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TINY > SEC Filings for TINY > Form 10-Q on 8-Nov-2012All Recent SEC Filings

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



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 September 30, 2012, Consolidated Financial Statements and the Company's audited 2011 Consolidated Financial Statements and notes thereto.


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.


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. Second, we provide shareholders with access to emerging nanotechnology-enabled companies 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, is both transparent and liquid.

We invest in companies enabled by nanotechnology and microsystems. We believe companies that leverage breakthroughs at the nanoscale are emerging as leaders in their respective industries. These companies primarily impact the energy, healthcare and electronics sectors. We focused the Company on making venture capital investments in companies that commercialize and integrate products enabled by nanotechnology beginning in 2002. We believe this was the period of time when nanotechnology was beginning to emerge from its gestational phase and entering its commercial phase. We believe the coming decades will be the period of time when the commercial impact of nanotechnology will become widespread. We believe that as this impact occurs, our portfolio companies are well positioned to profit and that we will see investment returns as a result.

We define venture capital investments as the money and resources made available to privately held and publicly traded small businesses with exceptional growth potential. We believe that we are the only U.S.-based, publicly traded venture capital company making investments exclusively in nanotechnology and microsystems. We believe we have invested in more nanotechnology-enabled companies than any other venture capital firm.

Nanotechnology and microsystems are technologies that allow for the characterization, design, manipulation and manufacture of materials and systems on the molecular and micro levels, respectively.

Nanotechnology is the study of technologies measured in nanometers, which are units of measurement in billionths of a meter. Microsystems are measured in micrometers, which are units of measurement in millionths of a meter. We sometimes use "tiny technology" to describe both of these disciplines.

We consider a company to fit our investment thesis if the company employs, or intends to employ, technology that we consider to be at the microscale or smaller, and if the employment of that technology is material to its business plan. By making these investments, we seek to provide our shareholders with a specific focus on nanotechnology and microsystems through a portfolio of venture capital investments that address a variety of industries, markets and products.

We believe nanotechnology can be classified as a transformative technology. An innovation qualifies as a transformative technology if it has the potential for pervasive use in a wide range of sectors in ways that change the competitive dynamics in those sectors. Transformative technologies often take decades to fully diffuse through respective sectors. We believe the period of 2001 through 2010 was the first decade in the commercial development of nanotechnology products. We believe we are currently in the second decade in the commercial development of nanotechnology products. We believe it will be this second decade and beyond where large portions of industry come to rely on nanotechnology as a fundamental enabler of advanced products.

Investment Objective and Strategy

Our principal investment objective is to achieve long-term capital appreciation by making equity-focused venture capital investments in companies that we believe have exceptional growth potential. Therefore, a significant portion of our current venture capital investment portfolio provides little or no income in the form of dividends or interest. Current income is a secondary investment objective. We seek to reach the point where future growth is financed through reinvestment of our capital gains from our venture capital investments and where current income offsets significant portions of our annual expenses during periods of time between realizations of capital gains on our investments. We also plan to implement a strategy to grow assets under management by raising one or more third-party funds to manage. It is possible that we will invest our capital alongside or through these funds in portfolio companies. These funds may be focused on investing in nanotechnology-enabled companies, or specific sectors such as life sciences, energy and electronics that are enabled by nanotechnology. It is also possible these funds will also invest in companies in each of these sectors that are not directly enabled by nanotechnology. There is no assurance when and if we will be able to raise such fund(s) or, if raised, whether they will be successful.

We have discretion in the investment of our capital to achieve our objectives. Our venture capital investments are made primarily in equity-related securities of companies that can range in stage from pre-revenue to generating positive cash flow. These businesses tend to be thinly capitalized, unproven, small companies that lack management depth, have little or no history of operations and are developing unproven technologies. These businesses may be privately held or publicly traded. We historically have invested in equity securities of these companies that are generally illiquid due to restrictions on resale and to the lack of an established trading market. We refer to our portfolio of investments in equity and equity-related securities in later sections of the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") as our "equity-focused" portfolio of investments. We may take advantage of opportunities to generate near-term cash flow by investing in non-convertible debt securities of small businesses. These businesses tend to be generating cash or have near-term visibility to reaching positive cash flow. We refer to our portfolio of investments in non-convertible debt in later sections of the MD&A as our "venture debt" portfolio of investments.

We are both early-stage and long-term investors. We seek to identify investment opportunities in industries and markets that will be growth opportunities three to seven years from the date of our initial investment. We expect to invest capital in these companies at multiple points in time subsequent to our initial investment. We refer to such investments as "follow-on" investments. Our efforts to identify and predict future growth industries and markets rely on patient and deep due diligence in nanotechnology-enabled innovations developed at universities and corporate and government research laboratories, and the examination of macroeconomic and microeconomic trends and industry dynamics. We believe it is the early identification of and investments in these growth opportunities that will lead to investment returns for our shareholders, growth of our net assets, and capital for us to invest in tomorrow's growth opportunities.

Involvement with 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 September 30, 2012, we held at least one board seat or observer rights on 23 of our 28 equity-focused portfolio companies (82 percent). We have not held a board seat or observer rights at either Solazyme, Inc., or NeoPhotonics Corporation since each company completed an initial public offering in May 2011 and February 2011, respectively.

Investments and Current Investment Pace

Since our investment in Otisville in 1983 through September 30, 2012, we have made a total of 94 equity-focused venture capital investments. We have completely exited 66 of these 94 investments and partially exited through the sale of shares and/or the sale of call options covered by shares of two of these 94 investments, recognizing aggregate net realized gains of $71,772,396 on invested capital of $92,754,150. For the securities of the 28 companies in our equity-focused portfolio held at September 30, 2012, we have net unrealized appreciation of $11,435,725 on invested capital of $107,328,018. We have aggregate net realized and unrealized appreciation for our 94 equity-focused investments of $83,208,121 on invested capital of $200,082,168.

The amount of net realized gains includes:

$13,992,952 in upfront payments received in 2011 from the sale of BioVex Group, Inc., to Amgen, Inc., the sale of Innovalight, Inc., to E.I. du Pont de Nemours and Company ("DuPont") and the sale of Crystal IS, Inc., to Asahi Kasei Group. We had invested a total of $11,383,299 in these three portfolio companies;

$953,480 from the portion of our upfront payment held in escrow from the sale of BioVex Group, Inc., to Amgen, Inc., which was released on March 16, 2012;

$11,140 from the portion of our upfront payment held in escrow from the sale of Crystal IS, Inc., to Asahi Kasei Group, which was released on April 30, 2012;

$4,112,340 from the sale of shares of Solazyme, Inc., on invested capital of $863,928. $1,926,000 of the total proceeds was generated from the call of shares of Solazyme under option contracts. $2,186,340 in total proceeds was generated from the sale of 173,359 shares of Solazyme through open market transactions; and

$458,911 in realized gains on our sale of call option covered by our shares of NeoPhotonics Corporation and Solazyme, Inc.

The aggregate net realized gains and the cumulative invested capital also do not reflect the cost or value of our shares of NeoPhotonics Corporation or Solazyme, Inc., which completed IPOs on February 2, 2011, and May 27, 2011, respectively, that we owned as of September 30, 2012. The aggregate net realized gains also do not include potential escrow payments from the sale of Crystal IS, Inc., or Innovalight, Inc., or potential milestone payments that could occur as part of the acquisition of BioVex Group, Inc., by Amgen, Inc., at points in time in the future as of September 30, 2012.

From August 2001 through September 30, 2012, all 52 of our initial equity-focused investments have been in companies commercializing or integrating products enabled by nanotechnology or microsystems. From August 2001 through September 30, 2012, we have invested a total (before any subsequent write-ups, write-downs or dispositions) of $153,096,224 in these companies. We currently have 26 equity-focused companies in our portfolio that have yet to complete liquidity events (e.g., IPO or M&A). At September 30, 2012, from first dollar in, the average and median holding periods for these 26 investments were 5.3 years and 5.5 years, respectively. Historically, as measured from first dollar in to last dollar out, the average and median holding periods for the 66 investments we have fully exited were 4.2 years and 3.3 years, respectively.

The following is a summary of our initial and follow-on equity-focused investments in nanotechnology companies from January 1, 2008, to September 30, 2012. 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
                                                                                                         Nine Months Ended
                                         2008             2009            2010             2011          September 30, 2012

Total Incremental Investments        $ 17,779,462     $ 12,334,051     $ 9,560,721     $ 17,688,903     $          9,097,840
No. of New Investments                          4                2               3                4                        1
No. of Follow-On Investment Rounds             25               29              27               31                       19
No. of Rounds Led                               4                5               5                4                        2
Average Dollar Amount - Initial      $    683,625     $    174,812     $   117,069     $  1,339,744     $            815,000
Average Dollar Amount - Follow-On    $    601,799     $    413,256     $   341,093     $    397,740     $            435,939

During the first nine months of 2012, we made one new venture debt investment. The following is a summary of our investments in venture debt to date.

                  Investments in Our Venture Debt Portfolio of Investments
                       In Privately Held and Publicly Traded Companies
                                                                         Nine Months Ended
                      2008      2009        2010           2011          Septmber 30, 2012

No. of Investments        0         0             1               3                       1

Total Dollar Amount $ 0 $ 0 $ 500,000 $ 1,400,000 $ 720,000

In the fourth quarter of 2011, we made a $500,000 venture debt investment in an equity-focused portfolio company, Ancora Pharmaceuticals Inc. We note that all amounts, values and numbers mentioned below regarding our equity-focused portfolio companies include this investment in those calculations.

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 September 30, 2012, and December 31, 2011, our total primary and secondary liquidity was $52,912,350 and $65,368,303, 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. Treasury securities and certain receivables. As of September 30, 2012, we held $10,000,000 in U.S. government obligations, and we had an additional $16,556,886 in cash, of which $11,905,005 was held in non-interest-bearing, fully FDIC insured bank accounts. 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. On April 30, 2012, the Company received $11,140 from the portion of our upfront payment held in escrow from the sale of Crystal IS, Inc., to Asahi Kasei Group. These payments immediately added to our primary liquidity. Payments upon achieving milestones of the BioVex Group, Inc., sale or expiration of the escrow periods for the Crystal IS, Inc., and Innovalight, Inc., dispositions would also add to our primary liquidity in future quarters if these milestones are achieved successfully and escrowed funds are released in part or in full. The probability-adjusted values of the future milestone payments for the sale of BioVex and of the funds held in escrow from the dispositions of Crystal IS and Innovalight, as determined at the end of each fiscal quarter, are 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 and the funds held in escrow are released, respectively. During the three months and nine months ended September 30, 2012, 104,300 and 192,600 shares, respectively, of our investment in Solazyme, Inc., were called under option contracts. In total, we received $4,112,340 in gross proceeds from these transactions, which added to our primary liquidity. We also sold an additional 173,359 shares of Solazyme on the open market during this period.

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 September 30, 2012, our secondary liquidity was $26,217,767. NeoPhotonics Corporation and Solazyme, Inc., account for $24,903,100 of this amount based on the closing price of each company as of September 30, 2012. As of September 30, 2012, shares of NeoPhotonics were trading below the strike price of the call options that were open and outstanding. The $10.00 Solazyme option contracts were in the money at September 30, 2012. The fair value of our shares of Champions Oncology, Inc., accounts for $1,314,667 of the total amount of secondary liquidity. As of September 30, 2012, our shares of each of these companies are freely tradable securities. 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.

Potential Pending Liquidity Events from Our Portfolio as of September 30, 2012

As of the end of the third quarter of 2012, six of our companies have commenced planning for and/or began the process of pursuing potential sales and/or IPOs of those companies within the next six to twelve months. These companies have either begun the process of hiring or have hired bankers and/or advisors to attempt to pursue such liquidity events or are in discussions with potential acquirers of those companies. As of September 30, 2012, these efforts are ongoing, and there can be no assurance that any of these companies will be able to consummate either type of transaction within the next six to twelve months, if at all.

As of September 30, 2012, we valued potential milestone payments from the sale of BioVex Group, Inc., at $3,400,488. 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 September 30, 2012, 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.

Strategy for Managing Publicly Traded Positions

During the third quarter of 2012, our strategy for managing our publicly traded positions has generated approximately $297,628 in net cash proceeds from premiums on call options sold. We also added approximately $1,039,720 in net cash proceeds to our primary liquidity resulting from the options called during the third quarter that were covered by a portion of our shares of Solazyme, Inc. During the third quarter of 2012, we sold an additional 173,359 shares of Solazyme for net cash proceeds of $2,178,338. The net increase in our primary liquidity from these transactions was $3,515,686. The average sale price on assignments under option contracts and open market sales was $11.59 for the quarter. Our cost basis in Solazyme is $2.36 per share. The proceeds from the premiums received from the sale of call options and the cash from the sale of shares discussed above have yielded cash that is approximately the same as the original amount we invested in Solazyme. This increase in primary liquidity is important for our efforts to continue to fund existing and new portfolio companies that could generate future investment returns.

We discuss our assessment of the benefits of selling covered call options on our publicly traded portfolio companies in detail in our Annual Report on Form 10-K for the year ended December 31, 2011. In addition to this assessment, we note that the shares of NeoPhotonics Corporation and Solazyme, Inc., remain relatively illiquid compared to the number of shares owned by us and are highly volatile. We may increase the number of in-the-money call options sold by us to facilitate an orderly liquidation of our positions in these companies. We may also purchase put options as a method of limiting the downside risk that the price per share of these companies may decrease substantially from current levels. A put option gives its holder the right to sell a specified number of shares of a specific security at a specific price (known as the exercise strike price) by a certain date. The buyer of a put option is betting that the price of the security will decrease before the option expires. The risk for us as the option holder is that the option expires unexercised, and we have lost the money spent on buying the option.

Maturity of Current Equity-Focused Venture Capital Portfolio

Our equity-focused venture capital portfolio is comprised of companies at varying maturities facing different types of risks. We have defined these levels of maturity and sources of risk as: 1) Early Stage/Technology Risk, 2) Mid Stage/Market Risk and 3) Late Stage/Execution Risk. We provide detailed descriptions of each of these classifications in our Annual Report on Form 10-K for the year ended December 31, 2011.

We believe a portfolio of companies focused on a diverse set of industries reduces the potential impact of cyclicality within any one industry. Our current portfolio is comprised of companies at varying stages of maturity in a diverse set of industries within three sectors. We consider NanoGram Devices to have been both an energy and a healthcare portfolio company. 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. This diversity of industries and our pipeline of investment maturities are demonstrated by the distribution of our current early- and mid-stage portfolio companies within each sector shown in the table below.

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During the third quarter of 2012, we transitioned one company, Adesto Technologies Corporation, from a mid-stage company to a late-stage company.

Portfolio Company Revenue

We currently have 23 companies in our equity-focused venture capital portfolio that generate revenues ranging from nominal to significant from commercial sales of products and/or services, from commercial partnerships and/or from government grants. In aggregate, our portfolio companies had approximately $424 million in revenue in 2011, an 11.6 percent increase from aggregate 2010 revenue of approximately $380 million and a 58.8 percent increase from aggregate 2009 revenue of $267 million.

Current Business Environment

The third quarter of 2012 ended with increases in value in the public market indices. These increases were not reflected in the number and dollar amounts of IPOs and M&A transactions, which were both down for the third quarter as compared with the same quarter last year. Ten U.S. venture-backed companies raised $1.1 billion through IPOs in the third quarter of 2012, which is a slight decline from the second quarter of 2012 and the third quarter of 2011 (11 companies each), according to Dow Jones VentureSource and Thomson Reuters and the NVCA. The average disclosed deal value for venture-backed M&A transactions (30 disclosed of 99 deals) in the third quarter of 2012 was $253.3 million, a 26 percent increase from the second quarter of 2012. The IT sector dominated these deals, with 70 of the 96 deals. Life science companies had 16 deals, with an average disclosed price (9 disclosing of 16) of $105 million. However, according to Thomson Reuters, the IT industry saw a 50 percent drop in M&A activity from the third quarter of 2011 to the third quarter of 2012. Fifty-three U.S. venture capital funds raised $5.0 billion in the third quarter of 2012 according to Thomson Reuters and the National Venture Capital Association (NVCA). This is a 23 percent increase in the number of funds (up from 38) and a 17 percent decrease in the amount of capital raised (down from $5.9 billion). The top five venture capital funds accounted for 55 percent of the total fundraising in the third quarter, which is down from 80 percent in the second quarter. Fundraising for all but the top-tier venture capital funds continues to be difficult owing in part to the closely watched 10-year benchmark for venture capital returns that stood at only 5.28 percent as of June 30, 2012, which is the most recent data available for this statistic from Cambridge Associates, LLC.

The current business environment is also complicated by global economic uncertainty and regional unrest. It remains unclear if and how the debt crisis in Europe will develop and whether it will result in a slowing of worldwide economic growth or even trigger a further global financial crisis. It is unclear if the rising budget deficits in the United States will result in further downgrades in its credit rating. Any outcome could be heightened potentially should an alternative to U.S. Treasury securities emerge as the global safe-haven for invested capital or should large holders of these securities, such as China, decide to divest of them in large quantities or in full. All of this uncertainty could lead to a further broad reduction in risk taken by investors and corporations, which could reduce further the capital available to our portfolio companies, could affect the ability of our portfolio companies to build and grow their respective businesses, and could decrease the liquidity options available to our portfolio companies.

Historically, difficult venture environments have resulted in a higher than normal number of companies not receiving financing and being subsequently closed down with a loss to venture investors, and other companies receiving financing but at significantly lower valuations than the preceding financing rounds. This issue is compounded by the fact that many existing venture capital firms have few remaining years of investment and available capital owing to the finite lifetime of the funds managed by these firms. Additionally, even if a firm was able to raise a new fund, commonly venture capital firms are not permitted to invest new funds in existing investments. This limitation of available capital can lead to fractured syndicates of investors. A fractured syndicate can result in a portfolio company being unable to raise additional capital to fund operations; this issue is especially acute in capital-intensive sectors that are enabled by nanotechnology, such as energy, healthcare and electronics, which are generally not in favor among venture capital firms. The result of these difficulties is that the portfolio company may be forced to sell before reaching its full potential or be shut down entirely if the remaining investors cannot financially support the company. As such, improvements in the exit environment for venture-backed companies through IPOs and M&A transactions may not translate to an increase in the available capital to venture-backed companies, . . .

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