $7,784,328). . . . . . . . . . . . . . . . . . . . . . $ 7,785,853
-----------
Total Investments -- 100% (cost: $23,890,425) . . . . . . . . $44,236,607
===========
The accompanying notes are an integral part of this consolidated schedule.
9
CONSOLIDATED SCHEDULE OF INVESTMENTS JUNE 30, 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 six months
ended June 30, 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 June 30, 2000, the market price per share of Alliance Pharmaceutical
Corp. (National Market Symbol: ALLP) was $11.25. The Company's holding in
Alliance Pharmaceutical before a discount for illiquidity was valued at
$9,000,000. During July and on August 1, 2000, the Company sold a total of
200,000 shares for total proceeds of $2,370,283. The 200,000 shares were
acquired for $490,000 on February 9, 2000 through the exercise of a
warrant, thereby generating a short-term gain. The Company believes
that by partially offsetting current year expenses with the realized
short-term gain, it will neither owe federal income taxes on this gain,
nor be required to distribute any portion of this gain to shareholders.
There can be no assurance of this tax treatment. On August 4, 2000,
the market price per share of Alliance Pharmaceutical was $11.50.
(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 June 30, 2000, the market price per share of Kana
Communications was $61.875. The Company's holding in Kana
Communications before a discount for the 10 percent escrow
was valued at $4,197,229. On August 4, 2000, the market price per share
of Kana Communications was $36.0625.
The accompanying notes are an integral part of this consolidated schedule.
10
(9) On June 29, 2000, Sundial Marketplace Corporation was acquired in a tax-
free merger by Essential.com, Inc.
(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) Previously named iPacer Corporation.
(12) As of June 30, 2000, the market price per share of Nanophase Technologies
Corporation (National Market Symbol: NANX) was $10.4375. The Company's
holding in Nanophase Technologies before a discount for illiquidity was
valued at $7,023,561. On August 4, 2000, the market price per share of
Nanophase Technologies was $9.75.
(13) Previously named MyPersonalAdvocate.com, Inc.
(14) 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.
(15) 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.
(16) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $7,605,214. The gross unrealized appreciation
based on the tax cost for these securities is $12,529,448. The gross
unrealized depreciation based on the tax cost for these securities is
$930,012.
(17) 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 proportion of the company's
securities owned by the Company and the nature of any rights to
13
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 and 2000 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 June 30, 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 December 31, 1999 and June 30, 1999 financial statements to
conform to the June 30, 2000 presentation.
Estimates by Management. The preparation of the consolidated
financial statements in conformity with Generally Accepted
17
Accounting Principles in the United States requires management to
make estimates and assumptions that affect the reported amounts of
assets and liabilities as of June 30, 2000 and December 31, 1999,
and the reported amounts of revenues and expenses for the three and
six months ended June 30, 2000 and June 30, 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 Statements 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.
18
Matthews, 0.453 percent. If a participant leaves the Company for
other than cause, the amount earned will be accrued and may
subsequently be paid to such participant.
Notwithstanding any provisions of the Plan, in no event may the
aggregate amount of all awards payable for any Plan year during
which the Company remains a "business development company" within
the meaning of 1940 Act be greater than 20 percent of the Company's
"net income after taxes" within the meaning of Section 57(n)(1)(B)
of the 1940 Act. In the event the awards exceed such amount, the
awards will be reduced pro rata.
The Plan may be modified, amended or terminated by the
Company's Board of Directors at any time with the stipulation that
no such modification, amendment or termination may adversely affect
any participant that has not consented to such modification,
amendment or termination.
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 second quarter of 2000, the
Company, as a result of a decrease in the net unrealized
appreciation reduced the profit-sharing accrual by $2,465,091, which
decreased the cumulative accrual under the Plan to $4,293,344 at
June 30, 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. During 1998 and
1999, the directors bought directly from the Company 24,491 and
5,816 shares, respectively.
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
19
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.
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. These shares were reduced by the purchases made by the
directors.
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 $208,315, 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
20
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.
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 $147,656 as of June 30, 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)
21
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 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 June 30, 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
22
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.
During the six months ended June 30, 2000, the Company accrued
a net tax provision of $2,487,769 consisting primarily of a
provision on the gains realized on the sale of its position of
SciQuest.com. The Company plans to retain the proceeds rather than
distribute such funds to shareholders as a cash dividend.
For the three and six months ended June 30, 2000 and 1999, the
Company's income tax provision was allocated as follows:
Three Months Three Months Six Months Six Months
Ended Ended Ended Ended
June 30, 2000 June 30, 1999 June 30, 2000 June 30,1999
Investment operations. $ 0 $ 0 $ 0 $ 0
Realized gain
on investments . . . 1,457,455 0 2,641,073 2,479,821
Net increase (decrease)
in unrealized
appreciation on
investments. . . . . 0 29,097 (153,304) (1,676,279)
--------- ----------- ------------- ------------
Total income tax
provision. . . . . . $1,457,455 $ 29,097 $ 2,487,769 $ 803,542
========== =========== ============= ============
The above tax provision (benefit) consists of the following:
Current -- Federal . . $1,457,455 $ 0 $ 2,641,073 $ 0
Deferred -- Federal. . 0 29,097 (153,304) 803,542
---------- ----------- ------------- ------------
Total income tax
provision. . . . . . $1,457,455 $ 29,097 $ 2,487,769 $ 803,542
========== =========== ============= ============
The Company's net deferred tax liability at June 30, 2000 and
December 31, 1999 consists of the following:
June 30, 2000 December 31, 1999
Tax on unrealized appreciation
on investments. . . . . . . . . . . . $ 1,630,506 $ 1,783,810
Net operating loss and capital
loss carryforward . . . . . . . . . . $ (266,036) $ (266,036)
------------- --------------
Net deferred income tax liability . . . $ 1,364,470 $ 1,517,774
============= ==============
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
was $41,634 and $41,378 for the three months ended June 30, 2000 and
June 30, 1999, and $83,109 and $82,756 for the six months ended June
30, 2000 and June 30, 1999, respectively. Future minimum lease
payments in each of the following years are: 2001 -- $178,561; 2002
-- $178,561; 2003 -- $101,946.
23
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 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
During July and on August 1, 2000, the Company sold a total of
200,000 shares of Alliance Pharmaceutical for total proceeds of
$2,370,283. The 200,000 shares were acquired for $490,000 on
February 9, 2000 through the exercise of a warrant, thereby
generating a short-term gain. The Company believes that by partially
offsetting current year expenses with the realized short-term gain,
it will neither owe federal income taxes on this gain, nor be
required to distribute any portion of this gain to shareholders.
There can be no assurance of this tax treatment.
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,
$44,815,295 and $35,863,725 at June 30, 2000, compared with
$65,320,768 and $53,634,805 at December 31, 1999.
Among the significant changes in the six months ended June 30,
2000 were: (1) decline in the value of the Company's holdings in
24
SciQuest.com of $31,981,750 offset by the gain realized on the sale
of the Company's position in SciQuest.com of $7,407,377; (2) the
decline in the value of the Company's holding in Silknet Software
(which subsequently merged with Kana Communications) and Questech
Corporation, of $1,622,027 and $1,165,879, respectively; (3)
increases in the values of the Company's holdings in Nanophase
Technologies, Alliance Pharmaceutical, Genomica and Essential.com,
(which on June 29, 2000 acquired Sundial Marketplace in a tax-free
merger) of $2,995,410, $3,019,000, $1,330,520, and $854,467
respectively; (4) a decrease in the Company's profit-sharing plan of
$4,116,427 reflected in a credit to the profit-sharing accrual, which
generated operating income for the six months ended June 30, 2000 of
$3,047,705. In addition, the Company increased its total tax
liability by $2,519,109 to reflect a tax on the gains realized on the sale of
its investment in 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.")
The changes in the values of SciQuest.com, Kana Communications,
Nanophase Technologies and Alliance Pharmaceutical occurred during a
period of extreme volatility of publicly traded, small
capitalization, high technology stocks.
Net asset value per share ("NAV") was $3.88 at June 30, 2000
versus $5.80 at December 31, 1999.
The Company's shares outstanding remained unchanged during the
six months ended June 30, 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 June 30, 2000, $18,648,240 or 41.6 percent of the
Company's total assets consisted of investments at fair value in
publicly traded securities (two of the three investments were in
private equities at the time the Company made the investments) of
which net unrealized appreciation was $15,294,036; $17,802,514 or
39.7 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 $5,050,621.
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 $18,648,240 at June 30, 2000 is
primarily owing to the decrease in the value of SciQuest.com and the
sale of the Company's position in SciQuest.com; the decrease in the
value of Kana Communications; offset by the increase from the
25
reclassification of Alliance Pharmaceutical by 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, Kana
Communications, Nanophase Technologies and Alliance Pharmaceutical
occurred during a period of extreme volatility of publicly traded,
small capitalization, high technology stocks. 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")
The decrease in the value of the non-publicly traded securities
from $18,892,731 at December 31, 1999 to $17,802,514 at June 30, 2000
resulted from the reclassification of Alliance Pharmaceutical to a
publicly traded security by the conversion of the note and the
exercise of the warrant, the dissolution of and subsequent
liquidation of Adaptive Web Technologies and the decrease in the
value of the Company's investment in Questech Corporation net of its
additional $100,000 investment in that company. These decreases were
offset by the additional investment in and the increase in the value
of Genomica and Sundial Marketplace (which on June 29, 2000 was
acquired in a tax-free merger by Essential.com) as well as the
Company's new investments in Experion Systems (formerly named
MyPersonalAdvocate.com, Inc.) and Informio (formerly named iPacer
Corporation).
A summary of the Company's investment portfolio is as follows:
June 30, 2000 December 31, 1999
Investments, at cost $23,890,425 $16,653,130
Unrealized appreciation 20,346,182 46,882,521
----------- -----------
Investments, at fair value $44,236,607 $63,535,651
=========== ===========
The accumulated unrealized appreciation on investments net of
deferred taxes is $18,715,676 at June 30, 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.
26
The following table is a summary of the cash investments made by
the Company in its private placement portfolio during the six months
ended June 30, 2000:
New Investments: Amount
Experion Systems, Inc. (1) $1,500,000
Informio, Inc. (2) $ 500,000
Additional Investments:
Genomica Corporation $ 500,000
Loans:
NeuroMetrix, Inc. $ 750,000
Questech Corporation $ 100,000
Sundial Marketplace Corporation (3) $ 150,000
Exercise of Warrants Held:
Alliance Pharmaceutical Corp. $ 490,000
Sundial Marketplace Corporation (3) $ 427,500
----------
Total $4,417,500
==========
(1) Formerly named MyPersonalAdvocate.com, Inc.
(2) Formerly named iPacer Corporation
(3) Acquired by Essential.com, Inc.
Results of Operations
Investment Income and Expenses:
The Company realized a net operating income (loss) of $3,047,705
and ($2,166,102) for the six months ended June 30 2000, and 1999,
respectively. The Company's net operating income in the six months
ended June 30, 2000 reflected a decrease in the employee profit-
sharing accrual that resulted in a credit to expenses of $4,116,427.
The Company's principal objective is to achieve capital
appreciation. Therefore, a significant portion of the investment
portfolio is structured to maximize the potential for capital
appreciation and provides little or no current yield in the form of
dividends or interest. The Company does earn interest income from
fixed-income securities, including U.S. Government Obligations. The
amount of interest income earned varies based upon the average
balance of the Company's fixed-income portfolio and the average yield
on this portfolio.
The Company had interest income from fixed-income securities of
$144,815 and $121,208 for the six months ended June 30, 2000 and
1999, respectively. The increase of $23,607 or 19.5 percent is the
result of an increase in the balance of the Company's fixed income
portfolio during the first three months of the six months ended June
30, 2000 versus the same period in 1999. The balance of the
27
Company's fixed income portfolio increased as a result of the funds
received during March 1999 as a result of the sale of NBX as well as
the $3,000,000 one-year, 12 percent note placed privately by the
Company during January 2000. Accordingly, the Company incurred total
interest costs of $146,141 on this note during the six months ended
June 30, 2000.
The Company had interest income from affiliated companies of
$34,058 and $9,317 for the six months ended June 30, 2000 and 1999,
respectively. The increase of $24,741 or 265.5 percent is owing to
the increase in outstanding loans to the investee companies during
the six months ended June 30, 2000 versus the six months ended June
30, 1999. The amount of outstanding loans to investee companies
varies depending on the investee companies' needs. Typically, loans
made to investee companies are bridge loans and are converted into
equity at the next financing.
The Company had other income of $35,064 and $300 for the six
months ended June 30, 2000 and June 30, 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 six months ended
June 30, 1999.
Operating expenses were ($2,833,768) and $2,296,927 for the six
months ended June 30, 2000 and June 30, 1999, respectively. The
operating expenses for the six months ended June 30, 2000 reflect a
decrease in the employee profit-sharing accrual resulting in a credit
to expenses of $4,116,427, that reduced the total expenses for that
period by such amount. Salaries and benefits increased $129,953 or
33.1 percent primarily as the result of the Company's contribution to
the Supplemental Executive Retirement Plan or SERP which started
January 1, 2000 for Mr. Harris. Administration and operations
increased $57,220 or 30.4 percent as a result of increased printing
and distribution costs for the Company's shareholder reports as a
result of a significant increase in the number of beneficial
shareholders from last year to this year. Professional fees
increased $82,024 or 66.2 percent as a result of increased legal fees
due to legal review and preparation of corporate documents for the
Company's annual meeting. Most of the Company's operating expenses
are related to employee and director compensation, office and rent
expenses and consulting and professional fees (primarily legal and
accounting fees).
The portion of profit sharing accruals resulting from the
realized gains during 2000, net of operating expenses and taxes for
the year, will be paid out as soon as practicable following the 2000
year-end audit.
The Company realized a net operating income (loss) of $1,952,632
and ($877,754) for the three months ended June 30, 2000 and June 30,
1999, respectively. The Company's net operating income in the three
months ended June 30, 2000 reflected a decrease in the employee
profit-sharing accrual that resulted in a credit to expenses of
$2,465,091.
The Company had interest income from fixed-income securities of
$60,861 and $75,999 for the three months ended June 30, 2000 and June
30, 1999, respectively, reflecting net changes in the Company's
investments in short-term fixed income securities and prevailing
interest rate levels.
28
The Company had interest income from affiliated companies of
$12,376 and $8,689 for the three months ended June 30, 2000 and June
30, 1999, respectively. The increase of $3,687 or 42.4 percent is
owing to the increase in the outstanding loans of investee companies
during the second quarter of 2000. The amount of outstanding loans
to investee companies varies depending on the investee companies'
needs. Typically, loans made to investee companies are bridge loans
and are converted into equity at the next financing.
The Company had other income of $19,252 and $300 for the three
months ended June 30, 2000 and June 30, 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 second quarter of
1999.
Operating expenses were ($1,860,143) and $962,742 for the three
months ended June 30, 2000 and June 30, 1999, respectively. The
operating expenses of the second 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 June 30, 2000,
resulting in a credit to expenses of $2,465,091 that reduced the
total expenses for that period by such amount. Salaries and benefits
increased $59,485 or 32.1 percent primarily as the result of the
Company's contribution to the Supplemental Executive Retirement Plan
or SERP which started January 1, 2000 for Mr. Harris. Administration and
operations increased $37,371 or 32.4 percent as a result of increased printing
and distribution costs for the Company's shareholder reports as a
result of a significant increase in the number of beneficial
shareholders from last year to this year. Professional fees
increased $57,734 or 91.7 percent as a result of increased legal fees
due to legal review and preparation of corporate documents for the
Company's annual meeting. The remaining expenses are related to rent
expenses and director compensation.
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 six months ended June 30, 2000 and June 30, 1999, the
Company realized gains of $8,095,682 and $11,125,818, respectively.
During the six months ended June 30, 2000, the Company realized
a total gain of $8,095,682 consisting primarily of a gain of
$7,407,377 on the sale of its position in SciQuest.com; $241,025 on
the sale of Nanophase Technologies shares and $147,528 on the
realization of the reserve on the NBX/3Com escrow (the Company
received in full the escrowed funds on March 31, 2000).
During the six months ended June 30, 1999, the Company realized
a gain of approximately $10,584,630 on the acquisition of NBX
Corporation by 3Com Corporation; a gain of approximately $160,918 on
29
its sale of Princeton Video Image, Inc. stock; and received a cash
distribution from PHZ Capital Partners L.P. of approximately
$586,311. The Company also incurred losses of approximately $206,041
on the sale of various publicly traded investments.
During the three months ended June 30, 2000 and June 30, 1999,
the Company realized gains of $4,332,410 and $380,270, respectively.
During the three months ended June 30, 2000, the Company realized a
total gain of $4,332,410, consisting primarily of a net gain of
$4,142,388 on the sale of 417,639 shares of SciQuest.com. During the
three months ended June 30, 1999, the Company sold various publicly
traded securities realizing a net loss of $206,041 and received a
cash distribution from PHZ Capital Partners L.P. of $586,311.
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
$26,536,339 or 56.6 percent during the six months ended June 30,
2000, from $46,882,521 to $20,346,182, primarily as a result of
declines in the value of SciQuest.com, Kana Communications and
Questech of $31,981,750, $1,622,027 and $1,165,879, respectively,
offset by increases in the value of Nanophase Technologies, Alliance
Pharmaceutical, Genomica and Essential.com of $2,995,410, $3,019,000,
$1,330,520 and $854,467, respectively. The changes in the values of
SciQuest.com, Kana Communications, Nanophase Technologies and
Alliance Pharmaceutical occurred during a period of extreme
volatility of publicly traded, small capitalization, high technology
stocks. (See "Risk Factors.")
Net unrealized appreciation on investments decreased by
$2,274,868 or 21.8 percent during the six months ended June 30, 1999,
from $10,407,549 to $8,132,681, primarily as a result of the
reclassification of the NBX Corporation from unrealized to realized
gain of approximately $4,716,062, offset by the increase in value of
SciQuest.com, of approximately $2,350,962.
Net unrealized appreciation on investments decreased by
$15,936,083 or 43.9 percent during the three months ended June 30,
2000, from $36,282,265 to $20,346,182 owing primarily as a result of
declines in the value of SciQuest.com, Nanophase Technologies,
Alliance Pharmaceutical and Questech of $9,247,287, $3,823,004,
$2,794,900 and $1,165,879, respectively offset by an increase in
Essential.com and Kana Communications of $854,467 and $239,472,
respectively.
Net unrealized appreciation on investments increased by
$3,169,623 or 63.8 percent during the three months ended June 30,
1999, from $4,963,058 to $8,132,681, primarily as a result of the
increase in the value of SciQuest.com, of approximately $2,350,962
and Alliance Pharmaceutical of approximately $324,000.
30
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 June 30, 2000 and
December 31, 1999, respectively, the Company's total primary
liquidity was $26,688,031 and $6,622,216. On the corresponding
dates, the Company's total secondary liquidity was $0 and
$38,230,812, respectively.
The increase in the Company's primary source of liquidity from
December 31, 1999 to June 30, 2000 is primarily owing to: (1) the
proceeds from the sale of its investment in SciQuest.com stock of
approximately $8,257,377; (2) the increase in the value of Nanophase
Technologies of approximately $2,995,410; (3) the conversion of the
Alliance Pharmaceutical Note and exercise of the warrant for a total
of 800,000 shares which became freely tradeable on June 30, 2000 and
had a value of $8,550,000; (4) the receipt of escrowed funds plus
interest for a total of $1,541,136; and (5) 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 $1,500,000 in Experion Systems, $500,000 in Informio,
$500,000 in Genomica, $490,000 for the exercise of warrants to
purchase common stock in Alliance Pharmaceutical, $577,500 in
Sundial Marketplace (which was acquired on June 29, 2000 by
Essential.com in a tax-free merger); (3) loans of $750,000 to
NeuroMetrix, and $100,000 to Questech; and (4) the use of funds for
operating expenses.
The decrease in the Company's secondary source of liquidity
from December 31, 1999 to June 30, 2000 is primarily owing to the
expiration of the lock-up on SciQuest.com and Silknet Software
(which subsequently merged with Kana Communications).
The changes in the values of SciQuest.com, Kana Communications,
Nanophase Technologies and Alliance Pharmaceutical reflected the
extreme stock market volatility in the six months ended June 30,
2000.
From December 31, 1999 to June 30, 2000, the Company's
liabilities for accrued employee profit sharing and deferred income
tax liability changed significantly. Accrued profit sharing
decreased by $5,141,123 or 54.5 percent to $4,293,344 as a result of
payment of approximately $1,024,696 of the 1999 profit sharing and
the decrease of $4,116,427 in the liability for accrued employee
profit sharing owing to the decrease in the unrealized appreciation
for the six months ended June 30, 2000.
The Company's total income tax liability increased by
$2,519,109 or 165.9 percent to $4,036,883 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.
31
Sub-Chapter M Status
On September 25, 1997, the Company's Board of Directors
approved a proposal to seek qualification of the Company as a RIC
under Sub-Chapter M of the Code. In order to qualify as a RIC, the
Company must, in general (1) annually derive at least 90 percent of
its gross income from dividends, interest and gains from the sale of
securities; (2) quarterly meet certain investment diversification
requirements; and (3) annually distribute at least 90 percent of its
investment company taxable income as a dividend. In addition to the
requirement that the Company must annually distribute at least 90
percent of its investment company taxable income, the Company may
either distribute or retain its taxable net capital gains from
investments, but any net capital gains not distributed could be
subject to corporate level tax. 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
32
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").
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.
33
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.
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.
*Assumes all capital gains qualify for long-term rates of 20 percent.
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.
34
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.
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
35
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.
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 issuers. 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
36
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.")
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.
37
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.
Forward-Looking Statements
The information contained herein contains certain forward-
looking statements. These statements include the plans and
objectives of management for future operations and financial
objectives, portfolio growth and availability of funds. These
forward-looking statements are subject to the inherent uncertainties
in predicting future results and conditions. Certain factors that
could cause actual results and conditions to differ materially from
those projected in these forward-looking statements are set forth
herein. Other factors that could cause actual results to differ
materially include the uncertainties of economic, competitive and
market conditions, and future business decisions, all of which are
difficult or impossible to predict accurately and many of which are
beyond the control of the Company. Although the Company believes
that the assumptions underlying the forward-looking statements
included herein are reasonable, any of the assumptions could be
inaccurate and therefore there can be no assurance that the forward-
looking statements included or incorporated by reference herein will
prove to be accurate. Therefore, the inclusion of such information
should not be regarded as a representation by the Company or any
other person that the objectives and plans of the Company will be
achieved.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company's business activities contain elements of risk.
The Company considers a principal type of market risk to be
valuation risk. Investments are stated at "fair value" as defined
in the 1940 Act and in the applicable regulations of the 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
38
that lack management depth and have not attained profitability or
have no history of operations. 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. 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."
39
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Not Applicable
Item 2. Changes in Securities and Use of Proceeds
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
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 six months ended June 30, 2000.
40
EXHIBIT INDEX
Item Number (of Item 601 of Regulation S-K)
27. Financial Data Schedule
41
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: August 10, 2000
