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EX-32 - EXHIBIT 32 - HARRIS & HARRIS GROUP INC /NY/v327768_ex32.htm
EX-31.01 - EXHIBIT 31.01 - HARRIS & HARRIS GROUP INC /NY/v327768_ex31-01.htm
EX-31.02 - EXHIBIT 31.02 - HARRIS & HARRIS GROUP INC /NY/v327768_ex31-02.htm

 

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 the quarterly period ended September 30, 2012

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ____________ to _____________

 

Commission file number: 0-11576

 

HARRIS & HARRIS GROUP, INC.
(Exact Name of Registrant as Specified in Its Charter)

 

New York 13-3119827
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)  
   
1450 Broadway, New York, New York 10018
(Address of Principal Executive Offices) (Zip Code)

 

(212) 582-0900
(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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes     ¨                  No     ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ¨ Accelerated filer x
Non-accelerated filer ¨ Smaller reporting company ¨
(Do not check if a smaller reporting company)  

 

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 November 8, 2012
    Common Stock, $0.01 par value per share   31,000,601 shares

 

 
 

 

Harris & Harris Group, Inc.

Form 10-Q, September 30, 2012

 

  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 37
   
Financial Highlights 58
   
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations 59
   
Background 59
   
Overview 59
   
Investment Objective and Strategy 60
   
Involvement with Portfolio Companies 61
   
Investments and Current Investment Pace 61
   
Our Sources of Liquid Capital 63
   
Potential Pending Liquidity Events from our Portfolio as of September 30, 2012 64
   
Strategy for Managing Publicly Traded Positions 64
   
Maturity of Current Equity-Focused Venture Capital Portfolio 65
   
Portfolio Company Revenue 66
   
Current Business Environment 66
   
Valuation of Investments 67
   
Results of Operations 70
   
Financial Condition 78
   
Liquidity 80
   
Borrowings 81
   
Contractual Obligations 82
   
Critical Accounting Policies 82
   
Recent Developments – Portfolio Companies 85
   
Cautionary Statement Regarding Forward-Looking Statements 86
   
Item 3.  Quantitative and Qualitative Disclosures About Market Risk 88
   
Item 4.  Controls and Procedures 90
   
PART II.  OTHER INFORMATION  
   
Item 1A.  Risk Factors 91
   
Item 6.     Exhibits 91
   
Signatures 92
   
Exhibit Index 93

 

 
 

 

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.® (the "Company," "us," "our" and "we"), is an internally managed venture capital company that has elected to operate as a business development company ("BDC") under the Investment Company Act of 1940 (the "1940 Act"). Certain information and disclosures normally included in the consolidated financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP") have been condensed or omitted as permitted by Regulation S-X and Regulation S-K. Accordingly, they do not include all information and disclosures necessary for a fair presentation of our financial position, results of operations and cash flows in conformity with GAAP. The results of operations for any interim period are not necessarily indicative of the results for the full year. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2011.

 

1
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES

  

   September 30, 2012   December 31, 2011 
   (Unaudited)     
ASSETS          
Investments, in portfolio securities at value:          
Unaffiliated privately held companies (cost: $28,812,415 and $23,794,145, respectively)  $29,279,753   $23,748,247 
Unaffiliated rights to milestone payments (adjusted cost basis: $3,291,750 and $3,291,750, respectively)   3,400,488    3,362,791 
Unaffiliated publicly traded securities (cost: $11,879,859 and $12,743,787, respectively)   24,903,100    29,484,527 
Non-controlled affiliated privately held companies (cost: $51,924,083 and $48,968,029, respectively)   58,722,585    47,601,785 
Non-controlled affiliated publicly traded companies (cost: $2,000,000 and $2,000,000, respectively)   1,314,667    1,973,334 
Controlled affiliated privately held companies (cost: $14,243,460 and $12,518,936, respectively)   6,256,363    6,877,566 
Total, investments in private portfolio companies, rights to milestone payments and public securities at value (cost: $112,151,567 and $103,316,647, respectively)  $123,876,956   $113,048,250 
Investments in U.S. Treasury obligations, at value (cost: $9,999,914 and $0, respectively)   10,000,000    0 
Cash   16,556,886    33,841,394 
Restricted funds (Note 3)   2,010,010    1,512,031 
Funds held in escrow from sales of investments, at value (Note 3)   588,276    1,064,234 
Receivable from portfolio company   49,288    37,331 
Receivable from unsettled trade   64,185    0 
Interest receivable   13,911    14,635 
Prepaid expenses   145,235    398,858 
Other assets   391,966    426,920 
Total assets  $153,696,713   $150,343,653 
           
LIABILITIES & NET ASSETS          
           
Post retirement plan liabilities  $1,818,490   $1,660,958 
Revolving loan (Note 5)   2,000,000    1,500,000 
Accounts payable and accrued liabilities   972,269    906,910 
Deferred rent   377,000    378,980 
Written call options payable (premiums received:          
$1,011,413 and $315,000, respectively) (Note 7)   364,080    195,000 
Debt interest and other payable   4,497    3,398 
Total liabilities   5,536,336    4,645,246 
           
Net assets  $148,160,377   $145,698,407 
           
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 9/30/12 and 12/31/11; 32,829,341 issued at 9/30/12 and 12/31/11   328,294    328,294 
Additional paid in capital (Note 8)   212,927,792    210,470,369 
Accumulated net operating and realized loss   (74,062,986)   (71,546,328)
Accumulated unrealized appreciation of investments   12,372,808    9,851,603 
Treasury stock, at cost (1,828,740 shares at 9/30/12 and 12/31/11)   (3,405,531)   (3,405,531)
           
Net assets  $148,160,377   $145,698,407 
           
Shares outstanding   31,000,601    31,000,601 
Net asset value per outstanding share  $4.78   $4.70 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

2
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

  

   Three Months Ended Sept. 30,   Nine Months Ended Sept. 30, 
   2012   2011   2012   2011 
Investment income:                    
Interest from:                    
Unaffiliated companies  $64,019   $69,569   $185,340   $196,806 
Non-controlled affiliated companies   236,695    30,715    86,319    101,412 
Controlled affiliated companies   44,042    51,844    111,043    127,574 
Cash and U.S. Treasury obligations   5,213    9,490    17,910    31,270 
Miscellaneous income   46,277    40,909    128,078    70,115 
Total investment income   396,246    202,527    528,690    527,177 
                     
Expenses:                    
Salaries, benefits and stock-based compensation (Note 8)   1,200,902    1,490,116    5,148,293    4,073,995 
Administration and operations   212,917    207,491    795,143    683,292 
Professional fees   222,467    413,156    740,106    869,717 
Rent   105,705    99,323    303,402    278,323 
Directors’ fees and expenses   63,015    80,387    240,747    264,559 
Custody fees   13,653    4,380    35,635    52,380 
Depreciation   15,020    12,729    43,618    37,895 
Interest and other debt expense   12,901    13,103    36,741    26,870 
Total expenses   1,846,580    2,320,685    7,343,685    6,287,031 
                     
Net operating loss   (1,450,334)   (2,118,158)   (6,814,995)   (5,759,854)
                     
Net realized gain (loss):                    
Realized gain (loss) from investments:                    
Unaffiliated companies   0    (2,017,949)   476,887    5,310,794 
Non-Controlled affiliated companies   354    (665,269)   11,775    (2,631,859)
Publicly traded companies   2,695,339    0    3,366,218    0 
Written call options   80,573    0    458,911    0 
U.S. Treasury obligations/other   (218)   0    (218)   (82)
Realized gain (loss) from investments   2,776,048    (2,683,218)   4,313,573    2,678,853 
                     
Income tax expense (Note 9)   7,161    1,250    15,236    3,643 
Net realized gain (loss) from investments   2,768,887    (2,684,468)   4,298,337    2,675,210 
                     
Net (decrease) increase in unrealized appreciation on investments:                    
Change as a result of investment sales   (3,616,482)   2,663,050    (4,287,361)   (2,015,594)
Change on investments held   (2,483,303)   (30,945,031)   6,281,233    (7,888,307)
Change on written call options   1,111,515    0    527,333    0 
Net (decrease) increase in unrealized appreciation on investments   (4,988,270)   (28,281,981)   2,521,205    (9,903,901)
                     
Net realized and unrealized (loss) gain on investments   (2,219,383)   (30,966,449)   6,819,542    (7,228,691)
                     
Net (decrease) increase in net assets resulting from operations:                    
                     
Total  $(3,669,717)  $(33,084,607)  $4,547   $(12,988,545)
                     
Per average basic and diluted outstanding share  $(0.12)  $(1.07)  $0.00   $(0.42)
                     
Average outstanding shares - basic   31,000,601    31,000,601    31,000,601    30,973,353 
                     
Average outstanding shares - diluted   31,000,601    31,000,601    31,000,681    30,973,353 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

  

   Nine Months Ended   Nine Months Ended 
   September 30, 2012   September 30, 2011 
       (Corrected) 
Cash flows used in operating activities:          
Net increase (decrease) in net assets resulting from operations  $4,547   $(12,988,545)
Adjustments to reconcile net increase in net assets resulting from operations to net cash (used in) provided by operating activities:          
Net realized (gain) loss and (increase) decrease in          
unrealized appreciation on investments   (6,834,778)   7,225,048 
Depreciation of fixed assets, amortization of premium or          
discount on U.S. government securities, and bridge note interest   (168,346)   (238,886)
Stock-based compensation expense   2,457,423    1,427,321 
Purchase of U.S. government securities   (9,999,356)   (100,032,726)
Sale of U.S. government securities   0    125,682,274 
Purchase of affiliated portfolio companies   (8,242,326)   (12,465,603)
Purchase of unaffiliated portfolio companies   (1,575,514)   (3,732,015)
Principal payments received on debt investments   331,264    1,523,736 
Proceeds from sale of investments   5,062,210    12,804,733 
Proceeds from call option premiums   2,654,935    0 
Payments for call option purchases   (1,367,364)   0 
           
Changes in assets and liabilities:          
Restricted funds   (497,979)   (1,262,025)
Receivable from portfolio company   (11,957)   (4,500)
Receivable from unsettled trades   (64,185)   0 
Interest receivable   165    24,402 
Income tax receivable   7,161    1,185 
Prepaid expenses   253,623    252,393 
Other assets   (525)   8,366 
Post retirement plan liabilities   157,532    89,733 
Accounts payable and accrued liabilities   66,458    491,235 
Deferred rent   (1,980)   2,772 
           
Net cash (used in) provided by operating activities   (17,768,992)   18,808,898 
           
Cash flows from investing activities:          
Purchase of fixed assets   (15,516)   (4,071)
Net cash used in investing activities   (15,516)   (4,071)
           
Cash flows from financing activities:          
Proceeds from stock option exercises   0    491,058 
Proceeds from drawdown of credit facility   500,000    1,250,000 
           
Net cash provided by financing activities   500,000    1,741,058 
           
Net increase (decrease) in cash:          
Cash at beginning of the period   33,841,394    3,756,919 
Cash at end of the period   16,556,886    24,302,804 
           
Net (decrease) increase in cash  $(17,284,508)  $20,545,885 
           
Supplemental disclosures of cash flow information:          
Income taxes paid  $8,075   $2,458 
Interest paid  $21,158   $14,303 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

4
 

  

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS

 

   Nine Months Ended   Year Ended 
   September 30, 2012   December 31, 2011 
   (Unaudited)     
         
Changes in net assets from operations:          
           
Net operating loss  $(6,814,995)  $(8,338,365)
Net realized gain on investments   4,298,337    2,449,705 
Net (decrease) increase in unrealized appreciation on investments as a result of sales   (4,287,361)   74,649 
Net increase in unrealized appreciation on investments held   6,281,233    2,152,648 
Net increase in unrealized appreciation on written call options   527,333    120,000 
           
Net increase (decrease) in net assets resulting from operations   4,547    (3,541,363)
           
Changes in net assets from capital stock transactions:          
           
Issuance of common stock upon the exercise of stock options   0    1,224 
Additional paid in capital on common stock issued net of offering expenses   0    489,834 
Stock-based compensation expense   2,457,423    1,894,800 
           
Net increase in net assets resulting from capital stock transactions   2,457,423    2,385,858 
           
Net increase (decrease) in net assets   2,461,970    (1,155,505)
           
Net Assets:          
           
Beginning of the period   145,698,407    146,853,912 
           
End of the period  $148,160,377   $145,698,407 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

5
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

  

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Unaffiliated Companies (3) – 38.9% of net assets at value               
                          
Private Placement Portfolio (Illiquid) (4) – 19.8% of net assets at value                         
                          
Bridgelux, Inc. (7)(8)        Energy                
Manufacturing high-power light emitting diodes (LEDs) and arrays                         
Series B Convertible Preferred Stock   (M)        $1,000,000    1,861,504   $1,244,490 
Series C Convertible Preferred Stock   (M)         1,352,196    2,130,699    1,776,485 
Series D Convertible Preferred Stock   (M)         1,371,622    999,999    1,570,301 
Series E Convertible Preferred Stock   (M)         672,599    440,334    858,734 
Series E-1 Convertible Preferred Stock   (M)         534,482    399,579    584,309 
Warrants for Series C Convertible Preferred Stock expiring 12/31/14   ( I )         168,270    163,900    48,013 
Warrants for Series D Convertible Preferred Stock expiring 8/26/14   ( I )         88,531    124,999    61,111 
Warrants for Series D Convertible Preferred Stock expiring 3/10/15   ( I )         40,012    41,666    20,370 
Warrants for Series E Convertible Preferred Stock expiring 12/31/17   ( I )         93,969    170,823    101,019 
Warrants for Common Stock expiring 6/1/16   ( I )         72,668    132,100    9 
Warrant for Common Stock expiring 10/21/18   ( I )         18,816    84,846    6 
              5,413,165         6,264,847 
                          
Cambrios Technologies Corporation (7)(9)(10)        Electronics                
Developing nanowire-enabled electronic materials for the display industry                         
Series B Convertible Preferred Stock   (M)         1,294,025    1,294,025    1,165,383 
Series C Convertible Preferred Stock   (M)         1,300,000    1,300,000    1,170,764 
Series D Convertible Preferred Stock   (M)         515,756    515,756    773,634 
Series D-2 Convertible Preferred Stock   (M)         92,400    92,400    92,400 
Series D-4 Convertible Preferred Stock   (M)         216,168    216,168    216,168 
              3,418,349         3,418,349 
                          
Cobalt Technologies, Inc. (7)(9)(11)        Energy                
Developing processes for making bio- butanol through biomass fermentation                         
Series C-1 Convertible Preferred Stock   (M)         749,998    352,112    930,400 
Series D-1 Convertible Preferred Stock   (M)         122,070    48,828    140,109 
Secured Convertible Bridge Note, 10%, acquired 5/25/12   (M)         46,691   $45,097    46,691 
              918,759         1,117,200 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

6
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Unaffiliated Companies (3) – 38.9% of net assets at value (Cont.)                   
                          
Private Placement Portfolio (Illiquid) (4) – 19.8% of net assets at value (Cont.)                    
                          
Ensemble Therapeutics Corporation (7)(9)(12)        Healthcare                
Developing DNA-Programmed ChemistryTM for the discovery of new classes of therapeutics                         
Series B Convertible Preferred Stock   (M)        $2,000,000    1,449,275   $0 
Secured Convertible Bridge Note, 8%, acquired 9/11/08   (M)         331,505   $250,211    1,563,296 
Secured Convertible Bridge Note, 8%, acquired 12/10/09   (M)         59,872   $48,868    300,451 
Secured Convertible Bridge Note, 8%, acquired 1/25/12   (M)         115,428   $109,400    654,006 
              2,506,805         2,517,753 
                          
GEO Semiconductor Inc. (13)        Electronics                
Developing programmable, high-performance video and geometry processing solutions                          
Participation Agreement with Montage Capital relating to the following assets:                         
Senior secured debt, 13.75%, maturing on 11/30/12   ( I )         314,769   $406,851    388,220 
Warrants for Series A Pref. Stock expiring on 9/17/17   ( I )         66,684    100,000    69,540 
Warrants for Series A-1 Pref. Stock expiring on 6/30/18   ( I )         23,566    34,500    24,417 
Loan and Security Agreement with GEO Semiconductor relating to the following assets:                         
Subordinated secured debt, 15.75%, maturing on 11/30/12   ( I )         108,587   $125,000    123,420 
Warrants for Series A Pref. Stock expiring on 3/1/18   ( I )         7,512    10,000    6,501 
Warrants for Series A-1 Pref. Stock expiring on 6/29/18   ( I )         7,546    10,000    6,523 
              528,664         618,621 
                          
Mersana Therapeutics, Inc. (7)(9)(14)        Healthcare                
Developing treatments for cancer based on novel drug delivery polymers                         
Series A-1 Convertible Preferred Stock   (M)         316,453    294,019    316,453 
Common Stock   (M)         3,875,395    350,539    172,816 
              4,191,848         489,269 
                          
Molecular Imprints, Inc. (7)(15)        Electronics                
Manufacturing nanoimprint lithography capital equipment                         
Series B Convertible Preferred Stock   (M)         2,000,000    1,333,333    1,789,108 
Series C Convertible Preferred Stock   (M)         2,406,595    1,285,071    2,138,498 
Non-Convertible Bridge Note   ( I )         0   $0    3,033,338 
              4,406,595         6,960,944 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

7
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Unaffiliated Companies (3) – 38.9% of net assets at value (Cont.)                    
                          
Private Placement Portfolio (Illiquid) (4) – 19.8% of net assets at value (Cont.)                    
                          
Nanosys, Inc. (7)        Energy                
Developing inorganic nanowires and quantum dots for use in batteries and LED-backlit devices                         
Series C Convertible Preferred Stock   (M)        $1,500,000    803,428   $143,903 
Series D Convertible Preferred Stock   (M)         3,000,003    1,016,950    2,812,469 
Series E Convertible Preferred Stock   (M)         496,573    433,688    698,298 
Unsecured Convertible Bridge Note, 4%, acquired 7/16/12   (M)         44,191   $43,821    248,890 
              5,040,767         3,903,560 
                          
NanoTerra, Inc. (9)        Energy                
Developing surface chemistry and nano- manufacturing solutions                         
Senior secured debt, 12.0%, maturing on 2/22/14   ( I )         201,796   $258,445    254,360 
Senior secured debt, 12.0%, maturing on 2/22/13   ( I )         44,597   $57,117    56,922 
Warrants for Series A-2 Pref. Stock expiring on 2/22/21   ( I )         69,168    446,248    66,390 
              315,561         377,672 
                          
Nantero, Inc. (7)(9)(10)        Electronics                
Developing a high-density, nonvolatile, random access memory chip, enabled by carbon nanotubes                         
Series A Convertible Preferred Stock   (M)         489,999    345,070    1,349,224 
Series B Convertible Preferred Stock   (M)         323,000    207,051    809,569 
Series C Convertible Preferred Stock   (M)         571,329    188,315    736,312 
              1,384,328         2,895,105 
                          
OHSO Clean, Inc. (16)(17)        Healthcare                
Developing natural, hypoallergenic household cleaning products enabled by nanotechnology- enabled formulations of thyme oil                          
Participation Agreement with Montage Capital relating to the following assets:                         
Senior secured debt, 13.00%, maturing on 9/30/14   ( I )         595,832   $697,920    625,800 
Warrants for Series C Pref. Stock expiring on 3/30/22   ( I )         91,742    1,109,333    90,633 
              687,574         716,433 
                          
Total Unaffiliated Private Placement Portfolio (cost: $28,812,415)                      $29,279,753 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

8
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Rights to Milestone Payments (Illiquid) (5) – 2.3% of net assets at value                    
                          
Amgen, Inc. (7)(10)        Healthcare                
Rights to Milestone Payments from Acquisition of BioVex Group, Inc.   ( I )        $3,291,750   $3,291,750   $3,400,488 
                          
Total Unaffiliated Rights to Milestone Payments (cost: $3,291,750)                      $3,400,488 
                          
Publicly Traded Portfolio (6) – 16.8% of net assets at value                         
                          
NeoPhotonics Corporation (10)(18)        Electronics                
Developing and manufacturing optical devices and components                         
Common Stock   (M)        $7,299,590    450,907   $2,633,297 
                          
Solazyme, Inc. (10)(19)        Energy                
Developing algal biodiesel, industrial chemicals and specialty ingredients using synthetic biology                         
Common Stock   (M)         4,580,269    1,938,190    22,269,803 
                          
Total Unaffiliated Publicly Traded Portfolio (cost: $11,879,859)                      $24,903,100 
                          
Total Investments in Unaffiliated Companies (cost: $43,984,024)                      $57,583,341 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

9
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Non-Controlled Affiliated Companies (3) – 40.5% of net assets at value                    
                          
Private Placement Portfolio (Illiquid) (20) – 39.6% of net assets at value                    
                          
ABSMaterials, Inc. (7)(9)(10)        Energy                
Developing nano-structured absorbent materials for environmental remediation                         
Series A Convertible Preferred Stock   (M)        $435,000    390,000   $1,170,000 
                          
Adesto Technologies Corporation (7)(9)(10)        Electronics                
Developing low-power, high-performance memory devices                         
Series A Convertible Preferred Stock   (M)         2,200,000    6,547,619    6,220,239 
Series B Convertible Preferred Stock   (M)         2,200,000    5,952,381    5,654,762 
Series C Convertible Preferred Stock   (M)         1,485,531    2,122,187    2,016,078 
Series D Convertible Preferred Stock   (M)         1,393,147    1,466,470    1,393,147 
              7,278,678         15,284,226 
                          
Contour Energy Systems, Inc. (7)(9)(10)        Energy                
Developing batteries using nanostructured materials                         
Series A Convertible Preferred Stock   (M)         2,009,995    2,565,798    1,806,192 
Series B Convertible Preferred Stock   (M)         1,300,000    812,500    981,004 
Series C Convertible Preferred Stock   (M)         1,200,000    1,148,325    1,050,000 
              4,509,995         3,837,196 
                          
D-Wave Systems, Inc. (7)(9)(21)        Electronics                
Developing high-performance quantum computing systems                         
Series 1 Class B Convertible Preferred Stock   (M)         1,002,074    1,144,869    1,513,173 
Series 1 Class C Convertible Preferred Stock   (M)         487,804    450,450    595,360 
Series 1 Class D Convertible Preferred Stock   (M)         748,473    855,131    1,130,227 
Series 1 Class E Convertible Preferred Stock   (M)         248,049    269,280    355,907 
Series 1 Class F Convertible Preferred Stock   (M)         238,323    258,721    341,952 
Series 2 Class D Convertible Preferred Stock   (M)         736,019    678,264    896,462 
Series 2 Class E Convertible Preferred Stock   (M)         409,032    317,746    419,965 
Series 2 Class F Convertible Preferred Stock   (M)         392,993    305,286    403,496 
Warrants for Common Stock expiring 6/30/15   ( I )         98,644    153,890    53,058 
              4,361,411         5,709,600 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

10
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Non-Controlled Affiliated Companies (3) – 40.5% of net assets at value (Cont.)                    
                          
Private Placement Portfolio (Illiquid) (20) – 39.6% of net assets at value (Cont.)                   
                          
Enumeral Biomedical Corp. (7)(9)(10)        Healthcare                
Developing therapeutics and diagnostics through functional assaying of single cells                         
Series A Convertible Preferred Stock   (M)        $1,026,832    957,038   $1,325,507 
Series A-1 Convertible Preferred Stock   (M)         750,000    576,923    750,000 
              1,776,832         2,075,507 
                          
HzO, Inc. (7)(9)(10)        Electronics                
Developing novel industrial coatings that protect electronics against damage from liquids                         
Series A Convertible Preferred Stock   (M)         666,667    4,057,294    1,130,362 
Series B Convertible Preferred Stock   (M)         1,000,000    3,947,888    1,099,882 
              1,666,667         2,230,244 
                          
Kovio, Inc. (7)(9)(10)        Electronics                
Developing semiconductor products using printed electronics and thin-film technologies                         
Series A' Convertible Preferred Stock   (M)         5,242,993    2,160,000    1,437,286 
Series B' Convertible Preferred Stock   (M)         2,006,540    3,015,493    2,006,540 
              7,249,533         3,443,826 
                          
Metabolon, Inc. (7)(10)        Healthcare                
Developing service and diagnostic products through the use of a metabolomics, or biochemical, profiling platform                         
Series B Convertible Preferred Stock   (M)         2,500,000    371,739    1,951,723 
Series B-1 Convertible Preferred Stock   (M)         706,214    148,696    780,689 
Series C Convertible Preferred Stock   (M)         1,000,000    1,000,000    1,794,510 
Series D Convertible Preferred Stock   (M)         1,499,999    835,882    1,499,999 
Warrants for Series B-1 Convertible Preferred                         
Stock expiring 3/25/15   ( I )         293,786    74,348    54,886 
              5,999,999         6,081,807 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

11
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

  

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Non-Controlled Affiliated Companies (3) – 40.5% of net assets at value (Cont.)                    
                          
Private Placement Portfolio (Illiquid) (20) – 39.6% of net assets at value (Cont.)                    
                          
Nextreme Thermal Solutions, Inc. (7)(9)(10)        Energy                
Developing thin-film thermoelectric devices for cooling and energy conversion                         
Common Stock   (M)        $4,384,762    8,080,153   $0 
                          
OpGen, Inc. (7)(10)(16)        Healthcare                
Developing tools for genomic sequence assembly and analysis                         
Series C Convertible Preferred Stock   (M)         815,000    5,905,797    815,000 
                          
Produced Water Absorbents, Inc. (7)(9)(10)        Energy                
Developing nano-stuctured absorbent materials for environmental remediation of contaminated water in the oil and gas industries                         
Series A Convertible Preferred Stock   (M)         1,000,000    1,000,000    1,000,000 
                          
Senova Systems, Inc. (7)(9)(10)        Healthcare                
Developing next-generation sensors to measure pH                         
Series B Convertible Preferred Stock   (M)         1,218,462    1,350,000    810,000 
Warrants for Series B Preferred Stock expiring 7/18/17   ( I )         131,538    164,423    98,637 
              1,350,000         908,637 
                          
SiOnyx, Inc. (7)(9)(10)        Electronics                
Developing silicon-based optoelectronic products enabled by its proprietary Black Silicon                         
Series A Convertible Preferred Stock   (M)         750,000    233,499    160,367 
Series A-1 Convertible Preferred Stock   (M)         890,000    2,966,667    2,037,507 
Series A-2 Convertible Preferred Stock   (M)         2,445,000    4,207,537    2,889,736 
Series B-1 Convertible Preferred Stock   (M)         1,169,561    1,892,836    1,300,000 
Series C Convertible Preferred Stock   (M)         1,171,316    1,674,030    1,255,523 
Warrants for Series B-1 Convertible Preferred                         
Stock expiring 2/23/17   ( I )         130,439    247,350    60,688 
Warrants for Common Stock expiring 3/28/17   ( I )         84,207    418,507    38,872 
              6,640,523         7,742,693 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

12
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

  

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Non-Controlled Affiliated Companies (3) – 40.5% of net assets at value (Cont.)                    
                          
Private Placement Portfolio (Illiquid) (20) – 39.6% of net assets at value (Cont.)                    
                          
Ultora, Inc. (7)(9)        Energy                
Developing energy-storage devices enabled by carbon nanotubes                         
Series A Convertible Preferred Stock   (M)        $282,821    282,821   $282,821 
Secured Convertible Bridge Note, 3%, acquired 7/12/12   (M)         65,082   $64,652    65,082 
Secured Convertible Bridge Note, 3%, acquired 9/28/12   (M)         107,780   $107,753    107,780 
              455,683         455,683 
                          
Xradia, Inc. (7)(10)        Electronics                
Designing, manufacturing and selling ultra- high resolution 3D x-ray microscopes and fluorescence imaging systems                         
Series D Convertible Preferred Stock   (M)         4,000,000    3,121,099    7,968,166 
                          
Total Non-Controlled Private Placement Portfolio (cost: $51,924,083)                      $58,722,585 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

13
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Non-Controlled Affiliated Companies (3) – 40.5% of net assets at value (Cont.)                    
                          
Publicly Traded Portfolio (Illiquid) (22) – 0.09% of net assets at value                    
                          
Champions Oncology, Inc. (10)        Healthcare                
Developing its TumorGraftTM platform for personalized medicine and drug development                         
Common Stock   (M)        $2,000,000    2,666,667   $1,314,667 
                          
Total Non-Controlled Affiliated Publicly Traded Portfolio (cost: $2,000,000)                      $1,314,667 
                          
Total Investments in Non-Controlled Affiliated Companies (cost: $53,924,083)                      $60,037,252 
                          
                          
Investments in Controlled Affiliated Companies (3)(23) – 4.2% of net assets at value                         
                          
Private Placement Portfolio (Illiquid) – 4.2% of net assets at value                         
                          
Ancora Pharmaceuticals Inc. (7)(9)        Healthcare                
Developing synthetic carbohydrates for pharmaceutical applications                         
Common Stock   (M)        $2,729,817    57,463   $1,724 
Series A' Convertible Preferred Stock   (M)         4,855,627    4,855,627    3,641,720 
Senior Secured Debt, 12.00%, maturing on 12/11/12   ( I )         486,635   $500,000    467,200 
              8,072,079         4,110,644 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

14
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of           Shares/     
     Valuation (1)     Industry (2)   Cost   Principal   Value 
                     
Investments in Controlled Affiliated Companies (3)(23) – 4.2% of net assets at value (Cont.)                    
                          
Private Placement Portfolio (Illiquid) – 4.2% of net assets at value (Cont.)                    
                          
Laser Light Engines, Inc. (7)(9)        Energy                
Manufacturing solid-state light sources for digital cinema and large-venue projection displays                         
Series A Convertible Preferred Stock   (M)        $2,000,000    7,499,062   $0 
Series B Convertible Preferred Stock   (M)         3,095,802    13,571,848    1,070,140 
Secured Convertible Bridge Note, 12%, acquired 10/7/11   (M)         223,671   $200,000    223,671 
Secured Convertible Bridge Note, 12%, acquired 11/17/11   (M)         105,684   $95,652    105,684 
Secured Convertible Bridge Note, 12%, acquired 12/21/11   (M)         90,349   $82,609    90,349 
Secured Convertible Bridge Note, 12%, acquired 3/5/12   (M)         464,802   $434,784    464,802 
Secured Convertible Bridge Note, 12%, acquired 7/26/12   (M)         191,073   $186,955    191,073 
              6,171,381         2,145,719 
                          
Total Controlled Private Placement Portfolio (cost: $14,243,460)                      $6,256,363 
                          
Total Investments in Controlled Affiliated Companies (cost: $14,243,460)                      $6,256,363 
                          
Total Private Placement and Publicly Traded Portfolio (cost: $112,151,567)                      $123,876,956 

 

     Method of       Shares/     
     Valuation (1)   Cost   Principal   Value 
                 
U.S. Government Securities (24) – 6.7% of net assets at value                
                     
U.S. Treasury Bill — due date 10/04/12   (M)   $9,999,914   $10,000,000   $10,000,000 
                     
Total Investments in U.S. Government Securities (cost: $9,999,914)                 $10,000,000 
                     
Total Investments (cost: $122,151,481)                 $133,876,956 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

15
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

     Method of   Number of     
     Valuation (1)   Contracts   Value 
Written Call Options (16)(25) – (0.25)% of net assets at value               
                
Solazyme, Inc. — Strike Price $12.50, October 20, 2012   (M)    32   $(320)
                
Solazyme, Inc. — Strike Price $15.00, October 20, 2012   (M)    1,000    (9,000)
                
Solazyme, Inc. — Strike Price $10.00, December 22, 2012   (M)    74    (12,210)
                
Solazyme, Inc. — Strike Price $12.50, December 22, 2012   (M)    4,000    (260,000)
                
Solazyme, Inc. — Strike Price $15.00, December 22, 2012   (M)    2,750    (13,750)
                
Solazyme, Inc. — Strike Price $17.50, December 22, 2012   (M)    2,000    (10,000)
                
Solazyme, Inc. — Strike Price $17.50, March 8, 2013   (M)    4,010    (53,800)
                
NeoPhotonics Corporation — Strike Price $7.50, February 16, 2013   (M)    500    (5,000)
                
Total Written Call Options (Premiums Received $1,011,413)            $(364,080)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

16
 

  

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

Notes to Consolidated Schedule of Investments

 

(1)See "Footnote to Consolidated Schedule of Investments" on page 33 for a description of the "Valuation Procedures."

 

(2)We classify "Energy" companies as those that seek to improve performance, productivity or efficiency, and to reduce environmental impact, waste, cost, energy consumption or raw materials using nanotechnology-enabled solutions. We classify "Electronics" companies as those that use nanotechnology to address problems in electronics-related industries, including semiconductors. We classify "Healthcare" companies as those that use nanotechnology to address problems in healthcare-related industries, including biotechnology, pharmaceuticals and medical devices.

 

(3)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 but do not control the company. Investments in controlled affiliated companies consist of investments in which we own 25 percent or more of the voting shares of the portfolio company or otherwise control the company.

 

(4)The aggregate cost for federal income tax purposes of investments in unaffiliated privately held companies is $28,812,415. The gross unrealized appreciation based on the tax cost for these securities is $5,307,124. The gross unrealized depreciation based on the tax cost for these securities is $4,839,786.

 

(5)The aggregate cost for federal income tax purposes of investments in unaffiliated rights to milestone payments is $3,291,750. The gross unrealized appreciation based on the tax cost for these securities is $108,738. The gross unrealized depreciation based on the tax cost for these securities is $0.

 

(6)The aggregate cost for federal income tax purposes of investments in unaffiliated publicly traded companies is $11,879,859. The gross unrealized appreciation based on the tax cost for these securities is $17,689,534. The gross unrealized depreciation based on the tax cost for these securities is $4,666,293.

 

(7)We are subject to legal restrictions on the sale of our investment(s) in this company.

 

(8)With the conversion of our bridge note into shares of Series E-1 Preferred Stock, we received a warrant to purchase shares of common stock at $0.25 per share. The number of shares is determined by certain financial targets for 2012 set upon receipt of the audited financial statements for 2012. Should the company complete a sale or an IPO prior to the end of 2012, the warrant will become void.

 

(9)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.

 

The accompanying notes are an integral part of this consolidated schedule.

 

17
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

(10)Represents a non-income producing security. Investments that have not paid dividends or interest within the last 12 months are considered to be non-income producing.

 

(11)Cobalt Technologies, Inc., also does business as Cobalt Biofuels.

 

(12)With our investment in a convertible bridge note issued by Ensemble Therapeutics Corporation, we received a warrant to purchase a number of shares of the class of stock sold in the next financing of Ensemble Therapeutics Corporation equal to $149,540 divided by the price per share of the class of stock sold in the next financing of Ensemble Therapeutics Corporation. The ability to exercise this warrant is, therefore, contingent on Ensemble Therapeutics Corporation completing successfully a subsequent round of financing. This warrant shall expire and no longer be exercisable on September 10, 2015. The cost basis of this warrant is $89.86.

 

(13)The maturity dates of the senior secured debt and the subordinated secured debt are expected to be extended to the end of 2012 or 2013. As such, the notes were not repaid on September 28, 2012.

 

(14)With our investment in the Mersana Therapeutics, Inc., Series A-1 financing, we received a warrant to purchase 277,760 shares of Series A-2 Convertible Preferred Stock. The purchase price and exercise dates of the warrant are contingent upon Mersana's achievement of certain milestones. The warrant will expire on July 27, 2022.

 

(15)As part of a loan the Company made to Molecular Imprints in the second quarter of 2011, we received a liquidation preference payable upon a sale of the company equal to three times the principal of the loan, or $4,044,450. This preference is senior to the preferences of the outstanding preferred stock. While the loan has since been repaid, this liquidation preference remains outstanding as of September 30, 2012.

 

(16)Initial investment was made during 2012.

 

(17)OHSO Clean, Inc. also does business as CleanWell Company.

 

(18)A portion of this security is held in connection with written call option contracts: 50,000 shares have been pledged to brokers.

 

(19)A portion of this security is held in connection with written call option contracts: 1,386,600 shares have been pledged to brokers.

 

(20)The aggregate cost for federal income tax purposes of investments in non-controlled affiliated companies is $51,924,083. The gross unrealized appreciation based on the tax cost for these securities is $16,103,134. The gross unrealized depreciation based on the tax cost for these securities is $9,304,632.

 

(21)D-Wave Systems, Inc., is located and is doing business primarily in Canada. We invested in D-Wave Systems, Inc., through Parallel Universes, Inc., a Delaware company. Our investment is denominated in Canadian dollars and is subject to foreign currency translation. See "Note 3. Summary of Significant Accounting Policies."

 

The accompanying notes are an integral part of this consolidated schedule.

 

18
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF SEPTEMBER 30, 2012

(Unaudited)

 

(22)The aggregate cost for federal income tax purposes of investments in non-controlled affiliated publicly traded companies is $2,000,000. 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 $685,333.

 

(23)The aggregate cost for federal income tax purposes of investments in controlled affiliated companies is $14,243,460. 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 $7,987,097.

 

(24)The aggregate cost for federal income tax purposes of our U.S. government securities is $9,999,914. The gross unrealized appreciation on the tax cost for these securities is $86. The gross unrealized depreciation on the tax cost of these securities is $0.

 

(25)The call options with expiration dates of October 20, 2012, expired, and we retained the shares originally covered by these contracts.

 

The accompanying notes are an integral part of this consolidated schedule.

 

19
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of           Shares/     
   Valuation (1)   Industry (2)   Cost   Principal   Value 
Investments in Unaffiliated Companies (3)(4)(5)(6) – 38.8% of net assets at value                         
                          
Private Placement Portfolio (Illiquid) –  16.3% of net assets at value                         
                          
Bridgelux, Inc. (7)(8)       Energy                
Manufacturing high-power light emitting diodes (LEDs) and arrays                         
Series B Convertible Preferred Stock  (M)        $1,000,000    1,861,504   $2,245,039 
Series C Convertible Preferred Stock  (M)         1,352,196    2,130,699    2,757,625 
Series D Convertible Preferred Stock  (M)         1,371,622    999,999    1,687,433 
Series E Convertible Preferred Stock  (M)         730,369    440,334    832,335 
Warrants for Series C Convertible Preferred Stock expiring 12/31/14  ( I )         168,270    163,900    123,541 
Warrants for Series D Convertible Preferred Stock expiring 8/26/14  ( I )         88,531    124,999    93,385 
Warrants for Series D Convertible Preferred Stock expiring 3/10/15  ( I )         40,012    41,666    31,128 
Warrants for Series E Convertible Preferred Stock expiring 12/31/17  ( I )         108,867    170,823    130,872 
Secured Convertible Bridge Note (including interest)  (M)         529,697   $538,945    548,513 
Warrant for Common Stock expiring 10/21/18  ( I )         18,816    56,564    2,581 
             5,408,380         8,452,452 
                         
Cambrios Technologies Corporation (7)(9)      Electronics                
Developing nanowire-enabled electronic materials for the display industry                        
Series B Convertible Preferred Stock  (M)         1,294,025    1,294,025    720,672 
Series C Convertible Preferred Stock  (M)         1,300,000    1,300,000    724,000 
Series D Convertible Preferred Stock  (M)         515,756    515,756    870,338 
Series D-2 Convertible Preferred Stock  (M)         92,400    92,400    86,625 
             3,202,181         2,401,635 
                         
Cobalt Technologies, Inc. (7)(9)(10)      Energy                
Developing processes for making bio- butanol through biomass fermentation                        
Series C-1 Convertible Preferred Stock  (M)         749,998    352,112    216,651 
Series D-1 Convertible Preferred Stock  (M)         122,070    48,828    33,937 
             872,068         250,588 
                         
Ensemble Therapeutics Corporation (7)(9)(11)      Healthcare                
Developing DNA- Programmed ChemistryTM for the discovery of new classes of therapeutics                        
Series B Convertible Preferred Stock  (M)         2,000,000    1,449,275    0 
Secured Convertible Bridge Notes (including interest)  (M)         373,439   $299,169    1,298,436 
              2,373,439         1,298,436 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

20
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of           Shares/     
   Valuation (1)   Industry (2)   Cost   Principal   Value 
Investments in Unaffiliated Companies (3)(4)(5)(6) –  38.8% of net assets at value (Cont.)                         
                          
Private Placement Portfolio (Illiquid) –  16.3% of net assets at value (Cont.)                         
                          
GEO Semiconductor Inc.       Electronics                
Developing programmable, high-performance video and geometry processing solutions                          
Participation Agreement with Montage Capital relating to the following assets:                         
Senior secured debt, 13.75%, maturing on 6/30/12  ( I )        $403,732   $500,000   $476,700 
Warrants for Series A Pref. Stock expiring on 9/17/17  ( I )         66,684    100,000    61,814 
Warrants for Series A-1 Pref. Stock expiring on 6/30/18  ( I )         23,566    34,500    21,686 
Loan and Security Agreement with GEO Semiconductor relating to the following assets:                        
Subordinated secured debt, 15.75%, maturing on 1/1/12  ( I )         109,942   $125,000    121,880 
Warrants for Series A Pref. Stock expiring on 3/1/18  ( I )         7,512    10,000    5,819 
Warrants for Series A-1 Pref. Stock expiring on 6/29/18  ( I )         7,546    10,000    5,836 
             618,982         693,735 
                         
Molecular Imprints, Inc. (7)(12)      Electronics                
Manufacturing nanoimprint lithography capital equipment                        
Series B Convertible Preferred Stock  (M)         2,000,000    1,333,333    1,789,108 
Series C Convertible Preferred Stock  (M)         2,406,595    1,285,071    2,138,498 
Non-Convertible Bridge Note  ( I )         0    0    3,033,338 
             4,406,595         6,960,944 
                         
Nanosys, Inc. (7)(13)      Energy                
Developing inorganic nanowires and quantum dots for use in batteries and LED-backlit devices                        
Series C Convertible Preferred Stock  (M)         1,500,000    803,428    255,503 
Series D Convertible Preferred Stock  (M)         3,000,003    1,016,950    698,410 
Series E Convertible Preferred Stock  (M)         496,573    433,688    496,573 
             4,996,576         1,450,486 
                         
NanoTerra, Inc. (9)(14)      Energy                
Developing surface chemistry and nano- manufacturing solutions                        
Senior secured debt, 12.0%, maturing on 2/22/14  ( I )         329,307   $378,564    342,650 
Senior secured debt, 12.0%, maturing on 2/22/13  ( I )         133,121   $153,032    144,855 
Warrants for Series A-2 Pref. Stock expiring on 2/22/21  ( I )         69,168    446,248    67,659 
              531,596         555,164 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

21
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of           Shares/     
   Valuation (1)   Industry (2)   Cost   Principal   Value 
Investments in Unaffiliated Companies (3)(4)(5)(6) –  38.8% of net assets at value (Cont.)                         
                          
Private Placement Portfolio (Illiquid) –  16.3% of net assets at value (Cont.)                         
                          
Nantero, Inc. (7)(9)(13)       Electronics                
Developing a high-density, nonvolatile, random access memory chip, enabled by carbon nanotubes                         
Series A Convertible Preferred Stock  (M)        $489,999    345,070   $746,548 
Series B Convertible Preferred Stock  (M)         323,000    207,051    451,499 
Series C Convertible Preferred Stock  (M)         571,329    188,315    486,760 
              1,384,328         1,684,807 
                          
Total Unaffiliated Private Placement Portfolio (cost: $23,794,145)                      $23,748,247 
                          
Rights to Milestone Payments (Illiquid) –  2.3% of net assets at value                         
                          
Amgen, Inc. (7)(13)       Healthcare                
Rights to Milestone Payments from  Acquisition of BioVex Group, Inc.  ( I )        $3,291,750   $3,291,750   $3,362,791 
                          
Total Unaffiliated Rights to Milestone Payments (cost: $3,291,750)                      $3,362,791 
                          
Publicly Traded Portfolio  –  20.2% of net assets at value                         
                          
NeoPhotonics Corporation (13)       Electronics                
Developing and manufacturing optical devices and components                        
Common Stock  (M)        $7,299,590    450,907   $2,065,154 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

22
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of         Shares/     
   Valuation (1)  Industry (2)  Cost   Principal   Value 
                   
Solazyme, Inc. (13)(15)(16)     Energy               
Developing algal biodiesel, industrial chemicals and specialty ingredients using  synthetic biology                     
Common Stock  (M)     $5,444,197    2,304,149   $27,419,373 
                      
Total Unaffiliated Publicly Traded Portfolio (cost: $12,743,787)                  $29,484,527 
                      
Total Investments in Unaffiliated Companies (cost: $39,829,682)                  $56,595,565 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

23
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of         Shares/     
   Valuation (1)  Industry (2)  Cost   Principal   Value 
Investments in Non-Controlled  Affiliated Companies (3)(17)(18) – 34.1% of net assets at value                     
                      
Private Placement Portfolio (Illiquid) –  32.7% of net assets at value                     
                      
ABSMaterials, Inc. (7)(9)(13)     Energy               
Developing nano-structured absorbent materials for environmental remediation                     
Series A Convertible Preferred Stock  (M)     $435,000    390,000   $1,560,000 
                      
Adesto Technologies Corporation (7)(9)     Electronics               
Developing low-power, high- performance memory devices                     
Series A Convertible Preferred Stock  (M)      2,200,000    6,547,619    3,328,635 
Series B Convertible Preferred Stock  (M)      2,200,000    5,952,381    3,076,031 
Series C Convertible Preferred Stock  (M)      1,485,531    2,122,187    1,271,982 
          5,885,531         7,676,648 
                      
Contour Energy Systems, Inc. (7)(9)(13)     Energy               
Developing batteries using nanostructured materials                     
Series A Convertible Preferred Stock  (M)      2,009,995    2,565,798    2,520,935 
Series B Convertible Preferred Stock  (M)      1,300,000    812,500    1,348,249 
Series C Convertible Preferred Stock  (M)      720,000    688,995    767,076 
          4,029,995         4,636,260 
                      
D-Wave Systems, Inc. (7)(9)(19)     Electronics               
Developing high- performance quantum computing systems                     
Series B Convertible Preferred Stock  (M)      1,002,074    1,144,869    1,311,562 
Series C Convertible Preferred Stock  (M)      487,804    450,450    516,036 
Series D Convertible Preferred Stock  (M)      1,484,492    1,533,395    1,756,657 
Series E Convertible Preferred Stock  (M)      248,049    269,280    308,487 
Series F Convertible Preferred Stock  (M)      238,323    258,721    296,391 
Warrants for Common Stock expiring 6/30/15  ( I )      98,644    153,890    64,272 
Secured Convertible Bridge Note (including interest)  (M)      341,047   $337,579    332,058 
          3,900,433         4,585,463 
                      
Enumeral Biomedical Corp. (7)(9)     Healthcare               
Developing therapeutics and diagnostics through functional assaying of single cells                     
Series A Convertible Preferred Stock  (M)      1,026,832    957,038    1,110,164 

 

The accompanying notes are an integral part of these consolidated financial statements.

24
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of         Shares/     
   Valuation (1)  Industry (2)  Cost   Principal   Value 
Investments in Non-Controlled  Affiliated Companies (3)(17)(18) – 34.1% of net assets at value (Cont.)                     
                      
Private Placement Portfolio (Illiquid) –  32.7% of net assets at value (Cont.)                     
                      
HzO, Inc. (7)(9)(13)(14)     Electronics               
Developing novel industrial coatings that  protect electronics against damage from liquids                  
Series A Convertible Preferred Stock  (M)     $666,667    4,057,294   $1,130,362 
Series B Convertible Preferred Stock  (M)      1,000,000    3,947,888    1,099,882 
          1,666,667         2,230,244 
                      
Kovio, Inc. (7)(9)(13)     Electronics               
Developing semiconductor products using printed electronics and thin-film technologies                  
Series A' Convertible Preferred Stock  (M)      5,242,993    2,160,000    1,437,286 
Series B' Convertible Preferred Stock  (M)      1,418,540    2,131,827    1,418,539 
          6,661,533         2,855,825 
                      
Mersana Therapeutics, Inc. (7)(9)     Healthcare               
Developing treatments for cancer based on novel drug delivery polymers                    
Series A Convertible Preferred Stock  (M)      700,000    68,451    0 
Series B Convertible Preferred Stock  (M)      1,542,098    866,500    0 
Unsecured Convertible Bridge Notes (including interest)  (M)      1,442,871   $1,195,875    1,442,871 
          3,684,969         1,442,871 
                      
Metabolon, Inc. (7)(13)     Healthcare               
Developing service and diagnostic products through the use of a metabolomics, or biochemical, profiling platform                     
Series B Convertible Preferred Stock  (M)      2,500,000    371,739    1,951,723 
Series B-1 Convertible Preferred Stock  (M)      706,214    148,696    780,689 
Series C Convertible Preferred Stock  (M)      1,000,000    1,000,000    1,794,510 
Series D Convertible Preferred Stock  (M)      1,499,999    835,882    1,499,999 
Warrants for Series B-1 Convertible Preferred Stock expiring 3/25/15  ( I )      293,786    74,348    71,142 
        5,999,999         6,098,063 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

25
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of         Shares/     
   Valuation (1)  Industry (2)  Cost   Principal   Value 
Investments in Non-Controlled  Affiliated Companies (3)(17)(18) – 34.1% of net assets at value (Cont.)                     
                      
Private Placement Portfolio (Illiquid) –  32.7% of net assets at value (Cont.)                     
                      
Nextreme Thermal Solutions, Inc. (7)(9)(13)     Energy               
Developing thin-film thermoelectric devices for cooling and energy conversion                     
Series A Convertible Preferred Stock  (M)     $4,384,762    44,053   $0 
                      
Produced Water Absorbents, Inc. (7)(9)(13)(14)     Energy               
Developing nano-structured absorbent materials for environmental remediation of contaminated water in the oil and gas industries                     
Series A Convertible Preferred Stock  (M)      1,000,000    1,000,000    1,000,000 
                      
Senova Systems, Inc. (7)(9)(13)(14)     Healthcare               
Developing next-generation sensors to measure pH                       
Series B Convertible Preferred Stock  (M)      692,308    692,308    692,308 
                      
SiOnyx, Inc. (7)(9)(13)     Electronics               
Developing silicon-based optoelectronic products enabled by its proprietary Black Silicon                     
Series A Convertible Preferred Stock  (M)      750,000    233,499    160,367 
Series A-1 Convertible Preferred Stock  (M)      890,000    2,966,667    2,037,507 
Series A-2 Convertible Preferred Stock  (M)      2,445,000    4,207,537    2,889,736 
Series B-1 Convertible Preferred Stock  (M)      1,169,561    1,892,836    1,300,000 
Warrants for Series B-1 Convertible Preferred                     
Stock expiring 2/23/17  ( I )      130,439    247,350    132,552 
          5,385,000         6,520,162 
                      
Ultora, Inc. (7)(9)(13)     Energy               
Developing energy-storage devices enabled by carbon nanotubes                      
Series A Convertible Preferred Stock  (M)      215,000    215,000    215,000 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

26
 

 

HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of         Shares/     
   Valuation (1)  Industry (2)  Cost   Principal   Value 
Investments in Non-Controlled  Affiliated Companies (3)(17)(18) – 34.1% of net assets at value (Cont.)                     
                      
Private Placement Portfolio (Illiquid) –  32.7% of net assets at value (Cont.)                     
                      
Xradia, Inc. (7)(13)     Electronics               
Designing, manufacturing and selling ultra- high resolution 3D x-ray microscopes and fluorescence imaging systems                     
Series D Convertible Preferred Stock  (M)     $4,000,000    3,121,099   $6,978,777 
                      
Total Non-Controlled Private Placement Portfolio (cost: $48,968,029)                  $47,601,785 
                      
Publicly Traded Portfolio (Illiquid) –  1.4% of net assets at value                     
                      
Champions Oncology, Inc. (13)(14)(20)     Healthcare               
Developing its TumorGraftTM platform for personalized medicine and drug development                     
Common Stock  (M)     $2,000,000    2,666,667   $1,973,334 
                      
Total Non-Controlled Affiliated Publicly Traded Portfolio (cost: $2,000,000)                  $1,973,334 
                      
Total Investments in Non-Controlled Affiliated Companies (cost: $50,968,029)                  $49,575,119 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of         Shares/     
   Valuation (1)  Industry (2)  Cost   Principal   Value 
                   
Investments in Controlled Affiliated Companies (3)(21) – 4.7% of net assets at value                     
                      
Private Placement Portfolio (Illiquid) – 4.7% of net assets at value                     
                      
Ancora Pharmaceuticals Inc. (7)(9)     Healthcare               
Developing synthetic carbohydrates for pharmaceutical applications                      
Common Stock  (M)     $2,729,817    57,463   $0 
Series A Convertible Preferred Stock  (M)      3,855,627    3,855,627    3,855,627 
Senior Secured Debt, 12.00%, maturing on 12/11/12  ( I )      452,060   $500,000    455,190 
          7,037,504         4,310,817 
                      
Laser Light Engines, Inc. (7)(9)     Energy               
Manufacturing solid-state light sources for digital cinema and large-venue projection displays                     
Series A Convertible Preferred Stock  (M)      2,000,000    7,499,062    0 
Series B Convertible Preferred Stock  (M)      3,095,802    13,571,848    2,181,119 
Secured Convertible Bridge Note (including interest)  (M)      385,630   $378,261    385,630 
          5,481,432         2,566,749 
                      
Total Controlled Private Placement Portfolio (cost: $12,518,936)                  $6,877,566 
                      
Total Investments in Controlled Affiliated Companies (cost: $12,518,936)                  $6,877,566 
                      
Total Private Placement and Publicly Traded Portfolio (cost: $103,316,647)                  $113,048,250 
                      
Total Investments (cost: $103,316,647)                  $113,048,250 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

   Method of  Number of     
   Valuation (1)  Contracts   Value 
            
Written Call Options (15) –  (0.1)% of net assets at value             
              
Solazyme, Inc. — Strike Price $15.00, 3/17/12  (M)   3,000   $(195,000)
              
Total Written Call Options (Premiums Received $315,000)          $(195,000)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

Notes to Consolidated Schedule of Investments

 

(1)See "Footnote to Consolidated Schedule of Investments" on page 33 for a description of the "Valuation Procedures."

 

(2)We classify "Energy" companies as those that seek to improve performance, productivity or efficiency, and to reduce environmental impact, waste, cost, energy consumption or raw materials using nanotechnology-enabled solutions. We classify "Electronics" companies as those that use nanotechnology to address problems in electronics-related industries, including semiconductors. We classify "Healthcare" companies as those that use nanotechnology to address problems in healthcare-related industries, including biotechnology, pharmaceuticals and medical devices. We use the term "Other" for companies that operate primarily in industries other than those within "Energy," "Electronics" and "Healthcare." We do not have any portfolio companies classified as "Other" as of December 31, 2011. In the first quarter of 2011, we renamed the sector classification "Electronics/Semiconductors" to "Electronics" and reclassified three companies, NeoPhotonics Corporation, Polatis, Inc., and Xradia, Inc., from a sector classification of "Other" to "Electronics" to reflect a broader definition of electronics to include photonics, metrology, and test and measurement. We also renamed the sector classification "Healthcare/Biotech" to "Healthcare." In the fourth quarter of 2011, we renamed the sector classification, "Cleantech" to "Energy."

 

(3)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 but do not control the company. Investments in controlled affiliated companies consist of investments in which we own 25 percent or more of the voting shares of the portfolio company or otherwise control the company.

 

(4)The aggregate cost for federal income tax purposes of investments in unaffiliated privately held companies is $23,794,145. The gross unrealized appreciation based on the tax cost for these securities is $5,997,220. The gross unrealized depreciation based on the tax cost for these securities is $6,043,118.

 

(5)The aggregate cost for federal income tax purposes of investments in unaffiliated rights to milestone payments is $3,291,750. The gross unrealized appreciation based on the tax cost for these securities is $71,041. The gross unrealized depreciation based on the tax cost for these securities is $0.

 

(6)The aggregate cost for federal income tax purposes of investments in unaffiliated publicly traded companies is $12,743,787. The gross unrealized appreciation based on the tax cost for these securities is $21,975,176. The gross unrealized depreciation based on the tax cost for these securities is $5,234,436.

 

(7)We are subject to legal restrictions on the sale of our investment(s) in this company.

 

The accompanying notes are an integral part of this consolidated schedule.

 

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HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

(8)With our investment in the Series E round of financing, we received a warrant to purchase shares of common stock of up to 30 percent of the amount invested in the Series E round of financing of Bridgelux, Inc., depending on certain financial performance metrics of the company as of December 31, 2011, at a price per share of $1.9056. The number of shares able to be purchased and beginning of the period for when this warrant is exercisable will be set upon receipt of the audited financial statements of the company for the 2011 fiscal year or upon the completion of an IPO or sale of the company, whichever comes first. Bridgelux did not complete an IPO or sale of the company as of December 31, 2011. Also as of that date, the audited financials for the company’s 2011 fiscal year were not available. This warrant is, therefore, a contingent asset as of December 31, 2011. With our investment in the bridge note financing in the fourth quarter of 2011, we received a warrant for the purchase of common stock that is exercisable at the date of issuance, but the number of shares for which it can be exercised increases monthly from the date of issuance through the close of the next round of equity financing of the company up to 50 percent of the principal amount invested in the note divided by $1.9056. The warrant for common stock is exercisable for 56,564 shares of common stock of Bridgelux as of December 31, 2011.

 

(9)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.

 

(10)Cobalt Technologies, Inc., also does business as Cobalt Biofuels.

 

(11)With our investment in a convertible bridge note issued by Ensemble Therapeutics Corporation, we received a warrant to purchase a number of shares of the class of stock sold in the next financing of Ensemble Therapeutics Corporation equal to $149,539.57 divided by the price per share of the class of stock sold in the next financing of Ensemble Therapeutics Corporation. The ability to exercise this warrant is, therefore, contingent on Ensemble Therapeutics Corporation completing successfully a subsequent round of financing. This warrant shall expire and no longer be exercisable on September 10, 2015. The cost basis of this warrant is $89.86.

 

(12)As part of a loan the Company made to Molecular Imprints in the second quarter of 2011, we received a liquidation preference payable upon a sale of the company equal to three times the principal of the loan, or $4,044,450. This preference is senior to the preferences of the outstanding preferred stock. While the loan has since been repaid, this liquidation preference remains outstanding as of December 31, 2011.

 

(13)Represents a non-income producing security. Investments that have not paid dividends or interest within the last 12 months are considered to be non-income producing.

 

(14)Initial investment was made during 2011.

 

(15)A portion of this security is held in connection with written call option contracts: 300,000 shares have been pledged to brokers.

 

(16)The lock-up period on our 2,304,149 shares of Solazyme, Inc., expired on November 25, 2011.

 

The accompanying notes are an integral part of this consolidated schedule.

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HARRIS & HARRIS GROUP, INC.

CONSOLIDATED SCHEDULE OF INVESTMENTS AS OF DECEMBER 31, 2011

 

(17)The aggregate cost for federal income tax purposes of investments in non-controlled affiliated companies is $48,968,029. The gross unrealized appreciation based on the tax cost for these securities is $9,066,325. The gross unrealized depreciation based on the tax cost for these securities is $10,432,569.

 

(18)The aggregate cost for federal income tax purposes of investments in non-controlled affiliated publicly traded companies is $2,000,000. 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 $26,666.

 

(19)D-Wave Systems, Inc., is located and is doing business primarily in Canada. We invested in D-Wave Systems, Inc., through Parallel Universes, Inc., a Delaware company. Our investment is denominated in Canadian dollars and is subject to foreign currency translation. See "Note 2. Summary of Significant Accounting Policies."

 

(20)Our 2,666,667 shares of Champions Oncology, Inc., became freely tradable on October 1, 2011, pursuant to Rule 144.

 

(21)The aggregate cost for federal income tax purposes of investments in controlled affiliated companies is $12,518,936. 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 $5,641,370.

 

The accompanying notes are an integral part of this consolidated schedule.

 

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HARRIS & HARRIS GROUP, INC.

FOOTNOTE TO CONSOLIDATED SCHEDULE OF INVESTMENTS

 

VALUATION PROCEDURES

 

I.Determination of Net Asset Value

 

The 1940 Act requires periodic valuation of each investment in the portfolio of the Company to determine its net asset value. Under the 1940 Act, unrestricted securities with readily available market quotations are to be valued at the current market value; all other assets must be valued at "fair value" as determined in good faith by or under the direction of the Board of Directors.

 

The Board of Directors is also responsible for (1) determining overall valuation guidelines and (2) ensuring that the investments of the Company are valued within the prescribed guidelines.

 

The Valuation Committee, comprised of all of the independent Board members, is responsible for determining the valuation of the Company’s assets within the guidelines established by the Board of Directors. The Valuation Committee receives information and recommendations from management. An independent valuation firm also reviews select portfolio company valuations. The independent valuation firm does not provide proposed valuations.

 

The fair values assigned to these investments are based on available information and do not necessarily represent amounts that might ultimately be realized when that investment is sold, as such amounts depend on future circumstances and cannot reasonably be determined until the individual investments are actually liquidated or become readily marketable.

 

II.Approaches to Determining Fair Value

 

Accounting principles generally accepted in the United States of America ("GAAP") define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). In effect, GAAP applies fair value terminology to all valuations whereas the 1940 Act applies market value terminology to readily marketable assets and fair value terminology to other assets.

 

The main approaches to measuring fair value utilized are the market approach and the income approach.

 

·Market Approach (M): The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. For example, the market approach often uses market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range each appropriate multiple falls requires judgment considering factors specific to the measurement (qualitative and quantitative).

 

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·Income Approach (I): The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present value amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model), which incorporate present value techniques; and the multi-period excess earnings method, which is used to measure the fair value of certain assets.

 

GAAP classifies the inputs used to measure fair value by these approaches into the following hierarchy:

 

    Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets;

 

    Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 2 inputs are in those markets for which there are few transactions, the prices are not current, little public information exists or instances where prices vary substantially over time or among brokered market makers; and

 

    Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement. Unobservable inputs are those inputs that reflect our own assumptions that market participants would use to price the asset or liability based upon the best available information.

 

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement and are not necessarily an indication of risks associated with the investment.

 

III. Investment Categories

 

The Company’s investments can be classified into five broad categories for valuation purposes:

 

·Equity-related securities;
·Long-term fixed-income securities;
·Short-term fixed-income securities;
·Investments in intellectual property, patents, research and development in technology or product development; and
·All other securities.

 

The Company applies the methods for determining fair value discussed above to the valuation of investments in each of these five broad categories as follows:

 

34
 

 

A.EQUITY-RELATED SECURITIES

 

Equity-related securities, including options or warrants, are valued using the market or income approaches. The following factors may be considered when the market approach is used to fair value these types of securities:

 

§Readily available public market quotations;

 

§The cost of the Company’s investment;

 

§Transactions in a company's securities or unconditional firm offers by responsible parties as a factor in determining valuation;

 

§The financial condition and operating results of the company;

 

§The company's progress towards milestones;

 

§The long-term potential of the business and technology of the company;

 

§The values of similar securities issued by companies in similar businesses;

 

§Multiples to revenue, net income or EBITDA that similar securities issued by companies in similar businesses receive;

 

§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; and

 

§The rights and preferences of the class of securities we own as compared with other classes of securities the portfolio company has issued.

 

When the income approach is used to value warrants, the Company uses the Black-Scholes-Merton formula.

 

B.LONG-TERM FIXED-INCOME SECURITIES

 

1.Readily Marketable: Long-term fixed-income securities for which market quotations are readily available are valued using the most recent bid quotations when available.

 

2.Not Readily Marketable: Long-term fixed-income securities for which market quotations are not readily available are fair valued using the income approach. The factors that may be considered when valuing these types of securities by the income approach include:

 

·Credit quality;
·Interest rate analysis;
·Quotations from broker-dealers;
·Prices from independent pricing services that the Board believes are reasonably reliable; and
 ·Reasonable price discovery procedures and data from other sources.

 

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C.SHORT-TERM FIXED-INCOME SECURITIES

 

Short-term fixed-income securities 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.

 

D.INVESTMENTS IN INTELLECTUAL PROPERTY, PATENTS, RESEARCH AND DEVELOPMENT IN TECHNOLOGY OR PRODUCT DEVELOPMENT

 

Such investments are fair valued using the market approach. The Company may consider factors specific to these types of investments when using the market approach including:

 

·The cost of the Company’s investment;
·Investments in the same or substantially similar intellectual property or patents or research and development in technology or product development or offers by responsible third parties;
·The results of research and development;
·Product development and milestone progress;
·Commercial prospects;
·Term of patent;
·Projected markets; and
·Other subjective factors.

 

E.ALL OTHER SECURITIES

 

All other securities are reported at fair value as determined in good faith by the Valuation Committee using the approaches for determining valuation as described above.

 

For all other securities, the reported values shall reflect the Valuation Committee's judgment of fair values as of the valuation date using the outlined basic approaches of valuation discussed in Section III. 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.

36
 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

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 (the "1940 Act") that specializes in making investments in companies commercializing and integrating products enabled by nanotechnology and microsystems. We operate as an internally managed company whereby our officers and employees, under the general supervision of our Board of Directors, conduct our operations.

 

H&H Ventures Management, Inc.SM ("Ventures"), formerly Harris & Harris Enterprises, Inc., is a 100 percent wholly owned subsidiary of the Company. Ventures is taxed under Subchapter C of the Internal Revenue Code of 1986 (the "Code") (a "C Corporation"). Harris Partners I, L.P, is a limited partnership and, from time to time, may be used to hold certain interests in portfolio companies. The partners of Harris Partners I, L.P., are Ventures (sole general partner) and the Company (sole limited partner). Ventures pays taxes on any non-passive investment income generated by Harris Partners I, L.P. For the period ended September 30, 2012, there was no non-passive investment income generated by Harris Partners I, L.P. Ventures, as the sole general partner, consolidates Harris Partners I, L.P. The Company consolidates its wholly owned subsidiary, Ventures, for financial reporting purposes.

 

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 accounting principles generally accepted in the United States of America ("GAAP") applicable to interim financial information. Accordingly, they do not include all information and disclosures necessary for a fair statement of our financial position, results of operations and cash flows in conformity with GAAP. In the opinion of management, these financial statements reflect all adjustments, consisting of valuation adjustments and normal recurring accruals, necessary for a fair statement 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, 2011.

 

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:

 

37
 

 

Principles of Consolidation. The consolidated financial statements have been prepared in accordance with GAAP and include the accounts of the Company and its wholly owned subsidiary. In accordance with GAAP and Regulation S-X, the Company may only consolidate its interests in investment company subsidiaries and controlled operating companies whose business consists of providing services to the Company. Our wholly owned subsidiary, Ventures, is a controlled operating company that provides services to us and is, therefore, consolidated. All significant inter-company accounts and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform to the current period presentation.

 

Revision of Previously Reported Consolidated Financial Statements During the First Quarter of 2012. During the period ended March 31, 2012, the Company concluded the Consolidated Statements of Cash Flows erroneously classified cash flow items within operating and investing activities. Specifically, the Company's purchases and sales of various debt, equity and other securities were previously classified within investing activities when such purchases and sales activities should have been classified within operating activities.  Following is a list of purchases and sales activities that have now been included in operating activities, rather than investing activities, in the Consolidated Statements of Cash Flows:

 

Purchase of U.S. government securities
Sale of U.S. government securities
Investment in affiliated portfolio companies
Investment in unaffiliated portfolio companies
Proceeds from sale of investments
Proceeds from call option premiums
Payments for call option purchases
Principal payments received on debt investments

 

The net impact of these revisions was to increase the total cash used in operating activities and decrease the total cash used in investing activities by $4,475,222, $3,765,559 and $23,780,399 for the three months ended March 31, 2011, the six months ended June 30, 2011, and the nine months ended September 30, 2011, respectively. For the years ended December 31, 2011, and 2010, the net impact was to increase total operating activities and decrease total investing activities by $35,665,311 and $8,058,322, respectively. For the year ended December 31, 2009, the net impact was to decrease total operating activities and increase total investing activities by $15,432,513. The Company assessed the impact of the error on its prior period financial statements and concluded that the error was not material to any of those financial statements.

 

Use of Estimates. The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities and the reported amounts of revenues and expenses. Actual results could differ from these estimates, and the differences could be material. The most significant estimates relate to the fair valuations of our investments.

 

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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 ("SEC") and in accordance with GAAP. 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.") As of September 30, 2012, our financial statements include privately held investments and one illiquid publicly traded venture capital investment, Champions Oncology, Inc., collectively fair valued at $98,973,856. The fair values of our privately held and illiquid publicly traded venture capital investments 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.

 

Cash. Cash includes demand deposits. Cash is carried at cost, which approximates fair value.

 

Restricted Funds. At September 30, 2012, and December 31, 2011, we held $2,010,010 and $1,512,031, respectively, in "Restricted funds." At September 30, 2012, and December 31, 2011, we held $2,000,000 and $1,500,000, respectively, in a collateral account for our credit facility discussed in "Note 5. Debt." At September 30, 2012, and December 31, 2011, we also held $10,010 and $12,031, respectively, in security deposits for sublessors.

 

Unaffiliated Rights to Milestone Payments. At September 30, 2012, the outstanding milestone payments from Amgen, Inc.’s acquisition of Biovex Group, Inc., were valued at $3,400,488. The milestone payments are derivatives and valued using the probability-adjusted, present value of proceeds from future payments that would be due upon successful completion of certain regulatory and sales milestones. If all remaining milestones are met, we would receive $9,526,393. There can be no assurances as to how much of this amount we will ultimately realize or when it will be realized, if at all.

 

Funds Held in Escrow from Sales of Investments. At September 30, 2012, there were funds held in escrow fair valued at $588,276 relating to the sales of Innovalight, Inc., and Crystal IS, Inc. Funds held in escrow are valued using certain discounts applied to the amounts withheld. Funds held in escrow from the Innovalight transaction will be released in January 2013 upon settlement of any indemnity claims and expenses related to the transaction. A portion of the funds held in escrow from the Crystal IS transaction was released on April 30, 2012. The balance of the Crystal IS funds in escrow will be released in March 2013 upon settlement of any remaining indemnity claims and expenses related to the transaction. If the funds held in escrow for these transactions are released in full, we would receive $1,201,074. On March 16, 2012, the Company received payment of its portion of the proceeds held in escrow since the closing of the transaction on March 4, 2011, from Amgen, Inc.’s acquisition of BioVex Group, Inc., totaling $953,480.

 

Prepaid Expenses. We include prepaid insurance premiums and deferred financing charges in "Prepaid expenses." Prepaid insurance premiums are recognized over the term of the insurance contract. Deferred financing charges consist of fees and expenses paid in connection with the closing of credit facilities and are capitalized at the time of payment. Deferred financing charges are amortized over the term of the credit facility discussed in "Note 5. Debt." Amortization of the financing charges is included in "Interest and other debt expense" in the "Consolidated Statements of Operations."

 

Property and Equipment. Property and equipment are included in "Other assets" and are carried at $302,688 and $331,006 at September 30, 2012, and December 31, 2011, respectively, representing cost, less accumulated depreciation. Depreciation is provided using the straight-line method over the estimated useful lives of the premises and equipment. We estimate the useful lives to be five to ten years for furniture and fixtures, three years for computer equipment, and ten years for leasehold improvements.

 

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Post Retirement Plan Liabilities. The Company provides a Retiree Medical Benefit Plan for employees who meet certain eligibility requirements. Until it was terminated on May 5, 2011, the Company also provided an Executive Mandatory Retirement Benefit Plan for certain individuals employed by us in a bona fide executive or high policy-making position. The net periodic postretirement benefit cost for the year is determined as the sum of service cost for the year, interest on the accumulated postretirement benefit obligation and amortization of the transition obligation (asset) less previously accrued expenses over the average remaining service period of employees expected to receive plan benefits. Unrecognized actuarial gains and losses are recognized as net periodic benefit cost pursuant to the Company's historical accounting policy for amortizing such amounts. Actuarial gains and losses that arise that are not recognized as net periodic benefit cost in the same periods are recognized as a component of net assets.

 

Interest Income Recognition. Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis. When securities are determined to be non-income producing, the Company ceases accruing interest and writes off any previously accrued interest. Securities are deemed to be non-income producing if, on their last interest or dividend date, no cash was paid or no cash or in-kind dividends were declared. These write-offs are recorded as a debit to interest income. During the three months and nine months ended September 30, 2012, the Company earned $74,821 and $210,146, respectively, in interest on U.S. government securities, senior secured debt, participation agreements, subordinated secured debt and interest-bearing accounts. During the three months and nine months ended September 30, 2012, the Company recorded, on a net basis, $275,148 and $190,466, respectively, of bridge note interest. The nine months total includes a partial write-off of previously accrued bridge note interest of $200,583, which was recognized in the second quarter of 2012, offset by $236,238 of interest recognized in the third quarter upon conversion of this investment.

 

Loan Fees. Loan fees received in connection with our venture debt investments are deferred. The unearned fee income is accreted into income based on the effective interest method over the life of the investment.

 

Call Options. The Company writes covered call options on publicly traded securities with the intention of earning option premiums. Option premiums may increase the Company’s realized gains and, therefore, may help increase distributable income, but may limit the realized gains on the security. When a Company writes (sells) an option, an amount equal to the premium received by the Company is recorded in the Consolidated Statements of Assets and Liabilities as a liability. The amount of the liability is subsequently marked-to-market to reflect the current market value of the option written. When an option expires, the Company realizes a gain on the option to the extent of the premiums received. Premiums received from writing options that are exercised or closed are added to or offset against the proceeds or amount paid on the transaction to determine the realized gain or loss.

 

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Stock-Based Compensation. The Company has a stock-based employee compensation plan. The Company accounts for the Amended and Restated Harris & Harris Group, Inc. 2012 Equity Incentive Plan (the "Amended Stock Plan") by determining the fair value of all share-based payments to employees, including the fair value of grants of employee stock options and restricted stock awards, and records these amounts as an expense in the Consolidated Statements of Operations over the vesting period with a corresponding increase to our additional paid-in capital. At September 30, 2012, and December 31, 2011, 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 potential tax benefits associated with the expensing of stock options because the Company currently intends to qualify as a regulated investment company ("RIC") under Subchapter M of the Code, and the deduction attributable to such expensing, therefore, is unlikely to provide any additional tax savings. The amount of non-cash, 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 stock-based awards vested and pre-vesting forfeitures. 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 and is accounted for in the current period and prospectively. See "Note 8. Stock-Based Compensation" for further discussion.

 

Rent expense. Our lease at 1450 Broadway, New York, New York, commenced on January 21, 2010. The lease expires on December 31, 2019. The base rent is $36 per square foot with a 2.5 percent increase per year over the 10 years of the lease, subject to a full abatement of rent for four months and a rent credit for six months throughout the lease term. Certain leasehold improvements were also paid for on our behalf by the landlord, the cost of which is accounted for as property and equipment and "Deferred rent" in the accompanying Consolidated Statements of Assets and Liabilities. These leasehold improvements are depreciated over the lease term. We apply these rent abatements, credits, escalations and landlord payments on a straight-line basis in the determination of rent expense over the lease term.

 

Realized Gain or Loss and Unrealized Appreciation or Depreciation of Portfolio Investments. Realized gain or loss is recognized when an investment is disposed of and is computed as the difference between the Company's cost basis in the investment at the disposition date and the net proceeds received from such disposition. Realized gains and losses on investment transactions are determined by specific identification. Unrealized appreciation or depreciation is computed as the difference between the fair value of the investment and the cost basis of such investment.

 

Income Taxes. As we intend to qualify as a RIC under Subchapter M of the Code, the Company does not provide for income taxes. The Company has capital loss carryforwards that can be used to offset net realized capital gains. The Company recognizes interest and penalties in income tax expense.

 

We pay federal, state and local income taxes on behalf of our wholly owned subsidiary, Ventures, which is a C Corporation. See "Note 9. Income Taxes."

 

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. For the nine months ended September 30, 2012, included in the net increase in unrealized appreciation on investments was unrealized appreciation of $199,932 resulting from foreign currency translation.

 

Securities Transactions. Securities transactions are accounted for on the date the transaction for the purchase or sale of the securities is entered into by the Company (i.e., trade date).

 

Concentration of Credit Risk. The Company places its cash and cash equivalents with financial institutions and, at times, cash held in money market accounts may exceed the Federal Deposit Insurance Corporation insured limit.

 

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NOTE 4. BUSINESS RISKS AND UNCERTAINTIES

 

We invest primarily in privately held companies, the securities of which are inherently illiquid. We also have investments in small publicly traded companies. Although these companies are publicly traded, their stock may not trade at high volumes and prices can be volatile, which may restrict our ability to sell our positions. These privately held and publicly traded businesses tend to not have attained profitability, and many of these businesses also lack management depth and have limited or no history of operations. Because of the speculative nature of our investments and the lack of a liquid market for and restrictions on transfers of privately held investments and some of our publicly traded investments, there is greater risk of loss than is the case with traditional investment securities.

 

We do not choose investments based on a strategy of diversification. We also do not rebalance the portfolio should one of our portfolio companies increase in value substantially relative to the rest of the portfolio.  Therefore, the value of our portfolio may be more vulnerable to microeconomic events affecting a single sector, industry or portfolio company and to general macroeconomic events that may be unrelated to our portfolio companies. These factors may subject the value of our portfolio to greater volatility than a company that follows a diversification strategy. As of September 30, 2012, our largest 10 investments by value accounted for approximately 73 percent of the value of our equity-focused venture capital portfolio. Our largest two investments, by value, Solazyme, Inc., a publicly traded company, and Adesto Technologies Corporation, a privately held company, accounted for approximately 18.8 percent and 12.9 percent, respectively, of our equity-focused venture capital portfolio at September 30, 2012.

 

Approximately 78 percent of our equity-focused venture capital portfolio by value was comprised of securities of 25 privately held companies. Because there is typically no public or readily ascertainable market for our interests in the small privately held companies in which we invest, the valuation of the securities in that portion of our portfolio is determined in good faith by our Valuation Committee, comprised of all of the independent members of our Board of Directors, in accordance with our Valuation Procedures and is subject to significant estimates and judgments. The determined value of the securities in our portfolio may differ significantly from the values that would be placed on these securities if a ready market for the securities existed. Any changes in valuation are recorded in our Consolidated Statements of Operations as "Net increase in unrealized appreciation on investments." Changes in valuation of any of our investments in privately held companies from one period to another may be volatile.

 

NOTE 5. DEBT

 

On February 24, 2011, the Company established a $10 million three-year revolving credit facility (the “credit facility”) with TD Bank, N.A. to be used in conjunction with its investments in venture debt.

 

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The credit facility matures on February 24, 2014, and generally bears interest, at the Company’s option, based on (i) LIBOR plus 1.25 percent or (2) the higher of the federal funds rate plus fifty basis points (0.50 percent) or the U.S. prime rate as published in the Wall Street Journal.  The credit facility generally requires payment of interest on a monthly basis and requires the payment of a non-use fee of 0.15 percent annually.  All outstanding principal is due upon maturity.  The credit facility is secured by cash collateral held in a non-interest bearing account at TD Bank. The credit facility contains affirmative and restrictive covenants, including: (a) periodic financial reporting requirements, (b) maintaining our status as a BDC (c) maintaining unencumbered, liquid assets of not less than $7,500,000, (d)  limitations on the incurrence of additional indebtedness, (e) limitations on liens, and (f) limitations on mergers and dissolutions. The credit facility is used to supplement our capital to make additional venture debt investments.

 

The Company’s outstanding debt balance was $2,000,000 and $1,500,000, at September 30, 2012, and December 31, 2011, respectively. At September 30, 2012, and December 31, 2011, $2,000,000 and $1,500,000, respectively, was held in a collateral account at T.D. Bank as security for the loan. The weighted average annual interest cost for the nine months ended September 30, 2012, and twelve months ended December 31, 2011, was 1.6 percent and 1.5 percent, respectively, exclusive of amortization of closing fees and other expenses related to establishing the credit facility. The remaining capacity under the credit facility was $8,000,000 at September 30, 2012. At September 30, 2012, the Company was in compliance with all financial covenants required by the credit facility.

 

NOTE 6. FAIR VALUE OF INVESTMENTS

 

At September 30, 2012, our financial assets were categorized as follows in the fair value hierarchy:

 

    Fair Value Measurement at Reporting Date Using:  
Description   September 30, 2012    
Unadjusted Quoted
Prices in Active Markets
for Identical Assets
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant 
Unobservable
 Inputs
 (Level 3)
 
U.S. Government Securities   $ 10,000,000     $ 10,000,000     $ 0     $ 0  
                                 
Privately Held Portfolio Companies:                                
Preferred Stock   $ 84,272,454     $ 0     $ 0     $ 84,272,454  
Bridge Notes   $ 4,061,774     $ 0     $ 0     $ 4,061,774  
Warrants   $ 616,083     $ 0     $ 0     $ 616,083  
Rights to Milestone Payments   $ 3,400,488     $ 0     $ 0     $ 3,400,488  
Common Stock   $ 174,540     $ 0     $ 0     $ 174,540  
Senior Secured Debt   $ 778,482     $ 0     $ 0     $ 778,482  
Participation Agreements   $ 1,198,610     $ 0     $ 0     $ 1,198,610  
Subordinated  Secured  Debt   $ 123,420     $ 0     $ 0     $ 123,420  
Non-Convertible Promissory Note   $ 3,033,338     $ 0     $ 0     $ 3,033,338  
                                 
Publicly Traded Portfolio Companies:                                
Common Stock   $ 26,217,767     $ 24,903,100     $ 0     $ 1,314,667  
                                 
Total Investments   $ 133,876,956     $ 34,903,100     $ 0     $ 98,973,856  
                                 
Liabilities:                                
Written Call Options   $ 364,080     $ 364,080     $ 0     $ 0  
                                 
Total   $ 364,080     $ 364,080     $ 0     $ 0  

 

Significant Unobservable Inputs

 

The table below presents the valuation technique and quantitative information about the significant unobservable inputs utilized by the Company in the fair value measurements of Level 3 assets. Unobservable inputs are those inputs for which little or no market data exists and, therefore, require an entity to develop its own assumptions.

 

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   Fair Value at
Sept. 30, 2012
   Valuation Techniques(s)  Unobservable Input   Range 
                 
           Private Offering Price   $0.14 - $6.73 
           Non-Performance Risk   0% - 100% 
           Revenue Multiple   1.3 - 2.7 
           Discount for Lack of Marketability   20%
Preferred Stock  $84,272,454   Market Approach  Probability of Exit Outcomes   0% - 100% 
                 
           Private Offering Price  $1.00 
Bridge Notes   4,061,774   Market Approach  Non-Performance Risk   0%
                 
           Private Offering Price   $0.54 - $47.51 
Common Stock   174,540   Market Approach  Non-Performance Risk   0% -100% 
                 
           Stock Price   $.09 - $2.36 
        Black-Sholes-Merton  Volatility   107%
Warrants   616,083   Model  Expected Term   0.50 – 9.50 Years 
                 
        Probability Weighted  Probability of Achieving Independent Milestones   0% - 75% 
Rights to Milestone Payments   3,400,488   Discounted Cash Flow  Probability of Achieving Dependent Milestones   0.44% - 28.125% 
                 
           Warrant Adjusted Effective Yield   23.1% - 29.9% 
           Effective Yield   23.1% - 37.4% 
           Non-Performance Risk   0% - 25% 
           Participation Payment Risk   0%
Participation Agreements   1,198,610   Income Approach  Discount for Comparable Prices of High-Yield Debt   0%
                 
           Warrant Adjusted Effective Yield   33.1%
           Effective Yield   41.4%
Subordinated  Secured Debt   123,420   Income Approach  Non-Performance Risk   25%
                 
           Effective Yield   15.7%
Senior Secured Debt   778,482   Income Approach  Non-Performance Risk   0%
                 
           Probability of Exit Outcomes   25% - 75% 
           Private Offering Price  $1.50 
Non-Convertible Promissory Note   3,033,338   Income Approach  Non-Performance Risk   50%
                 
           Non-Performance Risk   25%
OTC Traded Common Stock  $1,314,667   Market Approach  Volume Weighted Average Price per Share   $0.63 - $0.81 
                 
Total  $98,973,856         

 

Valuation Methodologies and Inputs for Level 3 Assets

 

The following sections describe the valuation techniques and significant unobservable inputs used to measure Level 3 assets.

 

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Preferred Stock, Bridge Notes and Common Stock

 

Preferred stock, bridge notes and common stock are valued by a market approach using internal models with inputs, most of which are not market observable. Common inputs for valuing Level 3 preferred stock, bridge note and private common stock investments include: prices from recently executed private transactions in a company’s securities or unconditional firm offers, revenue multiples of comparable publicly traded companies, discounts for lack of marketability, rights and preferences of the class of securities we own as compared with other classes of securities the portfolio company has issued, particularly related to potential liquidity scenarios of an IPO or an acquisition transaction, and management’s best estimate of risk attributable to non-performance risk. We define non-performance as the risk that the price per share (or implied valuation of a portfolio company) or the effective yield of a debt security of a portfolio company, as applicable, does not appropriately represent the risk that a portfolio company with negative cash flow will be: (a) unable to raise capital, will need to be shut down and will not return our invested capital; or (b) able to raise capital, but at a valuation significantly lower than the implied post-money valuation of the last round of financing.  The assessment of non-performance risk typically includes an evaluation of the financial condition and operating results of the company, the company's progress towards milestones, and the long-term potential of the business and technology of the company and how this potential may or may not affect the value of the shares owned by us. An increase to the non-performance risk or a decrease in the private offering price of a future round of financing from that of the most recent round would result in a lower fair value measurement and/or a change in the distribution of value among the classes of securities we own.

 

Bridge notes commonly contain terms that provide for the conversion of the full amount of principal, and sometimes interest, into shares of preferred stock at a defined price per share and/or the price per share of the next round of financing. The use of a discount for non-performance risk in the valuation of bridge notes would indicate the potential for conversion of only a portion of the principal, plus interest when applicable, into shares of preferred stock or the potential that a conversion event will not occur and that the likely outcome of a liquidation of assets would result in payment of less than the remaining principal outstanding of the note. An increase in non-performance risk would result in a lower fair value measurement.

 

Warrants

 

We use the Black-Scholes-Merton option-pricing model to determine the fair value of warrants held in our portfolio. Option pricing models, including the Black-Scholes-Merton 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-Merton model, variations in the expected volatility or expected term assumptions have a significant impact on fair value. Because the securities underlying the warrants in our portfolio are not publicly traded, many of the required input assumptions are more difficult to estimate than they would be if a public market for the underlying securities existed.

 

An input to the Black-Scholes-Merton option-pricing model is the value per share of the type of stock for which the warrant is exercisable as of the date of valuation. This input is derived according to the methodologies discussed in “Preferred Stock, Bridge Notes and Common Stock.”

 

Rights to Milestone Payments

 

Rights to Milestone Payments are valued using a probability-weighted discounted cash flow model. As part of Amgen Inc.’s acquisition of our former portfolio company, BioVex Group, Inc., we are entitled to potential future milestone payments based upon the achievement of certain regulatory and sales milestones. We assign probabilities to the achievements of the various milestones. Milestones identified as independent milestones can be achieved irrespective of the achievement of other contractual milestones. Dependent milestones are those that can only be achieved after another, or series of other, milestones are achieved. The interest rates used in these models are observable inputs from sources such as the Federal Reserve published interest rates.

 

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Participation Agreements, Subordinated Secured Debt and Senior Secured Debt

 

We invest in venture debt investments through participation agreements, subordinated secured debt and senior secured debt. We value these securities using an income approach. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present value amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. Common inputs for valuing Level 3 debt investments include: the effective yield of the debt investment or, in the case where we have received warrant coverage, the warrant-adjusted effective yield of the security, adjustments for changes in the yields of comparable publicly traded high-yield debt funds and risk-free interest rates and an assessment of non-performance risk. For those debt investments made through participation agreements, we include discounts for the risk of breach of the participation agreements. For venture debt investments, an increase in yields would result in a lower fair value measurement. Furthermore, yields would decrease, and value would increase, if the company is exceeding targets and risk has been substantially reduced from the level of risk that existed at the time of investment. Yields would increase, and values would decrease, if the company is failing to meet its targets and risk has been increased from the level of risk that existed at the time of investment.

 

Non-Convertible Promissory Note

 

We have one non-convertible promissory note, which we value using an income approach that uses a valuation technique to convert future amounts to a single present value. This security has a liquidation preference payable upon a sale of the company equal to three times the principal of the loan. While the loan has since been repaid, this liquidation preference remains outstanding as of September 30, 2012. Inputs include the preferred stock price of the portfolio company, an assessment of non-performance risk, the probability of exit outcomes between an IPO and an acquisition and the resulting impact on rights and preferences of the class of securities we own as compared with other classes of securities the portfolio company has issued.

 

OTC Traded Common Stock

 

Common stock that is thinly traded in OTC markets is valued using internal models with inputs that are not market observable. Common inputs for stock include the volume-weighted average of recent prices per share of privately negotiated financing transactions and the volume-weighted price per share of the stock over a period of time and an assessment of non-performance risk.

 

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The following table shows the components of change in the financial assets categorized as Level 3 for the three months ended September 30, 2012.

 

   Beginning
Balance
7/1/2012
   Total
Realized
Gains
(Losses)
Included
in Changes
in Net
Assets
   Transfers   Total   
Unrealized
Appreciation
(Depreciation)
Included in
Changes in
 Net Assets
  

Investments in
Portfolio
Companies,
Interest on
Bridge Notes,
and
Amortization of

 Loan Fees, Net 

     Disposals   Ending
Balance
9/30/2012
   Amount of Total
Appreciation
(Depreciation) for the
Period Included in
Changes in Net Assets
Attributable to the
Change in Unrealized
Gains or Losses Relating
to Assets Still Held at the
Reporting  Date
 
                                 
Preferred Stock  $79,123,640   $0   $0   $2,108,893   $3,039,921   $0   $84,272,454   $2,108,893 
                                         
Bridge Notes   3,474,341    0    (1,633,296)   1,542,398    678,331    0    4,061,774    1,542,398