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HARRIS & HARRIS GROUP INC /NY/ - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.
(Edgar Glimpses Via Acquire Media NewsEdge) The information contained in this section should be read in conjunction with the
Company's 2011 Consolidated Financial Statements and notes thereto.
Cautionary Statement Regarding Forward-Looking Statements
This Annual Report on Form 10-K contains forward-looking statements that involve
substantial risks and uncertainties. These forward-looking statements are not
historical facts, but rather are based on current expectations, estimates and
projections about the Company, our current and prospective portfolio
investments, our industry, our beliefs, and our assumptions. Words such as
"anticipates," "expects," "intends," "plans," "will," "may," "continue,"
"believes," "seeks," "estimates," "would," "could," "should," "targets,"
"projects," and variations of these words and similar expressions are intended
to identify forward-looking statements. The forward-looking statements contained
in this Annual Report involve risks and uncertainties, including statementsas
to:
• our future operating results;
• our business prospects and the prospects of our portfolio companies; • the impact of investments that we expect to make;
• our contractual arrangements and relationships with third parties;
• the dependence of our future success on the general economy and its impact on
the industries in which we invest;
• the ability of our portfolio companies to achieve their objectives;
• our expected financings and investments;
• the adequacy of our cash resources and working capital; and
• the timing of cash flows, if any, from the operations and/or monetization of
our positions in our portfolio companies.
These statements are not guarantees of future performance and are subject to
risks, uncertainties, and other factors, some of which are beyond our control
and difficult to predict and could cause actual results to differ materially
from those expressed or forecasted in the forward-looking statements, including
without limitation:
• an economic downturn could impair our portfolio companies' ability to continue
to operate, which could lead to the loss of some or all of our investments in
such portfolio companies;
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• a contraction of available credit and/or an inability to access the equity
markets could impair our investment activities;
• interest rate volatility could adversely affect our results, particularly if we
elect to use leverage as material part of our venture debt investment strategy;
• currency fluctuations could adversely affect the results of our investments in
foreign companies, particularly to the extent that we receive payments
denominated in foreign currency rather than U.S. dollars; and
• the risks, uncertainties and other factors we identify in "Risk Factors" and
elsewhere in this Annual Report on Form 10-K and in our other filings with the
SEC.
Although we believe that the assumptions on which these forward-looking
statements are based are reasonable, any of those assumptions could prove to be
inaccurate, and as a result, the forward-looking statements based on those
assumptions also could be inaccurate. Important assumptions include our ability
to originate new investments, certain margins and levels of profitability and
the availability of additional capital. In light of these and other
uncertainties, the inclusion of a projection or forward-looking statement in
this Annual Report on Form 10-K should not be regarded as a representation by us
that our plans and objectives will be achieved. These risks and uncertainties
include those described or identified in "Risk Factors" and elsewhere in this
Annual Report on Form 10-K. You should not place undue reliance on these
forward-looking statements, which apply only as of the date of this AnnualReport on Form 10-K.
Background and Overview
We incorporated under the laws of the state of New York in August 1981. In 1983,
we completed an 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 65of
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.
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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 in 2002. We believe this was the period of time when
nanotechnology was beginning to emerge from its gestational phase to 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 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 is the study of structures 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. According to the National Science Foundation and the National
Nanotechnology Initiative, this decade witnessed average growth rates of
nanotechnology-related research and development funding, peer-reviewed
publications and patent applications of 23 percent to 35 percent. According to
the same institutions, nanotechnology-enabled companies created over 300,000
jobs worldwide and introduced over $200 billion worth of products. Our portfolio
companies experienced similar growth during this period of time with aggregate
revenues increasing 21 percent from 2007 to 2011, and 11.6 percent from 2010 to
2011.
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.
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Investment Objective and Strategy
Our principal investment objective is to achieve long-term capital appreciation
by making equity-focused venture capital investments. 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 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. 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.
We seek long-term capital appreciation through venture capital investments in
equity-related securities of companies that we believe have exceptional growth
potential. These businesses 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 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 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
December 31, 2011, we held at least one board seat or observer rights on 22 of
our 27 equity-focused portfolio companies (81 percent).
We may hold two or more board seats in early-stage portfolio companies or those
in which we have significant ownership. We may transition off of the board of
directors to an observer role as our portfolio companies raise additional
capital from new investors, as they mature or as they are able to attract
independent members who have relevant industry experience and contacts. We also
typically step off the board of directors upon the completion of an IPO. Our
observer rights at board of directors meetings commonly cease when companies
complete an IPO. We held observer rights in NeoPhotonics Corporation and
Solazyme, Inc., until the completion of each company's IPO.
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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.
Historical Investments and Current Investment Pace
Since our investment in Otisville in 1983 through December 31, 2011, we have
made a total of 93 equity-focused venture capital investments. We have exited 66
of these 93 investments, realizing total gross proceeds of $158,872,869 on our
cumulative invested capital of $91,890,222. The gross proceeds received include
our upfront payment from the sale of BioVex Group, Inc., to Amgen, Inc., in the
first quarter of 2011, but do not include the potential milestone payments that
could occur as part of this transaction at points in time in the future or the
portion of the upfront payment held in escrow as of December 31, 2011.
The gross proceeds received also include our upfront payment from the sale of
Innovalight, Inc., to E.I. du Pont de Nemours and Company ("DuPont") in the
third quarter of 2011 and the sale of Crystal IS, Inc., to the Asahi Kasei Group
in the fourth quarter of 2011, but do not include the portion of the upfront
payments held in escrow as of December 31, 2011. Both the gross proceeds and the
cumulative invested capital do not reflect the cost or value of our ownership of
NeoPhotonics or Solazyme which completed IPOs on February 2, 2011, and May 27,
2011, respectively, as we have not yet sold or had our shares called from us
through exercise of the call options written by us on a portion of these
investments.
From August 2001 through December 31, 2011, all 51 of our initial equity-focused
investments have been in companies commercializing or integrating products
enabled by nanotechnology or microsystems. From August 2001 through December 31,
2011, we have invested a total (before any subsequent write-ups, write-downs or
dispositions) of $143,998,386 in these companies. We currently have 27
equity-focused companies in our portfolio. At December 31, 2011, from first
dollar in, the average and median holding periods for these 27 investments were
each 5.0 years. Historically, as measured from first dollar in to last dollar
out, the average and median holding periods for the 66 investments we have
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, 2007, to December 31,
2011. 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.
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Investments in Our Equity-Focused Portfolio of Investments
in Privately Held and Publicly Traded Companies
2007 2008 2009 2010 2011
Total Incremental
Investments $ 20,595,161 $ 17,779,462 $12,334,051 $ 9,560,721 $ 17,688,903
No. of New Investments 7 4 2 3 4
No. of Follow-On Investment
Rounds 20 25 29 27 31
No. of Rounds Led 3 4 5 5 4
Average Dollar Amount -
Initial $ 1,086,441 $ 683,625 $ 174,812 $ 117,069 $ 1,339,744
Average Dollar Amount -
Follow-On $ 649,504 $ 601,799 $ 413,256 $ 341,093 $ 397,740
During the twelve months ended December 31, 2011, we made three venture debt
investments. The following is a summary of our investments in venture debtto
date.
Investments in Our Venture Debt Portfolio of Investments
In Privately Held and Publicly Traded Companies
2007 2008 2009 2010 2011
No. of Investments 0 0 0 1 3 Total Dollar Amount $ 0 $ 0 $ 0 $ 500,000 $ 1,400,000
In the fourth quarter of 2011, we made a $500,000 venture debt investment in one
of our equity-focused portfolio companies. We note that all amounts, values and
numbers mentioned below regarding our equity-focused portfolio companies include
this investment in those calculations.
Importance of Availability of Liquid Capital
Private venture capital funds are structured commonly as limited partnerships
with a committed level of capital and finite lifetime. Capital is "called" from
limited partners to make investments and pay for expenses of running the firm at
various points within the lifetime of the fund. For each initial investment, the
fund must reserve additional capital for follow-on investments at later stages
of the life of the portfolio companies. These follow-on investments are required
because often venture-backed portfolio companies in areas in which we invest,
whether privately held or publicly traded, operate with negative cash flow for
lengthy periods of time. In general, the cumulative total of initial invested
capital and reserves cannot exceed the committed level of capital of the fund.
Our strategy for investing capital is similar to this approach in some respects.
We make initial investments in privately held and publicly traded companies and
project the amount of capital that may be required should the company mature
successfully. These projections, equivalent to the reserves of private venture
capital funds, are reviewed weekly by management, are updated frequently and are
a component of the data that guide our decisions on whether to make new and
follow-on investments. As a publicly traded, internally managed venture capital
company, our cash used to make investments and pay expenses is held by us and
not called from external sources when needed. Accordingly, it is crucial that we
operate the company with a substantial balance of liquid capital for this reason
and for four additional reasons.
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1) We manage the company and our investment criteria and pace such that our
projected needs for capital to make new and follow-on investments do not
exceed the total of our liquid investments. Although we use best efforts to
predict when this capital will be required for use in new and follow-on
investments, we cannot predict with certainty the timing for these
investments. We would be unable to make new or follow-on investments in our
portfolio companies without having substantial liquid resources of capital
available to us.
2) Venture capital firms traditionally invest beside other venture capital firms
in a process called syndication. The size of the fund and the amount of
capital reserves available to syndicate partners is often an attribute that
potential co-investors consider when deciding on syndicate partners. As we do
not have committed capital from limited partners, we believe we must have
adequate available liquid capital on our balance sheet to be able to have
access to high-quality deal flow.
3) We rarely commit the total amount of cumulative capital intended for
investment in any portfolio company at one point in time. Instead, our
investments consist of multiple rounds of financing of a given portfolio
company, in which we typically participate if we believe that the merits of
such an investment outweigh the risks. We also commonly have preemptive rights
to invest additional capital in our privately held portfolio companies. These
rights are useful to protect and potentially increase the value of our
positions in our portfolio companies as they mature. Commonly, the terms of
such financings in privately held companies also include penalties for those
investors that do not invest in these subsequent rounds of financing. Without
available capital at the time of investment, our ownership in the company
would be subject to these penalties that can lead to a partial or complete
loss of the capital invested prior to that round of financing.
4) We may have the opportunity to increase ownership in late rounds of financing
in some of our most mature companies. Many private venture capital funds that
invested in these companies are reaching the end of the term associated with
their limited partnerships. This issue may limit the available capital to
these funds for follow-on investments, and the ability to take advantage of
potentially valuable terms given to those who have investable capital. Having
permanent, liquid capital available for investment and access to the capital
markets allows us to take advantage of these opportunities as they arise.
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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 December 31, 2011, and December 31, 2010,
our total primary and secondary liquidity was $65,368,303 and $42,079,934,
respectively. We do not include our credit facility as primary or secondary
liquidity. Primary liquidity is comprised of cash and certain receivables. As of
December 31, 2011, we held $33,841,394 in cash, of which $25,251,666 was held in
non-interest-bearing, fully FDIC insured bank accounts. As of December 31, 2011,
we held $0 in U.S. government obligations. During the first quarter of 2011, we
received the upfront payment of $7.7 million from the disposition of BioVex.
During the third quarter of 2011, we received approximately $4.5 million from
the disposition of Innovalight. During the fourth quarter of 2011, we received
approximately $1.7 million from the disposition of Crystal IS. These payments
immediately added to our primary liquidity. Payments upon achieving milestones
of the BioVex acquisition or expiration of the escrow periods for the BioVex,
Crystal IS and Innovalight acquisitions 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 value of the
future milestone payments for the BioVex acquisition and of the funds held in
escrow from the acquisitions of BioVex, Crystal IS and Innovalight, 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 when payment is received for achievement of the
milestones.
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 December 31, 2011, our secondary liquidity
was $31,457,861. NeoPhotonics and Solazyme account for $29,484,527 of this
amount based on the closing price of each company as of December 31, 2011.
Champions Oncology accounts for $1,973,334 of the total amount of secondary
liquidity. As of December 31, 2011, 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.
Should additional portfolio companies successfully complete IPOs or should we
make additional investments in publicly traded companies, our source of
secondary liquidity could materially increase. We believe these developments
make it important, therefore, to examine both our primary and secondary
liquidity when assessing the strength of our balance sheet and our future
investment capabilities.
Liquidity Events from Our Portfolio in 2011
During the year ended December 31, 2011, we had five liquidity events in the
portfolio.
On December 28, 2011, the Asahi Kasei Group completed its acquisition of Crystal
IS. We received a portion of our payment of $1.74 million for our securities of
Crystal IS. As of December 31, 2011, approximately $288,000 in additional
proceeds from the transaction is held in escrow to cover potential indemnity
claims, working capital shortfalls and the expenses of the stockholder agent.
The majority of this amount is held in escrow for a period of 15 months from the
date of the transaction.
On July 21, 2011, DuPont completed its acquisition of Innovalight. We received
payment of $4.55 million for our securities of Innovalight. As of December 31,
2011, approximately $928,000 in additional proceeds from the transaction is held
in escrow to cover potential indemnity claims for a period of 18 months from the
date of the transaction.
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On May 27, 2011, Solazyme completed an IPO by selling 10,975,000 shares of
common stock at $18 per share. The common stock of Solazyme trades on the Nasdaq
Global Select Market under the symbol "SZYM." As of December 31, 2011, we owned
an aggregate of 2,304,149 shares of Solazyme. This position was valued at
$27,419,373 as of December 31, 2011. Our valuation of Solazyme as of December
31, 2011, was based on the share price as of the close of trading on December
30, 2011, which was $11.90. As of March 13, 2012, Solazyme's closing price was
$14.43 per share. In December 2011, we sold call options covered by a portion of
our shares owned of Solazyme that resulted in cash premiums paid to the Company
of $300,000.
On March 4, 2011, Amgen completed its acquisition of BioVex. The acquisition
included an upfront payment of $425 million and milestone payments of up to $575
million. On March 11, 2011, we received our upfront payment of $7,702,470. As of
December 31, 2011, our portion of the upfront payment that remained in escrow
was approximately $953,000. As of December 31, 2011, we valued potential
milestone payments and funds held in escrow from the sale of BioVex at
$3,839,384. If all the remaining milestone payments were to be paid by Amgen,
and if the full amount held in escrow is released, we would receive $10,479,604.
We have not received any milestone payments as of December 31, 2011, and there
can be no assurances as to how much of this amount we will ultimately realize in
the future, if any.
On February 2, 2011, NeoPhotonics completed an IPO by selling 7,500,000 shares
of common stock at $11 per share. The common stock of NeoPhotonics trades on the
New York Stock Exchange under the symbol "NPTN." As of December 31, 2011, we
owned an aggregate of 450,907 shares of NeoPhotonics. This position was valued
at $2,065,154 as of December 31, 2011.
Potential Liquidity Events from Our Portfolio in 2012
In the first quarter of 2012, one of our portfolio companies received a
non-binding letter of interest for the potential acquisition of the company. As
of March 13, 2012, the discussion between these two companies is ongoing, and
there can be no assurance that these companies will reach mutually acceptable
terms to consummate a transaction.
Also in the first quarter of 2012, three of our portfolio companies have
commenced planning for and/or began the process of hiring bankers to pursue
potential sales and/or IPOs of those companies. As of March 13, 2012, these
efforts are ongoing, and there can be no assurance that either of these
companies will be able to consummate either type of transaction.
Strategy for Managing Publicly Traded Positions
Our equity-focused portfolio companies may seek to raise capital and provide
liquidity to shareholders through IPOs. It is generally rare that pre-IPO
investors are afforded the ability to sell a portion of shares owned in the IPO.
These pre-IPO shares are often subject to lock-up provisions that prevent the
sale of those shares, options against those shares or other transactions
associated with those shares until expiration of the lock-up period, which is
often 180 days from the date of the IPO. We commonly plan to hold our shares of
our publicly traded portfolio companies following the expiration of the lock-up
restrictions if we believe that the prospects for future growth of the portfolio
company and the underlying value of our shares are as great or greater than
other opportunities we are currently encountering. We believe we are able to
make such assessments using our extensive knowledge of the companies having
actively worked with them and their management teams over multiple years as
pre-IPO investors. As such, we may hold our shares of publicly traded portfolio
companies for extended periods of time from the date of IPO.
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Following the expiration of the lock-up restrictions, we may pursue the sale of
call options covered by our ownership of shares in our publicly traded portfolio
companies. The Company will only "sell" or "write" options on common stocks held
in the Company's portfolio. We will not sell "naked" call options, i.e., options
representing more shares of the stock than are held in the portfolio. These call
options give the buyer the right to purchase our stock at a given price, the
"strike price," prior to a specific date, the "expiration date." A call option
whose strike price is above the current price of the underlying stock is called
"out-of-the-money." Most of the options that will be sold by us are expected to
be out-of-the-money, allowing for potential appreciation in addition to the
proceeds from the sale of the option. When stocks in the portfolio rise, call
options that were out-of-the-money when written may become in-the-money, thereby
increasing the likelihood that they could be exercised, and we would be forced
to sell the stock. For conventional listed call options, the options' expiration
date can be up to nine months from the date the call options are first listed
for trading. Longer-term call options can have expiration dates up to three
years from the date of listing. We currently expect to write call options with
expirations of no more than nine months from the date the call option is first
listed for trading.
We believe this strategy of selling covered call options on our publicly traded
portfolio companies provides at least three benefits:
1) We receive payment of a premium in cash at the time of the sale of the call
option. The amount of the premium received is negotiated between the buyer and
us and is influenced generally by the market price of the underlying stock,
the volatility of the stock and the length of time between the date of sale of
the call option and the expiration date. If the option expires
out-of-the-money, we retain the premium as a gain on our investment.
2) If the option is exercised, it enables the monetization of the stock held by
us in an orderly transaction that yields known returns. Our publicly traded
portfolio companies currently trade at small average daily volumes of shares
compared with our positions in these companies. As such, a decision by us to
sell a portion or all of our shares in these companies in the public markets
through brokers could negatively affect the price at which we would be able to
sell these shares and, therefore, our ultimate returns. The sale of a call
option sets a price at which our shares would sell if the option is exercised,
which negates the potential impact of illiquidity or other market dynamics on
our returns from the sale of these shares. That said, it also sets an upper
limit for the proceeds we would receive in such sale. We plan to enter into
such contracts at a price per share and in a timeframe that we would be
willing to sell those shares. While we may repurchase call options when
advantageous to us, we commonly do not sell call options with the expectation
that we will repurchase them at a future date.
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3) The sale of options may help generate interest and liquidity in the stock of
our publicly traded portfolio companies. Current market dynamics make it
difficult for small capitalization stocks to attract interest from
institutional and retail investors. This difficulty leads to low average
trading volumes and low liquidity options for existing shareholders. We
believe the sale of call options may aid in increasing the interest and
liquidity in the stock of these companies and may be beneficial to our future
potential returns on these investments.
Maturity of Current Equity-Focused Venture Capital Portfolio
Our equity-focused venture capital portfolio is composed 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. Early-stage companies have a
high degree of technical, market and execution risk, which is typical of initial
investments by venture capital firms, including us. These companies often
require substantial development of their technologies before they begin
introducing products to market. Mid-stage companies are those that have overcome
most of the technical risk associated with their products and are now focused on
addressing the market acceptance for their products. For those companies
developing therapeutics or medical devices, the focus is on bringing their
products through the first phases of clinical trials. Late-stage companies are
those that have determined there is a market for their products, and they are
now focused on sales execution and scale. Late-stage healthcare and
biotechnology companies are typically either in Phase III Clinical Trials, which
are the pivotal trials before a possible FDA approval and commercial launch of a
product, or are generating revenue from the commercial sale of one or more
products. The charts below show our assessment of the stage of maturity of the
27 companies in our equity-focused portfolio of investments and include the cost
and value ascribed to the companies within each of these stages of maturity.
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We seek to create a portfolio of companies that enables consistent flows of
potential liquidity events in multiple industries in three sectors, energy,
healthcare and electronics, which can be monetized as these companies mature.
We classify energy companies as those that seek to improve performance,
productivity or efficiency, and to reduce environmental impact, waste, cost,
consumption or raw materials using nanotechnology-enabled solutions. We have
historically used the term "cleantech" to describe these types of companies. We
now use the term energy to describe these companies and include our companies
formerly classified as cleantech companies in this category.
We classify healthcare companies as those that use nanotechnology to address
problems in healthcare-related industries, including biotechnology,
pharmaceuticals and medical devices.
We classify electronics companies as those that address problems in
electronics-related industries, including semiconductors.
We believe a portfolio of companies focused on a diverse set of industries
reduces the potential impact of cyclicality of 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 also include our positive exits from
these portfolios. 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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[[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 are
commonly 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 fourth quarter of 2011, we did not transition any companies between
classifications of stage of maturity; however, we sold Crystal IS, Inc., which
was included in our energy portfolio as an early-stage company.
We currently have 22 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 2009revenue of $267 million.
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Current Business Environment
The fourth quarter of 2011 ended with broad increases in value in the public
market indices, but the values of nanotechnology-related companies and
investment companies lagged behind these indices. Venture capital fundraising,
investment activity, and the volume of liquidity events were all down in the
fourth quarter from the prior quarter in 2011. This downtrend precipitated from
continued general macroeconomic instability and uncertainty and volatility in
the public markets. In 2011, fewer exits by U.S. venture-backed companies netted
more capital as the median price paid for an acquisition and the median amount
raised during an IPO increased. Throughout 2011, 522 mergers, acquisitions,
buyouts and IPOs netted $53.2 billion, a 14 percent drop in deal activity and 26
percent increase in capital raised compared with 2010. The difference in capital
raised in IPOs can largely be attributed to two companies that combined raised
$1.7 billion through their IPOs. Thirty-eight U.S. venture capital funds raised
$5.6 billion in the fourth quarter of 2011, according to Thomson Reuters and the
National Venture Capital Association. This level marks a 162 percent increase by
dollar commitments, but a 41 percent decline by number of funds compared with
the third quarter of 2011, which saw 64 funds raise $2.1 billion during the
period. This quarter marks the lowest number of funds raising money since the
third quarter of 2009. U.S. venture capital fundraising for all of 2011 totaled
$18.2 billion from 169 funds, a 32 percent increase by dollars compared with
2010 and with the same number of funds. 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 2.59
percent as of September 30, 2011, 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 spread from Greece, Portugal, Italy, Ireland and Spain to other
countries in the region or beyond 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. It is unclear how regional unrest will affect the global economy should it
persist and/or expand beyond northern Africa and the Middle East. 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. 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 merger and acquisition transactions may not translate
to an increase in the available capital to venture-backed companies,
particularly those that have investments from funds that are in the latter stage
of life unless the markets improve for some time into the future.
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Our overall goal remains unchanged. We want to maintain our leadership position
in investing in nanotechnology and microsystems and to increase our net asset
value. The current environment for venture capital financings continues to favor
those firms that have capital to invest regardless of the stage of the investee
company. We continue to finance our new and follow-on equity and convertible
debt investments from our cash reserves held in bank accounts. We have
historically held, and may in the future again hold, our cash that finances our
operations in U.S. Treasury securities. We believe the turmoil of the venture
capital industry and the current economic climate provide opportunities to
invest this capital at historically low valuations in equity and convertible
debt securities and at high yields in non-convertible debt securities of new and
existing privately held and publicly traded companies of varying maturities.
Valuation of Investments
We value our privately held venture capital investments each quarter as
determined in good faith by our Valuation Committee, a committee of all the
independent directors, within guidelines established by our Board of Directors
in accordance with the 1940 Act. (See "Footnote to Consolidated Schedule of
Investments" contained in "Consolidated Financial Statements.")
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The values of privately held, venture capital-backed companies are inherently
more difficult than publicly traded companies to assess at any single point in
time because securities of these types of companies are not actively traded. We
believe, perhaps even more than in the past, that illiquidity, and the
perception of illiquidity, can affect value. Management believes further that
the long-term effects of the difficult venture capital market and difficult exit
environments will continue to affect negatively the fundraising ability of weak
companies regardless of near-term improvements in the overall global economy and
public markets, and that these factors can also affect value.
In each of the years in the period 2007 through 2011, the Company recorded the
following gross write-ups in privately held securities as a percentage of net
assets at the beginning of the year ("BOY"), gross write-downs in privately held
securities as a percentage of net assets at the beginning of the year, and
change in value of private portfolio securities as a percentage of net assets at
the beginning of the year.
Gross Write-Ups and Write-Downs of the Privately Held Portfolio
2007 2008 2009 2010 2011
Net Asset Value, BOY $113,930,303 $138,363,344 $109,531,113 $134,158,258 $146,853,912
Gross Write-Downs During $(7,810,794) $(39,671,588) $(12,845,574) $(11,391,367) $(11,375,661)
Year
Gross Write-Ups During $11,694,618 $820,559 $21,631,864 $30,051,847 $11,997,991
Year
Gross Write-Downs as a
Percentage of Net Asset -6.86% -28.67% -11.7% -8.5% -7.8%
Value, BOY
Gross Write-Ups as a
Percentage of Net Asset 10.26% 0.59% 19.7% 22.4% 8.2%
Value, BOY
Net Change as a Percentage 3.40% -28.08% 8.0% 13.9% 0.4%
of Net Asset Value, BOY
From December 31, 2010, to December 31, 2011, the value of our equity-focused
venture capital portfolio, including our rights to potential future milestone
payments from the sale of BioVex to Amgen increased by $6,120,349, from
$105,679,002 to $111,799,351.
This increase results primarily from new and follow-on investments of
$18,188,903, rights to milestone payments from Amgen valued at $3,362,791, an
increase in the net value of investments of $2,047,373, realized net gains of
$2,415,534 and accrued net bridge note interest of $316,565, offset by a
decrease of $20,210,817 in the unrealized value of investments owing to sales of
certain investments.
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Net of the investments sold during the year, and not including our rights to
potential future milestone payments from the sale of BioVex to Amgen, our
equity-focused portfolio companies increased in value by $18,641,083. This
increase results primarily from new and follow-on investments of $17,734,955, a
net increase in value due to the terms and pricing of new rounds of financing of
$12,346,656, a net increase due to valuations of publicly traded portfolio
companies of $1,432,424, accrued bridge note interest of $309,687 and a net
increase in currency fluctuations and warrant values of $12,666, offset by a net
increase in discounts for non-performance risk of $9,546,905, a decrease in the
values of publicly traded comparable companies used to derive the value of one
of our portfolio companies of $2,300,250 and repayment of a short-term
non-convertible loan of $1,348,150.
We note that our Valuation Committee and ultimately our Board of Directors take
into account multiple sources of quantitative and qualitative inputs to
determine the value of our privately held portfolio companies and our publicly
traded portfolio companies whose values are not derived solely from the closing
price on the last day of the quarter.
We also note that our Valuation Committee does not set the value of our freely
tradable publicly traded portfolio companies, Solazyme, Inc., and NeoPhotonics
Corporation. Even though our position in Champions Oncology, Inc., is freely
tradable as of December 31, 2011, subjective inputs are also included in the
determination of value. Therefore, our Valuation Committee sets the value of
this position.
Non-performance risk is the risk that a portfolio company will be: (a) unable to
raise capital, will need to be shut down and will not return our invested
capital; or (b) able to raise capital, but at a valuation significantly lower
than the implied post-money valuation. Our best estimate of the non-performance
risk of our portfolio companies has been quantified and included in the
valuation of the companies as of December 31, 2011, and this net estimate of
$9,546,905 is the primary offset of the unrealized appreciation of our portfolio
companies due to the terms and pricing of new rounds of financing that occurred
during 2011. In the future, as these companies receive terms for additional
financings or if they are unable to receive additional financing and, therefore,
proceed with sales or shutdowns of the business, we expect the contribution of
the discount for non-performance risk to vary in importance in determining the
values of our securities of these companies. As of December 31, 2011,
non-performance risk was a significant factor in determining the values of 10 of
our 25 equity-focused portfolio companies that are fair valued by our Board of
Directors. These 10 companies accounted for approximately $30.3 million, or 28
percent, of the total value of our equity-focused venture capital portfolio, not
including our rights to milestone payments from the sale of BioVex to Amgen. As
of December 31, 2010, non-performance risk was a significant factor in
determining the values of 12 of our 32 privately held equity-focused, portfolio
companies. These 12 companies accounted for $27 million, or 25.4 percent, of the
total value of our privately held, equity-focused venture capital portfolio.
We also note that our valuation of our securities of Molecular Imprints, Inc.,
includes $3,033,338 that is ascribed to a non-convertible bridge note. The
principal plus interest of this note was repaid in full in the third quarter of
2011. The remaining value results from a liquidation preference that survived
the repayment of the note and, as currently written, would pay the Company
$4,044,450 should the company be sold for more than its outstanding debt and a
contractual payment to management of Molecular Imprints. This amount assumes
that the total non-convertible bridge note preferences are paid in full. Our
value of this portion of our securities of Molecular Imprints as of December 31,
2011, reflects a probability-weighted discount applied to the total amountof
the preference.
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As of December 31, 2011, our top ten investments by value accounted for
approximately 77 percent of the value of our equity-focused venture capital
portfolio.
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Assessment of Venture Capital Investment Portfolio as of December 31, 2011
As a foundational technology, nanotechnology is applicable across a diverse set
of sectors, including energy, healthcare, and electronics. We have built a
portfolio of investments in each of these sectors comprised of companies that
address today's growth markets and what we believe could be tomorrow's growth
opportunities. The value and cost of our equity-focused portfolio is currently
distributed among the three sectors as follows:
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[[Image Removed]]
In the first quarter of 2011, we renamed the sector classification
"Electronics/Semiconductors" to "Electronics" and reclassified three companies,
NeoPhotonics Corporation, Polatis, Inc., and Xradia, Inc., from a sector
classification of "Other" to "Electronics" to reflect a broader definition of
electronics to include photonics, metrology, and test and measurement. We also
renamed the sector classification "Healthcare/Biotech" to "Healthcare." In the
fourth quarter of 2011, we renamed "Cleantech" to "Energy," a term that we
believe encompasses cleantech-related technologies and applications.
The chart below compares the values and numbers of companies that comprise our
venture capital investments in our energy, healthcare and electronics portfolios
as of December 31, 2011, and as of December 31, 2010.
[[Image Removed]]
55
During 2011, we sold our positions in four energy companies, two electronics
companies and two healthcare companies. We made new investments in one energy
company, one electronics company and two healthcare companies.
We note that the value in Healthcare as of December 31, 2011, does not include
our rights to potential future milestone payments from the sale of BioVex to
Amgen. These rights were valued at $3,362,791 as of December 31, 2011, and were
a part of the value of BioVex prior to its sale to Amgen of $11,430,062 as of
December 31, 2010. We note that the amounts in Healthcare and Energy as of
December 31, 2011, do not include the values of amounts held in escrow of
$476,593, $463,228, and $124,413 for the acquisitions of BioVex, Innovalight and
Crystal IS, respectively.
We have and may continue to make investments outside these sectors, and we may
not maintain these sectors or the weightings within these sectors in future
quarters.
Assessment of Our Energy Portfolio as of December 31, 2011
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 using nanotechnology-enabled
solutions. 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 believe macroeconomic
and microeconomic trends, including ongoing growth in consumption of energy and
resources, energy security concerns and volatility of commodity prices, create
attractive investment opportunities in energy. We believe nanotechnology enables
innovation in energy markets through:
· New Approaches to Production: Nanotechnology-enabled methods of production can
enable lower energy use at lower cost and operate with better performance than
current methods of production.
· New Materials: New materials enable the development of new products that
overcome inherent limitations of existing technology and processes.
We continue to believe we are positioned well to take advantage of today's
growth markets within energy. We have been early investors in many of these
markets. Our initial investments in biofuels in 2004 (Solazyme), light-emitting
diodes in 2005 (Bridgelux) and batteries in 2007 (Contour Energy), represent
three of our top ten investments by value. Solazyme completed a successful IPO
in the second quarter of 2011, raising over $200 million. Bridgelux and Contour
Energy achieved record revenue growth in 2011. All of these companies continue
to make progress in their respective markets. Additionally, we believe the
acquisition of Innovalight by Dupont in the third quarter of 2011 and Crystal IS
by Asahi Kasei in the fourth quarter of 2011 provided validation of commercial
interest in using nanoscale-enabled inks to enhance the performance of solar
cells and ultraviolet light emitting diodes for water purification,
respectively.
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We also believe we have a pipeline of companies that are developing solutions
for growth markets that are emerging today or may develop in future years such
as ground-water and other environmental remediation (ABSMaterials), renewable
chemicals and fuels (Cobalt) and alternative sources for high-intensity light
(Laser Light Engines). We made one new energy investment in 2011. This initial
investment made in the second quarter of 2011 was in a produced water
remediation company, Produced Water Absorbents, Inc. The table below shows the
breakdown of our Energy portfolio as of December 31, 2011, based on stage of
maturity of the investment including the year of our initial investment ineach
of the companies.
[[Image Removed]]
Many of our Energy portfolio companies are generating commercial revenues and/or
have entered into partnerships and joint development agreements with large
corporations. We include some of the commercial developments from these
portfolio companies during the fourth quarter below.
Bridgelux:
In October 2011, Bridgelux LED arrays were selected for the installation of 1000
downlights at the new Sheraton Hotel at D-Cube City in Seoul, South Korea. The
new LED lighting will reduce energy consumed by up to 63 percent compared to the
typical use of halogen and compact fluorescent downlights.
In December 2011, Bridgelux announced the commercial availability of its latest
generation LED arrays, which are able to deliver increased efficiency of up to
30 percent and a reduction of up to 30 percent in cost per lumen compared to
previous product generations.
In December 2011, Bridgelux was named to Forbes' list of America's Most
Promising Companies. Bridgelux was ranked 58th on the list of 100 privately held
companies selected from 22 industries for their innovative business models and
strong management teams. Forbes noted that Bridgelux's revenue grew 168 percent
from 2008 to 2010.
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Contour Energy Systems:
In November 2011, Contour Energy Systems announced that it won the second annual
2011 Los Angeles Business Journal Patrick Soon-Shiong Innovation Award. Contour
Energy Systems was also listed among 15 of the most innovative companies inthe
Los Angeles area.
Crystal IS:
In December 2011, Crystal IS was acquired by Asahi Kasei Group for an
undisclosed amount.
Solazyme:
In October 2011, Solazyme Roquette Nutritionals announced the location of its
facility that will produce its microalgae-derived food ingredient, Whole Algalin
Flour, at Roquette's commercial production plant in Lestrem, France. This
facility was completed at the end of 2011 and began operations in early 2012.
In November 2011, a United Airlines jet flew from Houston to Chicago with a 40
percent blend of Solazyme's biofuel. This was the first biofuel powered
commercial flight in the United States. Additionally, United Continental
Holdings Inc. (UAL) agreed to buy 20 million gallons of jet fuel each year from
Solazyme for delivery beginning in 2014. Also, Qantas announced it would launch
its first commercial flight powered by Solazyme sustainable fuel in early 2012.
In December 2011, the Navy and the Agriculture Department announced the purchase
of nearly a half million gallons of biofuel for an air-sea military exercise in
2012 from Solazyme and Dynamic Fuels LLC. Separately, Solazyme fuel was used for
testing on a Spruance-class destroyer on a 185-mile trip from San Diego, CA, to
Oxnard, CA. It was the Navy's largest alternative fuel demonstration to date.
We believe the macroeconomic and microeconomic dynamics that supported our
thesis for historical investments in energy and the potential for nanotechnology
to impact energy-related markets will continue for the foreseeable future. Some
of the market opportunities we are currently investigating for investment
opportunities include energy efficiency, energy storage and new methods for
production, extraction and purification of high-value materials.
Assessment of Healthcare Portfolio as of December 31, 2011
We classify companies in our Healthcare portfolio as those that use
nanotechnology to address problems in healthcare-related industries, including
biotechnology, pharmaceuticals and medical devices. We believe macroeconomic and
microeconomic trends, including an aging population, increasing life expectancy,
increasing prosperity that drives efforts to extend life, the increased global
reach of disease and the need to address exponential growth of expenses of
entitlement programs in some wealthy countries, create attractive investment
opportunities in healthcare. We believe nanotechnology enables innovation in
healthcare markets through:
58
· Engineering of Biological Systems: The ability to study, optimize, and engineer
biological systems at the nanoscale enables the use of biological systems for
diagnosis and treatment of disease.
· Convergence of Multiple Disciplines: Much of the exciting work in
nanotechnology is enabled by the convergence of the knowledge from multiple
scientific disciplines. This convergence enables advances in healthcare that
could not otherwise occur within one discipline.
· New Tools: Complex biological processes include and are often the result of
nanoscale phenomena. The ability to study and interpret these processes
requires new tools. The information produced by these tools may advance the
understanding and facilitate the engineering of biological systems.
We continue to believe we are positioned well to take advantage of today's
growth markets within healthcare having been early investors in many of these
markets. We believe our initial investments in drug delivery vehicles in 2002
(Mersana), metabolomics in 2006 (Metabolon), synthetic carbohydrates in 2007
(Ancora), oncolytic viruses in 2007 (BioVex, which was acquired by Amgen in
2011) and therapeutic discovery platforms in 2007 (Ensemble), positioned us well
to capture the growth of commercial interest in cancer therapeutics, vaccines
and molecular diagnostics. Mersana and Amgen are in clinical trials with their
respective treatments for cancer, and Metabolon generated record revenue in 2010
and in 2011. Additionally, we believe the acquisition of BioVex by Amgen on
March 4, 2011, provided validation of commercial interest in the promise of
oncolytic virus technology.
We also believe we have an emerging pipeline of companies that are developing
solutions for growth markets that exist today or may develop in future years
such as personalized medicine (Enumeral Biomedical). We made two new healthcare
investments in 2011. We made an investment in a personalized medicine company,
Champions Oncology, Inc., in the second quarter of 2011 and an investment in a
solid-state pH meter company, Senova Systems, Inc., in the third quarter of
2011. The table below shows the breakdown of our Healthcare portfolio as of
December 31, 2011, based on stage of maturity of the investment, including the
year of our initial investment in each of the companies.
[[Image Removed]]
59
Our Healthcare companies demonstrate progress and growth through different
mechanisms depending on their respective businesses. Businesses that provide
services, such as Metabolon, generate revenues from the commercial sale of these
services. Businesses that enter into partnerships for discovery and development
of therapeutics, vaccines and diagnostics may generate revenue from upfront
fees, milestone payments and royalties on sales of approved products. Businesses
that endeavor to advance a therapeutic, diagnostic or vaccine product through
clinical trials may not generate revenue until an approved product is on the
market, if ever. Progress for these types of companies can be measured by
progress through clinical trials. We include some of the developments from these
portfolio companies during the fourth quarter below.
Enumeral Biomedical:
In December 2011, Enumeral's antibody discovery platform technology was featured
in an article in Xconomy.com.
Metabolon:
In December 2011, Metabolon announced the identification of a novel role for
adenosine-mediated signaling in sickle cell disease and associated end organ
damage, and the findings were reported in Nature Medicine. Metabolon also
announced the publication of a paper titled, "Biochemical Alterations Associated
with ALS" in the journal Amyotrophic Lateral Sclerosis that describes the use of
its biomarker discovery platform to identify biochemical changes underlying ALS,
a devastating and fatal neurodegenerative disorder characterized by motor neuron
loss.
Senova Systems:
In January 2012, Senova announced the successful completion of Series B
financing of $6.7 million.
We believe the macroeconomic and microeconomic dynamics that supported our
thesis for historical investments in healthcare and the potential for
nanotechnology to impact healthcare-related markets will continue for the
foreseeable future. Some of the market opportunities we are currently
investigating for investment opportunities include molecular diagnostics, 3D
biology, cellular therapy and tissue engineering.
Assessment of Electronics Portfolio as of December 31, 2011
We classify companies in our Electronics portfolio as those that use
nanotechnology to address problems in electronics-related industries, including
semiconductors, telecommunications and data communications, metrology and test
and measurement. We believe macroeconomic and microeconomic trends, including
global connectivity, demand for increasing bandwidth due to pervasiveness of
electronics in daily life, the desire to see not just hear, and need for
real-time availability of data and demand for more functionality driven by
increasing global prosperity, create attractive investment opportunities in
electronics. We believe nanotechnology enables innovation in electronics markets
through:
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· New Methods of Production: Nanotechnology enables continuation of Moore's Law
for exponential increases of the number of integrated circuits in semiconductor
devices.
· New Materials: New materials enable unique capabilities, performance and
form-factors in electronic devices.
· New Forms of Computation: Nanotechnology enables methods of solving equations
and other problems that would be difficult or impossible with standard digital
computing techniques.
We continue to believe we are positioned well to take advantage of today's
growth markets within electronics having been early investors in many of these
markets. We believe our initial investments in non-volatile memory in 2001 and
2007 (Nantero and Adesto, respectively), transparent conductors in 2004
(Cambrios), image sensors in 2006 (SiOnyx), integrated photonics in 2003
(NeoPhotonics) and metrology in 2006 (Xradia), positioned us well to capture the
growth of commercial interest in smartphones and tablet computers with
touchscreens, the exponential increase in demand for bandwidth for data and
telecommunications and the demand for non-destructive imaging capabilitiesin a
variety of industries.
We also believe we have an emerging pipeline of companies that are developing
solutions for growth markets that exist today or may develop in future years
such as high-performance computing enabled by quantum mechanics (D-Wave Systems)
and radio-frequency identification and near-field communication devices enabled
by printed electronics (Kovio). We made one new electronics investment in 2011.
This initial investment was in an electronic water proofing technology company,
HzO, Inc., in the third quarter of 2011. The table below shows the breakdown of
our Electronics portfolio as of December 31, 2011, based on stage of maturity of
the investment, including the year of our initial investment in each of thecompanies.
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[[Image Removed]]
Many of our Electronics portfolio companies are generating commercial revenues
and/or have entered into partnerships and joint development agreements with
large corporations. We include some of the commercial developments from these
portfolio companies during the fourth quarter below.
Adesto Technologies:
In October 2011, Adesto announced the close of its third round of financing led
by a new investor and Adesto's manufacturing partner, Altis Semiconductor.
D-Wave Systems:
In October 2011, the D-Wave quantum computer purchased by Lockheed Martin was
installed at the University of Southern California's Information Sciences
Institute.
In November 2011, the founder of D-Wave, Geordie Rose, was named Canadian
Innovator of the Year for 2011.
HzO
In January 2012, HzO was named an International Consumer Electronics Show (CES)
Innovations 2012 Design and Engineering Awards Honoree in the embedded
technologies category.
In January 2012, HzO announced a $3 million equity investment from Horizons
Ventures, Ltd., a Hong Kong investment firm that manages the private investments
in the technology sector for Mr. Li Ka-shing.
Molecular Imprints
In November 2011, Molecular Imprints announced that the company has been awarded
a contract by a leading IC manufacturer to build the industry's first 450mm
capable lithography system.
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NeoPhotonics
In November 2011, NeoPhotonics announced that the company received the
prestigious Golden Award as an Excellent Core Partner from Huawei Technologies,
one of the world's leading providers of telecommunications network solutions.
SiOnyx
In November 2011, SiOnyx won a $3 million contract from the Department of
Defense to help develop next-generation laser targeting systems for tactical
imaging systems.
We believe the macroeconomic and microeconomic dynamics that supported our
thesis for historical investments in electronics and the potential for
nanotechnology to impact electronics-related markets will continue for the
foreseeable future, albeit with some adjustment. The high capital intensity of
traditional semiconductor investments and the reduced values placed on these
companies at exit in the current market environment have resulted in these
investments becoming less favorable to investors, including ourselves. We are
currently investigating opportunities that do not require such substantial
capital investment to reach commercial revenues and breakeven cash flow. Our new
electronics portfolio company, HzO, Inc., is an example of such an opportunity.
Results of Operations
We present the financial results of our operations utilizing accounting
principles generally accepted in the United States of America ("GAAP") for
investment companies. On this basis, the principal measure of our financial
performance during any period is the net increase (decrease) in our net assets
resulting from our operating activities, which is the sum of the followingthree
elements:
Net Operating Income (Loss) - the difference between our income from interest,
dividends, and fees and our operating expenses.
Net Realized Gain (Loss) on Investments - the difference between the net
proceeds of sales of portfolio securities and their stated cost, plus income
from interests in limited liability companies.
Net Increase (Decrease) in Unrealized Appreciation or Depreciation on
Investments - the net unrealized change in the value of our investment
portfolio.
Owing to the structure and objectives of our business, we generally expect to
experience net operating losses and seek to generate increases in our net assets
from operations through the long-term appreciation and monetization of our
venture capital investments. We have relied, and continue to rely, primarily on
proceeds from sales of investments, rather than on investment income, to defray
a significant portion of our operating expenses. Because such sales are
unpredictable, we attempt to maintain adequate working capital to provide for
fiscal periods when there are no such sales. During 2011, we made three venture
debt investments. While the interest income generated from these investments did
not defray a significant portion of our operating expenses in 2011, further
investments in venture debt could generate more substantial investment income in
future years.
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The potential for, or occurrence of, inflation could result in rising interest
rates for government-backed debt. This trend would have two effects on our
business. First, the spread between the interest rates we can obtain from
investing low-risk government debt versus high-risk venture debt will compress,
which would result in a reduction of the risk premium associated with
investments in venture debt. We may reduce the number and amount invested in
venture debt should this risk premium decrease substantially as to not
compensate us adequately for the risk associated with such investments. Second,
funds drawn from our line of credit will accrue interest at a rate that
fluctuates with the London Interbank Offered Rate (LIBOR). LIBOR is expected to
increase in times of inflation. Our venture debt investments may include both
fixed and floating interest rates. Our interest income would decrease if the
spread between the interest rate on funds from our line of credit and our
venture debt investments decrease.
Comparison of Years Ended December 31, 2011, 2010, and 2009
During the year ended December 31, 2011, we had a net decrease in net assets
resulting from operations of $3,541,363.
During the year ended December 31, 2010, we had a net increase in net assets
resulting from operations of $10,586,850.
During the year ended December 31, 2009, we had a net decrease in net assets
resulting from operations of $148,465.
Investment Income and Expenses:
During the years ended December 31, 2011, 2010, and 2009, we had net operating
losses of $8,338,365, $7,555,807, and $8,761,215, respectively. The variation in
these results is primarily owing to the changes in investment income and
operating expenses, including decreasing non-cash expense of $1,894,800 in 2011,
$2,088,091 in 2010, and $3,089,520 in 2009 associated with the granting of stock
options. During the years ended December 31, 2011, 2010, and 2009, total
investment income was $702,765, $446,038, and $247,848, respectively. During the
years ended December 31, 2011, 2010, and 2009, total operating expenses were
$9,041,130, $8,001,845, and $9,009,063, respectively.
During 2011, as compared with 2010, investment income increased from $446,038 to
$702,765, reflecting an increase in interest income from convertible bridge
notes, non-convertible promissory notes, subordinated and senior secured debt,
and senior secured debt through a participation agreement, offset by a decrease
in interest earned on our U.S. government securities. During the twelve months
ended December 31, 2011, our average holdings of U.S. government securities were
$24,295,971, as compared with $47,139,264 during the twelve months ended
December 31, 2010. The average yield on our U.S. government securities for the
twelve months ended December 31, 2011, and 2010, was 0.08 percent and 0.10
percent, respectively. We decreased our average holdings of U.S. government
securities and ended 2011 with no holdings of U.S. government securities
primarily due to the decrease in yield available over the durations of
maturities in which we were willing to invest and the availability of fully FDIC
insured demand deposit bank accounts.
64
Operating expenses, including non-cash, stock-based compensation expenses, were
$9,041,130 and $8,001,845 for the twelve months ended December 31, 2011, and
December 31, 2010, respectively. The increase in operating expenses for the
twelve months ended December 31, 2011, as compared with the twelve months ended
December 31, 2010, was primarily owing to increases in salaries, benefits and
stock-based compensation expense, administration and operations expense and
professional fees, offset by decreases in rent expense and custody fees.
Salaries, benefits and stock-based compensation expense increased by $684,801,
or 13.0 percent, through December 31, 2011, as compared with December 31, 2010,
primarily as a result of an increase of $529,179 in the projected benefit
obligation expense accrual for medical retirement benefits and an increase in
year-end employee bonuses of $400,000, offset by a decrease in non-cash expense
of $193,291 associated with the Stock Plan and a decrease in salaries and
benefits owing primarily to a decrease in our head count. While the non-cash,
stock-based compensation expense for the Stock Plan increased our operating
expenses by $1,894,800, this increase was offset by a corresponding increase to
our additional paid-in capital, resulting in no net impact to our net asset
value. Administration and operations expense increased by $34,977, or 3.5
percent, through December 31, 2011, as compared with December 31, 2010,
primarily as a result of an increase in accrued expenses associated with
increased investor outreach expenses and a one-time leasing commission expense
associated with subletting our office space located 420 Florence Street, Suite
200, Palo Alto, CA, commencing on July 1, 2011, offset by a decrease in our
directors' and officers' liability insurance expense, decreases in the cost of
non-employee-related insurance and decreases in managing directors'
travel-related expenses. Professional fees increased by $403,608, or 53.6
percent, through December 31, 2011, as compared with December 31, 2010,
primarily as a result of an increase in legal and accounting fees of $50,058 and
$40,000, respectively, associated with exploring alternative means for
increasing assets under management by potentially raising one or more
third-party funds and increases in consulting fees related to investor outreach
and marketing efforts. Rent expense decreased by $25,745, or 6.4 percent, for
the period ended December 31, 2011, as compared with the twelve months ended
December 31, 2010. Our rent expense of $376,487 for the twelve months ended
December 31, 2011, includes $336,265 of rent paid in cash and $40,222 non-cash
rent expense, credits and abatements that we recognize on a straight-line basis
over the lease term. For the twelve months ended December 31, 2010, we had a
loss of $56,540 as a result of abandoning our lease at our former office prior
to the end of the lease term that expired in April 2010. Custody fees decreased
by $33,662, or 35.1 percent, for the twelve months ended December 31, 2011, as
compared with December 31, 2010, owing to the lower fees charged by our new
custodian, Union Bank.
During 2010, as compared with 2009, investment income increased from $247,848 to
$446,038, reflecting an increase in interest income from bridge notes and senior
secured debt through a participation agreement, offset by a decrease in our
average holdings of U.S. government securities as well as a substantial decrease
in interest rates. The average yield on our U.S. government securities decreased
from 0.3 percent for the year ended December 31, 2009, to 0.1 percent for the
year ended December 31, 2010. During the twelve months ended December 31, 2010,
our average holdings of such securities were $47,139,264, as compared with
$52,154,428 during the year ended December 31, 2009.
65
Operating expenses, including non-cash, stock-based compensation expenses, were
$8,001,845 and $9,009,063 for the twelve months ended December 31, 2010, and
December 31, 2009, respectively. The decrease in operating expenses for the
twelve months ended December 31, 2010, as compared with the twelve months ended
December 31, 2009, was primarily owing to decreases in salaries, benefits and
stock-based compensation expense, administration and operations expense and
professional fees, offset by an increase in rent expense, directors' fees and
expenses, and custody fees. Salaries, benefits and stock-based compensation
expense decreased by $1,040,081, or 16.4 percent, through December 31, 2010, as
compared with December 31, 2009, primarily as a result of a decrease in non-cash
expense of $1,001,429 associated with the Harris & Harris Group, Inc. 2006
Equity Incentive Plan (the "Stock Plan"). While the non-cash, stock-based,
compensation expense for the Stock Plan increased our operating expenses by
$2,088,091, this increase was offset by a corresponding increase to our
additional paid-in capital, resulting in no net impact to our net asset value.
The non-cash, stock-based, compensation expense and corresponding increase to
our additional paid-in capital may increase in future quarters. Administration
and operations expense decreased by $114,504, or 10.2 percent, for the year
ended December 31, 2010, as compared with the year ended December 31, 2009,
primarily as a result of a decrease in our directors' and officers' liability
insurance expense and decreases in the expenses related to the annual report and
proxy, offset by increases in the cost of non-employee related insurance and
expenses associated with the relocation of our corporate headquarters in New
York City. Professional fees decreased by $14,551, or 1.9 percent, for the year
ended December 31, 2010, as compared with the year ended December 31, 2009,
primarily as a result of a decrease in accounting and legal fees, offset by an
increase in certain consulting fees. Rent expense increased $85,628, or 27.1
percent, for the year ended December 31, 2010. Our rent expense of $402,232 for
the year ended December 31, 2010, includes $319,129 of rent paid in cash and
$83,103 of non-cash rent expense, credits and abatements that we recognize on a
straight-line basis over the lease term. Our cash-based rent expense in 2009 was
$316,604. Our rent paid in cash of $319,129 includes $47,094 of real estate tax
escalation charges from 2003 to 2010 paid on our previous corporate headquarters
located at 111 West 57 Street in New York City. For the year ended December 31,
2010, we had a loss of $56,540 as a result of abandoning our lease at our former
office prior to the end of the lease term, which expired in April 2010.
Directors' fees and expenses increased by $6,773, or 2.0 percent, for the year
ended December 31, 2010, as compared with the year ended December 31, 2009,
primarily as a result of increases in directors' travel-related expenses.
Custody fees increased by $12,543, or 15.0 percent, for the year ended December
31, 2010, as compared with the year ended December 31, 2009, owing to the higher
fees charged by our new custodian, The Bank of New York Mellon, which has more
expertise in working with investment companies than our prior custodian.
Realized Income and Losses from Investments:
During the year ended December 31, 2011, we realized net gains on investments of
$2,449,705. During the years ended December 31, 2010 and 2009, we realized net
losses on investments of $3,740,518, and $11,105,577, respectively. The
variation in these results is primarily owing to variations in gross realized
gains and losses from investments. For the year ended December 31, 2011, we
realized gains from investments, before taxes, of $2,456,627. For the years
ended December 31, 2010, and 2009, we realized losses from investments, before
taxes, of $3,736,057, and $11,106,330, respectively. Income tax expense
(benefit) for the years ended December 31, 2011, 2010, and 2009 was $6,922,
$4,461, and $(753), respectively.
66
During the year ended December 31, 2011, we realized net gains of $2,456,627,
consisting primarily of realized gains on our investments in BioVex Group, Inc.,
of $7,508,365, Crystal IS, Inc., of $120,668, and in Siluria Technologies, Inc.,
of $25,000, offset by realized losses on our investments in Innovalight, Inc.,
of $664,880, Molecular Imprints, Inc., of $93,405, Polatis, Inc., of $2,018,278,
PolyRemedy, Inc., of $204,206, Questech Corporation of $1,966,591, and in
TetraVitae Bioscience, Inc., of $250,000. The realized loss in Molecular
Imprints, Inc., was owing to the cashless exercise of the warrant to purchase
shares of preferred stock upon its expiration. The cashless exercise resulted in
an increase in our ownership of preferred shares as of December 31, 2011.
A portion of the proceeds from the sale of BioVex Group, Inc., is held in escrow
and valued at $476,593. A portion of the proceeds from the sale of Crystal IS,
Inc., is held in escrow against indemnity claims and valued at $124,413. Should
the full amount of the indemnity escrow of $287,801 be released, the realized
gain on the transaction will be $284,056. A portion of the proceeds from the
sale of Innovalight are held in escrow and valued at $463,228. Should the full
amount of the escrow of $927,713 be released, the realized loss on the
transaction will decrease to $200,395.
During the year ended December 31, 2010, we realized net losses of $3,736,057,
consisting primarily of realized losses on a portion of our investment in Kovio,
Inc., of $257,007, on a portion of our investment in Mersana Therapeutics, Inc.,
of $190,902, in NanoGram Corporation of $3,136,552, in Orthovita, Inc., of
$167,300, and realized losses on the disposal of fixed assets, offset by
realized gains on our investment in Satcon Technology Corporation of $14,320 and
realized gains on the sale of U.S. government securities. The realized losses on
our investments in Kovio, Inc., and Mersana Therapeutics, Inc., were owing to
the termination and expiration of certain warrants, respectively. The warrant
from Kovio, Inc., was terminated pursuant to the terms of the Series A'
financing which closed during the second quarter of 2010. The warrant from
Mersana Therapeutics, Inc., expired unexercised on October 21, 2010. On July 11,
2010, NanoGram was acquired for an undisclosed amount; holders of common stock
did not receive any proceeds from this transaction. During the second quarter of
2010, we received a dividend payment of $13,218 representing our pro rata
portion of the residual net proceeds from the liquidation of Optiva, Inc. We had
invested in Optiva during 2002, and in 2005, it began liquidation under an
assignment for the benefit of creditors. This sum represents the final payment
from the liquidation.
During the year ended December 31, 2009, we realized net losses of $11,106,330,
consisting primarily of realized losses on our investments in CSwitch
Corporation of $5,649,297, in Exponential Business Development Company of
$14,330, in Kereos, Inc., of $1,500,000, in Nanomix, Inc., of $3,176,125, in
Questech Corporation of $16,253, and in Starfire Systems, Inc., of $750,000.
Since the date of our investment of $25,000 in Exponential Business Development
Company in 1995, we periodically received cash distributions totaling $31,208
through the date of the sale. During the third quarter of 2009, we received a
payment of $4,115 from the sale of our interest in Nanomix, Inc. The realized
loss on Questech Corporation was owing to an unexercised warrant that expired on
November 19, 2009.
Net Unrealized Appreciation and Depreciation of Portfolio Securities:
During the year ended December 31, 2011, net unrealized appreciation on total
investments increased by $2,347,297.
During the year ended December 31, 2010, net unrealized depreciation on total
investments decreased by $21,883,175.
67
During the year ended December 31, 2009, net unrealized depreciation on total
investments decreased by $19,718,327.
During the year ended December 31, 2011, net unrealized appreciation on our
venture capital investments increased by $2,228,565, from net unrealized
appreciation of $7,503,038 at December 31, 2010, to net unrealized appreciation
of $9,731,603 at December 31, 2011, owing primarily to increases in the
valuations of the following investments held:
Investment Amount of Write-Up
Solazyme, Inc. $ 4,193,551
Molecular Imprints, Inc. 2,988,447
Bridgelux, Inc. 2,201,705
Metabolon, Inc. 1,979,920
Adesto Technologies Corporation 1,571,117
ABSMaterials, Inc. 1,125,000
Cambrios Technologies Corporation 754,344
Kovio, Inc. 620,397
HzO, Inc. 563,577
GEO Semiconductor, Inc. 86,583
Enumeral Biomedical Corp. 83,333
NanoTerra, Inc. 23,568
The write-ups for the year ended December 31, 2011, were offset by write-downs
of the following investments held:
Investment Amount of Write-Down
NeoPhotonics Corporation $ 2,734,461
Xradia, Inc. 2,300,249
Laser Light Engines, Inc. 2,033,591
Mersana Therapeutics, Inc. 1,869,902
Nanosys, Inc. 1,450,495
Ensemble Therapeutics Corporation 1,075,003
Ancora Pharmaceuticals Inc. 952,303
Nantero, Inc. 561,602
Nextreme Thermal Solutions, Inc. 550,657
Cobalt Technologies, Inc. 246,482
Contour Energy Systems, Inc. 206,118
D-Wave Systems, Inc. 67,877
Champions Oncology, Inc. 26,666
SiOnyx, Inc. 8,189
68
We had an increase in unrealized appreciation for Innovalight, Inc., of
$1,489,110, Molecular Imprints, Inc., of $121,527, Polatis, Inc., of $2,018,288,
PolyRemedy, Inc., of $312,313, Questech Corporation of $1,632,310, and
TetraVitae Bioscience, Inc., of $250,000, owing to realized losses on the sale
of these securities. The realized loss on our investment in Molecular Imprints,
Inc., was owing to the exercise of certain warrants on December 31, 2011.
We had an increase in unrealized appreciation for Crystal IS, Inc., of
$1,746,837 owing to a realized gain on the sale of its securities.
We had an increase in unrealized appreciation of $71,041 on the rights to
milestone payments from Amgen from its acquisition of BioVex in the first
quarter of 2011.
We had a decrease in unrealized appreciation for BioVex of $7,467,615, which
resulted from a realized gain on the sale of its securities.
We had a decrease in unrealized appreciation owing to foreign currency
translation of $53,193 on our investment in D-Wave Systems, Inc.
Unrealized appreciation on our U.S. government securities portfolio decreased
from unrealized appreciation of $1,268 at December 31, 2010, to $0 at December
31, 2011.
During the year ended December 31, 2010, net unrealized depreciation on our
venture capital investments decreased by $21,869,464, or 152.2 percent, from net
unrealized depreciation of $14,366,426 at December 31, 2009, to net unrealized
appreciation of $7,503,038 at December 31, 2010, owing primarily to increases in
the valuations of the following investments held:
Investment Amount of Write-Up
Solazyme, Inc. $ 10,971,812
BioVex Group, Inc. 9,060,913
Xradia, Inc. 3,555,811
SiOnyx, Inc. 3,076,044
D-Wave Systems, Inc. 1,121,841
Mersana Therapeutics, Inc. 937,882
Ensemble Therapeutics Corporation 500,000
Laser Light Engines, Inc. 118,907
Questech Corporation 72,755
Metabolon, Inc. 58,366
The write-ups for the year ended December 31, 2010, were partially offset by
decreases in the valuations of the following investments held:
69
Investment Amount of Write-Down
Nextreme Thermal Solutions, Inc. $ 3,854,600
Molecular Imprints, Inc. 2,031,749
Kovio, Inc. 1,750,165
NeoPhotonics Corporation 1,519,991
Innovalight, Inc. 1,241,665
Ancora Pharmaceuticas Inc. 301,573
Nanosys, Inc. 280,649
Bridgelux, Inc. 220,252
TetraVitae Bioscience, Inc. 125,000
PolyRemedy, Inc. 53,893
GEO Semiconductor Inc. 11,830
We had a decrease in unrealized depreciation for Kovio, Inc., of $227,469, and
Mersana Therapeutics, Inc., of $171,752, owing to the termination and expiration
of certain warrants, respectively. The warrant for Kovio, Inc., was terminated
pursuant to the terms of the Series A' financing which closed during the second
quarter of 2010. The warrant for Mersana Therapeutics, Inc., expired unexercised
on October 21, 2010.
70
We had a decrease in unrealized depreciation for NanoGram Corporation of
$3,136,552, which resulted from a realized loss on such investment during the
period. On July 11, 2010, NanoGram was acquired for an undisclosed amount.
Holders of common stock did not receive any proceeds from this transaction.
We had a decrease in unrealized depreciation for Orthovita, Inc., of $72,432
owing to the sale of its securities.
We had a decrease in unrealized depreciation owing to foreign currency
translation of $178,295 on our investment in D-Wave Systems, Inc.
Unrealized depreciation on our U.S. government securities portfolio decreased
from unrealized depreciation of $12,443 at December 31, 2009, to unrealized
appreciation of $1,268 at December 31, 2010.
During the year ended December 31, 2009, net unrealized depreciation on our
venture capital investments decreased by $19,758,422, or 57.9 percent, from net
unrealized depreciation of $34,124,848 at December 31, 2008, to net unrealized
depreciation of $14,366,426 at December 31, 2009, owing primarily to increases
in the valuations of the following investments held:
Investment Amount of Write-Up
Solazyme, Inc. $ 5,376,988
Molecular Imprints, Inc. 3,841,541
NeoPhotonics Corporation 3,350,923
Nextreme Thermal Solutions, Inc. 2,202,628
Xradia, Inc. 1,723,215
Adesto Technologies Corporation 1,320,000
Bridgelux, Inc. 987,642
BioVex Group, Inc. 845,952
CFX Battery, Inc. 812,383
Ensemble Discovery Corporation 500,000
Questech Corporation 297,104
Metabolon, Inc. 196,512
Siluria Technologies, Inc. 160,723
These write-ups for the twelve months ended December 31, 2009, were partially
offset by the following write-downs:
71
Investment Amount of Write-Down
Nanosys, Inc. $ 2,685,059
Kovio, Inc. 2,266,912
Innovalight, Inc. 1,537,713
NanoGram Corporation 1,471,805
SiOnyx, Inc. 1,076,155
Ancora Pharmaceuticals Inc. 1,072,811
Laser Light Engines, Inc. 999,999
D-Wave Systems, Inc. 826,786
Crystal IS, Inc. 779,094
Cambrios Technologies Corporation 257,878
Cobalt Technologies, Inc. 187,499
PolyRemedy, Inc. 136,170
Orthovita, Inc. 72,432
Mersana Therapeutics, Inc. 17,500
We also had decreases to unrealized depreciation for CSwitch Corporation of
$5,629,011, Exponential Business Development Company of $15,361, Kereos, Inc.,
of $1,500,000, Nanomix, Inc., of $3,150,190 and Starfire Systems, Inc., of
$750,000 owing to the disposal of their securities and changes in the capital
account balance of Exponential Business Development Company prior to its sale.
We had a decrease to unrealized depreciation for Questech Corporation of $16,253
owing to a realized loss on an unexercised warrant that expired on November19,
2009.
We had an increase owing to foreign currency translation of $469,809 on our
investment in D-Wave Systems, Inc.
Unrealized appreciation on our U.S. government securities portfolio decreased
from $27,652 at December 31, 2008, to unrealized depreciation of $12,443 at
December 31, 2009.
Financial Condition
December 31, 2011
At December 31, 2011, our total assets and net assets were $150,343,653 and
$145,698,407, respectively. At December 31, 2010, they were $149,289,168 and
$146,853,912, respectively. At December 31, 2011, our net asset value per share
was $4.70 as compared with $4.76 at December 31, 2010.
At December 31, 2011, our shares outstanding increased to 31,000,601 from
30,878,164 at December 31, 2010, owing to the exercise of 122,437 options. These
options provided $491,058 of cash to the Company.
Significant developments in the twelve months ended December 31, 2011, included
an increase in the holdings of our venture capital investments of $6,897,828 and
decreases in our holdings of U.S. government obligations and cash of $8,190,142.
The increase in the value of our venture capital investments from $106,150,422
at December 31, 2010, to $113,048,250 at December 31, 2011, resulted primarily
from an increase in the net value of our venture capital investments of
$2,228,565 and by five new and 32 follow-on investments of $19,088,903, offset
by the sale of our securities in BioVex Group, Inc., Crystal IS, Inc.,
Innovalight, Inc., Polatis, Inc., PolyRemedy, Inc., Questech Corporation,
Siluria Technologies, Inc., and TetraVitae BioScience, Inc. The decrease in the
value of our U.S. government obligations and cash from $42,031,536 at December
31, 2010, to $33,841,394 at December 31, 2011, is primarily owing to the payment
of cash for operating expenses of $6,323,055 and to new and follow-on venture
capital investments totaling $19,088,903, offset by cash received from the sale
of our securities in BioVex Group, Inc., Crystal IS, Inc., Innovalight, Inc.,
Polatis, Inc., PolyRemedy, Inc., Questech Corporation and Siluria Technologies,
Inc.
72
The following table is a summary of additions to our portfolio of venture
capital investments made during the twelve months ended December 31, 2011:
New Equity-Focused(1) and
Venture Debt(2) Investments Amount of Investment
Champions Oncology, Inc.(1) $ 2,000,000
HzO, Inc.(1) 1,666,667
Produced Water Absorbents, Inc.(1) 1,000,000
NanoTerra, Inc.(2) 750,000
Senova Systems, Inc.(1) 692,308
Follow-On Equity-Focused(1) and
Venture Debt(2) Investments Amount of Investment
Metabolon, Inc.(1) $ 1,499,999
Ancora Pharmaceuticals Inc.(1)(2) 1,300,000
Adesto Technologies Corporation(1) 1,032,058
Kovio, Inc.(1) 892,315
Molecular Imprints, Inc.(1) 866,668
Bridgelux, Inc.(1) 813,805
Contour Energy Systems, Inc.(1) 720,000
Enumeral Biomedical Corp.(1) 650,000
NeoPhotonics Corporation(1) 550,000
Bridgelux, Inc.(1) 538,945
Ancora Pharmaceuticals Inc.(1) 500,000
Molecular Imprints, Inc.(1) 481,482
Adesto Technologies Corporation(1) 445,659
D-Wave Systems, Inc.(1) 337,579
Mersana Therapeutics, Inc.(1) 298,900
Innovalight, Inc.(1) 272,369
Ancora Pharmaceuticals Inc. (1) 200,000
Ancora Pharmaceuticals Inc.(1) 200,000
Laser Light Engines, Inc.(1) 200,000
Innovalight, Inc.(1) 181,579
Ultora, Inc.(1) 150,500
GEO Semiconductor, Inc.(2) 150,000
Cobalt Technologies, Inc.(1) 121,560
Ancora Pharmaceuticals Inc.(1) 100,000
Enumeral Biomedical Corp.(1) 99,999
Laser Light Engines, Inc.(1) 95,652
Laser Light Engines, Inc.(1) 82,609
Ultora, Inc.(1) 63,250
ABSMaterials, Inc.(1) 60,000
Mersana Therapeutics, Inc.(1) 25,000
Mersana Therapeutics, Inc.(1) 25,000
Mersana Therapeutics, Inc.(1) 25,000
Total $ 19,088,903
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December 31, 2010
At December 31, 2010, our total assets and net assets were $149,289,168 and
$146,853,912, respectively. Our net asset value per share at that date was
$4.76, and our shares outstanding increased to 30,878,164 as of December 31,
2010.
Significant developments in the twelve months ended December 31, 2010, included
an increase in the holdings of our venture capital investments of $28,126,941
and a decrease in our holdings of U.S. government obligations and cash of
$15,527,510. The increase in the value of our venture capital investments from
$78,023,481 at December 31, 2009, to $106,150,422 at December 31, 2010, resulted
primarily from an increase in the net value of our venture capital investments
of $18,132,021 and by four new and 27 follow-on investments of $10,060,721. The
decrease in the value of our U.S. government obligations and cash from
$57,559,046 at December 31, 2009, to $42,031,536 at December 31, 2010, is
primarily owing to the payment of cash for operating expenses of $5,672,401 and
to new and follow-on venture capital investments totaling $10,060,721.
The following table is a summary of additions to our portfolio of venture
capital investments made during the twelve months ended December 31, 2010:
New Investments Amount of Investment
GEO Semiconductor Inc. $ 500,000
ABS Materials, Inc. 250,000
Satcon Technology Corporation 99,957
Ultora, Inc. 1,250
74
Follow-On Investments Amount of Investment
Solazyme, Inc. $ 1,499,991
SiOnyx, Inc. 956,740
Laser Light Engines, Inc. 910,000
Ancora Pharmaceuticals Inc. 600,000
D-Wave Systems, Inc. 580,257
Kovio, Inc. 526,225
Ancora Pharmaceuticals Inc. 500,000
Nanosys, Inc. 496,573
Ancora Pharmaceuticals Inc. 400,000
BioVex Group, Inc. 354,390
SiOnyx, Inc. 339,760
BioVex Group, Inc. 323,077
Ancora Pharmaceuticals Inc. 300,000
Bridgelux, Inc. 250,041
Laser Light Engines, Inc. 250,000
Laser Light Engines, Inc. 250,000
ABS Materials, Inc. 125,000
Cambrios Technologies Corporation 92,400
Orthovita, Inc. 98,427
Laser Light Engines, Inc. 90,000
Mersana Therapeutics, Inc. 87,500
Mersana Therapeutics, Inc. 84,475
Laser Light Engines, Inc. 40,000
Satcon Technology Corporation 27,960
Satcon Technology Corporation 22,134
NeoPhotonics Corporation 2,455
NeoPhotonics Corporation 2,109
Total $ 10,060,721
The following tables summarize the values of our portfolios of venture capital
investments and U.S. government obligations, as compared with their cost, at
December 31, 2011, and December 31, 2010:
December 31,
2011 2010
Venture capital investments, at cost $ 103,316,647 $ 98,647,384
Net unrealized appreciation(1)
9,731,603 7,503,038
Venture capital investments, at value $ 113,048,250 $ 106,150,422
December 31,
2011 2010U.S. government obligations, at cost $ 0 $ 38,273,349
Net unrealized appreciation(1)
0 1,268
U.S. government obligations, at value $ 0 $ 38,274,617
(1) At December 31, 2011, and December 31, 2010, the net accumulated unrealized
appreciation on investments was $9,851,603 and $7,504,306, respectively.
Included in total net accumulated unrealized appreciation at December 31, 2011,
is $9,731,603 unrealized appreciation on venture capital investments and
$120,000 unrealized appreciation on written call options.
75
Cash Flow
Year Ended December 31, 2011
Net cash used in operating activities for the year ended December 31, 2011, was
$7,553,855, primarily reflecting the payment of operating expenses.
Net cash provided by investing activities for the year ended December 31, 2011,
was $35,647,272, primarily reflecting net proceeds from the sale of U.S.
government securities of $38,248,334 and the sale of venture capital investments
of $14,547,826, offset by the purchase of venture capital investments of
$19,037,403.
Cash provided by financing activities for the year ended December 31, 2011, was
$1,991,058, resulting from the exercise of stock options, and proceeds from the
drawdown of our credit facility.
Year Ended December 31, 2010
Net cash used in operating activities for the year ended December 31, 2010, was
$5,843,791, primarily reflecting the payment of operating expenses.
Net cash provided by investing activities for the year ended December 31, 2010,
was $7,968,532, primarily reflecting proceeds from the sale of U.S. government
securities of $17,700,144 and venture capital investments of $408,899, offset by
venture capital investments of $10,050,721.
Cash provided by financing activities for the year ended December 31, 2010, was
$20,713, resulting from the exercise of stock options, offset by the payment of
certain offering costs relating to the public follow-on offering that closed on
October 9, 2009.
Year Ended December 31, 2009
Net cash used in operating activities for the year ended December 31, 2009, was
$5,277,132, primarily reflecting the payment of operating expenses.
Net cash used in investing activities for the year ended December 31, 2009, was
$15,433,826, primarily reflecting venture capital investments of $12,344,051,
less proceeds from the sale of venture capital investments of $7,365.
Cash provided by financing activities for the year ended December 31, 2009, was
$21,686,090, resulting from the issuance of 4,887,500 new shares of our common
stock on October 9, 2009, in a public follow-on offering and exercise of stock
options.
76
Liquidity and Capital Resources
Our liquidity and capital resources are generated and are generally available
through our cash holdings, interest earned on our investments on U.S. government
securities, cash flows from the sales of U.S. government securities and payments
received on our venture debt investments, proceeds from periodic follow-on
equity offerings and realized capital gains retained for reinvestment. As of
December 31, 2011, we did not hold any U.S. government securities and funded all
of our operations from cash held in bank accounts.
We fund our day-to-day operations using interest earned and proceeds from our
cash holdings, the sales of our investments in U.S. government securities, when
applicable, and interest earned from our venture debt securities. We believe the
increase or decrease in the value of our venture capital investments does not
materially affect the day-to-day operations of the Company or our daily
liquidity. As of December 31, 2011, and December 31, 2010, we had no investments
in money market mutual funds.
We have a $10 million three-year revolving credit facility with TD Bank, N.A.
This credit facility is used to fund our venture debt investments and not for
the payment of day-to-day operating expenses. As of December 31, 2011, we had
debt outstanding of $1,500,000, which is approximately one percent of our net
assets. This debt is collateralized with cash held in a restricted account on a
one-for-one basis with the amount of debt outstanding from the credit facility.
Therefore, repayment of the outstanding debt as of December 31, 2011, would not
have a significant impact on our daily liquidity. We have not issued any debt
securities, and, therefore, are not subject to credit agency downgrades.
As a venture capital company, it is critical that we have capital available to
support our best companies until we have an opportunity for liquidity in our
investments. As such, we will continue to maintain a substantial amount of
liquid capital on our balance sheet. However, to complement our equity-focused
portfolio investing, we seek to invest some of this capital in venture debt
where we will have more defined investment return timelines than we currently
have in our existing portfolio. In addition, we may from time to time opt to
borrow money to make investments, specifically in debt securities that generate
cash flow and have a known timeframe for return on investment.
Except for a rights offering, we are also generally not able to issue and sell
our common stock at a price below our net asset value per share, exclusive of
any distributing commission or discount, without shareholder approval. As of
December 31, 2011, our net asset value was $4.70 per share and our closing
market price was $3.46 per share. We do not currently have shareholder approval
to issue or sell shares below our net asset value per share.
December 31, 2011
At December 31, 2011, and December 31, 2010, our total net primary and secondary
liquidity was $65,368,303 and $42,079,934, respectively.
77
At December 31, 2011, and December 31, 2010, our total net primary liquidity was
$33,910,442 and $42,079,934, respectively. Our primary liquidity is principally
comprised of our cash, U.S. government securities, when applicable, and certain
receivables. The decrease in our primary liquidity from December 31, 2010, to
December 31, 2011, is primarily owing to the use of funds for investments and
payment of net operating expenses, offset by the proceeds received from thesale
of investments.
At December 31, 2011, and December 31, 2010, our secondary liquidity was
$31,457,861 and $0, respectively. Our secondary liquidity consists of our
publicly traded securities. Although these companies are publicly traded, their
stock may not trade at high volumes and prices can be volatile, which may
restrict our ability to sell our positions at any given time. We may also be
restricted for a period of time in selling our positions in these companies due
to our shares being unregistered. As of December 31, 2011, none of our publicly
traded securities were restricted from sale.
We do not include funds held in escrow from the sale of investments in primary
or secondary liquidity. These funds will become primary liquidity if and when
they are received at the expiration of the escrow period.
We believe that the difficult venture capital environment may continue to
adversely affect the valuation of investment portfolios, tighter lending
standards and reduced access to capital. These conditions may lead to a further
decline in net asset value and/or decline in valuations of our portfolio
companies. Although we cannot predict future market conditions, we continue to
believe that our current cash and our ability to adjust our investment pace will
provide us with adequate liquidity to execute our current business strategy.
On July 1, 2008, we signed a five-year lease for office space at 420 Florence
Street, Suite 200, Palo Alto, California, commencing on August 1, 2008, and
expiring on August 31, 2013. Total rent expense for our office space in Palo
Alto was $132,831 in 2011, $128,962 in 2010 and $125,205 in 2009. Future minimum
lease payments in each of the following years are: 2012 - $136,816 and 2013-
$93,135.
On September 24, 2009, we signed a ten-year lease for office space at 1450
Broadway, New York, New York. The lease commenced on January 21, 2010, and this
office space replaced our corporate headquarters previously located at 111 West
57th Street in New York City. The base rent is $36 per square foot with a 2.5
percent increase per year over the 10 years of the lease, subject to a full
abatement of rent for four months and a rent credit for six months throughout
the lease term. The lease expires on December 31, 2019. Total rent expense for
our office space in New York City was $230,302 in 2011 and $215,319 in 2010.
Future minimum lease payments in each of the following years are: 2012 -
$238,885; 2013 - $244,857; 2014 - $250,979; 2015 - $280,673; 2016 - $287,690;
and thereafter for the remaining term - an aggregate of $906,948.
78
On January 21, 2010, we relocated our corporate headquarters from 111 West 57th
Street in New York City to 1450 Broadway in New York City. The lease and
sublease for our offices at 111 West 57th Street expired on April 17, 2010 and
on April 29, 2010, respectively. Total rent expense for the office space at 111
West 57th Street was $57,951 in 2010 and $191,399 in 2009. Our rent expense in
2010 of $57,951 includes $47,094 of real estate tax escalation charges from 2003
to 2010 paid on the office space at 111 West 57th Street.
On April 26, 2011, we signed a one-year lease for office space at 530 Lytton
Avenue, 2nd Floor, Palo Alto, California, commencing on July 1, 2011, and
expiring on June 30, 2012. Total rent expense for this office space in Palo Alto
was $13,354 in 2011. Future minimum lease payments in 2012 are $13,354.
December 31, 2010
At December 31, 2010, and December 31, 2009, our total net primary liquidity was
$42,079,934 and $57,642,233, respectively.
Our primary liquidity, which is comprised of our cash, U.S. government
securities, receivables from unsettled trades, receivables from portfolio
companies and interest receivables, are adequate to cover our gross cash
operating expenses. Our gross cash operating expenses for 2010 and 2009 totaled
$5,672,401 and $5,683,624, respectively.
The decrease in our primary liquidity from December 31, 2009, to December 31,
2010, is primarily owing to the use of funds for investments and payment ofnet
operating expenses.
At December 31, 2010, and December 31, 2009, our secondary liquidity was $0 and
$226,395, respectively. Our secondary liquidity consists of our publicly traded
securities. Although these companies are publicly traded, their stock may not
trade at high volumes and prices can be volatile, or our stock may be subject to
restrictions on transfer, such as lock-up provisions, which may restrict our
ability to sell our positions at any given time.
Borrowings
On February 24, 2011, we established a $10 million three-year revolving credit
facility with TD Bank, N.A., to be used in conjunction with our venture debt
investments.
The credit facility, among other things, matures on February 24, 2014, and
generally bears interest, at the Company's option, based on (i) LIBOR plus 1.25
percent or (2) the higher of the federal funds rate plus fifty basis points
(0.50 percent) or the U.S. prime rate as published in the Wall Street
Journal. The credit facility generally requires payment of interest on a monthly
basis and requires the payment of a non-use fee of 0.15 percent annually. All
outstanding principal is due upon maturity. The credit facility is secured by
cash collateral to be held in a non-interest bearing account at TD Bank. The
credit facility contains affirmative and restrictive covenants, including:
(a) periodic financial reporting requirements, (b) maintaining our status as a
BDC (c) maintaining unencumbered, liquid assets of not less than $7,500,000,
(d) limitations on the incurrence of additional indebtedness, (e) limitations
on liens, and (f) limitations on mergers and dissolutions. The credit facility
is used to supplement our capital to make additional venture debt investments.
79
The Company's outstanding debt balance was $1,500,000 at December 31, 2011. The
annual weighted average interest cost for the twelve months ended December 31,
2011, was 1.5 percent, exclusive of amortization of closing fees and other
expenses related to establishing the credit facility. The remaining capacity
under the credit facility was $8,500,000 at December 31, 2011. At December 31,
2011, the Company was in compliance with all financial covenants required by the
credit facility.
Contractual Obligations
A summary of our significant contractual payment obligations is as follows:
Payments Due by Period
Less than More Than
Total 1 Year 1-3 Years 3-5 Years 5 YearsRevolving credit facility(1) $ 1,500,000 $ - $ 1,500,000 $ - $ -
Operating leases $ 2,453,336 $ 389,055 $ 588,971 $ 568,363 $ 906,948
As of December 31, 2011, we had $8,500,000 of unused borrowing capacity under
our credit facility.
Critical Accounting Policies
The Company's significant accounting policies are described in Note 2 to the
Consolidated Financial Statements and in the Footnote to the Consolidated
Schedule of Investments. Critical accounting policies are those that are both
important to the presentation of our financial condition and results of
operations and those that require management's most difficult, complex or
subjective judgments. The Company considers the following accounting policies
and related estimates to be critical:
Valuation of Portfolio Investments
The most significant estimate inherent in the preparation of our consolidated
financial statements is the valuation of investments and the related amounts of
unrealized appreciation and depreciation of investments recorded. As a BDC, we
invest in primarily illiquid securities that generally have no establishedtrading market.
80
Investments are stated at "value" as defined in the 1940 Act and in the
applicable regulations of the SEC and U.S. GAAP. ASC 820 defines fair value,
establishes a framework for measuring fair value and expands disclosures about
assets and liabilities measured at fair value. ASC 820 provides a consistent
definition of fair value that focuses on exit price in the principal, or most
advantageous, market and prioritizes, within a measurement of fair value, the
use of market-based inputs over entity-specific inputs. ASC 820 also establishes
the following three-level hierarchy for fair value measurements based upon the
transparency of inputs to the valuation of an asset or liability as of the
measurement date.
• Level 1 - inputs to the valuation methodology are quoted prices (unadjusted)
for identical assets or liabilities in active markets;
81
• Level 2 - inputs to the valuation methodology include quoted prices for similar
assets and liabilities in active markets, and inputs that are observable for
the asset or liability, either directly or indirectly, for substantially the
full term of the financial instrument. Level 2 inputs are in those markets for
which there are few transactions, the prices are not current, little public
information exists or instances where prices vary substantially over time or
among brokered market makers; and
• Level 3 - inputs to the valuation methodology are unobservable and significant
to the fair value measurement. Unobservable inputs are those inputs that
reflect our own assumptions that market participants would use to price the
asset or liability based upon the best available information.
See "Note 5. Investments" in the accompanying notes to our Consolidated
Financial Statements for additional information regarding fair value
measurements.
Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price
for those securities for which a market quotation is readily available and (ii)
the fair value as determined in good faith by, or under the direction of, the
Board of Directors for all other assets. (See "Valuation Procedures" in the
"Footnote to Consolidated Schedule of Investments.") As of December 31, 2011,
our financial statements include venture capital investments valued at
$83,563,723, the fair values of which were determined in good faith by, or under
the direction of, the Board of Directors. As of December 31, 2011, approximately
57.4 percent of our net assets represent investments in portfolio companies at
fair value by the Board of Directors.
Determining fair value requires that judgment be applied to the specific facts
and circumstances of each portfolio investment, although our valuation policy is
intended to provide a consistent basis for determining fair value of the
portfolio investments. Factors that may be considered include, but are not
limited to, the cost of the Company's investment; transactions in the portfolio
company's securities or unconditional firm offers by responsible parties; the
financial condition and operating results of the company; the long-term
potential of the business and technology of the company; the values of similar
securities issued by companies in similar businesses; multiples to revenues, net
income or EBITDA that similar securities issued by companies in similar
businesses receive; the proportion of the company's securities we own and the
nature of any rights to require the company to register restricted securities
under the applicable securities laws; the assessment of non-performance risk;
the achievement of milestones; discounts for restrictions on transfers of
publicly traded securities; and the rights and preferences of the class of
securities we own as compared with other classes of securities the portfolio has
issued.
In addition, with respect to our debt investments for which no readily available
market quotations are available, we will generally consider the financial
condition and current and expected future cash flows of the portfolio company;
the creditworthiness of the portfolio company and its ability to meet its
current debt obligations; the relative seniority of our debt investment within
the portfolio company's capital structure; the availability and value of any
available collateral; and changes in market interest rates and credit spreads
for similar debt investments.
82
Historically, difficult venture capital environments have resulted in companies
not receiving financing and being subsequently closed down with a loss of
investment to venture investors, and other companies receiving financing but at
significantly lower valuations than the preceding rounds, leading to very deep
dilution for those who do not participate in the new rounds of investment. Our
best estimate of this non-performance risk has been quantified and included in
the valuation of our portfolio companies as of December 31, 2011.
All investments recorded at fair value are categorized based upon the level of
judgment associated with the inputs used to measure their fair value.
Hierarchical levels related to the amount of subjectivity associated with the
inputs to fair valuation of these assets, are as follows:
· Level 1: Unadjusted quoted prices in active markets for identical assets or
liabilities.
· Level 2: Quoted prices in active markets for similar assets or liabilities, or
quoted prices for identical or similar assets or liabilities in markets that
are not active, or inputs other than quoted prices that are observable for the
asset or liability.
· Level 3: Unobservable inputs for the asset or liability.
As of December 31, 2011, over 70 percent of our portfolio company investments
were classified as Level 3 in the hierarchy, indicating a high level of judgment
required in their valuation.
The values assigned to our assets are based on available information and do not
necessarily represent amounts that might ultimately be realized, as these
amounts depend on future circumstances and cannot be reasonably determined until
the individual investments are actually liquidated or become readily marketable.
Upon sale of investments, the values that are ultimately realized may be
different from what is presently estimated. This difference could be material.
Stock-Based Compensation
Determining the appropriate fair-value model and calculating the fair value of
share-based awards on the date of grant requires judgment. Historically, we have
used the Black-Scholes-Merton option pricing model to estimate the fair value of
employee stock options.
Management uses the Black-Scholes-Merton option pricing model in instances where
we lack historical data necessary for more complex models and when the share
award terms can be valued within the model. Other models may yield fair values
that are significantly different from those calculated by the
Black-Scholes-Merton option pricing model.
Management uses a binomial lattice option pricing model in instances where it is
necessary to include a broader array of assumptions. We used the binomial
lattice model for the 10-year NQSOs granted on March 18, 2009. These awards
included accelerated vesting provisions that were based on market conditions.
83
Option pricing models require the use of subjective input assumptions, including
expected volatility, expected life, expected dividend rate, and expected
risk-free rate of return. Variations in the expected volatility or expected term
assumptions have a significant impact on fair value. As the volatility or
expected term assumptions increase, the fair value of the stock option
increases. The expected dividend rate and expected risk-free rate of return are
not as significant to the calculation of fair value. A higher assumed dividend
rate yields a lower fair value, whereas higher assumed interest rates yield
higher fair values for stock options.
In the Black-Scholes-Merton model, we use the simplified calculation of expected
term as described in the SEC's Staff Accounting Bulletin 107 because of the lack
of historical information about option exercise patterns. In the binomial
lattice model, we use an expected term that assumes the options will be
exercised at two-times the strike price because of the lack of option exercise
patterns. Future exercise behavior could be materially different than thatwhich
is assumed by the model.
Expected volatility is based on the historical fluctuations in the Company's
stock. The Company's stock has historically been volatile, which increases the
fair value of the underlying share-based awards.
GAAP requires us to develop an estimate of the number of share-based awards that
will be forfeited owing to employee turnover. Quarterly changes in the estimated
forfeiture rate can have a significant effect on reported share-based
compensation, as the effect of adjusting the rate for all expense amortization
after the grant date is recognized in the period the forfeiture estimate is
changed. If the actual forfeiture rate proves to be higher than the estimated
forfeiture rate, then an adjustment will be made to increase the estimated
forfeiture rate, which would result in a decrease to the expense recognized in
the financial statements. If the actual forfeiture rate proves to be lower than
the estimated forfeiture rate, then an adjustment will be made to decrease the
estimated forfeiture rate, which would result in an increase to the expense
recognized in the financial statements. Such adjustments would affect our
operating expenses and additional paid-in capital, but would have no effecton
our net asset value.
Pension and Post-Retirement Benefit Plan Assumptions
The Company provides a Retiree Medical Benefit Plan for employees who meet
certain eligibility requirements. Until it was terminated on May 5, 2011, the
Company also provided an Executive Mandatory Retirement Benefit Plan for certain
individuals employed by us in a bona fide executive or high policy-making
position. Our former President accrued benefits under this plan prior to his
retirement, and the termination of the plan has no impact on his accrued
benefits. Several statistical and other factors that attempt to anticipate
future events are used in calculating the expense and liability values related
to our post-retirement benefit plans. These factors include assumptions we make
about the discount rate, the rate of increase in healthcare costs, and
mortality, among others.
84
The discount rate reflects the current rate at which the post-retirement medical
benefit and pension liabilities could be effectively settled considering the
timing of expected payments for plan participants. In estimating this rate, we
consider the Citigroup Pension Liability Index in the determination of the
appropriate discount rate assumptions. The weighted average rate we utilized to
measure our post retirement medical benefit obligation as of December 31, 2011,
and to calculate our 2012 expense was 4.53 percent. We used a discount rate of
3.57 percent to calculate our pension obligation for the Executive Mandatory
Retirement Benefit Plan.
Recent Developments - Portfolio Companies
In January 2012, we closed our written call option position in Solazyme, Inc.,
expiring on March 17, 2012, for a payment of $159,000. In January 2012, we sold
3,000 written call option contracts on Solazyme expiring in June 2012, with a
strike price of $15. We received premiums of approximately $291,000 for these
contracts.
In January and February 2012, we sold 2,000 written call option contracts on
Solazyme, expiring in September 2012, with a strike price of $17.50. We received
premiums of approximately $133,500 for these contracts.
In January and February 2012, we sold 250 written call option contracts on
NeoPhotonics Corporation, expiring in August 2012, with a strike price of $7.50.
We received premiums of approximately $14,500 for these contracts.
On January 19, 2012, the Company made a $480,000 follow-on investment in a
privately held, equity-focused portfolio company.
On January 25, 2012, the Company made a $109,433 follow-on investment in a
privately held, equity-focused portfolio company.
On February 29, 2012, the Company made a $434,784 follow-on investment in a
privately held, equity-focused portfolio company.
On March 5, 2012, the Company made an $815,000 new investment in OpGen, Inc., a
privately held, equity-focused portfolio company.
In the first quarter of 2012, one of our portfolio companies received a
non-binding letter of interest for the potential acquisition of the company. As
of March 13, 2012, the discussion between these two companies is ongoing, and
there can be no assurance that these companies will reach mutually acceptable
terms to consummate a transaction.
Also in the first quarter of 2012, three of our companies have commenced
planning for and/or began the process of hiring bankers to pursue potential
sales and/or IPOs of those companies. As of March 13, 2012, these efforts are
ongoing, and there can be no assurance that either of these companies will be
able to consummate either type of transaction.
85
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