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Executives

Patricia N. Egan - Chief Accounting Officer, Vice President and Senior Controller

Douglas W. Jamison - Chairman, Chief Executive Officer, and Managing Director, and Chairman of Executive Committee

Analysts

Sam Rebotsky

Harris & Harris Group (TINY) Q2 2012 Earnings Call August 14, 2012 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Harris & Harris Second Quarter 2012 Financial Results. [Operator Instructions] As a reminder, this conference call is being recorded. Now, I'll turn the conference over to Patty Egan. Please begin.

Patricia N. Egan

Thanks. This presentation may contain statements of a forward-looking nature relating to future events. Statements contained in this presentation that are forward-looking statements are intended to be made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. These statements reflect the company's current beliefs, and a number of important factors could cause actual results to differ materially from those expressed herein.

Please see the company's annual report on Form 10-K, as well as subsequent filings filed with the Securities and Exchange Commission for a more detailed discussion of the risks and uncertainties associated with the company's business, including, but not limited to, the risks and uncertainties associated with venture capital investing and other significant factors that could affect the company's actual results. Except as otherwise required by federal securities laws, Harris & Harris Group, Inc. undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.

Douglas W. Jamison

Thank you, Patty. Good morning. This is Doug Jamison, and welcome to our call reporting on the second quarter of 2012. Harris & Harris Group is an early-stage active investor in transformative nanotechnology companies.

I'll begin the call this morning with a few remarks on our business. Patty Egan, our Chief Accounting Officer, will then provide a brief summary of our June 30, 2012 financials. Patty will reference our recently filed quarter report on Form 10-Q. I will then close with additional remarks and open up the lines for questions. We expect the call to last approximately 45 minutes.

Our priorities remain focused for 2012 and beyond. Our 3 priorities include: first, working with our existing portfolio companies to reach positive liquidity events. As we have stated previously, we believe our late stage companies are well positioned for liquidity events between now and 2014. And we believe many of our mid-stage companies could be in a position to complete transactions that create liquidity over this same time period; second, generating predictable and near-term income by increasing our venture debt investments and taking advantage of opportunities provided us by our newly publicly traded positions, such as selling covered calls on our position in Solazyme; and third, increasing our assets under management without issuing common stock.

Of these priorities, the first and third as listed create the potential to fundamentally change the return potential of Harris & Harris Group, as they give us new capital to manage and they provide a spark for movement in NAV per share. The second priority permits us to have more control of our future by offsetting expenses in a predictable manner and it reduces the downward pressure on NAV that comes from the long and unpredictable development of our early-stage venture portfolio. Said another way, priority 2 permits us to survive, while 1 and 3 permit us to thrive. Our goal is to thrive and our time is focused accordingly.

I think Steve Waite, in a recent article for SoundView Research, summarized us well. Harris & Harris Group has 2 core businesses. One, investing in nanotechnology, and two, operating a venture capital firm.

Addressing one, investing in nanotechnology. We will continue to invest in disruptive technologies enabled at the nano scale. Most of the really disruptive technologies we see in the sectors we invest in are enabled at the nano scale now. One doesn't open up an academic journal or popular press without reading about advances in nanotechnology. And now in its second commercial decade, its future is both bright and upon us.

A look at Slide 5 gives a brief indication of the power of the connectedness of nano scale-enabled technologies. Not only do disruptive technologies have become the basis of some of our portfolio companies impact one sector, but many times, these same technologies have an impact over multiple sectors. Therefore, the ecosystem and the learning across our portfolio is networked far more intimately than most other technology areas. This network ecosystem and our leadership will be difficult to replicate.

Additionally, as we look forward, the exciting technology domains that we believe will result in transformative companies of tomorrow are nano-enabled. Looking at Slide 6, these technology domains include areas such as precision chemistry, nanofluidics and fabrication, separations, sensing, merging semiconductors and biological molecular analysis, big data, which has gotten a lot of recent press and 3D biology. In many of these domains, we already have investments that are beginning to mature.

Addressing 2, operating a venture capital company. As any of you that follow us know, we have spent no small amount of time over the past few years discussing the issues surrounding the operation of a venture capital company with all the changes in this industry. These issues have caused us to rethink our model and to make sure we are well positioned for the future, hence, our priorities going forward. In the sectors we invest in, the lengthening time from investment to exit has resulted in venture capital backed companies needing to prove scale and manufacturing and often end market traction prior to liquidity event as Slide 7 depicts.

Venture industry is very good in early stage company building. Established corporations tend to be much better at scale in manufacturing, and most have better access to end markets. Thus, we believe the potential to partner with these corporations to increase our assets under management helps solve some of the issues facing early stage venture investing while also strengthening Harris & Harris Group and our assets under management.

Therefore, in the future, our ecosystem will go from a slide you've seen before, which is more weighted to financial venture capital and government dollars, to an ecosystem being far more weighted to corporate partners. We believe this is the direction the early-stage venture industry will need to move to be successful in the future. Patty, will you now take us to the financials?

Patricia N. Egan

Sure, Doug. At June 30, 2012, we had total assets of approximately $158 million on our balance sheet. Included in our total assets at June 30 is our venture capital portfolio, which was valued at $126.9 million versus its cost basis of $109.1 million. Therefore, at June 30, 2012, our venture capital portfolio was in an appreciated state of $17.8 million.

We also held $29.7 million in cash and restricted cash and had debt outstanding of $2 million as of June 30. Included in our cash balance is $990,000 of premiums from call options that we have collected during the first 6 months of this year.

Our net asset at June 30 were approximately $151.4 million and our net asset value per share was $4.88. This was an increase from our net asset value per share of $4.70 at December 31, 2011.

Turning to our income statement. For the first 6 months ended June 30, 2012, we had investment income of approximately $132,000. This compares with approximately $325,000 in investment income during the same period of 2011.

Our total expenses were approximately $5.5 million for the first 6 months of 2012, compared with approximately $4 million during the first 6 months of 2011. These total expense figures include both cash and noncash-based operating expenses, such as stock-based compensation. Our total cash base and accrued operating expenses for the 6 months ended June 30, 2012, were approximately $3.4 million as compared with $2.9 million during the comparable period in 2011. This yielded a net operating loss of $5.4 million through June 30, 2012, which is an increase compared to our net operating loss of $3.6 million for the 6 months ended June 30.

During the 6 months ended June 30, 2012, we had total noncash stock-based compensation costs of approximately $2 million. On May 11, 2012, the senior officers of the company voluntarily canceled all of their outstanding stock options. These officers did not receive any compensation for this position to cancel outstanding vested and unvested options. Included in the $2 million compensation costs for 2012 is a onetime, noncash charge of $1.4 million related to the voluntary cancellation of these stock options. This amount of expense would have been recognized in full over time had these options remained outstanding, as these options vested over days extending out to June 2014. Accounting rules require that this expense be accelerated and recognized immediately upon the cancellation of the option. We will not incur any additional compensation expense related to these canceled options after this reporting period. This charge had no impact to NAV. The remaining stock-based compensation expense relates to outstanding options for nonexecutive employees and for restricted stock. These expenses also have no impact to NAV. Doug, will you continue?

Douglas W. Jamison

Thanks, Patty. As I stated earlier, we are excited about our existing venture capital portfolio. While Solazyme remains a large part of our portfolio, while its liquidity gives us potential capital for future investments and while we believe its business has plenty of upside potential that we can potentially capture, we believe investors have yet to focus on the next potential Solazymes in our portfolio. The stock market's inability to understand innovation and long-term investment stories means that a good portion of our future growth is being overlooked. You will see us turn more attention to what we believe are the underappreciated stories in our portfolio as we move forward.

Today, we will focus briefly on 4 of these companies that have the potential to be movers of future NAV per share.

I'll start with Metabolon. Metabolon is a late stage company in which we made our initial investment back in 2006. As of June 30, 2012, we own approximately 10% of Metabolon on a fully diluted basis. Metabolon is a leader in the rapidly developing personalized medicine and molecular diagnostic markets. It has the capital required to execute on its business plan. Metabolon uses its proprietary biochemical profiling platform to identify biomarkers useful for the development of diagnostics and to provide insight in the complex biological processes such as drug action, toxicology and bioprocess optimization and help complete our understanding at the genomic and proteomic levels.

Since our initial investment, the company has grown its revenue from its service business from $3 million in 2006 to over $17 million in 2011 at a compound annual growth rate of over 40%. This year, Metabolon announced the acquisition of Lipomics Technologies, a company that developed the TrueMass Profiling system through analysis of lipids, including metabolites of fatty acids, sterols and amino acids. This system is complementary to Metabolon's biochemical profiling platform and could expand the company's capabilities in the analysis of biomarkers relevant to metabolic diseases such as obesity and cancer.

Metabolon also announced a multiyear alliance with Takeda Pharmaceutical Company of Japan for the discovery of therapeutic targets in biomarkers.

The company also partnered with Health Diagnostic Laboratory to bring its Qantos test to market for the diagnosis of insulin resistance, which is an indicator of the risk of a patient becoming diabetic. Knowing this information may lead a patient in his or her physician to take steps that could help delay or prevent the onset of diabetes.

Turning to SiOnyx. We were the first investors in SiOnyx in 2006, when the company spun out of Professor Eric Mazur's lab at Harvard University. Since this investment, SiOnyx has secured investment from 4 other institutional investors, 1 corporation and its most recent new investor, In-Q-Tel, the venture capital investment firm of the U.S. intelligence agencies. As of June 30, 2012, we owned approximately 15% of SiOnyx on a fully diluted basis.

In-Q-Tel and the U.S. government are interested in SiOnyx's black silicon technology that extends the useful range of silicon-based image sensors into the near and shortwave infrared light. Standard silicon-based image sensors are generally transparent to these wavelengths of light. SiOnyx's black silicon image sensors may bring silicon economics to the security and surveillance industries of interest to the government and also of interest to commercial customers and those industries and in others such as gesture user interface applications. Gesture user interfaces enable people to interact with electronic devices through motion of their bodies rather than through physical contact with a keyboard, mouse or some other controlling device. Think of the Wii. While these capabilities are currently found mostly in gaming systems, they're becoming more prevalent in next-generation laptops and televisions. Imagine if you could change the channel of your television through waving your hand. That is the type of capabilities gesture user interface can provide, and enabling technology for these devices requires the ability to detect infrared light.

Turning to Adesto. We helped assemble and we're amongst the first group of investors in Adesto Technologies in 2007. Since our original investment, Adesto has secured multiple rounds of capital, each time bringing in new investors at increasing valuations from those of the prior rounds. As of June 30, 2012, we own between 5% and 10% of Adesto. Adesto just completed a successful financing, giving it capital to execute on its business. Adesto is developing a new class of computer memory products based on conductive bridging random-access memory or what we referred to as CB RAM. CB RAM is comprised of a thin layer of proprietary material, sandwiched between standard CMOS interconnect layers. This relatively simple architecture yields a low-power, a low-cost, a high-speed, high-density, nonvolatile memory device that has been demonstrated to be scalable down to the 12 nanometer semiconductor processing node. Adesto's memory chips are compatible with many existing electronics platforms as a drop and replacement for standard embedded memory chips without material increases in costs, but with material increases in performance of the overall system through power savings and increases in speed over traditional embedded memory products. These chips may find use in applications such as home appliances, wireless LAN routers, data storage systems and electricity meters. Additionally, these types of memory chips are found in every electronic greeting card and toy on the market today. Adesto's chips could bring added functionality to these everyday products while maintaining or lowering the costs to manufacturers.

And finally, I'd like to speak about D-Wave, perhaps one of the most exciting companies in the portfolio. We invested in D-Wave in 2006. As of June 30, 2012, we own between 3% and 5% of D-Wave. D-Wave recently completed a successful financing, giving it the necessary capital to execute on its business. When we made our initial investment, the company demonstrated low single-digit qubit quantum computers. Since our original investment, the company has demonstrated working processors with more than 100 qubits. It is making progress towards its next chip that will have over 500 qubits. It's confirmed the quantum mechanical nature of its chips through a peer reviewed paper published in Nature. It partnered with Google on Internet search applications and it completed the first sale of a commercial quantum computer, the D-Wave 1, to Lockheed Martin.

D-Wave's quantum computers are particularly well suited to solve computationally hard problems, including optimizations in learning systems, software and hardware verification, pattern recognition, financial analysis and bioinformatics. These types of problems include thousands and sometimes millions of independent variables that are all interconnected and can change based on the status of each of these variables.

First, I'll provide an example of 1 of -- something our New York crowd may well understand. Imagine trying to figure out how many people you need to invite to a party to make sure that a subset of them will know each other and another subset will not know each other and be forced to mingle. These type of problems are general problems referred to as Ramsey numbers. They're notoriously difficult to calculate and can take weeks of months of computational time to calculate on existing computers. In January of this year, D-Wave used its quantum computer to solve one of these problems in just 270 milliseconds.

Now I'll give you a more appropriate example that was published yesterday. Yesterday, published in Nature, was an article from a team of Harvard University researchers led by Professor Alan Aspuru-Guzik. It presented results of the largest protein folding problem solved to date using a quantum computer. The researchers ran instances of what's called a lattice protein folding model known as the Miyazawa-Jernigan model on a D-Wave quantum computer. Proteins contribute virtually every process that occurs within a cell. The shape of a protein is closely related to its function. Understanding the shape of a protein helps researchers understand how it behaves, accelerating advances in many different areas of life sciences including drug and vaccine design. Knowing that we can use real quantum computers to solve hard problems in biology is an exciting important result. The techniques developed in this report can also be used to tackle other biophysical problems such as molecular recognition, protein design and sequence alignment.

Additionally, in the second quarter of this year, NASA issued a solicitation for a project collaboration focused on solving problems of relevance to the space industry using a quantum computer. This solicitation noted the limitations of existing supercomputing resources to solve such problems. And that NASA currently intends to award this program to D-Wave Systems as it is not aware of any other vendor that has a product with the capabilities required by this program.

Again, we encourage our shareholders and those interested in learning more about our portfolio companies to go to our website or to our Facebook page, where we have posted links to announcements made by more of our portfolio companies than we have time to discuss on today's call.

In closing, we would like to put forward a bit more optimism than we have historically. Just as we need to be well ahead of the curve in our investment theses as early-stage investors, we are probably earlier than most in seeing optimism in the current economic market and political climate, and perhaps, we may be viewed as contrarian. But we think the tide will begin to shift in the future.

So why are we finally turning more optimistic? Well first, our nanotechnology thesis remains robust, giving us transformative companies to invest in at low valuations and allowing our existing companies to execute on their business plan successfully. Second, we think we have found the solutions necessary to make us successful in what has been a very difficult and changing venture capital environment over the last decade. We just need to execute on these priorities now. Third, the thought leaders, but certainly not the politicians in general market investors and traders, are beginning to finally focus on the correct issues to speed recovery out of the financial crisis, and what we do lies at the center of the solution. From an innovation perspective, stimulating new transformative products and risk taking and not crushing it is the only way to economic prosperity in a capitalist economy. From a financial market perspective, reinvigorating a long-term investment strategy that fosters listings and subsequent job growth that occurs with these listings is the answer. It's not financial engineering, trading volatility or regulations that protect the incumbents. We are seeing these concepts of innovation and investing come back into the conversation, finally, at least by the thought leaders. Hopefully, it will become contagious.

Some examples to close. I recently read a book by Edward Conard, a former Managing Director at Bain Capital. He gets it and I quote, "The 10% of workers who create close to half our GDP have to create more value to increase productivity and risk taking. Innovation is the only way to keep our economy at full utilization, and it's the only way to return to the heated level of employment and growth our economy achieved prior to the financial crisis."

In a July 18, 2012 presentation from David Weild, Head of Capital Markets at Grant Thornton, David correctly demonstrates the problems with the financial markets, in this case referring to the recent JOBS act. David correctly identifies the problem not as a cost issue for reviving the struggling IPO and listing markets in the U.S., but as a demand problem. Without addressing aftermarket support for small IPOs and micro capitalization companies, IPO growth and job growth will not be addressed. I quote, "Loss of the institutional liquidity did hurt the IPO market, but as a response to the loss of economic incentives to support small, micro and nano cap liquidity." David Weild has quite a following now at many of the higher levels of the political process with some of his recent writings on the IPO market and what's needed to fix it.

Even business luminaries are publishing on what we need. Norman Augustine, former Chairman and CEO of Lockheed Martin, written on multiple pieces recently along with his colleagues on the American Energy Innovation and Counsel, including Ursula Burns, Chairwoman and CEO of Xerox; John Doerr, partner at Kleiner Perkins Caulfield Byers; Bill Gates, former Chairman and CEO of Microsoft; Charles Holliday, former Chairman and CEO of DuPont; Jeff Immelt, Chairman and CEO of GE; and Tim Solso, Chairman and CEO of Cummins Inc., clearly, luminaries in the business world. These pieces focus on the energy issues permeating the challenges faced by our country. These pieces highlight the need for more vigorous public commitment to energy technology development. I quote from one of these pieces, "America's investment in energy innovation from public and private sectors together is less than 1/2 of 1% of the nation's energy bill. This fraction is eclipsed by innovation investment in most other sectors, particularly those in the high-tech arena. Meanwhile, we send $1 billion abroad each day to pay our energy bill to foreign producers. If these liabilities are to be overcome, the nation will need to depend more heavily on innovation, that is utilize high-quality research to create new knowledge and enlightened entrepreneurship."

And even the Wall Street Journal is coming -- is covering our need for transformative innovation. Nicholas Carr recently wrote an article in the Wall Street Journal about "What is behind innovation's turn towards the trifling?" as he calls it. He says, "One consequence is that inventions have become less visible and transformative. We're no longer changing the shape of the physical world or even of society. If we want to see a resurgence in big thinking and grand invention, if we want to promote breakthroughs that will improve not only our own lives but those of our grandchildren, we need to enlarge our aspirations."

And finally, the Wall Street Journal recently ran an opinion article by Michael Malone, focusing on innovation. He says and I quote, "Three years after the recession was declared officially over, unemployment remains high and there's worry that a new recession is down the road. And yet, waiting in the wings for when we get our economic policies in order are a mounting number of stunning discoveries, inventions and technological breakthroughs that could set off a burst of growth as big as any in living memory." Mr. Malone first highlights nanotechnology, saying, "Indeed, the range of emerging applications for nano materials is so wide-ranging and important that, together, they suggest an impending turning point in high tech, as important as silicon and integrated circuitry work half a century ago." Mr. Malone then focuses on a few other innovations before ending, "It's all on the way. Together, these trends offer the potential for a golden era."

We at Harris & Harris Group may be ahead of the curve and we should be as early stage investors. But if ever there was a group doing the proverbial "God's work." And if we are ever to recover from the recent debilitating financial crisis, Harris & Harris Group is well positioned to help lead this revival.

We will now open up the lines for any questions.

Question-and-Answer Session

Operator

[Operator Instructions] We have a question from Sam Rebotsky of SER Asset Management.

Sam Rebotsky

As far as what you're doing, as far -- I noticed the Mersana, when they raised the $27 million, and you participated in this. Is that the stock you're talking about that increased from $0.70 to $0.95 that would have a greater valuation? And could you sort of comment -- you have a rather significant loss on that and what is your expectations from Mersana going forward?

Douglas W. Jamison

Yes, I can certainly comment on that. That is not the stock we're referring to. We -- because it has not been announced, we have announced -- we have not announced what it is although, certainly, we have talked about some recent financings that have occurred, that are at up valuations. Mersana is actually the flip of that, and it's something that happens often in our business and that's why we talked about having dry powder available. Mersana, as you know, we were one of the first institutional investors in it. Mersana has gotten 2 products into the clinic, but it is a therapeutic deal and therapeutic deals need lots of capital. Mersana finally made a decision this past quarter as its business in what's called antibody drug conjugates has begun to take off. That, really, is the area the company is going to focus on. And since the announcement of the financing, we've actually seen some deals they have done, one most recently with Adimab. What happened on the financing, though, is they needed more capital and there were some syndicate issues as we've talked about historically in the venture capital industry, but there was also interest in it. So NEA, one of the largest venture capital firms -- I think NEA recently raised a $2.6 billion venture capital fund. It was very interested and wanted to come into the deal. But in order to have them come in, there was a significant decrease in the value that we recognized this quarter in the valuations. But we are excited about the future potential of the company because we had capital to invest. Although we took a write-down in the unrealized value, we are able to invest in the company and not invest significantly, not invest multiple millions, but to maintain a similar ownership position to what we had and now the company is set for the future. So I believe it raised in excess of $25 million. The round was oversubscribed. We participated. The existing investors actually got their act together and participated. And along with the deals they've now done, we don't believe they will need to go back to the market to raise capital. And in addition to the clinical programs they have going, which actually are not represented in our value, they have the exciting area of antibody drug conjugates that has become very exciting in the pharmaceutical industry. So in fact, we took a hit to our valuation to invest in an exciting company, to maintain ownership in that company, which we believe in the future will have the ability not only to return our capital but to make us a gain. And again, that sometimes happens. It's not our preferred route. Our preferred routes are the Solazymes and the D-Waves and the Adestos that continuously raise money at increased valuations. And so, in fact, we don't get diluted at all and ultimately have to invest less capital to own more of the company.

Sam Rebotsky

Okay. So let me own -- understand this. So the valuation at June 30 is similar to the valuation at the July 31. And as far as your philosophy is, is not to double down to get a larger position in something even though they're raising a substantial amount of more money, and this dilutes you -- I mean, even though -- it appears it dilutes you because $27 billion came in and...

Douglas W. Jamison

It does dilute us partially. Sam, you hit on a great point. We actually tried to get more of this. We tried to put more money to work in it. Unfortunately, it's always a game of he who has the gold makes the rule and NEA has a lot of gold, $2.6 billion. And unfortunately, the other players in this syndicate with us and have been investors for a while have far more gold than us as well. And there was a limitation on how much could come in. There was a decision at the end of the day that we didn't necessarily agree with, but it's probably good for the company. But Pfizer also came into the deal as a strategic partner. And we would've been able to get more if we didn't let Pfizer in. But as Pfizer is one of the largest pharmaceutical companies, it was deemed appropriate to have them involved in this going forward. But yes, we tried to get more. We were not able to get more in it, but we were also not able to write a $10 million or $15 million check, where we would've been making the rules.

Sam Rebotsky

Understandable. Now, the Russian part, did you say that you expect -- you sort of alluded to something, but I was not clear to raise additional funds that you can manage. Is there anything going on of substance? Is there any timetable where you expect something to happen if it's not the Russian partners that came in to NeoPhotonics? Is there some other people that you could get some money that you could have more power so that when the large group that came in and like new enterprise came in, you have more power? Is there anything that you're doing to try to sell what you're doing because you're first and you should be able to get somebody to let you in or give you money, et cetera?

Douglas W. Jamison

Yes. So, 2 things. First of all, we continue conversations with Russ nano on multiple levels both with our portfolio companies and with us. Secondly, it is a priority to bring in third-party capital. Again, we are fairly restricted as far as what we can say or not say in this field. But I think in the presentation, I clearly alluded to corporate partners. You should think about it that way. And you should also think that a normal venture fund, especially for a group like us that has never raised third-party money before, usually takes between 12 and 24 months. It is relationship-based. It is not like going to the market to sell additional common shares. And so it's an ongoing process. We are clearly making strides towards that, but I think that to expect anything imminent over the next quarter is probably aggressive.

Operator

[Operator Instructions] I'm showing no further questions. I'd like to turn the call over to management for any closing remarks.

Douglas W. Jamison

Great. Thank you very much. In closing, we'd like to thank you for your support of Harris & Harris Group. We believe we are taking the right steps to make this company successful for shareholders. Shareholders are first and foremost on our mind. We look forward to speaking in the future. Always, if you have questions, feel free to give us a call. Thank you, and goodbye.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a wonderful day.

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