Venture Capital for Tiny Technology

 

 

SECOND QUARTER REPORT 2006

 

FELLOW SHAREHOLDERS:

 

The venture capital business, the business of Harris & Harris Group, has always been violently cyclical. And funding of venture capital firms (which are usually organized as partnerships) by limited partners has always exacerbated that inherent cyclicality. Dating back to the infancy of venture capital after World War II, there have been capital-market cycles, in which bull markets that enable venture-capital-backed companies to complete initial public offerings (IPOs) are followed by bear markets in which relatively few IPOs are completed. Limited partners tend to increase their allocations to venture capital funds when there is a lot of IPO activity, and thus historical venture capital returns are high; and to cut their allocations when there is a scarcity of IPO activity, and thus historical venture capital returns are low. In keeping with the limited partner funding cycle, venture capitalists are in general able to negotiate better terms for their venture capital investments during the bear markets, and encounter the most competition for investment opportunities during the bull markets. In general, therefore, returns on venture capital investments initiated during bear markets are higher than such investments initiated during bull markets. (Shareholders who want to learn more about the cyclicality of venture capital may wish to obtain a copy of the out-of-print classic, Venture Capital at the Crossroads, by Bygrave and Timmons, published by Harvard Business School Press in 1992.)

 

Accordingly, we were delighted to see a well-researched, but gloomy, front-page article in the August 3, 2006, issue of The Wall Street Journal, entitled, "Silicon Valley's Backers Grapple With Era of Diminished Returns." The article quoted industry experts on the bleakness of the outlook for venture capital and pointed out that the "cumulative returns for the past six years remain negative, still smarting from the dot-com meltdown," and that "last year there were 56 venture-backed IPOs in the U.S., just a quarter as many as in 1995." Best of all, from our point of view, the article cited scaling back by college endowments of their commitments to venture capital.

 

In this context, during the first half of 2006, we accelerated our pace of venture-capital investments in nanotechnology. Altogether, we invested more dollars in the first half than we did in our previous record full year: $18,165,017 in the first half of this year, versus $16,251,339 in all of 2005. During the second quarter of this year alone, we invested a total of $8,752,253 in privately held companies working at the nanoscale. Three of these investments were initial deals, in which we invested a total of $5,000,547; the remaining $3,751,706 was invested in four follow-on deals in portfolio companies in which we held pre-emptive rights to participate in future rounds of financings.

 

So far this year, we have made five initial investments, and in all five of these deals, we have been the lead investor. The lead investor typically negotiates the price and terms of a deal with the investee company. Acceptability as a lead investor by entrepreneurs and by older, larger, tier-one, venture capital firms is a hallmark for a venture capital firm. We do not insist on being the lead investor when we make an initial investment in a company, if we like the company and the terms. But we believe that the increasing frequency with which we have been leading deals is a sign of the development of our business franchise.

 

Fortuitously, the adverse stock market conditions that have prevailed in recent months, accompanied by an especially poor environment for venture-backed IPOs, has had no adverse fundamental effect so far, that we can discern, on our Company or on our portfolio companies. We entered this year with record amounts of cash and had no plans to make an offering of our shares. And, as we had pointed out in our letter to shareholders in our 2005 Annual Report, "we [were] not aware of any potential blockbuster nanotechnology IPOs, either from our portfolio or elsewhere, that [were] being scheduled for 2006."

 

If, however, the current weak stock market portends an economic slowdown accompanied by cutbacks in capital spending by large corporations, many of our portfolio companies would experience difficulty introducing their new products. Conversely, if some economists are correct that accelerating capital spending will be the new locomotive of the economy as consumer spending moderates, our portfolio companies should find themselves in an economic environment conducive to the introduction of new products. Eventually, bull markets follow bear markets, and periods of ebullient IPO activity follow periods of IPO torpor.

 

As always, we thank you, our shareholders for your understanding of the cyclical nature of our business and your support of our business throughout the cycles. Meanwhile, our deal flow remains robust, and we are investing vigorously in tiny technology with the intent of building an exceptional, albeit highly cyclical, growth business.

 

 

 

Charles E. Harris

Douglas W. Jamison

Daniel V. Leff

Alexei A. Andreev

Chairman and Chief Executive Officer

President and Chief Operating Officer

Executive Vice President

Executive Vice President

Managing Director

Managing Director

Managing Director

Managing Director

 

 

August 16, 2006

 

 

 

 

This letter may contain statements of a forward-looking nature relating to future events. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. These statements reflect the Company's current beliefs, and a number of important factors could cause actual results to differ materially from those expressed in this letter. Please see the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2005, and the Company's report on Form 10-Q for the quarter ended June 30, 2006, filed with the Securities and Exchange Commission, for a more detailed discussion of the risks and uncertainties associated with the Company's business, including but not limited to the risks and uncertainties associated with venture capital investing and other significant factors that could affect the Company's actual results. Except as otherwise required by Federal securities laws, Harris & Harris Group, Inc., undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties. The reference to the portfolio company websites have been provided as a convenience, and the information contained on such websites is not incorporated by reference into this letter.


 



Unaudited Schedule of Investments*

 

(As of June 30, 2006)

 

 

Shares/

 

 

 

Principal

Value

 

Investment

 

AlphaSimplex Group, LLC

 

 

      Limited Liability Company Interest

        --

$        4,058

 

 

 

BridgeLux, Inc.

 

 

      Series B Convertible Preferred Stock

  1,861,504

    1,000,000

 

 

 

Cambrios Technologies Corporation

 

 

      Series B Convertible Preferred Stock

  1,294,025

    1,294,025

 

 

 

Chlorogen, Inc.

 

 

      Series A Convertible Preferred Stock

  4,478,038

       785,000

      Series B Convertible Preferred Stock

  2,077,930

       364,261

 

 

    1,149,261

Crystal IS, Inc.

 

 

      Series A Convertible Preferred Stock

     274,100

      199,983

      Secured Convertible Bridge Note (including interest)

     $68,568

       69,382

 

 

     269,365

CSwitch, Inc.

 

 

      Series A-1 Convertible Preferred Stock

  6,700,000

    3,350,000

 

 

 

D-Wave Systems, Inc.

 

 

      Series B Convertible Preferred Stock

  2,000,000

    1,793,722

      Warrants at $0.85 expiring 10/19/07

  1,800,000

                  0

 

 

    1,793,722

Evolved Nanomaterial Sciences, Inc.

 

 

      Series A Convertible Preferred Stock

  5,870,021

    2,800,000

 

 

 

Exponential Business Development Company

 

 

       Limited Partnership Interest

        --

                  0

 

 

 

Innovalight Inc.

 

 

      Series B Convertible Preferred Stock

16,666,666

    2,500,000

 

 

 

Kereos, Inc.

 

 

      Series B Convertible Preferred Stock

     349,092

       960,000

 

 

 

Kovio, Inc.

 

 

      Series C Convertible Preferred Stock

  2,500,000

    3,000,000

 

 

 

Mersana Therapeutics, Inc.

 

 

      Series A Convertible Preferred Stock

       68,452

       136,904

      Series B Convertible Preferred Stock

     616,500

    1,233,000

      Warrants at $2.00 expiring 10/21/10

       91,625

                  0

 

 

    1,369,904

Metabolon, Inc.

 

 

      Series B Convertible Preferred Stock

  2,173,913

    2,500,000

 

 

 

Molecular Imprints, Inc.

 

 

      Series B Convertible Preferred Stock

  1,333,333

    2,000,000

      Series C Convertible Preferred Stock

  1,250,000

    2,500,000

      Warrants at $2.00 expiring 12/31/11

     125,000

                  0

 

 

    4,500,000

NanoGram Corporation

 

 

      Series I Convertible Preferred Stock

       63,210

         64,259

      Series II Convertible Preferred Stock

  1,250,904

    1,271,670

      Series III Convertible Preferred Stock

  1,242,144

   1,262,764

 

 

   2,598,693

Nanomix, Inc.

 

 

      Series C Convertible Preferred Stock

  9,779,181

    2,500,000

 

 

 

NanoOpto Corporation

 

 

      Series A-1 Convertible Preferred Stock

     267,857

         32,490

      Series B Convertible Preferred Stock

  3,819,935

    1,110,073

      Series C Convertible Preferred Stock

  1,932,789

       842,503

      Series D Convertible Preferred Stock

  1,397,218

       433,138

      Warrants at $0.4359 expiring 03/15/10

     193,279

                  0

 

 

    2,418,204

Nanosys, Inc.

 

 

      Series C Convertible Preferred Stock

     803,428

    2,370,113

      Series D Convertible Preferred Stock

   1,016,950

    3,000,003

 

 

   5,370,116

Nantero, Inc.

 

 

      Series A Convertible Preferred Stock

     345,070

    1,046,908

      Series B Convertible Preferred Stock

     207,051

       628,172

      Series C Convertible Preferred Stock

     188,315

       571,329

 

 

    2,246,409

NeoPhotonics Corporation

 

 

      Common Stock

     716,195

         67,736

      Series 1 Convertible Preferred Stock

  1,831,256

    1,831,256

      Series 2 Convertible Preferred Stock

     741,898

       741,898

      Series 3 Convertible Preferred Stock

  2,750,000

     2,750,000

      Warrants at $0.15 expiring 01/26/10

       16,364

              164

      Warrants at $0.15 expiring 12/05/10

       14,063

              140

 

 

    5,391,194

Nextreme Thermal Solutions, Inc.

 

 

      Series A Convertible Preferred Stock

  1,000,000

    1,000,000

 

 

 

Polatis, Inc.

 

 

      Series A-1 Convertible Preferred Stock

       16,775

        47,828

      Series A-2 Convertible Preferred Stock

       71,611

      204,172

 

 

       252,000

Questech Corporation

 

 

      Common Stock

     646,954

       781,520

      Warrants at $1.50 expiring 08/03/06

         8,500

                  0

      Warrants at $1.50 expiring 11/21/07

         3,750

                  0

      Warrants at $1.50 expiring 11/19/08

         5,000

                  0

      Warrants at $1.50 expiring 11/19/09

         5,000

                  0

 

 

       781,520

SiOnyx, Inc.

 

 

      Series A Convertible Preferred Stock

   2,334,994

       750,000

 

 

 

Solazyme, Inc.

 

 

      Series A Convertible Preferred Stock

     988,204

       385,400

 

 

 

Starfire Systems, Inc.

 

 

      Common Stock

     375,000

       150,000

      Series A-1 Convertible Preferred Stock

     600,000

       600,000

 

 

       750,000

Zia Laser, Inc.

 

 

      Series C Convertible Preferred Stock

  1,500,000

                  0

Total

 

$50,933,871

=========

 


 


HARRIS & HARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES*

ASSETS

 

 

June 30, 2006

December 31, 2005

 

(Unaudited)

 

 

Cash, U.S. government and government agency securities and cash equivalents

$  66,135,126

$ 97,464,153

Investments, at value

    50,933,871

   33,187,333

Restricted funds

      1,942,840

     1,730,434

Receivable from portfolio company

                    0

          75,000

Interest receivable

         590,101

        248,563

Prepaid expenses

         293,709

            2,993

Other assets

         205,118

        229,644

Total assets

$120,100,765

==========

$132,938,120

==========

 

 

LIABILITIES & NET ASSETS

 

Accounts payable and accrued liabilities

$   3,344,448

$    3,174,183

Accrued profit sharing

        210,786

      2,107,858

Deferred rent

          24,727

           31,003

Current taxes payable

     1,354,504

      1,514,967

Taxes payable on behalf of shareholders

                   0

      8,122,367

Total liabilities

      4,934,465

    14,950,378

 

 

 

Net assets

$115,166,300

==========

$117,987,742

==========

 

 

 

Net assets are comprised of:

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