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, 2006
[_] 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)
111 West 57th Street, New York, New York 10019
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(Address of Principal Executive Offices) (Zip Code)
(212) 582-0900
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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 by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2
of the Exchange Act).
Large Accelerated Filer [_] Accelerated Filer [X] Non-Accelerated Filer [_]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [_] No [X]
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 9, 2006
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Common Stock, $0.01 par value per share 20,756,345 shares
Harris & Harris Group, Inc.
Form 10-Q, June 30, 2006
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements................................. 1
Consolidated Statements of Assets and Liabilities......................... 2
Consolidated Statements of Operations..................................... 3
Consolidated Statements of Cash Flows..................................... 4
Consolidated Statements of Changes in Net Assets.......................... 5
Consolidated Schedule of Investments...................................... 6
Notes to Consolidated Financial Statements................................16
Financial Highlights......................................................24
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................................25
Background and Overview...................................................25
Results of Operations.....................................................27
Financial Condition.......................................................30
Liquidity.................................................................32
Capital Resources.........................................................32
Critical Accounting Policies..............................................33
Recent Developments - Portfolio Companies.................................34
Forward Looking Statements................................................35
Item 3. Quantitative and Qualitative Disclosures About Market Risk......35
Item 4. Controls and Procedures.........................................36
PART II. OTHER INFORMATION
Item 1A. Risk Factors....................................................37
Item 6. Exhibits........................................................37
Signature.................................................................38
Exhibit Index.............................................................39
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
The information furnished in the accompanying consolidated financial
statements reflects all adjustments that are, in the opinion of management,
necessary for a fair statement of the results for the interim period presented.
Harris & Harris Group, Inc.(R) (the "Company," "us," "our" and "we"), is
an internally managed venture capital company that has elected to be treated as
a business development company under the Investment Company Act of 1940 (the
"1940 Act"). 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. The accompanying consolidated financial statements
should be read in conjunction with the audited consolidated financial statements
and notes thereto for the year ended December 31, 2005, contained in our Annual
Report on Form 10-K for the year ended December 31, 2005.
On September 25, 1997, our Board of Directors approved a proposal to seek
qualification as a regulated investment company ("RIC") under Subchapter M of
the Internal Revenue Code (the "Code"). At that time, we were taxable under
Subchapter C of the Code (a "C Corporation"). In order to qualify as a RIC, we
must, in general (1) annually, derive at least 90 percent of our gross income
from dividends, interest, gains from the sale of securities and similar sources;
(2) quarterly, meet certain investment diversification requirements; and (3)
annually, distribute at least 90 percent of our investment company taxable
income as a dividend. In addition to the requirement that we must annually
distribute at least 90 percent of our investment company taxable income, we may
either distribute or retain our taxable net capital gains from investments, but
any net capital gains not distributed could be subject to corporate level tax.
Further, we could be subject to a four percent excise tax to the extent we fail
to distribute at least 98 percent of our annual investment company taxable
income and would be subject to income tax to the extent we fail to distribute
100 percent of our investment company taxable income.
Because of the specialized nature of our investment portfolio, we
generally can satisfy the diversification requirements under Subchapter M of the
Code only if we receive a certification from the Securities and Exchange
Commission ("SEC") that we are "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 June 16, 2006, we received SEC certification for 2005, permitting us to
qualify for RIC treatment for 2005 (as we had for the years 1999 through 2004).
Although the SEC certification for 2005 was issued, there can be no assurance
that we will qualify for or receive such certification for subsequent years (to
the extent we need additional certification as a result of changes in our
portfolio) or that we will actually qualify for Subchapter M treatment in
subsequent years. In addition, under certain circumstances, even if we qualified
for Subchapter M treatment in a given year, we might take action in a subsequent
year to ensure that we would be taxed in that subsequent year as a C
Corporation, rather than as a RIC.
1
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
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ASSETS
------
June 30, 2006 December 31, 2005
(Unaudited)
Investments, at value (Cost: $123,047,918 at 6/30/06,
$134,026,747 at 12/31/05)............................................. $ 116,990,093 $ 129,438,197
Cash and cash equivalents.................................................. 78,904 1,213,289
Restricted funds........................................................... 1,942,840 1,730,434
Receivable from portfolio company.......................................... 0 75,000
Interest receivable........................................................ 590,101 248,563
Prepaid expenses........................................................... 293,709 2,993
Other assets............................................................... 205,118 229,644
----------------- ----------------
Total assets............................................................... $ 120,100,765 $ 132,938,120
================= ================
LIABILITIES & NET ASSETS
------------------------
Accounts payable and accrued liabilities................................... $ 3,344,448 $ 3,174,183
Accrued profit sharing (Note 5)............................................ 210,786 2,107,858
Deferred rent.............................................................. 24,727 31,003
Current taxes payable...................................................... 1,354,504 1,514,967
Taxes payable on behalf of shareholders (Note 7)........................... 0 8,122,367
----------------- ----------------
Total liabilities.......................................................... 4,934,465 14,950,378
----------------- ----------------
Net assets................................................................. $ 115,166,300 $ 117,987,742
================= ================
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, 45,000,000 shares
authorized at 6/30/06 and 30,000,000 at 12/31/05;
22,585,085 issued at 6/30/06 and 12/31/05............................. 225,851 225,851
Additional paid in capital (Notes 4 & 8)................................... 122,265,187 122,149,642
Accumulated net realized income............................................ 2,314,191 3,781,905
Accumulated unrealized depreciation of investments......................... (6,233,398) (4,764,125)
Treasury stock, at cost (1,828,740 shares at 6/30/06 and
12/31/05)............................................................. (3,405,531) (3,405,531)
----------------- ----------------
Net assets................................................................. $ 115,166,300 $ 117,987,742
================= ================
Shares outstanding......................................................... 20,756,345 20,756,345
================= ================
Net asset value per outstanding share...................................... $ 5.54 $ 5.68
================= ================
The accompanying notes are an integral part of these consolidated
financial statements.
2
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
--------------------------------------------------------------------------------
Three Months Ended June 30 Six Months Ended June 30
-------------------------- ------------------------
2006 2005 2006 2005
------------------ ---------------- ---------------- -----------------
Investment income:
Interest from:
Fixed-income securities ................. $ 780,265 $ 202,132 $ 1,582,627 $ 428,482
Portfolio companies...................... 0 (48,390) 0 (9,780)
Miscellaneous income..................... 5,000 4,975 7,500 5,124
----------------- ---------------- ---------------- -----------------
Total investment income.................. 785,265 158,717 1,590,127 423,826
----------------- ---------------- ---------------- -----------------
Expenses:
Salaries, benefits and stock-based
Compensation (Note 4).......................... 804,151 614,610 1,590,512 1,182,300
Administration and operations.................. 406,092 487,144 728,541 809,106
Profit-sharing provision (Note 5).............. 0 2,012,465 0 1,700,871
Professional fees............................. 97,938 218,122 387,825 490,587
Rent........................................... 57,381 51,180 118,619 99,861
Directors' fees and expenses.................. 94,900 55,082 180,802 140,741
Depreciation................................... 16,128 16,073 32,896 31,342
Custodian fees................................. 2,562 6,135 12,562 11,699
------------------ ---------------- ---------------- -----------------
Total expenses........................... 1,479,152 3,460,811 3,051,757 4,466,507
------------------ ---------------- ---------------- -----------------
Net operating loss................................ (693,887) (3,302,094) (1,461,630) (4,042,681)
------------------ ---------------- ---------------- -----------------
Net realized gain (loss) from investments:
Realized gain (loss) from investments.......... 1,500 (1,386,741) 13,453 (2,427,785)
Income tax expense (Note 7).................... 9,931 634 19,537 4,851
------------------ ---------------- ---------------- -----------------
Net realized loss from investments............. (8,431) (1,387,375) (6,084) (2,432,636)
------------------ ---------------- ---------------- -----------------
Net (increase) decrease in unrealized
depreciation on investments:
Change as a result of investment sales......... 0 1,766,210 0 2,956,491
Change on investments held..................... (580,679) 9,925,106 (1,469,273) 8,287,230
------------------ ---------------- ---------------- -----------------
Net (increase) decrease in unrealized
depreciation on investments.................... (580,679) 11,691,316 (1,469,273) 11,243,721
------------------ ---------------- ---------------- -----------------
Net realized and unrealized (loss)
gain from investments............................. (589,110) 10,303,941 (1,475,357) 8,811,085
------------------ ---------------- ---------------- -----------------
Net (decrease) increase in net assets
resulting from operations:
Total.......................................... $ (1,282,997) $ 7,001,847 $ (2,936,987) $ 4,768,404
================== ================= ================ =================
Per average basic and diluted
outstanding share.............................. $ (0.06) $ 0.41 $ (0.14) $ 0.28
================== ================ ================ =================
Average outstanding shares..................... 20,756,345 17,248,845 20,756,345 17,248,845
================== ================ ================ =================
The accompanying notes are an integral part of these
consolidated financial statements.
3
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
--------------------------------------------------------------------------------
Six Months Ended Six Months Ended
June 30, 2006 June 30, 2005
Cash flows from operating activities:
Net (decrease) increase in net assets resulting
from operations.......................................................... $ (2,936,987) $ 4,768,404
Adjustments to reconcile net increase (decrease)
in net assets resulting from operations to net cash
(used in) provided by operating activities:
Net realized and unrealized loss (gain) on investments................ 1,455,820 (8,815,936)
Depreciation and amortization......................................... (476,238) 31,342
Stock-based compensation expense...................................... 115,545 0
Changes in assets and liabilities:
Payable to broker for unsettled trade................................. 18,297,158
Restricted funds...................................................... (212,406) (25,214)
Receivable from portfolio company..................................... 75,000 10,000
Funds in escrow....................................................... 0 (999,999)
Interest receivable................................................... (341,538) (11,318)
Income tax receivable................................................. 0 (5,411)
Prepaid expenses ..................................................... (290,716) 310,136
Other assets.......................................................... 0 1,238
Accounts payable and accrued liabilities.............................. 170,265 (130,258)
Accrued profit sharing................................................ (1,897,072) 1,700,871
Deferred rent......................................................... (6,276) (3,401)
Current income tax liability.......................................... (8,282,830) 0
------------------ ---------------
Net cash (used in) provided by operating activities................... (12,627,433) 15,127,612
------------------ ---------------
Cash flows from investing activities:
Net sale of short-term investments
and marketable securities......................................... 29,644,461 8,237,450
Investment in private placements and loans............................ (18,165,017) (5,634,297)
Proceeds from sale of investments..................................... 22,188 661,458
Purchase of fixed assets.............................................. (8,584) (30,666)
------------------ ---------------
Net cash provided by investing activities............................. 11,493,048 3,233,945
------------------ ---------------
Net increase (decrease) in cash and cash equivalents:
Cash and cash equivalents at beginning of the period.................. 1,213,289 650,332
Cash and cash equivalents at end of the period........................ 78,904 19,011,889
------------------ ---------------
Net (decrease) increase in cash and cash equivalents.................. $ (1,134,385) $ 18,361,557
================== ===============
Supplemental disclosures of cash flow information:
Income taxes paid..................................................... $ 8,302,367 $ 7,150
The accompanying notes are an integral part of these consolidated
financial statements.
4
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
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Six Months Ended Year Ended
June 30, 2006 December 31, 2005
(Unaudited)
Changes in net assets from operations:
Net operating loss............................................ $ (1,461,630) $ (5,465,761)
Net realized (loss) income on investments..................... (6,084) 14,208,789
Net (increase) in unrealized depreciation
on investments as a result of sales....................... 0 (23,181,420)
Net (increase) decrease in unrealized depreciation
on investments held....................................... (1,469,273) 19,790,298
Net change in deferred taxes.................................. 0 1,364,470
------------------- ----------------
Net (decrease) increase in net assets
resulting from operations..................................... (2,936,987) 6,716,376
------------------- ----------------
Changes in net assets from capital
stock transactions:
Stock-based compensation...................................... 115,545 0
Proceeds from sale of stock................................... 0 35,075
Additional paid in capital on common stock issued............. 0 36,491,492
------------------- ----------------
Net increase in net assets resulting from
capital stock transactions.................................... 115,545 36,526,567
------------------- ----------------
Net (decrease) increase in net assets.............................. (2,821,442) 43,242,943
------------------- ----------------
Net assets:
Beginning of the period....................................... 117,987,742 74,744,799
------------------- -----------------
End of the period............................................. $ 115,166,300 $ 117,987,742
=================== =================
The accompanying notes are an integral part of these
consolidated financial statements.
5
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (6)(7) - 15.7% of net assets
Private Placement Portfolio (Illiquid) - 15.7% of net assets
AlphaSimplex Group, LLC (2) -- Investment management company headed by
Dr. Andrew W. Lo, holder of the Harris & Harris Group Chair at MIT
Limited Liability Company Interest...........................................(B) -- $ 4,058
-----------
Crystal IS, Inc. (1)(2)(5) -- Developing a technology to grow
single-crystal boules of aluminum nitride for gallium nitride
electronics
Series A Convertible Preferred Stock.........................................(A) 274,100 199,983
Secured Convertible Bridge Note (including interest).........................(A) $68,568 69,382
------------
269,365
------------
Exponential Business Development Company (1)(2) -- Venture capital partnership
focused on early stage companies
Limited Partnership Interest.................................................(B) -- 0
------------
Molecular Imprints, Inc. (1)(2) -- Manufacturing nanoimprint lithography
capital equipment
Series B Convertible Preferred Stock.........................................(A) 1,333,333 2,000,000
Series C Convertible Preferred Stock.........................................(A) 1,250,000 2,500,000
Warrants at $2.00 expiring 12/31/11..........................................(B) 125,000 0
------------
4,500,000
------------
Nanosys, Inc. (1)(2)(5) -- Developing zero and one-dimensional
inorganic nanometer-scale materials for use in nanotechnology-
enabled systems
Series C Convertible Preferred Stock.........................................(C) 803,428 2,370,113
Series D Convertible Preferred Stock.........................................(C) 1,016,950 3,000,003
------------
5,370,116
------------
Nantero, Inc. (1)(2)(5) -- Developing a high-density, nonvolatile, random
access memory chip, using nanotechnology
Series A Convertible Preferred Stock.........................................(C) 345,070 1,046,908
Series B Convertible Preferred Stock.........................................(C) 207,051 628,172
Series C Convertible Preferred Stock.........................................(C) 188,315 571,329
------------
2,246,409
------------
The accompanying notes are an integral part of these consolidated
financial statements.
6
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Unaffiliated Companies (6)(7) - 15.7% of net assets (cont.)
Private Placement Portfolio (Illiquid) - 15.7% of net assets (cont.)
NeoPhotonics Corporation (1)(2) -- Developing and manufacturing
planar optical devices and components
Common Stock ................................................................(C) 716,195 $ 67,736
Series 1 Convertible Preferred Stock..........................................(C) 1,831,256 1,831,256
Series 2 Convertible Preferred Stock..........................................(C) 741,898 741,898
Series 3 Convertible Preferred Stock..........................................(C) 2,750,000 2,750,000
Warrants at $0.15 expiring 01/26/10...........................................(C) 16,364 164
Warrants at $0.15 expiring 12/05/10...........................................(C) 14,063 140
------------
5,391,194
------------
Polatis, Inc. (1)(2)(5)(10) -- Developing optical networking components
by merging materials, MEMS and electronics technologies
Series A-1 Convertible Preferred Stock.......................................(B) 16,775 47,828
Series A-2 Convertible Preferred Stock.......................................(B) 71,611 204,172
------------
252,000
------------
Total Unaffiliated Private Placement Portfolio (cost: $18,280,716)........................................ $18,033,142
===========
Total Investments in Unaffiliated Companies (cost: $18,280,716)........................................... $18,033,142
===========
The accompanying notes are an integral part of these consolidated
financial statements.
7
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Non-Controlled Affiliated Companies (6)(8) - 25.5% of net assets
Private Placement Portfolio (Illiquid) - 25.5% of net assets
BridgeLux, Inc. (1)(2)(11) -- Manufacturing high-power light
emitting diodes
Series B Convertible Preferred Stock.........................................(A) 1,861,504 $ 1,000,000
--------------
Cambrios Technologies Corporation (1)(2)(5) -- Developing commercially relevant
materials by evolving biomolecules to express control over nanostructure
synthesis
Series B Convertible Preferred Stock.........................................(A) 1,294,025 1,294,025
--------------
Chlorogen, Inc. (1)(2)(5) -- Developing patented chloroplast technology
to produce plant-made proteins
Series A Convertible Preferred Stock.........................................(A) 4,478,038 785,000
Series B Convertible Preferred Stock.........................................(A) 2,077,930 364,261
--------------
1,149,261
CSwitch, Inc. (1)(2)(5) -- Developing next-generation, system-on-a-chip
solutions for communications-based platforms
Series A-1 Convertible Preferred Stock.......................................(C) 6,700,000 3,350,000
--------------
D-Wave Systems, Inc. (1)(2)(4)(5)(13) -- Developing high-performance quantum
computing systems
Series B Convertible Preferred Stock.........................................(A) 2,000,000 1,793,722
Warrants at $0.85 expiring 10/19/07..........................................(B) 1,800,000 0
--------------
1,793,722
--------------
Innovalight, Inc. (1)(2)(4)(5) - Developing renewable energy products
using silicon nanotechnology
Series B Convertible Preferred Stock.........................................(A) 16,666,666 2,500,000
--------------
Kereos, Inc. (1)(2)(5) -- Developing molecular imaging agents
and targeted therapeutics to image and treat cancer and
cardiovascular disease
Series B Convertible Preferred Stock.........................................(A) 349,092 960,000
--------------
The accompanying notes are an integral part of these
consolidated financial statements.
8
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Non-Controlled Affiliated Companies (6)(8) - 25.5% of net assets
(cont.)
Private Placement Portfolio (Illiquid) - 25.5% of net assets (cont.)
Kovio, Inc. (1)(2)(5) -- Developing semiconductor products
using printed electronics and thin-film technologies
Series C Convertible Preferred Stock.........................................(A) 2,500,000 $ 3,000,000
------------
Mersana Therapeutics, Inc. (1)(2)(5)(12) -- Developing advanced
polymers for drug delivery
Series A Convertible Preferred Stock..........................................(C) 68,452 136,904
Series B Convertible Preferred Stock..........................................(C) 616,500 1,233,000
Warrants at $2.00 expiring 10/21/10...........................................(B) 91,625 0
--------------
1,369,904
Metabolon, Inc. (1)(2)(4)(5) - Discovering biomarkers through
the use of metabolomics
Series B Convertible Preferred Stock.........................................(A) 2,173,913 2,500,000
--------------
NanoGram Corporation (1)(2)(5) -- Developing a broad suite of intellectual
property utilizing nanotechnology
Series I Convertible Preferred Stock.........................................(C) 63,210 64,259
Series II Convertible Preferred Stock........................................(C) 1,250,904 1,271,670
Series III Convertible Preferred Stock.......................................(C) 1,242,144 1,262,764
--------------
2,598,693
--------------
Nanomix, Inc. (1)(2)(5) -- Producing nanoelectronic sensors that
integrate carbon nanotube electronics with silicon microstructures
Series C Convertible Preferred Stock..........................................(A) 9,779,181 2,500,000
--------------
NanoOpto Corporation (1)(2)(5) -- Manufacturing discrete and integrated optical
communications sub-components on a chip by utilizing nano manufacturing and
nano coating technology
Series A-1 Convertible Preferred Stock........................................(C) 267,857 32,490
Series B Convertible Preferred Stock..........................................(C) 3,819,935 1,110,073
Series C Convertible Preferred Stock..........................................(C) 1,932,789 842,503
Series D Convertible Preferred Stock..........................................(C) 1,397,218 433,138
Warrants at $0.4359 expiring 03/15/10.........................................(B) 193,279 0
--------------
2,418,204
--------------
The accompanying notes are an integral part of these
consolidated financial statements.
9
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Non-Controlled Affiliated Companies (6)(8) - 25.5% of net assets
(cont.)
Private Placement Portfolio (Illiquid) - 25.5% of net assets (cont.)
Nextreme Thermal Solutions, Inc. (1)(2)(5) -- Developing thin-film
thermoelectric devices
Series A Convertible Preferred Stock..........................................(A) 1,000,000 $ 1,000,000
--------------
Questech Corporation (1)(2) -- Manufacturing and marketing
proprietary metal and stone decorative tiles
Common Stock.................................................................(B) 646,954 781,520
Warrants at $1.50 expiring 08/03/06..........................................(B) 8,500 0
Warrants at $1.50 expiring 11/21/07..........................................(B) 3,750 0
Warrants at $1.50 expiring 11/19/08..........................................(B) 5,000 0
Warrants at $1.50 expiring 11/19/09..........................................(B) 5,000 0
---------------
781,520
---------------
Solazyme, Inc. (1)(2)(5) -- Developing energy-harvesting
machinery of photosynthetic microbes to produce industrial
and pharmaceutical molecules
Series A Convertible Preferred Stock.........................................(C) 988,204 385,400
---------------
Starfire Systems, Inc. (1)(2)(5) --Producing ceramic-forming polymers
Common Stock.................................................................(A) 375,000 150,000
Series A-1 Convertible Preferred Stock.......................................(C) 600,000 600,000
---------------
750,000
---------------
Zia Laser, Inc. (1)(2)(5) -- Developing quantum dot semiconductor lasers
Series C Convertible Preferred Stock.........................................(B) 1,500,000 0
---------------
Total Non-Controlled Private Placement Portfolio (cost: $34,033,245)......................................... $ 29,350,729
===============
Total Investments in Non-Controlled Affiliated Companies (cost: $34,033,245)................................. $ 29,350,729
===============
The accompanying notes are an integral part of these
consolidated financial statements.
10
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HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Method of Shares/
Valuation (3) Principal Value
------------- --------- -----
Investments in Controlled Affiliated Companies (6)(9) - 3.1% of net assets
Private Placement Portfolio (Illiquid) - 3.1% of net assets
Evolved Nanomaterial Sciences, Inc. (1)(2)(4)(5) -- Developing
nanotechnology-enhanced approaches for the resolution of
chiral molecules
Series A Convertible Preferred Stock.........................................(A) 5,870,021 $ 2,800,000
------------
SiOnyx, Inc. (1)(2)(4)(5) -- Developing silicon-based
optoelectronic products enabled by its proprietary, "Black Silicon"
Series A Convertible Preferred Stock.........................................(A) 2,334,994 750,000
------------
Total Controlled Private Placement Portfolio (cost: $3,550,000)................................................. $ 3,550,000
============
Total Investments in Controlled Affiliated Companies (cost: $3,550,000)......................................... $ 3,550,000
============
U.S. Government and Agency Securities - 57.4% of net assets
U.S. Treasury Bills -- due date 08/31/06 .................................... (J) 10,415,000 $ 10,334,284
U.S. Treasury Notes -- due date 11/30/07, coupon 4.25%....................... (H) 6,500,000 6,414,200
U.S. Treasury Notes -- due date 02/15/08, coupon 3.375%...................... (H) 9,000,000 8,747,550
U.S. Treasury Notes -- due date 05/15/08, coupon 3.75%....................... (H) 9,000,000 8,772,570
U.S. Treasury Notes -- due date 09/15/08, coupon 3.125%...................... (H) 5,000,000 4,791,000
U.S. Treasury Notes -- due date 01/15/09, coupon 3.25%....................... (H) 3,000,000 2,866,650
U.S. Treasury Notes -- due date 02/15/09, coupon 4.50%....................... (H) 5,100,000 5,019,318
U.S. Treasury Notes -- due date 04/15/09, coupon 3.125%...................... (H) 3,000,000 2,845,560
U.S. Treasury Notes -- due date 07/15/09, coupon 3.625%...................... (H) 3,000,000 2,874,720
U.S. Treasury Notes -- due date 10/15/09, coupon 3.375%...................... (H) 3,000,000 2,843,910
U.S. Treasury Notes -- due date 01/15/10, coupon 3.625%...................... (H) 3,000,000 2,856,330
U.S. Treasury Notes -- due date 04/15/10, coupon 4.00%....................... (H) 3,000,000 2,886,570
U.S. Treasury Notes -- due date 07/15/10, coupon 3.875%...................... (H) 3,000,000 2,867,940
U.S. Treasury Notes -- due date 10/15/10, coupon 4.25%....................... (H) 2,000,000 1,935,620
Total Investments in U.S. Government and Agency
Securities (cost: $67,183,957)............................................................................. $ 66,056,222
------------
Total Investments (cost: $123,047,918).......................................................................... $116,990,093
============
The accompanying notes are an integral part of these
consolidated financial statements.
11
--------------------------------------------------------------------------------
HARRIS & HARRIS GROUP, INC.
CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF JUNE 30, 2006
(Unaudited)
--------------------------------------------------------------------------------
Notes to Consolidated Schedule of Investments
(1) Represents a non-income producing security. Equity investments that have
not paid dividends within the last 12 months are considered to be
non-income producing.
(2) Legal restrictions on sale of investment.
(3) See Footnote to Schedule of Investments for a description of the Valuation
Procedures.
(4) Initial investment was made during 2006.
(5) These investments are development stage companies. A development stage
company is defined as a company that is devoting substantially all of its
efforts to establishing a new business, and either it has not yet
commenced its planned principal operations, or it has commenced such
operations but has not realized significant revenue from them.
(6) Investments in unaffiliated companies consist of investments in which we
own less than five percent of the voting shares of the portfolio company.
Investments in non-controlled affiliated companies consist of investments
in which we own five percent or more, but less than 25 percent, of the
voting shares of the portfolio company or where we hold one or more seats
on the portfolio company's Board of Directors. Investments in controlled
affiliated companies consist of investments in which we own 25 percent or
more of the voting shares of the portfolio company.
(7) The aggregate cost for federal income tax purposes of investments in
unaffiliated companies is $18,280,716. The gross unrealized appreciation
based on the tax cost for these securities is $1,732,194. The gross
unrealized depreciation based on the tax cost for these securities is
$1,979,768.
(8) The aggregate cost for federal income tax purposes of investments in
non-controlled affiliated companies is $34,033,245. The gross unrealized
appreciation based on the tax cost for these securities is $356,709. The
gross unrealized depreciation based on the tax cost for these securities
is $5,039,225.
(9) The aggregate cost for federal income tax purposes of investments in
controlled affiliated companies is $3,550,000. The gross unrealized
appreciation based on the tax cost for these securities is $0. The gross
unrealized depreciation based on the tax cost for these securities is $0.
(10) Continuum Photonics, Inc., merged with Polatis, Ltd., to form Polatis,
Inc.
(11) BridgeLux, Inc., was previously named eLite Optoelectronics, Inc.
(12) Mersana Therapeutics, Inc., was previously named Nanopharma Corp.
(13) D-Wave Systems, Inc., is located and is doing business primarily in
Canada.
The accompanying notes are an integral part of this
consolidated schedule.
12
--------------------------------------------------------------------------------
HARRIS & HARRIS GROUP, INC.
FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS
(Unaudited)
--------------------------------------------------------------------------------
VALUATION PROCEDURES
Our 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; and
5) All Other Investments.
The 1940 Act requires periodic valuation of each investment in our
portfolio to determine our 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.
Our Board of Directors is responsible for (1) determining overall
valuation guidelines and (2) ensuring that our investments are valued within the
prescribed guidelines.
Our Valuation Committee, comprised of three or more independent Board
members, is responsible for reviewing and approving the valuation of our assets
within the guidelines established by the Board of Directors. The Valuation
Committee receives information and recommendations from management.
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 our assets, 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.
The values assigned to these investments are based on available
information and do not necessarily represent amounts that might ultimately be
realized, as such amounts depend on future circumstances and cannot reasonably
be determined until the individual investments are actually liquidated or become
readily marketable.
Our valuation policy with respect to the five broad investment
categories is as follows:
13
EQUITY-RELATED SECURITIES
Equity-related securities are valued using one or more of the following
basic methods of valuation:
A. Cost: The cost method is based on our original cost. 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
these 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 a company's common stock; and (5) significant positive or negative
changes in a company's business.
B. 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 us
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 our 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 we own and the nature of
any rights to require the company to register restricted securities under
applicable securities laws.
C. Private Market: The private market method uses actual, executed,
-------------------
historical transactions in a company's securities by responsible third parties
as a basis for valuation. The private market method may also use, where
applicable, unconditional firm offers by responsible third parties as a basis
for valuation.
D. Public Market: The public market method is used when there is an
------------------
established public market for the class of a company's securities held by us or
into which our securities are convertible. Securities for which market
quotations are readily available, and which are not subject to substantial legal
or contractual and transfer restrictions, 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. If, for any reason, the Valuation Committee determines that market
quotations are not reliable, such securities shall be fair valued by the
Valuation Committee in accordance with these valuation procedures. We discount
market value for securities that are subject to significant legal or contractual
transfer restrictions.
INVESTMENTS IN INTELLECTUAL PROPERTY, PATENTS, 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 our original cost. This 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.
14
F. 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 us 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 our 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, projected
markets, and other subjective factors.
G. Private Market: The private market method uses actual third-party
-------------------
investments in the same or substantially similar 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.
LONG-TERM FIXED INCOME SECURITIES
H. Readily Marketable: Long-term 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.
I. Not Readily Marketable: Long-term fixed-income securities for which
--------------------------
market quotations are not readily available are carried at fair value as
determined in good faith by the Valuation Committee on the basis of available
data, which may include credit quality, and interest rate analysis as well as
quotations from broker-dealers or, where such quotations are not available,
prices from independent pricing services that the Board believes are reasonably
reliable and based on reasonable price discovery procedures and data from other
sources.
SHORT-TERM FIXED-INCOME INVESTMENTS
J. Short-Term Fixed-Income Investments are valued in the same manner as
--------------------------------------
long-term fixed income securities until the remaining maturity is 60 days or
less, after which time such securities may be valued at amortized cost if there
is no concern over payment at maturity.
ALL OTHER INVESTMENTS
K. All Other Investments are reported at fair value as determined in
-------------------------
good faith by the Valuation Committee.
For all other investments, the reported values shall reflect the
Valuation Committee's judgment of fair values as of the valuation date using the
outlined basic methods of valuation or any other method of valuation within the
prescribed guidelines that the Valuation Committee determines after review and
analysis is more appropriate for the particular kind of investment. They do not
necessarily represent an amount of money that would be realized if we had to
sell such assets in an immediate liquidation. Thus, valuations as of any
particular date are not necessarily indicative of amounts that we may ultimately
realize as a result of future sales or other dispositions of investments we
hold.
15
--------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
--------------------------------------------------------------------------------
NOTE 1. THE COMPANY
--------------------
Harris & Harris Group, Inc. (the "Company," "us," "our" and "we"), is a
venture capital company operating as a business development company ("BDC")
under the Investment Company Act of 1940 ("1940 Act"). We operate as an
internally managed company whereby our officers and employees, under the general
supervision of our Board of Directors, conduct our operations.
We elected to become a BDC on July 26, 1995, after receiving the
necessary governmental approvals. From September 30, 1992, until the election of
BDC status, we operated as a closed-end, non-diversified investment company
under the 1940 Act. Upon commencement of operations as an investment company, we
revalued all of our assets and liabilities in accordance with the 1940 Act.
Prior to September 30, 1992, we were 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.SM ("Enterprises"), is a 100 percent
wholly owned subsidiary of the Company. Enterprises is a partner in Harris
Partners I, L.P.SM and is taxed under Subchapter C of the Code (a "C
Corporation"). Harris Partners I, L.P, is a limited partnership and owns our
interest in AlphaSimplex Group, LLC. The partners of Harris Partners I, L.P.,
are Enterprises (sole general partner) and Harris & Harris Group, Inc. (sole
limited partner).
We filed for the 1999 tax year to elect treatment as a regulated
investment company ("RIC") under Subchapter M of the Internal Revenue Code of
1986 (the "Code") and qualified for the same treatment for the years 2000
through 2005. However, there can be no assurance that we will qualify as a RIC
for 2006 or subsequent years. In addition, under certain circumstances, even if
we qualified for Subchapter M treatment for a given year, we might take action
in a subsequent year to ensure that we would be taxed in that subsequent year as
a C Corporation, rather than as a RIC. As a RIC, we must, among other things,
distribute at least 90 percent of our investment company taxable income and may
either distribute or retain our realized net capital gains on investments.
NOTE 2. INTERIM FINANCIAL STATEMENTS
-------------------------------------
Our interim financial statements have been prepared in accordance with
the instructions to Form 10-Q and Article 10 of Regulation S-X and in conformity
with generally accepted accounting principles applicable to interim financial
information. Accordingly, they do not include all information and disclosures
necessary for a presentation of our financial position, results of operations
and cash flows in conformity with generally accepted accounting principles in
the United States of America. In the opinion of management, these financial
statements reflect all adjustments, consisting only of normal recurring
accruals, necessary for a fair presentation of our financial position, results
of operations and cash flows for such periods. The results of operations for any
interim period are not necessarily indicative of the results for the full year.
These financial statements should be read in conjunction with the financial
statements and notes thereto contained in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2005.
16
NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
---------------------------------------------------
The following is a summary of significant accounting policies followed
in the preparation of the consolidated financial statements:
Principles of Consolidation. The consolidated financial statements have
been prepared in accordance with accounting principles generally accepted in the
United States of America for investment companies and include the accounts of
the Company and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.
Use of Estimates. The preparation of the consolidated financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and contingent assets
and liabilities as of June 30, 2006, and December 31, 2005, and the reported
amounts of revenues and expenses for the six months ended June 30, 2006 and
2005. The most significant estimates relate to the fair valuations of certain of
our investments. Actual results could differ from these estimates.
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 "value" as
defined in the 1940 Act and in the applicable regulations of the Securities and
Exchange Commission. Value, as defined in Section 2(a)(41) of the 1940 Act, is
(i) the market price for those securities for which a market quotation is
readily available and (ii) the fair value as determined in good faith by, or
under the direction of, the Board of Directors for all other assets. (See
"Valuation Procedures" in the "Footnote to Consolidated Schedule of
Investments.") At June 30, 2006, our financial statements include private
venture capital investments valued at $50,933,871 the fair values of which were
determined in good faith by, or under the direction, of the Board of Directors.
Upon sale of investments, the values that are ultimately realized may be
different from what is presently estimated. The difference could be material.
Foreign Currency Translation. The accounting records of the Company are
maintained in U.S. dollars. All assets and liabilities denominated in foreign
currencies are translated into U.S. dollars based on the rate of exchange of
such currencies against U.S. dollars on the date of valuation. At June 30, 2006,
included in the unrealized gain on investments was $43,175 resulting from
foreign currency translation.
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. The
Company ceases accruing interest when securities are determined to be non-income
producing and writes off any previously accrued interest. Realized gains and
losses on investment transactions are determined by specific identification for
financial reporting and tax reporting.
17
Income Taxes. Prior to January 1, 1999, we recorded income taxes using
the liability method, in accordance with the provisions of Statement of
Financial Accounting Standards No. 109. Accordingly, deferred tax liabilities
had been established to reflect temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases; the most significant such difference related to our
unrealized appreciation on investments.
We pay federal, state and local income taxes on behalf of our wholly
owned subsidiary, Harris & Harris Enterprises, which is a C corporation. (See
"Note 7. Income Taxes.")
Restricted Funds. The Company maintains a rabbi trust for the purposes
of accumulating funds to satisfy the obligations incurred by us for the
Supplemental Executive Retirement Plan ("SERP") under the employment agreement
with Charles E. Harris.
Property and Equipment. Property and equipment are included in "Other
Assets" and are carried at cost, less accumulated depreciation. Depreciation is
provided using the straight-line method over the estimated useful lives of the
premises and equipment.
NOTE 4. STOCK-BASED COMPENSATION
---------------------------------
On March 23, 2006, the Board of Directors of the Company voted to
terminate the Employee Profit Sharing Plan and establish the Harris & Harris
Group, Inc. 2006 Equity Incentive Plan (the "Stock Plan"), subject to
shareholder approval. This proposal was approved at the May 4, 2006 Annual
Meeting of Shareholders. The Stock Plan provides for the grant of equity-based
awards of restricted stock and stock options to our directors, officers,
employees, advisors and consultants who are selected by our Compensation
Committee for participation in the plan and subject to compliance with the 1940
Act.
On July 11, 2006, the Company filed an application with the SEC
regarding certain provisions of the Stock Plan. In the event that the SEC
provides exemptive relief, the Compensation Committee may, in the future,
authorize awards under the Stock Plan to certain former officers of the Company,
non-employee directors of the Company, authorize grants of restricted stock and
adjust the exercise price of options to reflect taxes paid for deemed dividends.
A maximum of 20 percent of our total shares of our common stock issued
and outstanding, calculated on a fully diluted basis, are available for awards
under the Stock Plan. Under the Stock Plan, no more than 25 percent of the
shares of stock reserved for the grant of the awards under the Stock Plan may be
restricted stock awards at any time during the term of the Stock Plan. If any
shares of restricted stock are awarded, such awards will reduce on a percentage
basis the total number of shares of stock for which options may be awarded. If
the Company does not receive exemptive relief from the SEC to issue restricted
stock, all shares granted under the Stock Plan may be subject to stock options.
If the Company does receive such exemptive relief and issues 25 percent
of the shares of stock reserved for grant under the Stock Plan as restricted
stock, no more than 75 percent of the shares granted under the Stock Plan may be
subject to stock options. No more than 1,000,000 shares of our common stock may
be made subject to awards under the Stock Plan to any individual in any year.
18
On June 26, 2006, the Compensation Committee of the Board of Directors
of the Company approved individual stock option awards for certain officers and
employees of the Company. Both non-qualified stock options ("NQSOs") and
incentive stock options ("ISOs") were awarded under the Stock Plan. The terms
and conditions of the stock options granted were determined by the Compensation
Committee and set forth in award agreements between the Company and each award
recipient. A total of 3,958,283 stock options were granted with vesting periods
ranging from six months to nine years, with an exercise price of $10.11. Upon
exercise, the shares will be issued from our previously authorized shares.
The Company accounts for the Stock Plan in accordance with the
provisions of SFAS No. 123(R), "Share-Based Payment," which requires that we
determine the fair value of all share-based payments to employees, including the
fair value of grants of employee stock options, and record these amounts as an
expense in the Statement of Operations over the vesting period with a
corresponding increase to our additional paid-in capital. At June 30, 2006, the
increase to our operating expenses was offset by the increase to our additional
paid-in capital, resulting in no net impact to our net asset value.
Additionally, the Company does not record the tax benefits associated with the
expensing of stock options because the Company intends to qualify as a RIC under
Subchapter M of the Code and as such, the Company cannot use all of its existing
operating expenses for tax purposes.
The fair value of each stock option award is estimated on the date of
grant using the Black-Scholes option pricing model. The stock options were
awarded in five different grant types, each with different contractual terms.
The assumptions used in the calculation of fair value using the Black-Scholes
model for each contract term were as follows:
Number Expected Expected Expected Risk-free Fair
of Options Term Volatility Dividend Interest Value
Type of Award Term Granted in Yrs Factor Yield Rates Per Share
------------- ---- ------- ------ ------ ----- ----- ---------
Non-qualified stock
options 1 Year 1,001,017 0.75 37.4% 0% 5.16% $1.48
Non-qualified stock
options 2 Years 815,000 1.625 45.2% 0% 5.12% $2.63
Non-qualified stock
options 3 Years 659,460 2.42 55.7% 0% 5.09% $3.81
Non-qualified stock
options 10 Years 690,000 5.75 75.6% 0% 5.08% $6.94
Incentive stock options 10 Years 792,806 7.03 75.6% 0% 5.08% $7.46
------------
Total 3,958,283
============
An option's expected term is the estimated period between the grant
date and the exercise date of the option. As the expected term period increases,
the fair value of the option and, thus, the compensation cost will also
increase. The expected term assumption is generally calculated using historical
stock option exercise data. The Company does not have historical exercise data
to develop such an assumption. In cases where companies do not have historical
data and where the options meet certain criteria, SEC Staff Accounting Bulletin
107 ("SAB 107") provides the use of a simplified expected term calculation.
Accordingly, the Company calculated the expected terms using the SAB 107
simplified method.
19
Expected volatility is the measure of how the stock's price is expected
to fluctuate over a period of time. An increase in the expected volatility
assumption yields a higher fair value of the stock option. Expected volatility
factors for the stock options were based on the historical fluctuations in the
Company's stock price over the term of the option, adjusted for stock splits and
dividends.
The expected dividend yield assumption is traditionally calculated
based on a company's historical dividend yield. An increase to the expected
dividend yield results in a decrease in the fair value of option and resulting
compensation cost. Although the Company has declared deemed dividends in
previous years, most recently in 2005, the amounts and timing of any future
dividends cannot be reasonably estimated. Therefore, for purposes of calculating
fair value, the Company has assumed an expected dividend yield of 0 percent.
The risk-free interest rate assumptions are based on the annual yield
on the measurement date of a zero-coupon U.S Treasury bond the maturity of which
equals the option's expected term. Higher assumed interest rates yield higher
fair values.
The amount of stock-based compensation expense recognized in the
Consolidated Statements of Operations is based on the fair value of the awards
the Company expects to vest, recognized over the vesting period on a
straight-line basis for each award, and adjusted for actual forfeitures that
occur before vesting. The forfeiture rate is estimated at the time of grant and
revised, if necessary, in subsequent periods if the actual forfeiture rate
differs from the estimated rate.
For the three months and six months ended June 30, 2006, the Company
recognized $115,545 of compensation expense in the Consolidated Statements of
Operations. As of June 30, 2006, there was approximately $15,467,946 of
unrecognized compensation cost related to unvested stock option awards. This
cost is expected to be recognized over a weighted-average period of
approximately 1.9 years.
At June 30, 2006, the calculation of the net decrease in net assets
resulting from operations per share excludes the stock options because such
options were anti-dilutive. The options may be dilutive in future periods in the
event that there is a significant increase in the average stock price or
significant decreases in the amount of unrecognized compensation cost.
20
A summary of the changes in outstanding stock options is as follows:
Weighted
Weighted Weighted Average
Average Average Remaining Aggregate
Exercise Grant Date Contractual Intrinsic
Shares Price Fair Value Term (Yrs) Value
Options outstanding at April 1, 2006 -
Granted 3,958,283 $ 10.11
Exercised -
Forfeited or expired -
----------
Options outstanding at June 30, 2006 3,958,283 $ 10.11 $4.25 4.9 $3,681,203
==========
Options exercisable -
==========
Available for grant 192,986
==========
The aggregate intrinsic value in the table above is calculated as the
difference between the Company's closing stock price of $11.04 on the last
trading day of the second quarter of 2006 and the exercise price, multiplied by
the number of in-the-money options. This represents the total pre-tax intrinsic
value that would have been received by the option holders had all option holders
fully vested and exercised their awards on June 30, 2006.
Unless earlier terminated by our Board of Directors, the Stock Plan will
expire on May 4, 2016. The expiration of the Stock Plan will not by itself
adversely affect the rights of plan participants under awards that are
outstanding at the time the Stock Plan expires. Our Board of Directors may
terminate, modify or suspend the plan at any time, provided that no modification
of the plan will be effective unless and until any required shareholder approval
has been obtained. The Compensation Committee may terminate, modify or amend any
outstanding award under the Stock Plan at any time, provided that in such event,
the award holder may exercise any vested options prior to such termination of
the Stock Plan or award.
NOTE 5. EMPLOYEE PROFIT SHARING PLAN
-------------------------------------
Prior to the adoption of the Stock Plan, the Company operated the
Amended and Restated Harris & Harris Group, Inc. Employee Profit-Sharing Plan
(the "2002 Plan"). Effective May 4, 2006, the 2002 Plan was terminated.
The 2002 Plan (and its predecessor) provided for profit sharing by our
officers and employees equal to 20 percent of our "qualifying income" for that
plan year.
As soon as practicable following the year-end, the Compensation
Committee determined whether, and if so how much, qualifying income existed for
a plan year. Ninety percent of the amount determined by the Compensation
Committee was then paid out to Plan participants pursuant to the distribution
percentages set forth in the 2002 Plan. The remaining 10 percent was paid out
after we filed our federal tax return for that plan year.
21
Each quarter, we performed a calculation to determine the accrual for
profit-sharing. We calculated 20 percent of qualifying income (i.e., realized
income) pursuant to the terms of the 2002 Plan and estimated the amount of
additional qualifying income, if any, that would result from selling all the
portfolio investments that were valued above cost (i.e., that were in an
unrealized appreciation position). Although the accrual would fluctuate as a
result of changes in qualifying income and changes in unrealized appreciation,
payments were made only to the extent that qualifying income existed. At June
30, 2006, and December 31, 2005, we accrued $210,786 and $2,107,858,
respectively, for profit sharing as a result of net realized gains. On March 1,
2006, the Company paid $1,897,072 to plan participants (employees and former
employees), which represented 90 percent of the total estimated profit sharing
payment for 2005. The balance of $210,786 is expected to be paid in September
2006.
As discussed in Note 4, subject to receiving exemptive relief from the
SEC, the Company may permit certain former officers of the Company to be
participants of the Stock Plan. Alternatively, the SEC may provide relief which
would permit us to pay out the remainder, if any, of the former officers'
grandfathered participations under the terminated 2002 Plan.
NOTE 6. DISTRIBUTABLE EARNINGS
-------------------------------
As of December 31, 2005, and June 30, 2006, there were no distributable
earnings. The difference between the book basis and tax basis components of
distributable earnings is primarily nondeductible deferred compensation and net
operating losses.
NOTE 7. INCOME TAXES
---------------------
Provided that a proper election is made, a corporation taxable under
Subchapter C of the Code or a C 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 (the "Inclusion Period") from sales of assets that
were held by the corporation on the effective date of the RIC election ("C
Corporation Assets"), to the extent of any gain built into the assets on such
date ("Built-In Gain"). If the corporation fails to make a proper election, it
is taxable on its Built-In Gain as of the effective date of its RIC election. We
had Built-In Gains at the time of our qualification as a RIC and made the
election to be taxed on any Built-In Gain realized during the Inclusion Period.
During 2005, we sold our investment in NeuroMetrix, Inc., realized the
Built-In Gains, and utilized all of our loss carryforwards.
At June 30, 2006 and December 31, 2005, we had no deferred tax asset or
liability.
To the extent that we retain capital gains and declare a deemed
dividend to shareholders, the dividend is taxable to the shareholders. We would
pay tax on behalf of shareholders, at the corporate rate, on the distribution,
and the shareholders would receive a tax credit equal to their proportionate
share of the tax paid. We took advantage of this rule for 2005. Included in net
realized income from investments for the year ended December 31, 2005, were net
realized gains before taxes of $23,862,037, which consisted primarily of a net
realized long term capital gain on the sale of our investment in Neurometrix,
Inc., offset by realized net long term capital losses on the sales of Agile
Materials & Technologies, Inc., Experion Systems, Inc., Nanotechnologies, Inc.,
and Optiva, Inc. We applied $140,751 of our capital loss carryforwards and
$501,640 of our pre-1999 loss carryforwards on Built-In Gains to these gains.
22
In December 2005, we declared a deemed dividend on net taxable realized
long-term capital gains of $23,206,763. The Company recorded a tax payable on
its Consolidated Statements of Assets and Liabilities of $8,122,367 for taxes
payable on behalf of its shareholders. This distribution of $8,122,367 was also
recorded as an income tax expense on the Consolidated Statements of Operations
for the year ended December 31, 2005. Shareholders of record at December 31,
2005, received a tax credit of $0.39131971 per share. The balance of $15,084,396
was retained by the Company. The Company paid $8,122,367 of taxes on behalf of
its shareholders on January 30, 2006.
We pay federal, state and local taxes on behalf of our wholly owned
subsidiary, Harris & Harris Enterprises, Inc., which is taxed as a C
Corporation. For the three months ended June 30, 2006, and 2005, our income tax
expense for Harris & Harris Enterprises, Inc., was $9,931 and $634,
respectively. For the six months ended June 30, 2006, and 2005, our income tax
expense was $19,537 and $4,851, respectively.
Continued qualification as a RIC requires us to satisfy certain
investment asset diversification requirements in future years. Our ability to
satisfy those requirements may not be controllable by us. There can be no
assurance that we will qualify as a RIC in subsequent years.
NOTE 8. CAPITAL TRANSACTIONS
-----------------------------
In 1998, the Board of Directors approved that effective January 1,
1998, 50 percent of all Directors' fees be used to purchase our common stock
from us. However, effective March 1, 1999, the Board of Directors approved that
Directors may purchase our common stock in the open market, rather than from us.
Since 1998, we have repurchased a total of 1,859,047 of our shares for
a total of $3,496,388, including commissions and expenses, at an average price
of $1.88 per share. These treasury shares were reduced by the purchases made by
the Directors. On July 23, 2002, because of our strategic decision to invest in
tiny technology, the Board of Directors reaffirmed its commitment not to
authorize the purchase of additional shares of stock in the foreseeable future.
In September of 2005, we completed the sale of an additional 3,507,500
shares for gross proceeds of $37,091,813; net proceeds of the offering, after
offering costs of $565,246, were $36,526,567. We intend to use, and have been
using, the net proceeds of the offering to make new investments in tiny
technology as well as follow-on investments in our existing venture capital
investments, and for working capital.
NOTE 9. SUBSEQUENT EVENTS
--------------------------
On August 2, 2006, we exercised our warrants to purchase 8,500 shares of
Questech Corporation. The total investment was $12,750.
On August 8, 2006, we made a $102,848 follow-on investment in a privately
held tiny technology portfolio company.
23
--------------------------------------------------------------------------------
HARRIS & HARRIS GROUP, INC.
FINANCIAL HIGHLIGHTS
(Unaudited)
--------------------------------------------------------------------------------
Three Months Ended June 30 Six Months Ended June 30
---------------------------------- ---------------------------------
2006 2005 2006 2005
-------------- ------------- -------------- --------------
Per Share Operating Performance
Net asset value per share, beginning
of period...................................... $ 5.60 $ 4.20 $ 5.68 $ 4.33
Net operating (loss)*..................... (0.03) (0.19) (0.07) (0.23)
Net realized (loss) on investments*....... (0.00) (0.08) (0.00) (0.14)
Net (increase) decrease in unrealized
depreciation as a result of sales* .... (0.00) (0.00)
Net (increase) decrease in unrealized
depreciation on investments held*...... (0.03) 0.68 (0.07) 0. 65
-------------- ------------- -------------- -------------
Total from investment operations*......... (0.06) 0.41 (0.14) 0.28
-------------- ------------- -------------- -------------
Net decrease as a result of deemed
dividend shareholder tax credit........ 0 0 0 0
Total distributions ...................... 0 0 0 0
------------- ---------------- ------------- -------------
Net increase as a result of
stock offering......................... 0 0 0 0
------------- ---------------- ------------- -------------
Total increase from capital
stock transactions..................... 0 0 0 0
------------- ---------------- ------------- -------------
Net asset value per share, end
of period................................. $ 5.54 $ 4.61 $ 5.54 $ 4. 61
============= ================ ============= =============
Stock price per share, end
of period................................. $ 11.04 $ 11.91 $ 11.04 $ 11.91
Total return based on stock price (1).......... (20.86)% (1.1)% (20.58)% (27.3)%
Supplemental Data:
Net assets, end of period...................... $ 115,166,300 $ 79,513,203 $ 115,166,300 $ 79,513,203
Ratio of expenses to average
net assets (1)............................ 1.3% 4.6% 2.6% 5.9%
Ratio of net operating income (loss) to
average net assets (1).................... (0.60)% (4.3)% (1.3)% (5.3)%
Cash dividends paid per share.................. $ 0 $ 0 $ 0 $ 0
Deemed dividend per share...................... $ 0 $ 0 $ 0 $ 0
Number of shares outstanding,
end of period............................. 20,756,345 17,248,845 20,756,345 17,248,845
*Based on Average Shares Outstanding
(1) Not annualized
The accompanying notes are an integral part of this schedule.
24
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The information contained in this section should be read in
conjunction with the unaudited June 30, 2006, Consolidated Financial Statements
and the Company's 2005 audited Consolidated Financial Statements and notes
thereto.
Background and Overview
We incorporated under the laws of the state of New York in August 1981.
In 1983, we completed an initial public offering and invested $406,936 in
Otisville BioTech, Inc., which also completed an initial public offering later
that year. In 1984, Charles E. Harris purchased a controlling interest in us and
became the control person in Otisville. We then divested our other assets and
became a financial services company, with the investment in Otisville as the
initial focus of our business activity. We hired new management for Otisville,
and Otisville acquired new technology targeting the development of a human blood
substitute.
By 1988, we operated two insurance brokerages and a trust company as
wholly-owned subsidiaries. In 1989, Otisville changed its name to Alliance
Pharmaceutical Corporation, and by 1990, we had completed selling our $406,936
investment in Alliance for total proceeds of $3,923,559.
In 1992, we sold our insurance brokerage and trust company subsidiaries
to their respective managements and registered as an investment company under
the 1940 Act, commencing operations as a closed-end, non-diversified investment
company. In 1995, we elected to become a business development company subject to
the provisions of Sections 55 through 65 of the 1940 Act. In 1994, we made our
first tiny technology investment. From August 2001 through June 30, 2006, all 30
of our initial investments have been in tiny technology.
Throughout our corporate history, we have made early stage venture
capital investments in a variety of industries. We define venture capital
investments as investments in start-up firms and small businesses with
exceptional growth potential. We have invested a substantial portion of our
assets in venture capital investments of private, development stage or start-up
companies. These private businesses tend to be thinly capitalized, unproven,
small companies that lack management depth, have little or no history of
operations and are developing unproven technologies. At June 30, 2006,
$50,933,871, or 44.3 percent, of our net assets at fair value consisted of
private venture capital investments, net of unrealized depreciation of
$4,930,090. At December 31, 2005, $33,187,333, or 28.1 percent, of our net
assets at fair value consisted of private venture capital investments, net of
unrealized depreciation of $4,519,009.
Since our investment in Otisville in 1983 through June 30, 2006, we
have made a total of 72 venture capital investments, including four private
placement investments in securities of publicly traded companies. We have sold
44 of these 72 investments, realizing total proceeds of $143,614,382 on our
invested capital of $51,144,319. Eighteen of these 44 investments were
profitable. As measured from first dollar in to last dollar out, the average and
median holding periods for these 44 investments were 3.63 years and 3.18 years,
respectively. As measured by the 149 separate rounds of investment within these
44 investments, the average and median holding periods for the 149 separate
rounds of investment were 2.85 years and 2.53 years, respectively. At June 30,
2006, we valued the 28 venture capital investments remaining in our portfolio at
$50,933,871, or 44.3 percent of our net assets, including net unrealized
depreciation of $4,930,090. At June 30, 2006, from first dollar in, the average
and median holding periods for these 28 venture capital investments were 2.85
years and 1.93 years, respectively. As measured by the 68 separate rounds of
investment within these 28 investments, the average and median holding periods
for the 68 separate rounds of investment were 2.40 years and 1.69 years,
respectively.
25
We value our private venture capital investments each quarter as
determined in good faith by our Valuation Committee, a committee of independent
directors, within guidelines established by our Board of Directors in accordance
with the 1940 Act. (See "Footnote to Consolidated Schedule of Investments"
contained in "Consolidated Financial Statements.")
We have discretion in the investment of our capital. However, we invest
primarily in illiquid equity securities of private companies. Generally, these
investments take the form of preferred stock, are subject to restrictions on
resale and have no established trading market. Our principal objective is to
achieve long-term capital appreciation. Therefore, a significant portion of our
investment portfolio provides little or no income in the form of dividends or
interest. We earn interest income from fixed-income securities, including U.S.
government and agency securities. The amount of interest income we earn varies
with the average balance of our fixed-income portfolio and the average yield on
this portfolio. Interest income is secondary to capital gains and losses in our
results of operations.
We present the financial results of our operations utilizing accounting
principles generally accepted in the United States for investment companies. On
this basis, the principal measure of our financial performance during any period
is the net increase/(decrease) in our net assets resulting from our operating
activities, which is the sum of the following three elements:
Net Operating Income / (Loss) - the difference between our income from
interest, dividends and fees and our operating expenses.
Net Realized Income / (Loss) on Investments - the difference between
the net proceeds of sales of portfolio securities and their stated cost, plus
income from interests in limited liability companies.
Net Increase / (Decrease) in Unrealized Appreciation or Depreciation on
Investments - the net unrealized change in the value of our investment
portfolio.
Owing to the structure and objectives of our business, we generally
expect to experience net operating losses and seek to generate increases in our
net assets from operations through the long-term appreciation of our venture
capital investments. We have relied, and continue to rely, on proceeds from
sales of investments, rather than on investment income, to defray a significant
portion of our operating expenses. Because such sales are unpredictable, we
attempt to maintain adequate working capital to provide for fiscal periods when
there are no such sales.
26
Results of Operations
Three months ended June 30, 2006, as compared to the three months ended June 30,
2005
In the three months ended June 30, 2006, we had a net decrease in net
assets resulting from operations of $1,282,997. In the three months ended June
30, 2005, we had a net increase in net assets resulting from operations of
$7,001,847.
Investment Income and Expenses:
We had net operating losses of $693,887 and $3,302,094 for the three
months ended June 30, 2006, and June 30, 2005, respectively. The variation in
these results is primarily owing to the changes in investment income and
operating expenses. During the three months ended June 30, 2006, and 2005, total
investment income was $785,265 and $158,717, respectively. During the three
months ended June 30, 2006, and 2005, total operating expenses were $1,479,152
and $3,460,811, respectively.
During the three months ended June 30, 2006, as compared with the same
period in 2005, investment income increased owing to an increase in our holdings
of U.S. government and agency securities and an increase in interest rates. At
June 30, 2006, our holdings of such securities were $66,056,222 as compared with
$36,374,618 at June 30, 2005.
The decrease in operating expenses for the three months ended June 30,
2006, as compared with the three months ended June 30, 2005, was primarily owing
to decreases in administrative and operations expenses, profit sharing expense
and professional fees, offset by increases in salaries, benefits and stock-based
compensation expense and directors' fees and expenses. Administration and
operations expense decreased by $81,052, or 16.6 percent, primarily as a result
of the decrease in our director's & officer's liability insurance expense and
decreases in the cost of proxy-related expenses. Profit sharing expense was $0
for the second quarter of 2006, as compared with $2,012,465 at June 30, 2005,
owing primarily to an increase in the market value of our holdings of
NeuroMetrix, Inc., in 2005 and the termination of the profit sharing plan
effective May 4, 2006. Professional fees decreased by $120,184, or 55.1 percent,
for the three months ended June 30, 2006, as compared to the same period in
2005. Professional fees were higher for the three months ended June 30, 2005, as
compared with June 30, 2006, primarily as the result of consulting costs
incurred for a temporary Senior Controller. Salaries, benefits and stock-based
compensation expense increased by $189,541, or 30.8 percent, through June 30,
2006, as compared with June 30, 2005, as a result of an increase in the number
of full-time employees as well as the adoption of the Equity Incentive Plan
during the second quarter of 2006. The increase in salaries, benefits and
stock-based compensation expense reflects expenses associated with ten full-time
employees and one part-time employee during the second quarter of 2006, as
compared with nine full-time employees during the second quarter of 2005.
Salaries, benefits and stock-based compensation also includes $115,545 of
expense associated with the Equity Incentive Plan. While our operating expenses
increased by $115,545, this was offset by a corresponding increase to our
additional paid-in capital, resulting in no net impact to net asset value. The
stock-based compensation expense is expected to increase in future quarters.
Directors' fees and expenses increased by $39,818, or 72.3 percent, as a result
of additional meetings held in the second quarter of 2006 related to the
adoption of the 2006 Equity Incentive Plan.
27
Realized Income and Losses on Investments:
During the three months ended June 30, 2006, we realized net gains on
investments of $1,500. During the three months ended June 30, 2005, we realized
net losses on investments of $1,386,741.
During the three months ended June 30, 2006, we realized net gains of
$1,500, consisting of income from our investment in AlphaSimplex Group, LLC.
During the three months ended June 30, 2005, we realized net losses of
$1,386,741, consisting primarily of the realized loss from the sale of our
investment in Nanotechnologies, Inc., of $1,091,209 and the loss on the sale of
the assets underlying our investment in Optiva Inc., of $294,245.
Net Unrealized Appreciation and Depreciation on Investments:
During the three months ended June 30, 2006, net unrealized
depreciation on total investments increased by $580,680, or 10.6 percent, from
net unrealized depreciation of $5,477,145 at March 31, 2006, to net unrealized
depreciation of $6,057,825 at June 30, 2006. Net unrealized appreciation on
total investments increased by $11,691,316, or 710.7 percent, during the three
months ended June 30, 2005, from net unrealized depreciation of $1,645,024 at
March 31, 2005, to net unrealized appreciation of $10,046,292 at June 30, 2005.
During the three months ended June 30, 2006, net unrealized
depreciation on our venture capital investments increased by $219,536, from
$4,710,554 to $4,930,090, owing primarily to a decrease in the valuation of our
investment in NeoPhotonics Corporation of $319,643 and an increase in the
valuation of Questech Corporation of $56,934. We also had an unrealized gain on
our investment in D-Wave Systems, Inc., of $43,175, which is attributable to
foreign currency translation gains. Unrealized depreciation on our U.S.
government and agency securities portfolio increased by $361,144, from $766,591
at March 31, 2006, to $1,127,735 at June 30, 2006.
During the three months ended June 30, 2005, net unrealized
appreciation on our venture capital investments increased by $11,551,546, from
net unrealized depreciation of $1,184,084 at March 31, 2005, to net unrealized
appreciation of $10,367,462 at June 30, 2005, primarily owing to an increase in
the valuation of our investment in NeuroMetrix, Inc., of $11,921,734,
realization of the losses on the sale of our investment in Nanotechnologies,
Inc., of $1,091,209 and the sale of the assets underlying our investment in
Optiva, Inc., of $675,000. In addition, decreases in the valuations of Zia
Laser, Inc., Nanopharma Corp. and NanoOpto Corporation decreased our unrealized
appreciation by $750,000, $563,097 and $571,283, respectively.
Six months ended June 30, 2006, as compared to the six months ended June 30,
2005
In the six months ended June 30, 2006, we had a net decrease in net
assets resulting from operations of $2,936,987. In the six months ended June 30,
2005, we had a net increase in net assets resulting from operations of
$4,768,404.
28
Investment Income and Expenses:
We had net operating losses of $1,461,630 and $4,042,681 for the six
months ended June 30, 2006, and June 30, 2005, respectively.
During the first six months of 2006, as compared with the same period
in 2005, investment income increased from $423,826 to $1,590,127, owing to an
increase in our holdings of U.S. government and agency securities and an
increase in interest rates. At June 30, 2006, our holdings of such securities
were $66,056,222, as compared with $36,374,618 at June 30, 2005.
Operating expenses were $3,051,757 and $4,466,507 for the six months
ended June 30, 2006, and June 30, 2005, respectively. The decrease in operating
expenses for the six months ended June 30, 2006, as compared to the six months
ended June 30, 2005, was primarily owing to decreases in administrative and
operations expenses, profit sharing expense and professional fees, offset by
increases in salaries, benefits and stock-based compensation expense and
directors' fees and expenses. Administrative and operations expense decreased by
$80,565, or 9.9 percent, primarily as a result of a decrease in our director's &
officer's liability insurance and decreases in the cost of proxy-related
expenses. Profit sharing expense was $0 for the six months ended June 30, 2006,
as compared with $1,700,871 through June 30, 2005, owing primarily to an
increase in the market value of our holdings in NeuroMetrix, Inc., in 2005 and
to the termination of the profit sharing plan effective May 4, 2006.
Professional fees decreased by $102,762, or 20.9 percent, for the six months
ended June 30, 2006, as compared to the same period in 2005. Professional fees
were higher for the six months ended June 30, 2005, as compared with June 30,
2006, primarily as a result of consulting costs incurred for a temporary Senior
Controller and other additional Sarbanes-Oxley compliance costs incurred in
2005. Salaries, benefits and stock-based compensation expense increased by
$408,212, or 34.5 percent, through June 30, 2006, as compared to June 30, 2005,
as a result of an increase in the number of full-time employees as well as the
adoption of the Equity Incentive Plan during the second quarter of 2006. The
increase in salaries, benefits and stock-based compensation expense reflects
expenses associated with ten full-time employees and one part-time employee
during the second quarter of 2006, as compared with nine full-time employees
during the second quarter of 2005. Salaries, benefits and stock-based
compensation also includes $115,545 of expense associated with the Equity
Incentive Plan. Directors' fees and expenses increased by $40,061, or 28.5
percent, as a result of additional meetings held in 2006 related to the adoption
of the 2006 Equity Incentive Plan.
Realized Income and Losses on Investments:
During the six months ended June 30, 2006, we realized net gains on
investments of $13,453. During the six months ended June 30, 2005, we realized
net losses on investments of $2,427,785.
During the six months ended June 30, 2006, we realized net gains of
$13,453, consisting primarily of proceeds received from the liquidation of
Optiva, Inc., offset by net losses realized on our investment in AlphaSimplex
Group, LLC. During 2005, we deemed the securities we held in Optiva, Inc.,
worthless and recorded the proceeds received and due to us on the liquidation of
our bridge notes, realizing a loss of $1,619,245. At December 31, 2005, we
recorded a $75,000 receivable for estimated proceeds from the final payment on
the Optiva, Inc., bridge notes. During the first quarter of 2006, we received
payment of $95,688 from these bridge notes, resulting in the realized gain of
$20,688 on Optiva, Inc. These gains were offset by net losses of $10,757 on our
investment in AlphaSimplex Group, LLC.
29
During the six months ended June 30, 2005, we realized losses on the
sale of investments, including $1,358,286 for Agile Materials & Technologies,
Inc., and $1,091,209 for Nanotechnologies, Inc. We also realized a loss of
$294,245 from the sale of the assets underlying our investment in Optiva, Inc.
These realized losses were partially offset by the realized gain of $255,486 on
a sale of our investment in NanoGram Devices Corporation.
Net Unrealized Appreciation and Depreciation on Investments:
During the six months ended June 30, 2006, net unrealized depreciation
on total investments increased by $1,469,275, or 32 percent, from net unrealized
depreciation of $4,588,550 at December 31, 2005, to net unrealized depreciation
of $6,057,825 at June 30, 2006. During the six months ended June 30, 2005, net
unrealized appreciation on total investments increased by $11,243,721, or 939.0
percent, from net unrealized depreciation of $1,197,429 at December 31, 2004, to
net unrealized appreciation of $10,046,292 at June 30, 2005.
During the six months ended June 30, 2006, net unrealized depreciation
on our venture capital investments increased by $411,081, from $4,519,009 to
$4,930,090, owing primarily to decreases in the valuation of our investments in
NeoPhotonics Corporation of $319,643, and Zia Laser, Inc., of $187,500, and an
increase in the valuation of Questech Corporation of $56,934. We also had an
increase owing to foreign currency translation of $43,175 on our investment in
D-Wave Systems, Inc. Unrealized depreciation on our U.S. government and agency
securities portfolio increased from $69,541 at December 31, 2005, to $1,127,735
at June 30, 2006.
During the six months ended June 30, 2005, we recorded a net increase
of $11,242,108 in unrealized appreciation of our venture capital investments,
primarily as a result of an increase in unrealized appreciation of NeuroMetrix,
Inc., of $9,671,705. In addition, unrealized appreciation increased as a result
of the realization of losses on the sale of our investments in Agile Materials
and Technologies, Inc., of $1,364,081, Nanotechnologies, Inc., of $917,410 and
the sale of the assets underlying our investment in Optiva, Inc., of $675,000.
Changes in valuation resulted in increased appreciation on our investment in
Nantero, Inc., of $813,771 and decreased appreciation on our investments in Zia
Laser, Inc., of $750,000 and Nanopharma Corporation of $563,097.
Financial Condition
Six Months ended June 30, 2006
At June 30, 2006, our total assets and net assets were $120,100,765 and
$115,166,300, compared with $132,938,120 and $117,987,742 at December 31, 2005.
At June 30, 2006, net asset value per share was $5.54, as compared with
$5.68 at December 31, 2005. Our shares outstanding remained unchanged during the
six months ended June 30, 2006.
30
Significant developments in the six months ended June 30, 2006, were an
increase in the value of our venture capital investments of $17,746,538 and a
decrease in the value of our investment in U.S. government and agency securities
of $30,194,642. The increase in the value of our venture capital investments,
from $33,187,333 at December 31, 2005, to $50,933,871 at June 30, 2006, resulted
primarily from five new and six follow-on investments, partially offset by a net
decrease of $411,081 in the net value of our previous venture capital
investments. The decrease in the value of our U.S. government and agency
securities, from $96,250,864 at December 31, 2005, to $66,056,222 at June 30,
2006, is primarily owing to the use of funds for investments totaling
$18,165,017, tax payments of $8,302,367, profit sharing payments of $1,897,072,
an increase in unrealized losses of $1,058,194 and payment of net operating
expenses.
The following table is a summary of additions to our portfolio of
venture capital investments during the six months ended June 30, 2006:
New Investments Amount
--------------- ----------
D-Wave Systems, Inc. $1,750,547
Evolved Nanomaterial Sciences, Inc. $2,800,000
Innovalight, Inc. $2,500,000
Metabolon, Inc. $2,500,000
SiOnyx, Inc. $ 750,000
Follow-on Investments
---------------------
Crystal IS, Inc. $ 68,568
CSwitch Corporation $2,850,000
NanoGram Corporation $1,262,764
NanoOpto Corporation $ 433,138
NeoPhotonics Corporation $2,750,000
Nextreme $ 500,000
----------
Total $18,165,017
===========
The following tables summarize the fair values of our portfolios of
venture capital investments and U.S. government and agency securities, as
compared with their cost, at June 30, 2006, and December 31, 2005:
June 30, 2006 December 31, 2005
------------- -----------------
Venture capital investments,
at cost $ 55,863,961 $37,706,342
Net unrealized depreciation (1) 4,930,090 4,519,009
------------- -----------
Venture capital investments,
at fair value $ 50,933,871 $33,187,333
============= ===========
June 30, 2006 December 31, 2005
------------- -----------------
U.S. government and agency
securities, at cost $ 67,183,957 $96,320,405
Net unrealized depreciation(1) 1,127,735 69,541
------------- -----------
U.S. government and agency
securities, at fair value $ 66,056,222 $96,250,864
============= ===========
31
1)At June 30, 2006, and December 31, 2005, the net accumulated unrealized
depreciation on investments, including deferred taxes, was $6,233,398 and
$4,764,125, respectively.
The following table summarizes the fair value composition of our
venture capital investment portfolio at June 30, 2006, and December 31, 2005.
June 30, 2006 December 31, 2005
------------- -----------------
Category
Tiny Technology 99.99% 99.9%
Other Venture Capital Investments 0.01% 0.1%
------ ------
Total Venture Capital Investments 100.0% 100.0%
====== ======
Liquidity
Our primary sources of liquidity are cash, receivables and freely
marketable securities, net of short-term indebtedness. Our secondary sources of
liquidity are restricted securities of companies that are publicly traded.
At June 30, 2006, and December 31, 2005, our total net primary
liquidity was $66,735,193 and $97,797,219, respectively, and our secondary
liquidity was $0 and $0, respectively.
The decrease in our primary liquidity from December 31, 2005, to June
30, 2006, is primarily owing to the use of funds for investments, profit sharing
and tax payments, as well as net operating expenses.
Capital Resources
In 2004, we registered with the Securities and Exchange Commission for
the sale of up to 7,000,000 shares of our common stock from time to time. In
July 2004, we sold 3,450,000 common shares for gross proceeds of $36,501,000;
net proceeds of the offering, after offering costs of $372,825, were
$36,128,175. In September 2005, we completed the sale of 3,507,500 common
shares, for total gross proceeds of $37,091,813. Net proceeds, after offering
costs of $565,246, were $36,526,567. We intend to use, and have been using, the
net proceeds of the offerings to make new investments in tiny technology as well
as follow-on investments in our existing venture capital investments, and for
working capital. Through June 30, 2006, we have used $43,152,938 from these two
offerings for these purposes.
32
Critical Accounting Policies
The Company's significant accounting policies are described in Note 3
to the Consolidated Financial Statements and in the Footnote to the Consolidated
Schedule of Investments. Critical accounting policies are those that are both
important to the presentation of our financial condition and results of
operations and those that require management's most difficult, complex or
subjective judgments. The Company considers the following accounting policies
and related estimates to be critical:
Stock-Based Compensation
Determining the appropriate fair-value model and calculating the fair
value of share-based awards at the date of grant requires judgment. We use the
Black-Scholes option pricing model to estimate the fair value of employee stock
options consistent with the provisions of SFAS No. 123(R). Management uses the
Black-Scholes option pricing model because of the lack of historical option data
which is required for use in other, more complex models. Other models may yield
fair values that are significantly different than those calculated by the
Black-Scholes option pricing model.
Option pricing models, including the Black-Scholes model, require the
use of subjective input assumptions, including expected volatility, expected
life, expected dividend rate, and expected risk-free rate of return. In the
Black-Scholes model, variations in the expected volatility or expected term
assumptions have a significant impact on fair value. As the volatility or
expected term assumptions increase, the fair value of the stock option
increases. In the Black-Scholes model, the expected dividend rate and expected
risk-free rate of return are not as significant to the calculation of fair
value. A higher assumed dividend rate yields a lower fair value, whereas higher
assumed interest rates yield higher fair values for stock options.
We use the simplified calculation of expected life described in the
SEC's Staff Accounting Bulletin 107, because of the lack of historical
information about option exercise patterns. Future exercise behavior could be
materially different than that which is assumed by the model.
Expected volatility is based on the historical fluctuations in the
Company's stock. The Company's stock has historically been volatile, which
increases the fair value.
SFAS No. 123(R) requires us to develop an estimate of the number of
share-based awards which will be forfeited owing to employee turnover. Quarterly
changes in the estimated forfeiture rate can have a significant effect on
reported share-based compensation, as the effect of adjusting the rate for all
expense amortization after June 30, 2006, is recognized in the period the
forfeiture estimate is changed. If the actual forfeiture rate proves to be
higher than the estimated forfeiture rate, then an adjustment will be made to
increase the estimated forfeiture rate, which would result in a decrease to the
expense recognized in the financial statements. If the actual forfeiture rate
proves to be lower than the estimated forfeiture rate, then an adjustment will
be made to decrease the estimated forfeiture rate, which would result in an
increase to the expense recognized in the financial statements. Such adjustments
would affect our operating expenses and additional paid-in capital, but would
have no effect on our net asset value.
33
Valuation of Portfolio Investments
As a business development company, we invest in illiquid securities
including debt and equity securities of private companies. These investments are
generally subject to restrictions on resale and generally have no established
trading market. We value substantially all of our equity investments at fair
value as determined in good faith by our valuation committee on a quarterly
basis. The valuation committee, comprised of three or more non-interested Board
members, reviews and approves the valuation of our investments within the
valuation procedures 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 our assets, 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. Upon sale of
investments, the values that are ultimately realized may be different from what
is presently estimated. This difference could be material.
Pension and Post-Retirement Benefit Plan Assumptions
The Company provides a Retirement Healthcare Benefit Plan for employees
who meet certain eligibility requirements. Several statistical and other factors
that attempt to anticipate future events are used in calculating the expense and
liability values related to our post-retirement benefit plans. These factors
include assumptions we make about the discount rate, the rate of increase in
healthcare costs, and mortality, among others.
The discount rate reflects the current rate at which the post
retirement benefit liabilities could be effectively settled considering the
timing of expected payments for plan participants. In estimating this rate, we
consider rates of return on high quality fixed-income investments included in
published bond indexes. We consider the Moody's Aa Corporate Bond Index and the
Citigroup Pension Liability Index in the determination of the appropriate
discount rate assumptions. The weighted average rate we utilized to measure our
post retirement benefit obligation as of December 31, 2005, and calculate our
2006 expense was 5.5 percent, which is a decrease from 5.75 percent used in
determining the 2005 expense.
Recent Developments -- Portfolio Companies
On August 2, 2006, we exercised our warrants to purchase 8,500 shares
of Questech Corporation. The total investment was $12,750.
On August 8, 2006, we made a $102,848 follow-on investment in a
privately held tiny technology portfolio company.
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 our control. Although we believe that
the assumptions underlying the forward-looking statements included herein are
reasonable, any of the assumptions could be inaccurate and therefore there can
be no assurance that the forward-looking statements included or incorporated by
reference herein will prove to be accurate. Therefore, the inclusion of such
information should not be regarded as a representation by us or any other person
that our plans will be achieved.
34
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our business activities contain elements of risk. We consider the
principal types of market risk to be valuation risk and the risk associated with
fluctuations in interest rates. Although we are risk-seeking rather than
risk-averse in our investments, we consider the management of risk to be
essential to our business.
Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the
market price for those securities for which a market quotation is readily
available and (ii) fair value as determined in good faith by, or under the
direction of, the Board of Directors for all other assets. (See the "Valuation
Procedures" in the "Footnote to Consolidated Schedule of Investments" contained
in "Item 1. Consolidated Financial Statements.")
Neither our investments nor an investment in us is intended to
constitute a balanced investment program.
We have invested a substantial portion of our assets in private
development stage or start-up companies. These private businesses tend to be
based on new technology and to be thinly capitalized, unproven, small companies
that lack management depth and have not attained profitability or have no
history of operations. Because of the speculative nature and the lack of a
public market for these investments, there is significantly greater risk of loss
than is the case with traditional investment securities. We expect that some of
our venture capital investments will be a complete loss or will be unprofitable
and that some will appear to be likely to become successful but never realize
their potential. Even when our private equity investments complete initial
public offerings (IPOs), we are normally subject to lock-up agreements for a
period of time, and thereafter, the market for the unseasoned publicly traded
securities may be relatively illiquid.
Because there is typically no public market for the equity interests
of many of the small privately held companies in which we invest, the valuation
of the equity interests in that portion of our portfolio is determined in good
faith by our Board of Directors in accordance with our Valuation Procedures. In
the absence of a readily ascertainable market value, the determined value of our
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 our consolidated statements of
operations as "Net increase (decrease) in unrealized appreciation on
investments."
We also invest in short-term money market instruments, and both short
and long-term U.S. government and agency securities. To the extent that we
invest in short and long-term U.S. government and agency securities, changes in
interest rates may result in changes in the value of these obligations which
would result in an increase or decrease of our net asset value. The level of
interest rate risk exposure at any given point in time depends on the market
environment, the expectations of future price and market movements, and the
quantity and duration of both the short and long-term U.S. government and agency
securities held by the Company, and it will vary from period to period. If the
average interest rate on U. S. government and agency securities at June 30,
2006, were to increase by 25, 75 and 150 basis points, the weighted average
value of these securities held by us at June 30, 2006, would decrease by
approximately $362,122, $1,086,366 and $2,172,733, respectively, and our net
asset value would decrease correspondingly.
35
Most of our investments are denominated in U.S. dollars. We currently
have one investment denominated in Canadian dollars. We are exposed to foreign
currency risk related to potential changes in foreign currency exchange rates.
The potential loss in fair value on this investment resulting from a 10 percent
adverse change in quoted foreign currency exchange rates is $179,372 at June 30,
2006.
In addition, in the future, we may from time to time opt to borrow
money to make investments in the future. Our net investment income will be
dependent upon the difference between the rate at which we borrow funds and the
rate at which we invest such funds. As a result, there can be no assurance that
a significant change in market interest rates will not have a material adverse
effect on our net investment income in the event we choose to borrow funds for
investing purposes.
Item 4. Controls and Procedures
(a) Disclosure Controls and Procedures. As of the end of the period
covered by this report, the Company's management, under the supervision and with
the participation of our chief executive officer and chief financial officer,
conducted an evaluation of the effectiveness of the design and operation of our
disclosure controls and procedures (as required by Rules 13a-15 of the
Securities Exchange Act of 1934 (the "1934 Act")). Disclosure controls and
procedures means controls and other procedures of an issuer that are designed to
ensure that information required to be disclosed by the issuer in the reports
that it files or submits under the 1934 Act is recorded, processed, summarized
and reported, within time periods specified in the SEC's rules and forms, and
that such information is accumulated and communicated to the issuer's
management, as appropriate, to allow timely decisions regarding required
disclosures. As of June 30, 2006, based upon this evaluation of our disclosure
controls and procedures, our chief executive officer and chief financial officer
concluded that our disclosure controls and procedures were effective.
(b) Changes in Internal Control Over Financial Reporting. There have
been no changes in our internal control over financial reporting that occurred
during the second quarter of 2006 to which this report relates that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
36
PART II. OTHER INFORMATION
Item 1A. Risk Factors
Investing in our shares of common stock involves significant risks
relating to our business and investment objective. You should carefully consider
the risks and uncertainties described below and those described in our Annual
Report on Form 10-K for the year ended December 31, 2005, before you purchase
any of our shares of common stock. The risks described below and those described
in our Annual Report on Form 10-K are not the only risks facing our Company.
Additional risks and uncertainties not currently known to us or that we
currently deem immaterial also may materially adversely affect our business,
financial condition and/or operating results.
Investment in foreign securities could result in additional risks.
The Company may invest in foreign securities. Investing in securities
of foreign issuers may subject us to risks not usually associated with owning
securities of U.S. issuers. These risks can include fluctuations in foreign
currencies, foreign currency exchange controls, social, political and economic
instability, differences in securities regulation and trading, expropriation or
nationalization of assets, and foreign taxation issues. In addition, changes in
government administrations or economic or monetary policies in the United States
or abroad could result in appreciation or depreciation of our securities and
could favorably or unfavorably affect our operations. It may also be more
difficult to obtain and enforce a judgment against a foreign issuer. Any foreign
investments made by us must be made in compliance with U.S. and foreign currency
restrictions and tax laws restricting the amounts and types of foreign
investments.
Although most of our investments are denominated in U.S. dollars, our
investments that are denominated in a foreign currency are subject to the risk
that the value of a particular currency may change in relation to the U.S.
dollar, in which we maintain financial statements and valuations. Among the
factors that may affect currency values are trade balances, the level of
short-term interest rates, differences in relative values of similar assets in
different currencies, long-term opportunities for investment and capital
appreciation, and political developments.
Item 6. Exhibits
3.1* Certificate of Amendment of the Certificate of Incorporation of
Harris & Harris Group, Inc.
10* Amendment No. 4 to Deferred Compensation Agreement.
31.1* Certification of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2* Certification of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32* Certification of CEO and CFO pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
*filed herewith
37
SIGNATURES
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 on behalf of the Registrant and as its chief
accounting officer.
Harris & Harris Group, Inc.
/s/ Douglas W. Jamison
----------------------------------
By: Douglas W. Jamison, President
and Chief Financial Officer
/s/ Patricia N. Egan
----------------------------------
By: Patricia N. Egan
Chief Accounting Officer
and Vice President
Date: August 9, 2006
38
EXHIBIT INDEX
Exhibit No. Description
----------- -----------
3.1 Certificate of Amendment of the Certificate of Incorporation of
Harris & Harris Group, Inc.
10 Amendment No. 4 to Deferred Compensation Agreement.
31.1 Certification of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32 Certification of CEO and CFO pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
39