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TINY > SEC Filings for TINY > Form 10-Q on 8-May-2014All Recent SEC Filings

Show all filings for HARRIS & HARRIS GROUP INC /NY/

Form 10-Q for HARRIS & HARRIS GROUP INC /NY/


8-May-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The information contained in this section should be read in conjunction with the Company's unaudited March 31, 2014, Consolidated Financial Statements and the Company's audited 2013 Consolidated Financial Statements and notes thereto.

Background

We incorporated under the laws of the state of New York in August 1981. In 1983, we completed an initial public offering ("IPO"). In 1984, we divested all of our assets except Otisville BioTech, Inc., and became a financial services company with the investment in Otisville as the initial focus of our business activity.

In 1992, we registered as an investment company under the 1940 Act, commencing operations as a closed-end, non-diversified investment company. In 1995, we elected to become a BDC subject to the provisions of Sections 55 through 65 of the 1940 Act.

Overview

We believe we provide five core benefits to our shareholders. First, we are an established firm with a positive track record of investing in venture capital-backed companies as further discussed in "Investments and Current Investment Pace" on page 64. Second, we provide shareholders with access to disruptive science-enabled companies, particularly ones that are enabled by BIOLOGY+, that would otherwise be difficult to access or inaccessible for most current and potential shareholders. Third, we have an existing portfolio of companies at varying stages of maturity that provide for a potential pipeline of investment returns over time. Fourth, we are able to invest opportunistically in a range of types of securities to take advantage of market inefficiencies. Fifth, we provide access to venture capital investments in a vehicle that, unlike private venture capital firms, has permanent capital, is transparent and is liquid.

We build transformative companies from disruptive science. We make venture capital investments in companies enabled by multidisciplinary, disruptive science. We define venture capital investments as the money and resources made available to privately held and publicly traded small businesses with exceptional growth potential.

As of March 31, 2014, we had 25 equity-focused companies in our portfolio that have yet to complete liquidity events (e.g., IPOs or M&A transactions). This does not include 1) our publicly traded shares of Solazyme, Inc., and Champions Oncology, Inc.; 2) our three venture debt deals, GEO Semiconductor Inc., Nano Terra, Inc., and OHSO Clean, Inc.; and 3) our rights to milestone payments from Amgen, Inc., and Laird Technologies, Inc. As of March 31, 2014, we valued our 25 privately held equity-focused companies at $81,617,444. Including the companies referenced above, we valued our total venture capital portfolio at $90,901,768 as of March 31, 2014. At March 31, 2014, from first dollar in, the average and median holding periods for the 25 privately held equity-focused investments were 6.1 years and 6.8 years, respectively. Historically, as measured from first dollar in to last dollar out, the average and median holding periods for the 70 investments we have exited were 4.4 years and 3.4 years, respectively.

Our execution strategy over the next five years has four parts: 1) Realize returns to increase shareholder value; 2) Invest for growth to increase shareholder value; 3) Partner to more effectively create value; and 4) Return value to our shareholders.

Realize

"Realize" refers to realizing value in our venture capital portfolio. Since our investment in Otisville in 1983 through March 31, 2014, we have made a total of 97 equity-focused venture capital investments. We have completely exited 70 of these 97 investments and partially exited through the sale of shares and/or the sale of call options covered by shares of two of these 97 investments, recognizing aggregate net realized gains of $78,811,932 on invested capital of $120,529,082, or 1.7 times invested capital. For the securities of the 25 companies in our equity-focused portfolio held at March 31, 2014, we have net unrealized depreciation of $22,251,595 on invested capital of $103,869,039. We have aggregate net realized gains on our exited companies offset by unrealized depreciation for our 25 currently held equity-focused investments of $56,560,337 on invested capital of $224,398,121.

The amount of net realized gains includes:

$30,253,957 in payments received from the sale of BioVex Group, Inc., to Amgen, Inc., the sale of Innovalight, Inc., to DuPont, the sale of Crystal IS, Inc., to Asahi Kasei Group and the sale of Xradia, Inc., to Carl Zeiss AG. We had invested a total of $15,383,299 in these four portfolio companies;

Realized gains of $16,845,010 from the sale of shares of Solazyme, Inc., on invested capital of $5,089,775. In addition, we generated $1,414,875 in realized gains on our sale and/or purchase of written call option and put option contracts covered by our shares of Solazyme, Inc.;

Realized gains of $292,402 from the sale of shares of Champions Oncology, Inc., on invested capital of $564,971; and

Realized loss of $4,839,811, including call options, on our investment in NeoPhotonics Corporation on invested capital of $7,299,590.

Realized loss of $7,299,533 on our investment in Kovio, Inc., on invested capital of $7,299,533. On January 21, 2014, substantially all of Kovio's assets were sold by Square 1 Bank, Kovio's secured creditor, to Thin Film Electronics ASA. Our shares were subsequently declared worthless on February 19, 2014.

The aggregate net realized gains and the cumulative invested capital do not reflect the cost or value of our shares of Solazyme, Inc., and Champions Oncology, Inc., that we owned as of March 31, 2014, or the premiums received on open option contracts of Solazyme of $342,735. The aggregate net realized gains also do not include potential escrow payments from the sale of Xradia, Inc., to Carl Zeiss AG or potential milestone payments that could occur as part of the acquisition of BioVex Group, Inc., by Amgen, Inc., or the acquisition of Nextreme Thermal Solutions, Inc., by Laird Technologies, Inc., at points in time in the future. The aggregate net realized gains also do not include the proceeds received to date or the additional amounts held in escrow and amounts due upon achievement of certain milestones related to the acquisition of the semiconductor manufacturing-related business of Molecular Imprints that was announced in the first quarter of 2014 and completed on April 18, 2014. If these amounts were included as of March 31, 2014, our aggregate net realized gains and cumulative invested capital would be $96,475,880 and $127,804,596, respectively, or 1.8-times invested capital.

Recent and Potential Liquidity Events From Our Portfolio as of March 31, 2014

On July 12, 2013, Carl Zeiss AG completed its acquisition of Xradia, Inc., and on July 19, 2013, we received our initial payment of $12,838,244. On January 23, 2014, we received the first escrow payment of $1,235,312. As of March 31, 2014, additional proceeds of $1,139,515 were held in escrow to be released in whole, or in part, in July of 2014, but there can be no assurance as to how much of this amount we will ultimately realize. As of March 31, 2014, we valued the funds held in escrow from the sale of Xradia at $551,294.

As of March 31, 2014, we valued potential milestone payments from the sale of BioVex Group, Inc., at $3,491,600. If all the remaining milestone payments were to be paid by Amgen, Inc., we would receive $9,526,393. We have not received any milestone payments as of March 31, 2014, and there can be no assurance as to the timing and how much of this amount we will ultimately realize in the future, if any. As of March 31, 2014, we valued potential milestone payments from the sale of Nextreme Thermal Solutions, Inc., to Laird Technologies, Inc., at $0.

Our companies often plan for and/or begin the process of pursuing potential sales and/or IPOs of those companies by hiring bankers and/or advisors to attempt to pursue such liquidity events. We consider these efforts to be in the ordinary course of business for those companies until the potential and timing of a transaction become tangible through events such as acceptance of letters of intent to acquire a company and/or the beginning of a road show to pursue an IPO.

On April 18, 2014, Canon, Inc., completed its acquisition of Molecular Imprints, Inc.'s semiconductor lithography equipment business. We received $6,486,461 at the close of the transaction and could receive an additional $625,000 from amounts held in escrow as well as up to $1.7 million upon the achievement of certain milestones. With the closing of the transaction, a new spin-out company, which retained the name "Molecular Imprints, Inc." was formed. This new company will continue development and commercialization of nanoscale patterning in consumer and biomedical applications. We are a shareholder of this new company.

On February 27, 2014, the board of directors of Contour Energy Systems, Inc., adopted a plan of complete liquidation and dissolution. Following the sale of Contour Energy's assets and settlement of its liabilities, any remaining proceeds will be distributed to its shareholders. At March 31, 2014, we valued our investment in Contour Energy at $21,418.

Strategy for Managing Publicly Traded Positions

During the three months ended March 31, 2014, our strategy for managing our publicly traded positions has generated $119,697 in net cash proceeds from premiums on call options sold of Solazyme, Inc. We also sold 17,834 shares of Solazyme in open market transactions for proceeds, net of commission, of $214,888. The net increase in our primary liquidity from these transactions was $334,585. Through March 31, 2014, we have generated $2,469,676 in net cash premiums on call options sold and put options purchased of Solazyme since the company completed an IPO in May 2011. We have sold a total of 2,154,149 shares of Solazyme since its IPO for net proceeds, after commission, of $21,207,864 or an average sale price of $9.85 per share. Including premiums from call and put options, the average sale price for these shares was $10.99 per share. Our cost basis in Solazyme is $2.36 per share.

As of March 31, 2014, our remaining 150,000 shares of Solazyme are under the following option contracts:

                 No. of Shares    Expiration Date     Strike Price
                    100,000        June 21, 2014      $       12.50
                    50,000       September 20, 2014   $       12.50

During the three months ended March 31, 2014, we sold 559,756 shares of our position in Champions Oncology, Inc., in open market transactions for net proceeds, after commission, of $619,690 or an average sale price of $1.11 per share. Our average cost basis in Champions is $0.67 per share.

These increases in primary liquidity are important for our efforts to continue to fund existing and new portfolio companies that could generate future investment returns.

Maturity of Current Equity-Focused Venture Capital Portfolio

There are three main drivers of our potential growth in value over the next five years. First, we have a larger portfolio of more mature companies than we have had historically. Second, we believe the quality of our existing portfolio is stronger than it has been historically. Third, we own larger percentages of the companies in the existing portfolio than we have owned historically.

Our current portfolio is comprised of BIOLOGY+ and other companies at varying stages of maturity in a diverse set of industries. As our portfolio companies mature, we seek to invest in new early- and mid-stage companies that may mature into mid- and late-stage companies. This continuous progression creates a pipeline of investment maturities that may lead to future sources of positive contributions to net asset value per share as these companies mature and potentially experience liquidity and exit events. Our pipeline of investment maturities for the 23 equity-focused companies in our portfolio that have yet to complete liquidity events (e.g., IPOs or M&A transactions) and are not in the process of being shut down are shown in the figure below.

[[Image Removed]]

We expect some of our portfolio companies to transition between stages of maturity over time. This transition may be forward if the company is maturing and is successfully executing its business plan or may be backward if the company is not successfully executing its business plan or decides to change its business plan substantially from its original plan. Transitions backward may be accompanied by an increase in non-performance risk, which reduces valuation. We discuss non-performance risk and its implications on value below in the section titled "Valuation of Investments."

During the first quarter of 2014, we did not transition the stage categorization of any of our portfolio companies.

As of March 31, 2014, we held securities in Molecular Imprints, Inc., a late-stage company. Molecular Imprints was acquired by Canon, Inc., in the second quarter of 2014. We will retain ownership in a new company created from the non-semiconductor manufacturing business of Molecular Imprints. We currently plan to categorize this new company as a mid-stage company once it is created.

Ownership of Our Portfolio Companies

By studying our portfolio in greater detail, it is evident to us that potential returns from approximately half of the companies in our portfolio could be the real drivers of net asset value growth over the coming years. These companies include ones in which we have substantial ownership and ones where we believe the potential value at exit is substantial. The table below provides some additional detail on our ownership of the 23 equity-focused companies in our portfolio that have yet to complete liquidity events (e.g., IPOs or M&A transactions) and are not in the process of being shut down.

       Portfolio Company          Voting Ownership Range

   Enumeral Biomedical Corp.
           HzO, Inc.
         ProMuc, Inc.                      >20%
     Senova Systems, Inc.
         Sionyx, Inc.
         Ultora, Inc.

        EchoPixel, Inc.                   15-20%
Produced Water Absorbents, Inc.

      ABSMaterials, Inc.
   Adesto Technologies Corp.              10-15%
        Metabolon, Inc.
          OpGen, Inc.

        AgBiome, L.L.C.                   5-10%

        Bridgelux, Inc.
  Cambrios Technologies Corp.
   Champions Oncology, Inc.
     D-Wave Systems, Inc.                 2.5-5%
  Ensemble Therapeutics Corp.
  Mersana Therapeutics, Inc.
   Molecular Imprints, Inc.
         Nantero, Inc.

   Cobalt Technologies, Inc.              0-2.5%
         Nanosys, Inc.

In previous communications with shareholders, we have discussed how we are managing our portfolio, feeding the "fat hogs" and starving the "lean hogs" to maximize our value at exit. Many of the leaner hogs have experienced write-downs in valuation, and we have de-emphasized them in terms of the time allocation of our team. These steps allow us to focus our time and capital on the companies we believe will be the drivers of our growth. This increases the risk and potential loss of invested capital in these portfolio companies, but it also may increase the potential returns if they are successful. We currently believe companies like D-Wave Systems, Inc., Metabolon, Inc., Adesto Technologies Corporation, HzO, Inc., Produced Water Absorbents, Inc., Ultora, Inc., AgBiome, LLC, Senova Systems, Inc., Enumeral Biomedical Corp. and EchoPixel, Inc., have the potential to be real drivers of growth in our portfolio in the coming years.

Level of Involvement in Our Portfolio Companies

The 1940 Act requires that BDCs offer to "make available significant managerial assistance" to portfolio companies. We are actively involved with our portfolio companies through membership on boards of directors, as observers to the boards of directors and/or through frequent communication with management. As of March 31, 2014, we held at least one board seat or observer rights on 19 of our 23 equity-focused portfolio companies that have yet to complete a liquidity event or an uplisting to a national exchange and are not in the process of being shut down (83 percent).

We may be involved actively in the formation and development of business strategies of our earliest stage portfolio companies. This involvement may include hiring management, licensing intellectual property, securing space and raising additional capital. We also provide managerial assistance to late-stage companies looking for potential exit opportunities by leveraging our relationships with the banking and investment community and our knowledge and experience in running a micro-capitalization publicly traded business.

Invest

Growth in Ownership of Portfolio Companies

The chart below depicts the change in our ownership of our portfolio companies from 2001 through 2013 as our assets have increased. Our fully diluted, investment-weighted average ownership has increased from approximately five percent for initial investments made between 2001 and 2004 to approximately 15 percent for initial investments made between 2009 and 2013. This increasing ownership, which we have noted in previous shareholder communications, gives us more control over these companies to potentially affect outcomes beneficial to the Company. Over the coming five years, as companies where our initial investment was made between 2005 and the present continue to mature and exit, we believe our increased levels of ownership have the potential to provide greater returns than our historical investments.

[[Image Removed]]

Our goal with our new investments is to have even greater ownership at the time of the realization of our return than we have had historically for all of the reasons discussed above.

Investments and Current Investment Pace

The following is a summary of our initial and follow-on equity-focused investments from January 1, 2010, to March 31, 2014. We consider a "round led" to be a round where we were the new investor or the leader of a group of investors in an investee company. Typically, but not always, the lead investor negotiates the price and terms of the deal with the investee company.

                                  Investments in Our Equity-Focused Portfolio of Investments
                                       in Privately Held and Publicly Traded Companies
                                                                                                         Three Months Ended
                                        2010             2011             2012             2013            March 31, 2014
Total Incremental Investments        $ 9,560,721     $ 17,688,903     $ 15,141,941     $ 18,076,288     $          2,386,980
No. of New Investments                         3                4                2                2                        0
No. of Follow-On Investment Rounds            27               31               26               37                        7
No. of Rounds Led                              5                4                3                9                        2
Average Dollar Amount - Initial      $   117,069     $  1,339,744     $  1,407,500     $    550,001     $                  0
Average Dollar Amount - Follow-On    $   341,093     $    397,740     $    474,113     $    449,359     $            340,997

Industry Sectors of Investment

We generally classify our investments in one of three industry sectors: Life Sciences, Energy and Electronics. The interdisciplinary nature of science-based inventions enables our portfolio companies to address needs in multiple sectors rather than being confined to addressing needs in one sector. As such, many of our companies can adjust their business foci to address needs in a secondary sector should opportunities in the company's primary sector decrease in number or magnitude.

We classify companies in our life sciences portfolio as those that address problems in life sciences-related industries, including biotechnology, agriculture, advanced materials and chemicals, diagnostics, healthcare, bioprocessing, water, industrial biotechnology, food, nutrition and energy. We classify companies that address life science-related problems as a primary or secondary sector as BIOLOGY+. With our focus on investing in BIOLOGY+ companies, we expect that the number of companies addressing life science-related industries as a primary focus will grow, while those that address electronics and energy-related sectors as a primary focus will decline. That said, we expect these companies may address electronics and energy-related sectors as a secondary sector given the interdisciplinary nature of BIOLOGY+ companies.

We classify companies in our energy portfolio as those that seek to improve performance, productivity or efficiency, and to reduce environmental impact, waste, cost, energy consumption or raw materials. Energy is a term used commonly to describe products and processes that solve global problems related to resource constraints. The term "cleantech" is also used commonly in a similar manner.

We classify companies in our electronics portfolio as those that address problems in electronics-related industries, including semiconductors, telecommunications and data communications, metrology and test and measurement.

Our Sources of Liquid Capital

The sources of liquidity that we use to make our investments are classified as primary and secondary liquidity. As of March 31, 2014, and December 31, 2013, our total primary and secondary liquidity was $30,263,296 and $33,620,478, respectively. We do not include funds available from our credit facility as primary or secondary liquidity. We believe it is important to examine both our primary and secondary liquidity when assessing the strength of our balance sheet and our future investment capabilities.

Primary liquidity is comprised of cash, U.S. government securities and certain receivables. As of March 31, 2014, we held $5,901,234 in cash, $19,999,600 in U.S. government securities and $106,466 in certain receivables. As of December 31, 2013, we held $8,538,548 in cash, $18,999,810 in U.S. government securities and $534,826 in certain receivables.

On January 23, 2014, funds totaling $1,235,312 from the sale of Xradia, Inc., were released from escrow, which added to our primary liquidity in the first quarter. The remaining funds held in escrow from the Xradia transaction will be released in July of 2014, net of any settlement of indemnity claims and expenses related to the transaction. If and when these amounts held in escrow are released, those funds would add to our primarily liquidity. Payments upon achieving milestones of the BioVex Group, Inc., sale would also add to our primary liquidity in future quarters if these milestones are achieved successfully. The probability-adjusted value of the future milestone payments for the sale of BioVex, as determined at the end of each fiscal quarter, is included as an asset on our Consolidated Statements of Assets and Liabilities and will be included in primary liquidity only if and when payment is received for achievement of the milestones. During the three months ended March 31, 2014, we sold 17,834 shares of our investment in Solazyme, Inc., in open market sales. We received $214,888 in net proceeds from these transactions. During the three months ended March 31, 2014, we sold 559,756 shares of our investment in Champions Oncology, Inc., in open market sales. We received $619,690 in net proceeds from these transactions. The proceeds received from these transactions added to our primary liquidity. On April 18, 2014, we received proceeds of $6,486,461 from the sale of Molecular Imprints, Inc.'s semiconductor business to Canon, Inc. This will add to our primary liquidity in the second quarter of 2014.

Our secondary liquidity is comprised of the stock of publicly traded companies. Although these companies are publicly traded, their stock may not trade at high volumes and prices may be volatile, which may restrict our ability to sell our positions at any given time. As of March 31, 2014, our secondary liquidity was $4,255,996. Solazyme, Inc., accounts for $1,741,500 of this amount based on its closing price as of March 31, 2014. If our option contracts are called at their strike prices, we would receive proceeds of $1,875,000. The common stock of Champions Oncology, Inc., accounts for $2,514,496 of the total amount of secondary liquidity based on its closing price as of March 31, 2014. As of December 31, 2013, our secondary liquidity was $5,547,294. Solazyme, Inc., accounted for $1,827,712 of this amount based on its closing price as of December 31, 2013. The common stock of Champions Oncology, Inc., accounted for $3,719,582 of the total amount of secondary liquidity based on its closing price as of December 31, 2013. All of our public securities were freely tradable as of March 31, 2014. A decision to sell our shares would result in the cash received from the sale of these assets being included in primary liquidity. Until that time, we will continue to include the value of our shares of our publicly traded portfolio companies in secondary liquidity unless the average trading volume of each company reaches sufficient levels for us to monetize our stock in such companies over a short period of time.

We also have the $20,000,000 Loan Facility, which we can draw on to increase liquidity. As of March 31, 2014, we had no outstanding debt relating to this Loan Facility.

Partner

As the structure of the public markets has changed over the last decade, the time and dollars required to build transformative companies has increased. Scale and manufacturing expertise is now critical to get to a successful outcome. We believe this expertise is best accomplished by partnering with corporations at earlier stages in the development of the enterprise. Proper partnering can lead to more capital efficient businesses that provide better returns for investors.

Return

Our plan for returning value to shareholders has three steps. Step one of our return plan was implemented over the past five years. It includes investing in early-stage companies where we believe we can own greater than 10 percent of the company at exit with invested capital of between $5 million and $10 million in each company.

Step two is our focus on BIOLOGY+. Our best investment returns over the past 10 years have come from companies that have businesses intersecting with the life sciences. We are now focusing our efforts on BIOLOGY+, as we believe the future returns for companies commercializing technologies that sell into the life science markets will be greater than those focused on other markets we have invested in historically. Since 2008, approximately 77 percent of our new initial investments have been in companies that fit our BIOLOGY+ investment thesis. This percentage will increase over the coming years. That said, we note that past performance may not be indicative of future performance.

Step three is our partnering efforts. We continue to pursue strategies to increase the return profile of early-stage investing, and to reduce the cost profile so that it shifts to a profile more representative of the venture capital industry of 15 to 20 years ago. We believe this will require an environment for doing early-stage investing that includes working with corporate partners earlier in the development of these companies to 1) ascertain if there is demand for the company's technology/products and 2) to help these start-ups prepare for scale and manufacturing in a way that permits seamless adoption by industry and the consumer. This is the basis of our partnership strategy.

We believe that execution of these three steps will generate returns for shareholders over the coming years. We are focused on increasing value for shareholders through growing net asset value per share, and we believe we may have an opportunity to reduce the number of shares outstanding and provide deemed dividends as well as cash dividends as we execute on this strategy.

Current Business Environment

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