Forward-Looking Statements

The information set forth in this report includes "forward-looking statements." Such statements may include, but are not limited to: projections of revenues, income or loss, capital expenditures, plans for product development and cooperative arrangements, future operations, financing needs, or plans of Hercules, as well as assumptions relating to the foregoing. The terms "may," "will," "should," "expects," "plans," "anticipates," "could," "intends," "target," "projects," "contemplates," "believes," "estimates," "predicts," "potential," or "continue," or the negatives of these terms, or other similar expressions generally identify forward-looking statements.

The forward-looking statements made in this Form 10-Q speak only to events as of the date on which the statements are made. You should not place undue reliance on such forward-looking statements, as substantial risks and uncertainties could cause actual results to differ materially from those projected in or implied by these forward-looking statements due to a number of risks and uncertainties affecting its business. The forward-looking statements contained in this Form 10-Q are made as of the date hereof, and Hercules assumes no obligation to update the forward-looking statements for subsequent events.

Overview

We are a specialty finance company that provides debt and equity growth capital to technology-related and life-science companies at all stages of development from seed and emerging growth to expansion and established stages of development. We primarily finance privately-held companies backed by leading venture capital and private equity firms, and may also finance select publicly listed companies and lower middle market companies. Our principal office is located in the Silicon Valley and we have additional offices in the Boston, Boulder, Chicago, Columbus and San Diego areas. Our goal is to be the leading structured mezzanine capital provider of choice for venture capital and private equity backed technology-related companies requiring sophisticated and customized financing solutions. Our strategy is to evaluate and invest in a broad range of companies active in the technology and life science industries and to offer a full suite of growth capital products up and down the capital structure. We invest primarily in structured mezzanine debt and, to a lesser extent, in senior debt and equity investments. We use the term "structured mezzanine debt investment" to refer to any debt investment, such as a senior or subordinated secured loan, that is coupled with an equity component, including warrants, options or rights to purchase common or preferred stock. Our structured mezzanine debt investments will typically be secured by some or all of the assets of the portfolio company.

Our investment objective is to maximize our portfolio total return by generating current income from our debt investments and capital appreciation from our equity-related investments. We are an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company under the 1940 Act. As a business development company, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in "qualifying assets," including securities of private U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less.

From incorporation through December 31, 2005, we were taxed as a corporation under Subchapter C of the Internal Revenue Code (the Code). We are treated for federal income tax purposes as a RIC under Subchapter M of the Code as of January 1, 2006. To qualify for the benefits allowable to a RIC, we must, among other things, meet certain source-of-income and asset diversification and income distribution requirements. Pursuant to this election, we generally will not have to pay corporate-level taxes on any income that we distribute to our stockholders. However, such an election and qualification to be treated as a RIC requires that we comply with certain requirements contained in Subchapter M of the Code. For example, a RIC must meet certain requirements, including source of income, asset diversification and income distribution requirements. The income source requirement mandates that we receive 90% or more of our income from qualified earnings, typically referred to as "good income." Qualified earnings may exclude such income as management fees received in connection with our SBIC and certain other fees.

Our portfolio is comprised of, and we anticipate that our portfolio will continue to be comprised of, investments primarily in technology-related companies at various stages of their development. Consistent with regulatory requirements, we invest primarily in United States based companies and to a lesser extent in foreign companies. During 2007 and the nine month period ended September 30, 2008, our investing emphasis has been primarily on private companies following or in connection with a subsequent institutional round of equity financing, which we refer to as expansion-stage companies and private companies in later rounds of financing and certain thinly traded public companies, which we refer to as established-stage companies. In the near-term we are shifting our investment focus to expansion- and established-stage companies as we believe these investments currently provide higher yield returns. We have also historically focused our investment activities in private companies following or in connection with the first institutional round of financing, which we refer to as emerging-growth companies.

Portfolio and Investment Activity

The total value of our investment portfolio was $636.7 million at September 30, 2008 as compared to $530.0 million at December 31, 2007. During the three and nine-month periods ended September 30, 2008, we made debt commitments to 7 and 35 portfolio companies totaling $54.2 million and $348.8 million, respectively. We funded $99.7 million to 29 companies and $291.6 million to 59 companies during the three and nine-month periods ended September 30, 2008, respectively. No equity investment was made during the three-month period ended September 30, 2008. We made equity investments in 10 portfolio companies totaling $5.9 million in the nine-month period ended September 30, 2008, bringing total equity investments at fair value to approximately $33.1 million. The fair value of our warrant portfolio at September 30, 2008 and December 31, 2007 was approximately $25.4 million and $21.6 million respectively. At September 30, 2008, we had unfunded contractual commitments of $141.8 million to 34 portfolio companies. In addition, as of September 30, 2008, we executed non-binding term sheets with nine prospective portfolio companies, representing approximately $95.5 million. However, we have determined to reduce the number of non-binding term sheets that we will continue to perform diligence on to approximately $17 million. We will postpone the remainder of these non-binding term sheets until the overall economy and credit markets stabilize.

We receive payments in our loan portfolio based on scheduled amortization of the outstanding balances. In addition, we receive repayments of some of our loans prior to their scheduled maturity date. The frequency or volume of these repayments may fluctuate significantly from period to period. During the nine month period ended September 30, 2008, we received normal principal repayments of $70.1 million, and early repayments and working line of credit paydowns totaling $114.8 million. Total portfolio investment activity (exclusive of unearned income) as of the nine month period ended September 30, 2008 is as follows:

                                                               September 30,
     (in millions)                                                 2008
     Beginning Portfolio                                      $         530.0
     Purchase of debt investments                                       283.5
     Purchase of equity investments                                       7.0
     Sale of equity investments                                           5.2
     Principal payments received on investments                         (70.1 )
     Early pay-offs and recoveries                                     (114.8 )
     Accretion of loan discounts and paid-in-kind principal               5.0
     Net realized and unrealized change in investments                   (9.1 )

     Ending Portfolio                                         $         636.7

The following table shows the fair value of our portfolio of investments by asset class as of September 30, 2008 and December 31, 2007 (excluding unearned income):

                                                  September 30, 2008                                    December 31, 2007
                                     Investments at Fair       Percentage of Total         Investments at Fair       Percentage of Total
(in thousands)                              Value                   Portfolio                     Value                   Portfolio
Senior debt with warrants           $             490,363                     77.0 %      $             441,838                     83.4 %
Senior debt                                       107,173                     16.8 %                     61,483                     11.6 %
Preferred stock                                    32,532                      5.1 %                     23,265                      4.4 %
Senior debt-second lien with
warrants                                            6,103                      1.0 %                         -                        -
Common Stock                                          576                      0.1 %                      2,938                      0.5 %
Subordinated debt with
warrants                                               -                        -                           448                      0.1 %

                                    $             636,747                    100.0 %      $             529,972                    100.0 %

A summary of our investment portfolio at value by geographic location as of September 30, 2008 and December 31, 2007 is as follows.

                             September 30, 2008                               December 31, 2007
                  Investments at Fair    Percentage of Total      Investments at Fair    Percentage of Total
(in thousands)           Value                Portfolio                  Value                Portfolio
United States    $             601,462                  94.4 %   $             512,724                  96.8 %
Canada                          15,177                   2.4 %                  15,001                   2.8 %
Israel                          17,108                   2.7 %                   2,247                   0.4 %
Netherlands                      3,000                   0.5 %

                 $             636,747                 100.0 %   $             529,972                 100.0 %

Our portfolio companies are primarily privately held expansion-and established-stage companies in the biopharmaceutical, communications and networking, consumer and business products, electronics and computers, energy, information services, internet consumer and business services, medical devices, semiconductor and software industry sectors. These sectors are characterized by high margins, high growth rates, consolidation and product and market extension opportunities. Value is often vested in intangible assets and intellectual property.

At September 30, 2008, we had investments in two portfolio companies deemed to be Affiliates. One investment is a non income producing equity investment and one portfolio company became an Affiliate on December 17, 2007 upon a restructure of the company. Income derived from these investments was less than $98,000 since these investments became Affiliates. No realized gains or losses related to Affiliates were recognized during the three and nine-month periods ended September 30, 2008.

The following table shows the fair value of our portfolio by industry sector at September 30, 2008 and December 31, 2007 (excluding unearned income):

                                                     September 30, 2008                                       December 31, 2007
                                        Investments at Fair        Percentage of Total          Investments at Fair        Percentage of Total
(in thousands)                                 Value                    Portfolio                      Value                    Portfolio
Communications & networking            $             131,914                      20.7 %       $             114,014                      21.5 %
Information services                                  62,865                       9.9 %                      58,464                      11.0 %
Drug discovery                                        76,332                      12.0 %                      95,294                      18.0 %
Software                                              86,442                      13.6 %                      38,963                       7.4 %
Specialty pharmaceuticals                             48,135                       7.6 %                      45,646                       8.6 %
Electronics & computer hardware                       46,818                       7.4 %                      50,953                       9.6 %
Semiconductors                                        27,031                       4.2 %                      25,501                       4.8 %
Consumer & business products                          33,124                       5.2 %                       2,817                       0.5 %
Drug delivery                                         20,200                       3.2 %                      22,725                       4.3 %
Internet consumer & business
services                                              20,964                       3.3 %                      16,918                       3.2 %
Biotechnology tools                                   22,776                       3.5 %                       9,714                       1.8 %
Therapeutic                                           17,293                       2.7 %                      12,853                       2.4 %
Diagnostic                                            13,164                       2.0 %                       2,316                       0.5 %
Media/Content/Info                                    16,920                       2.7 %                       7,193                       1.4 %
Surgical Devices                                       7,632                       1.2 %                      16,821                       3.2 %
Energy                                                 5,137                       0.8 %                       7,016                       1.3 %
Advanced Specialty Materials &
Chemicals                                                 -                         -                          2,764                       0.5 %

                                       $             636,747                     100.0 %       $             529,972                     100.0 %

We use an investment grading system, which grades each debt investment on a scale of 1 to 5, to characterize and monitor our expected level of risk on the debt investments in our portfolio with 1 being the highest quality. The following table shows the distribution of our outstanding debt investments on the 1 to 5 investment grading scale at fair value as of September 30, 2008 and December 31, 2007:

                                                September 30, 2008                                    December 31, 2007
                                   Investments at Fair       Percentage of Total         Investments at Fair       Percentage of Total
(in thousands)                            Value                   Portfolio                     Value                   Portfolio
Investment Grading
1                                 $              20,840                      3.6 %      $              27,678                      5.7 %
2                                               401,523                     69.4                      341,598                     70.9
3                                               149,041                     25.8                      103,380                     21.4
4                                                 2,264                      0.4                        9,467                      2.0
5                                                 4,617                      0.8                           -                        -

                                  $             578,285                   100.00 %      $             482,123                   100.00 %

As of September 30, 2008, our investments had a weighted average investment grading of 2.25 as compared to 2.20 at December 31, 2007. Our policy is to downgrade the grading on our portfolio companies as they approach the point in time when they will require additional equity capital. Additionally, we may downgrade our portfolio companies if they are not meeting our financing criteria and their respective business plans. Various companies in our portfolio will require additional funding in the near term or have not met their business plans and have therefore been downgraded until the funding is complete or their operations improve. At September 30, 2008, twenty one portfolio companies were graded 3, two portfolio companies were graded 4 and two portfolio companies were graded 5, as compared to fifteen, three and zero portfolio companies, respectively, at December 31, 2007. At September 30, 2008, there was one portfolio company on non-accrual status. In general, interest is not accrued on loans and debt securities if we have doubt about interest collection or where the enterprise value of the portfolio company may not support further accrual. To the extent interest payments are received on a loan that is not accruing interest, we may use such payments to reduce our cost basis in the investment in lieu of recognizing interest income. No loans or debt securities were on non-accrual at December 31, 2007.

The effective yield on our debt investments during the quarter was 13.1% which was lower than the effective yield of 14.3% in the preceding quarter due to the acceleration of fee income recognition from early loan repayments in the second quarter. The overall weighted average yield to maturity of our loan obligations was approximately 12.67% at September 30, 2008 as compared to 12.70% at December 31, 2007, attributed to increased investments to both expansion- and established-stage companies and asset based financing offered to more mature companies seeking revolver type financing solutions. The weighted average yield to maturity is computed using the interest rates in effect at the inception of each of the loans, and includes amortization of the loan facility fees, commitment fees and market premiums or discounts over the expected life of the debt investments, weighted by their respective costs when averaged and based on the assumption that all contractual loan commitments have been fully funded and held to maturity.

We generate revenue in the form of interest income, primarily from our investments in debt securities, and commitment and facility fees. Fees generated in connection with our debt investments are recognized over the life of the loan or, in some cases, recognized as earned. In addition, we generate revenue in the form of capital gains, if any, on warrants or other equity-related

securities that we acquire from our portfolio companies. Our investments generally range from $1.0 million to $30.0 million, with an average initial principal balance of between $1.0 million and $15.0 million. Our debt investments have a term of between two and seven years and typically bear interest at rates ranging from Prime rate to 14.0% (based on current interest rate conditions). In addition to the cash yields received on our loans, in some instances, our loans may also include any of the following: end-of-term payments, exit fees, balloon payment fees, PIK provisions, prepayment fees, and diligence fees, which may be required to be included in income prior to receipt. In most cases, we collateralize our investments by obtaining security interests in our portfolio companies' assets, which may include their intellectual property. In other cases, we may obtain a negative pledge covering a company's intellectual property. At September 30, 2008, approximately 44 portfolio company loans were secured by a first priority security in all of the assets of the portfolio company, 42 portfolio company loans were prohibited from pledging or encumbering their intellectual property and one portfolio company was secured with a second lien position. Interest on debt securities is generally payable monthly, with amortization of principal typically occurring over the term of the security for emerging-growth, expansion-stage and established-stage companies. In addition, certain loans may include an interest-only period ranging from three to eighteen months for emerging-growth and expansion-stage companies and longer for established-stage companies. In limited instances in which we choose to defer amortization of the loan for a period of time from the date of the initial investment, the principal amount of the debt securities and any accrued but unpaid interest become due at the maturity date.

Our senior debt investments also generally have equity enhancement features, typically in the form of warrants or other equity-related securities designed to provide us with an opportunity for capital appreciation. As of September 30, 2008, we have received warrants in connection with the majority of our debt investments in each portfolio company, and have realized gains on 13 warrant positions since inception. During the three-month period ended September 30, 2008, we recognized realized gains of approximately $430,000 primarily from our warrant exercise and sale of common stock on one biopharmaceutical company. We recognized realized losses during the three-month period ended September 30, 2008 of approximately $304,000 from the sale of a debt investment to a syndication partner and the write off of warrants in two companies.

Our warrant coverage generally ranges from 3% to 20% of the principal amount invested in a portfolio company, with a strike price equal to the most recent equity financing round. We currently hold warrants in 95 portfolio companies, with a fair value of approximately $25.4 million which is included in the investment portfolio of $636.7 million. The fair value of the warrant portfolio has increased by $12.2 million or 92.4% as compared to the fair value of $13.2 million at September 30, 2007. These warrant holdings would allow us to invest approximately $59 million if such warrants are exercised. However, these warrants may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our warrant interests.

Results of Operations

Comparison of the Three and Nine-Month Periods Ended September 30, 2008 and 2007

Operating Income

Interest income totaled approximately $17.3 and $47.7 million for the three and nine-month periods ended September 30, 2008, respectively, compared with $13.6 and $34.4 for the three and nine-month periods ended September 30, 2007. These increases were primarily due to higher outstanding investment balances and accelerated interest income from early repayments. Income from commitment, facility and loan related fees totaled approximately $1.9 and $6.2 million for the three and nine-month periods ended September 30, 2008, respectively, as compared with approximately $1.6 and $3.7 million for the three and nine-month periods ended September 30, 2007. The increases in investment income and income from commitment, facility and loan related fees for both periods presented are the result of higher average loan balances outstanding due to origination activity and yield from the related investments and additional fees collected during the quarter from loan amendments and prepayments . At September 30, 2008, we had approximately $7.8 million of deferred revenue related to commitment and facility fees, as compared to approximately $5.1 million as of September 30, 2007.

Operating Expenses

Operating expenses totaled approximately $9.3 million and $24.9 million during the three and nine-month periods ended September 30, 2008, respectively, compared with $5.1 million and $15.6 million during the three and nine-month periods ended September 30, 2007, respectively. Operating expenses for the three and nine-month periods ended September 30, 2008 included interest expense, loan fees and unused commitment fees of approximately $4.5 million and $10.3 million, respectively, compared with $972,000 and $3.9 million for the three and nine-month periods ended September 30, 2007, respectively. The 363% increase in these expenses was due to the higher average outstanding debt balance of approximately $221.4 million during the three months ended September 30, 2008 as compared to $33.2 million during the three months ended September 30, 2007, higher cost of debt under our Credit Facility and higher fees for our SBA debenture. The expense was higher for the nine month period of 2008 compared to 2007 by 164% due to a higher average debt balance of $180.5 million compared to $59.8 million.

Employee compensation and benefits were approximately $2.5 million and $8.2 million during the three and nine-month periods ended September 30, 2008, respectively, compared with $2.4 million and $6.4 million during the three and nine-month periods ended September 30, 2007, respectively. The increase in compensation expense was primarily related to an increase in our headcount from 39 employees at September 30, 2007 to 46 employees at September 30, 2008 with increases for salaries. General and administrative expenses which include legal and accounting fees, insurance premiums, rent and various other expenses increased to $1.9 million and $5.3 million for the three and nine-month periods ended September 30, 2008, up from $1.4 million and $4.4 million during the three and nine-month periods ended September 30, 2007, primarily due to increases in recruiting expense and rent expenses. In addition, we incurred approximately $0.2 million and $1.1 million of stock-based compensation expense during the three and nine-month periods ended September 30, 2008, as compared to $0.3 million and $0.8 million in 2007, respectively.

Net Investment Income Before Income Tax Expense and Investment Gains and Losses

Net investment income before provision for income tax expense for the three and nine-month periods ended September 30, 2008 totaled $10.0 and $29.0 million, respectively, as compared with net investment income before provision for income tax expense of approximately $10.0 and $22.5 million for the three and nine-month periods ended September 30, 2007. The changes are made up of the items described above under "Operating Income" and "Operating Expenses."

Net Investment Gains/Losses

. . .