Fellow Shareholders:
During the year 2000, Harris & Harris Group realized net capital gains of $19,065,267. Nevertheless, the Company's net asset value per share (NAV) declined from $5.80 per share to $3.51 per share. This sharp decline in NAV was in concert with declines in market prices of various of the Company's publicly traded holdings during the year, several of which were subject to lock-up agreements. This decline in NAV is also consistent with the economic slowdown and more particularly the collapse of Nasdaq stocks since March 10, 2000, and the near closing of the marketplace to initial public offerings (IPOs) for the types of early stage, high technology, private equity investments in the Company's portfolio. The single most significant of the Company's asset declines in 2000 occurred in the shares of SciQuest.com, Inc. (Nasdaq: SQST) during a period in which the Company was subject to a lock-up agreement.
The Company was very fortunate that in late September 2000 the IPO window was open enough to accommodate the offering of Genomica Corporation (Nasdaq: GNOM). The Company owns 731,111 shares of Genomica at an average historical cost of $2.05 per share. But the price action of Genomica after its IPO is illustrative of the effect of the bear market on the Company's NAV. Genomica came public at $19, traded above $23, then slumped below $5 before the end of the year.
The impact of the most severe decline in the history of the Nasdaq index since its founding in 1971 (the largest decline of a major United States stock market index since the Great Depression) on an early-stage, high technology, venture capital business like the Company's should be not underestimated. As the letter to shareholders in last year's Annual Report, dated March 8, 2000, noted: "In 1999 and in 2000 to the date of this writing, the Company has benefited from extraordinarily favorable stock market and general economic conditions that it would be folly to extrapolate into the future." And as noted in the letter to shareholders dated November 16, 2000, for the third quarter ended September 30, 2000: "Bear markets are difficult operating environments for venture capital firms like Harris & Harris Group. Bear markets tend to depress the value of publicly held portfolio companies, slow the issuance of IPOs and inhibit access to third-party capital by privately held portfolio companies."
Despite the difficult economic and capital markets environment, the Company generated significant cash during the year 2000 through realization of long-term capital gains in private equity investments that had become publicly traded: Alliance Pharmaceutical Corp. (Nasdaq: ALLP) (total net proceeds of $11,385,446 on an investment of $1,692,000); SciQuest.com (total net proceeds of $8,257,377 on an investment of $850,000); and Kana Communications, Inc. (Nasdaq: KANA) (net proceeds of $1,504,762 on the sale of 90 percent of the Company's position with a cost basis of $449,944). During 2000, some of the Company's cash was used to repay a $3 million note, the Company's only indebtedness, to pay a $0.02 per share cash dividend and to repurchase a total of 176,600 shares of the Company's common stock in the open market at an average net price of $3.00 per share.
Among the Company's new investments in 2000 were a total of $1,500,000 in Experion Systems, Inc. and $500,000 through conversion of a promissory note in Informio, Inc. Among the Company's follow-on investments were: $490,000 through exercise of a warrant to purchase shares of Alliance Pharmaceutical; a total of $577,500 in Sundial Marketplace Corporation; $500,000 in Genomica; $750,000 in a convertible note in NeuroMetrix, Inc.; $100,000 in Questech Corporation; and a total of $1,987,457 in open market purchases of SciQuest.com, common stock.
The Alliance Pharmaceutical shares purchased through the $490,000 warrant exercise were subsequently sold in 2000 for net proceeds of $2,370,283; Sundial Marketplace was subsequently acquired in 2000 in a stock swap with Essential.com, Inc.; Genomica subsequently went public in September 2000; NeuroMetrix and Questech subsequently completed private rounds of financing in 2001 and 2000, respectively; and the shares of SciQuest.com purchased in the open market were subsequently sold in 2001 in the open market at a net loss of $1,258,679. The Company's portfolio changes in 2000 also reflected the acquisition of publicly traded Silknet Software, Inc. through a stock swap with Kana Communications and the subsequent sale by the Company of the 90 percent portion of its shares in Kana that were not in escrow. Early in 2001, the Company also made a new private equity investment of $750,000 in Schwoo, Inc. and converted its $750,000 convertible note in NeuroMetrix into equity as part of a $13 million round of private follow-on financing.
In 2000, in addition to the $0.02 per share cash dividend, the Company declared a designated undistributed capital gain dividend (also known as a deemed dividend) of $1.784734 per share, in accordance with rules governing a Regulated Investment Company (RIC) under Sub-Chapter M of the Internal Revenue Code. As a consequence of the Company's qualification as a RIC for 2000, both the $0.02 cash dividend and the deemed dividend of $1.78 per share are treated as capital gains to shareholders. In the case of the deemed dividend, however, a special tax credit rule applies. Under that rule, each shareholder may claim a federal tax credit of $0.62 per share, which is the amount of the income tax that the Company has already paid in respect of the $1.78 per share deemed dividend. This credit more than offsets the federal capital gain tax imposed on any individual shareholder as a result of his or her receipt of the deemed dividend, as the maximum individual federal capital gain rate is less than the tax rate borne by the Company. In addition, shareholders enjoy the benefit of an increase in the cost basis of their stock of $1.16 per share (equal to the difference between the amount of the deemed dividend and the tax credit).
Shareholders should read the sections of this annual report dealing with tax information.
In summary, in spite of the economic slowdown and the bear market, the Company realized significant capital gains and generated net tax benefits for shareholders, while continuing its normal business of developing and making follow-on investments in its existing portfolio of private equity investments, making new investments and seeking out and examining potential investments. But, as noted in the letter to shareholders in last year's annual report, written at what turned out to be the peak of the booming economy and runaway bull market, "the Company believes that it is important that all shareholders truly appreciate the serious risks inherent in all aspects of the Company's business, and the Company urges all shareholders to read this annual report in its entirety. For example, as noted under 'Risk Factors' below, 'the Company expects that some of its venture capital investments will be a complete loss or will be unprofitable and that some will appear to be likely to become successful but never realize their potential. The Company has been risk seeking rather than risk [averse] in its approach to venture capital and other investments. Neither the Company's investments nor an investment in the Company is intended to constitute a balanced investment program.'"
In the sort of weak economic and capital markets environment in which we find ourselves today, the ever-present risk factors inherent in the Company's business are even more likely to manifest themselves. The bear market that started a year ago has continued unabated. But, just as we tried to be mindful a year ago that the economic boom and soaring bull market could not continue indefinitely, we are trying to be mindful today that the economic slump and the bear market will run their courses and that the marketplace should eventually become more receptive to IPOs. In the meantime, merger and acquisition activity may play a greater role than IPOs in the private equity sector, albeit at lower valuations than prevailed during the boom.
Additional information about Harris & Harris Group and its holdings can be found on its website on the internet at www.hhgp.com.
Charles E. Harris
Chairman and Chief Executive Officer
Mel P. Melsheimer
President and Chief Operating Officer
March 14, 2001
This letter may contain statements of a forward-looking nature relating to future events. Statements contained in this letter that are forward looking statements are intended to be made pursuant to the Safe Harbor Provisions for the Private Securities Litigation Reform Act of 1995. 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 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.
