EQUUS TOTAL RETURN, INC. - Quarter Report: 2004 June (Form 10-Q)

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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

For the quarterly period ended June 30, 2004 or

For the transition period              to             

Commission File Number 0-19509

EQUUS II INCORPORATED

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (713) 529-0900

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in 12b-2 of the Exchange Act).    Yes  ¨    No  x

There were 6,414,668 shares of the registrant’s common stock, $.001 par value, outstanding, as of August 13, 2004. The net asset value of a share at June 30, 2004 was $10.78.

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EQUUS II INCORPORATED

(A Delaware Corporation)

INDEX

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EQUUS II INCORPORATED

BALANCE SHEETS

JUNE 30, 2004 AND DECEMBER 31, 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

STATEMENTS OF OPERATIONS

FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

STATEMENTS OF CHANGES IN NET ASSETS

FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

SUPPLEMENTAL INFORMATION – SELECTED PER SHARE DATA AND RATIOS

FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

JUNE 30, 2004

(Unaudited)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

JUNE 30, 2004

(Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

JUNE 30, 2004

(Unaudited)

(Continued)

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

JUNE 30, 2004

(Unaudited)

(Continued)

Substantially all of the Fund’s portfolio securities are restricted from public sale without prior registration under the Securities Act of 1933. The Fund negotiates certain aspects of the method and timing of the disposition of the Fund’s investment in each portfolio company, including registration rights and related costs. In connection with the investments in American Trenchless Technology, LLC (“ATT”), Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Jones Industrial Services, Inc. and Sovereign Business Forms, Inc., rights have been obtained to demand the registration of such securities under the Securities Act of 1933, providing certain conditions are met. The Fund does not expect to incur significant costs, including costs of any such registration, in connection with the future disposition of its portfolio securities. The fair value of the Fund’s investment in ENGlobal, Inc. (“ENG”) includes a discount of $298,648 from the closing market price to reflect the estimated effect of restrictions on the sale of such securities at June 30, 2004.

As defined in the Investment Company Act of 1940, at June 30, 2004, the Fund was considered to have a controlling interest in Champion Window Holdings, Inc., Container Acquisition, Inc., The Drilltec Corporation, Equicom, Inc. (“Equicom”), PalletOne, Inc., Sovereign Business Forms, Inc., and Spectrum Management LLC.

Income was earned in the amount of $4,668,007 and $4,556,184 for the six months ended June 30, 2004 and 2003, respectively, on portfolio securities of companies in which the Fund has a controlling interest. Income was earned in the amount of $103,988 and $641,956 for the six months ended June 30, 2004 and 2003, respectively, on portfolio securities of companies that are affiliates of the Fund but are not controlled by the Fund.

As defined in the Investment Company Act of 1940, all of the Fund’s investments are in eligible portfolio companies except Sternhill Partners I, L.P. and Vanguard VII, L.P. The Fund provides significant managerial assistance to all of the portfolio companies in which it has invested, except Doane PetCare Enterprises, Inc. (“Doane”), ENG, Equicom, Sternhill Partners I, L.P., and Vanguard VII, L.P. The Fund provides significant managerial assistance to portfolio companies that comprise 83% of the total value of the investments in portfolio companies at June 30, 2004.

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

SCHEDULE OF PORTFOLIO SECURITIES

JUNE 30, 2004

(Unaudited)

(Continued)

The investments in portfolio securities held by the Fund are not geographically diversified. All of the Fund’s portfolio companies (except for Doane, PalletOne, Inc. and certain investments in the venture capital funds) are headquartered in Texas, although several have significant operations in other states.

The Fund’s investments in portfolio securities consist of the following types of securities at June 30, 2004:

The following is a summary by industry of the Fund’s investments as of June 30, 2004:

The accompanying notes are an

integral part of these financial statements.

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EQUUS II INCORPORATED

NOTES TO FINANCIAL STATEMENTS

JUNE 30, 2004 AND 2003

(Unaudited)

(1) Organization and Business Purpose

Equus II Incorporated (the “Fund”), a Delaware corporation, was formed by Equus Investments II, L.P. (the “Partnership”) on August 16, 1991. On July 1, 1992, the Partnership was reorganized and all of the assets and liabilities of the Partnership were transferred to the Fund in exchange for shares of common stock of the Fund. The shares of the Fund trade on the New York Stock Exchange under the symbol EQS.

The Fund seeks to achieve capital appreciation by making investments in equity and equity-oriented securities issued by privately-owned companies in transactions negotiated directly with such companies. The Fund seeks to invest primarily in companies which intend to grow internally or by acquiring other businesses. The Fund may also invest in recapitalizations of existing businesses or special situations from time to time. The Fund’s investments in Portfolio Companies consist principally of equity securities such as common and preferred stock, but also include other equity-oriented securities such as debt convertible into stock or debt combined with warrants, options or other rights to acquire common or preferred stock. The Fund elected to be treated as a business development company under the Investment Company Act of 1940. For tax purposes, the Fund has elected to be treated as a regulated investment company (“RIC”). The Fund has entered into a management agreement with Equus Capital Management Corporation, a Delaware corporation (the “Management Company”).

Pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been omitted. The unaudited financial statements have been prepared consistent with the accounting policies reflected in the Fund’s annual financial statements included in the Company’s Form 10-K for the year ended December 31, 2003 filed with the SEC and should be read in conjunction therewith. In management’s opinion, the unaudited financial statements include all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of such financial statements. Interim results are not necessarily indicative of results for a full year.

(2) Liquidity and Financing Arrangements

Liquidity and Revolving Line of Credit – At June 30, 2004, the Fund had $19,232,672 in cash and cash equivalents, most of which was invested in money market accounts.

In April 2004, the Fund sold its interest in Strategic Holdings, Inc. and SMIP, Inc. Proceeds of such sale included cash of $13.8 million, which was used to repay the outstanding balance under the Fund’s line of credit and promissory note payable.

In May 2004, the Fund and Alenco Window Holdings, LLC (“AWHLLC”) sold their respective interests in Alenco Holding Corporation. The proceeds of the sale and distributions from AWHLLC of approximately $9.75 million were invested in short-term investments.

In May 2004, the Fund announced and began a program to utilize up to $3,000,000 of its cash to repurchase shares of its common stock in the open market on the New York Stock Exchange, subject to the restrictions of the Investment Company Act of 1940 and the Securities Exchange Act of 1934. At June 30, 2004, the Fund had repurchased 74,105 shares of common stock (of which 50,000 shares were sold by a significant shareholder) for a total of $574,204. Since the shares were purchased at a discount to net asset value, these purchases added $0.03 to the net asset value per share at June 30, 2004.

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Effective March 15, 2004, the Fund entered into a $6,500,000 revolving line of credit loan with Frost National Bank. The new line of credit extends through March 31, 2005. The proceeds of the new line of credit were utilized to payoff the previous line of credit. The Fund had no balance outstanding under the line of credit at June 30, 2004.

The new loan is collateralized by the Fund’s investments in portfolio securities. The provisions of the new revolver include a borrowing base which cannot exceed 10% of the total value of eligible portfolio securities, as defined. As of August 14, 2004, the Fund’s availability under the revolving line of credit is approximately $4 million.

Interest on the new revolving line of credit is payable quarterly at a rate of .50% above the Frost National Bank floating prime rate, adjusted daily. A facility fee of .25% per annum on the unused portion of the line of credit is payable quarterly in arrears and the Fund paid a commitment fee of $65,000 at the closing of the loan. The line of credit restricts the Fund’s ability to incur additional indebtedness, pay dividends, merge with another entity, dispose of assets outside the ordinary course of business and engage in certain transactions with affiliates.

Under certain circumstances, the Fund may be called on to make follow-on investments in certain Portfolio Companies. As of June 30, 2004, the Fund has committed to invest up to an additional $1.6 million in the two venture capital funds and one of its portfolio companies.

At June 30, 2003, the Fund had $12 million outstanding on its line of credit and was being charged interest at a rate of 8.25%. The average daily balances outstanding on the Fund’s line of credit during the six months ended June 30, 2004, and 2003 were $2,725,877 and $11,624,144, respectively. During the six months ended June 30, 2004 and 2003, the amount of interest and loan fees paid in cash were $292,455 and $524,976, respectively.

RIC Borrowings, Restricted Cash and Temporary Investments - Because of the nature and size of its portfolio investments, the Fund periodically borrows money utilizing a margin account with a securities brokerage firm to make qualifying investments to maintain its tax status as a RIC under the Internal Revenue Code. As of June 30, 2004 and 2003, the Fund borrowed $22,999,361 and $55,938,355, respectively. The Fund collateralized such borrowings with restricted cash and temporary investments of $23,635,347 and $59,804,792, at June 30, 2004 and 2003, respectively. The temporary qualifying investments were sold, and the total amount borrowed was repaid in July 2004 and 2003, respectively. The Management Company believes the Fund will be able to use this financing arrangement to maintain its RIC status. However, there is no assurance that such arrangement will be available to the Fund in the future. If the Fund is unable to borrow funds in the future to make qualifying investments, the Fund may no longer qualify as a RIC. Failure to continue to qualify as a RIC could be material to the Fund and the Fund’s shareholders in that the Fund would be subject to corporate income tax on its net investment income and net realized gains, and any distributions to stockholders would be subject to income tax as ordinary dividends.

(3) Significant Accounting Policies

Valuation of Investments – Portfolio investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination of net assets. Valuations of portfolio securities are performed in accordance with accounting principles generally accepted in the United States and the financial reporting policies of the SEC. The applicable methods prescribed by such principles and policies are described below:

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Publicly-traded portfolio securities - Investments in companies whose securities are publicly traded are valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities (“Valuation Discount”), if applicable.

Privately-held portfolio securities – The fair value of investments for which no market exists is determined on the basis of procedures established in good faith by the Board of Directors of the Fund. As a general principle, the current “fair value” of an investment would be the amount the Fund might reasonably expect to receive for it upon its current sale, in an orderly manner. Appraisal valuations are necessarily subjective and the Management Company’s estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.

Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of the Board of Directors. Appraisal valuations are based upon such factors as a Portfolio Company’s earnings, cash flow and net worth, the market prices for similar securities of comparable companies, an assessment of the company’s current and future financial prospects and various other factors and assumptions. In the case of unsuccessful operations, the appraisal may be based upon liquidation value.

Most of the Fund’s common equity investments are appraised at a multiple of free cash flow generated by the Portfolio Company in its most recent fiscal year, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company’s experience in the private company marketplace, and are necessarily subjective in nature.

Most of the Portfolio Companies utilize a high degree of leverage. The banking environment currently has resulted in pressure on several of these Portfolio Companies to reduce the amount of leverage in order to maintain such financing. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that the Portfolio Company will be able to restructure the loan agreements to adjust for any defaults, the Portfolio Company’s securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on such indebtedness or is not successful in refinancing the debt upon its maturity, the Fund’s investment could be reduced or eliminated through foreclosure on the Portfolio Company’s assets or the Portfolio Company’s reorganization or bankruptcy.

The Fund may also use, when available, third-party transactions in a Portfolio Company’s securities as the basis of valuation (the “private market method”). The private market method will be used only with respect to completed transactions or firm offers made by sophisticated, independent investors.

The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial condition of the issuer. Certificates of deposit purchased by the Fund generally will be valued at their face value, plus interest accrued to the date of valuation.

Certain of the promissory notes provide that interest may be paid in kind or that the original issue discount may be accreted over the life of the notes, by adding such amounts to the principal of the notes.

Because of the inherent uncertainty of the valuation of portfolio securities which do not have readily ascertainable market values, amounting to $46,546,430 (including $1,706,295 in publicly-traded securities) and $75,553,608 (including $3,494,377 in publicly-traded securities) at June 30, 2004 and December 31, 2003, respectively, the Fund’s estimate of fair value may materially differ from the value that would have been used had a ready market existed for the securities. Appraised values do not reflect brokers’ fees or other normal selling costs which might become payable on disposition of such investments.

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On a daily basis, the Fund adjusts its net asset value for the changes in the value of its publicly held securities and material changes in the value of its private securities and reports those amounts to Lipper Analytical Services, Inc. Weekly and daily net asset values appear in various publications, including Barron’s and The Wall Street Journal.

Investment Transactions - Investment transactions are recorded on the accrual method. Realized gains and losses on investments sold are computed on a specific identification basis.

Escrowed Receivables, at Estimated Fair Value - Upon the sale of securities of certain portfolio companies, the Fund and other sellers were required to place a portion of the proceeds into escrow to secure representations and warranties made to the buyers. If no claims are made against the escrowed amounts, the Fund could receive up to approximately $3.5 million in additional sales proceeds over the next three years ending in May, 2007. The Fund has recorded these escrowed amounts at their estimated fair value of $2,513,000 at June 30, 2004.

Cash Flows - For purposes of the Statements of Cash Flows, the Fund considers all highly liquid temporary cash investments purchased with an original maturity of three months or less to be cash equivalents. The Fund includes its investing activities within cash flows from operations.

Stock-Based Compensation – The Fund accounts for stock-based compensation using the intrinsic value method in accordance with the provisions of APB No. 25. Had the Fund accounted for the options using the fair value method under SFAS 123, the increase (decrease) in net assets from operations for the six months ended June 30, 2004 and 2003, respectively, would have been:

Federal Income Taxes – The Fund intends to comply with the requirements of the Internal Revenue Code necessary to qualify as a regulated investment company (“RIC”) and, as such, will not be subject to federal income taxes on otherwise taxable income (including net realized capital gains) which is distributed to stockholders. Therefore, no provision for federal income taxes is recorded in the financial statements. The Fund borrows money from time to time to maintain its tax status under the Internal Revenue Code as a RIC. See Note 2 for further discussion of the Fund’s RIC borrowings.

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(4) Management

The Fund has entered into a management agreement with the Management Company. Pursuant to such agreement, the Management Company performs certain services, including management and administrative services necessary for the operation of the Fund. The Management Company receives a management fee at an annual rate of 2% of the net assets of the Fund, paid quarterly in arrears. The Management Company also receives compensation for providing certain investor communication services. The accompanying Statements of Operations include $25,000 related to such services for each of the six months ended June 30, 2004 and 2003. The management fees paid by the Fund represent the Management Company’s primary source of revenue and support. The Management Company is controlled by a privately-owned corporation.

As compensation for services to the Fund, each director who is not an officer of the Fund receives an annual fee of $20,000 paid quarterly in arrears, a fee of $2,000 for each meeting of the Board of Directors attended in person, a fee of $1,000 for participation in each telephonic meeting of the Board of Directors and a fee of $1,000 for each committee meeting attended, and reimbursement of all out-of-pocket expenses relating to attendance at such meetings. In addition, each director who is not an officer of the Fund is granted incentive stock options to purchase shares of the Fund’s stock from time to time. (See Note 8). Certain officers of the Fund serve as directors of Portfolio Companies, and may receive and retain fees, including non-employee director stock options, from such Portfolio Companies in consideration for such service.

The Management Agreement will continue in effect until June 30, 2005, and from year-to–year thereafter provided such continuance is approved at least annually by (i) a vote of a majority of the outstanding shares of the Fund or (ii) a majority of the directors who are not “interested persons” of the Fund, at a meeting called for the purpose of voting on such approval. The Management Agreement may be terminated at any time, without the payment of any penalty, by a vote of the Board of Directors of the Fund or the holders of a majority of the Fund’s shares on 60 days’ written notice to the Management Company, and would automatically terminate in the event of its “assignment” (as defined in the Investment Company Act).

(5) Federal Income Tax Matters

The Fund is required to make distributions of any net taxable investment income on an annual basis, and may elect to distribute or retain net taxable realized capital gains. The Internal Revenue Service approved the Fund’s request, effective October 31, 1998, to change its year-end for determining capital gains for purposes of Section 4982 of the Internal Revenue Code from December 31 to October 31.

The Fund was required to make a distribution for 2003 under income tax regulations. As of December 31, 2003, the Fund had a capital loss carryforward of $8,023,608, which may be used to offset future taxable capital gains. If not utilized, the loss carryforward will expire beginning in 2007.

(6) Dividends

The Fund declared no dividends during the six months ended June 30, 2004 and 2003. On January 16, 2004, the Fund paid $2,287,194 in cash for a dividend which had been declared in the fourth quarter of 2003.

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(7) Portfolio Securities

During the six months ended June 30, 2004, the Fund made follow-on investments of $1,799,328 in four companies and two venture funds, including $302,528 in accrued interest and dividends in the form of additional portfolio securities and $949,632 recorded as the cost of securities acquired in an exchange for securities of a new company that acquired the business and assets of a former portfolio company. In addition, the Fund realized a net capital gain of $4,135,150 during the six months ended June 30, 2004.

During the six months ended June 30, 2003, the Fund made follow-on investments of $1,829,112 in eight companies, including $624,112 in accrued interest and dividends in the form of additional portfolio securities and accretion of original issue discount on promissory notes. In addition, the Fund realized a net capital loss of $8,081,347 during the six months ended June 30, 2003.

(8) Stock Option Plan

The Equus II Incorporated 1997 Stock Incentive Plan (“Stock Incentive Plan”) authorizes the Fund to issue options to the directors and officers of the Fund in an aggregate amount of up to 20% of the outstanding shares of common stock of the Fund. The Stock Incentive Plan provides that each director who is not an officer of the Fund is, on the first business day following each annual meeting, granted an incentive stock option to purchase 2,200 shares of the Fund’s common stock. Options are issued to the officers of the Fund at the discretion of the compensation committee. The options have a ten year life and vest 50% six months after the grant date and 16 ²/3% on the first, second and third anniversaries of the date of the grant.

Under the Stock Incentive Plan, options to purchase 1,049,200 and 1,100,000 shares of the Fund’s common stock with a weighted average exercise price of $8.46 and $8.41 per share were outstanding at June 30, 2004 and 2003, respectively. Of these options, 855,950 and 750,188 shares, with a weighted average exercise price per share of $8.62 and $8.75 were exercisable at June 30, 2004 and 2003, respectively. Of the outstanding options at June 30, 2004, 992,000 have exercise prices ranging from $7.43 to $9.03 and the remaining options have exercise prices ranging from $14.15 to $24.95. These options expire in November 2007 through May 2014.

On May 7, 2004, options to acquire a total of 15,400 shares at $7.72 per share were issued to the non-officer directors. On May 12, 2003, options to acquire a total of 13,200 shares at $7.43 per share were issued to the non-officer directors.

On November 14, 2001, options to acquire a total of 990,000 shares at $7.69 per share were issued to officers of the Fund. These options included dividend equivalent rights. Generally accepted accounting principles require that the options be accounted for using variable plan accounting. Variable plan accounting resulted in non-cash compensation expense (benefit) of ($276,851) during the six months ended June 30, 2004.

Dividend equivalent rights represent the right of the officers of the Fund to receive a credit against the option exercise price for the amount of any dividends paid by the Fund during the option period. In January 2002, the Fund filed an application with the SEC seeking an amendment to an exemptive order previously issued by the SEC, to permit the Fund to grant dividend equivalent rights to the Fund’s independent directors as part of their stock option awards. During its review of such application, the SEC staff advised the Fund that it does not believe that dividend equivalent rights are permitted under the Investment Company Act. Accordingly, the Fund may be required to obtain a new exemptive order from the SEC permitting the Fund to issue dividend equivalent rights. Based on the ongoing discussion with the SEC, the Fund has not recorded any associated compensation expense for the 2003 dividend applicable to dividend equivalent rights, and the Fund has withdrawn the exemptive order application previously filed in January 2002. If the

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dividend equivalent rights had been in effect, additional non-cash compensation expense of approximately $650,000, with an offsetting credit to additional paid in capital, would have been recognized under variable plan accounting in the fourth quarter of 2003. Such recognition of the non-cash compensation expense would not have changed the Fund’s reported net assets.

On September 30, 1999, options to purchase 719,794 shares of common stock of the Fund were exercised by the officers of the Fund for $15.45 per share. The exercise price of $11,124,086 was paid in the form of promissory notes from the officers to the Fund. In September 2001, the officers of the Fund surrendered 802,662 shares in satisfaction of their notes receivable and accrued interest aggregating $10,505,551.

During its review of the exemptive application discussed above, the SEC staff also raised certain issues with respect to the manner in which the officer notes were settled. The Fund has responded to the staff’s questions and supplied additional information. Although the ultimate resolution of this matter cannot be determined at this time, management of the Fund believes that the resolution of this matter will not have an adverse financial impact on the Fund.

If all outstanding options for which the average market price exceeds the exercise price at June 30, 2004 and December 31, 2003, had been exercised, the fund’s net asset value would have been reduced by $0.03 and $0.06 per share, respectively, assuming the Fund had used the proceeds from the exercise of such options to repurchase shares at the market price pursuant to the treasury stock method.

(9) Subsequent Events

On July 1, 2004, the Fund sold U.S. Treasury bills for $23,000,000 and repaid the margin loan.

The Fund may repurchase its shares, subject to the restrictions of the Investment Company Act of 1940 and the Securities Exchange Act of 1934. During July, the Fund repurchased 126,400 shares (of which 125,000 shares were sold by a significant shareholder) of its common stock in the open market for $985,102 at an average discount of approximately 26% from net asset value.

On July 28, 2004, the Fund received $2,159,176 from ENG as payment in full of its outstanding 9.5% promissory note. The promissory note had a face value of $2,120,000 and the remaining $39,176 was for accrued interest.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

Equus II Incorporated is a business development company which invests in equity and equity-oriented securities issued by privately-owned companies in transactions negotiated directly with such companies. We attempt to limit risk by investing in a portfolio of companies involved in different industries. We limit our initial investment in any company to no more than 15% of the Fund’s net assets.

We had investments in fourteen Portfolio Companies and two venture capital funds at June 30, 2004. We did not make any new investments during the six months ended June 30, 2004 or 2003.

The valuation of our investments is the most significant area of judgment impacting our financial statements. Our portfolio investments are valued at our estimates of fair value, with the net change in unrealized appreciation or depreciation included in the determination of net assets. Almost all of our long-term investments are in privately-held or restricted securities, the valuation of which is necessarily subjective. Actual values may differ materially from the Fund’s estimated fair value. Portfolio valuations are determined quarterly by the Management Company, subject to the approval of the Board of Directors, and are based on a number of relevant factors.

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Most of our Portfolio Companies utilize leverage, and the leverage magnifies the return on our investments. For example, if a Portfolio Company has a total enterprise value of $10 million and $7.5 million in funded indebtedness, its equity is valued at $2.5 million. If the enterprise value increases or decreases by 20%, to $12 million or $8 million, respectively, the value of the equity increases or decreases by 80%, to $4.5 million or $0.5 million, respectively. This disproportionate increase or decrease adds a level of volatility to our equity-oriented portfolio securities.

We derive our cash flow from interest and dividends received and sales of securities from our investment portfolio. We pay certain administrative costs, management fees to the Management Company overseeing the portfolio, and interest expense on our existing debt. We also spend our cash on new investments, or follow-on investments which may be required by certain Portfolio Companies. Historically, our cash flow from interest and dividends has not been sufficient to cover our expenses and follow-on investments. Because our investments are illiquid, we have utilized leverage to provide the required funds, and the leverage is then repaid from the sale of portfolio securities. Our previous lender required that all proceeds from sale or repayment of our portfolio securities be applied to its loan, and reduced its commitment to advance funds under the loan agreement by a like amount. In April and May of 2004, we sold our interests in Strategic Holdings, Inc., SMIP, Inc. and Alenco Holding Corporation. Proceeds from such sales were used to pay off our existing borrowings, and the remaining proceeds may be used for new or follow-on investments or other corporate purposes.

We have distributed to our stockholders any net taxable investment income or realized capital gains on an annual basis. We declared a dividend of $0.72 per share in 2003, including $0.57 per share in qualifying dividend income and $0.15 per share as a return of capital. We did not declare a dividend for the six months ended June 30, 2004.

Since we are a closed-end business development company, stockholders have no right to present their shares to the Fund for redemption. Because our shares have traded at a discount from our net asset value, our Board of Directors has determined that it would be in the best interest of our stockholders to attempt to reduce or eliminate the market value discount. Accordingly, from time to time we may repurchase our shares to attempt to reduce the discount or to increase the net asset value of our remaining shares.

In May and June of 2004, the Fund repurchased 74,105 shares (of which 50,000 shares were sold by a significant shareholder) of its common stock for $574,204, pursuant to a plan to spend up to $3,000,000 to repurchase our common stock in the open market. The 74,105 shares were repurchased at an average discount rate of approximately 27% from net asset value, and the effect of these transactions added approximately $0.03 per share to the net asset value of our outstanding shares.

Significant Accounting Policies

Valuation of Investments - The valuation of our Portfolio Companies is the most significant area of judgment impacting the financial statements. Portfolio investments are carried at fair value with the net change in unrealized appreciation or depreciation included in the determination of net assets. Valuations of portfolio securities are performed in accordance with accounting principles generally accepted in the United States and the financial reporting policies of the SEC. The applicable methods prescribed by such principles and policies are described below:

Publicly-traded portfolio securities - Investments in companies whose securities are publicly traded are valued at their quoted market price at the close of business on the valuation date, less a discount to reflect the estimated effects of restrictions on the sale of such securities (“Valuation Discount”), if applicable.

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Privately-held portfolio securities – The fair value of investments for which no market exists is determined on the basis of procedures established in good faith by our Board of Directors. As a general principle, the current “fair value” of an investment is the amount we might reasonably expect to receive for it upon its current sale, in an orderly manner. Appraisal valuations are necessarily subjective and the Management Company’s estimate of values may differ materially from amounts actually received upon the disposition of portfolio securities.

Generally, cost is the primary factor used to determine fair value until significant developments affecting the Portfolio Company (such as results of operations or changes in general market conditions) provide a basis for use of an appraisal valuation. Thereafter, portfolio investments are carried at appraised values as determined quarterly by the Management Company, subject to the approval of our Board of Directors. Appraisal valuations are based upon such factors as a Portfolio Company’s earnings, cash flow and net worth, the market prices for similar securities of comparable companies, an assessment of the company’s current and future financial prospects and various other factors and assumptions. In the case of unsuccessful operations, the appraisal may be based upon liquidation value.

Most of our common equity investments are appraised at a multiple of free cash flow generated by the Portfolio Company in its trailing twelve months, less outstanding funded indebtedness and other senior securities such as preferred stock. Projections of current year free cash flow may be utilized and adjustments for non-recurring items are considered. Multiples utilized are estimated based on the Management Company’s experience in the private company marketplace, and are necessarily subjective in nature. Most of the Portfolio Companies utilize a high degree of leverage. From time to time, Portfolio Companies are in default of certain covenants in their loan agreements. When the Management Company has a reasonable belief that a Portfolio Company will be able to restructure its loan agreements to adjust for any defaults, the Portfolio Company’s securities continue to be valued assuming that the company is a going concern. In the event a Portfolio Company cannot generate adequate cash flow to meet the principal and interest payments on its indebtedness or is not successful in refinancing the debt upon its maturity, the value of our investment could be reduced or eliminated through foreclosure on the Portfolio Company’s assets or the Portfolio Company’s reorganization or bankruptcy.

We may also use, when available, third-party transactions in a Portfolio Company’s securities as the basis of valuation (the “private market method”). The private market method will be used only with respect to completed transactions or firm offers made by sophisticated, independent investors.

The fair values of debt securities, which are generally held to maturity, are determined on the basis of the terms of the debt securities and the financial conditions of the issuer. Certificates of deposit generally will be valued at their face value, plus interest accrued to the date of valuation.

Certain of the promissory notes provide that interest may be paid in kind or that the original issue discount may be accreted over the life of the notes, by adding such amounts to the principal of the notes.

On a daily basis, we adjust our net asset value for changes in the value of our publicly held securities and material changes in the value of our private securities, and report those amounts to Lipper Analytical Services, Inc. Weekly and daily net asset values appear in various publications, including Barron’s and The Wall Street Journal.

Federal Income Taxes – We intend to comply with the requirements of the Internal Revenue Code necessary to qualify as a regulated investment company (“RIC”) and, as such, will not be subject to federal income taxes on otherwise taxable income (including net realized capital gains) which is distributed to stockholders. Therefore, no provision for federal income taxes is recorded in the financial statements. As of December 31, 2003, we had a capital loss carryforward of approximately $8,024,000, which may be used to offset future taxable capital gains. We borrow money from time to time to maintain our tax status as a RIC.

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Liquidity and Capital Resources

At June 30, 2004, we had $19,232,672 in cash and cash equivalents, most of which was invested in money market accounts. Such cash may be used to pay operating expenses, for new and follow-on investments in portfolio securities, to pay dividends to our shareholders or to repurchase shares of our common stock. We had $46,546,430 of our total assets of $94,103,557 invested in portfolio securities of fourteen operating companies and two venture capital funds. $22,999,361 of our remaining assets were invested in U.S. Treasury Bills for the purpose of satisfying the diversification requirement to maintain our pass-through tax treatment. These securities were held by a securities brokerage firm and were pledged along with cash and other securities to secure the payment of the margin account balance. The U.S. Treasury bills were sold and the margin loan was repaid in July, 2004.

Effective March 15, 2004, we entered into a new $6,500,000 revolving line of credit loan with Frost National Bank. The new line of credit extends through March 31, 2005. The proceeds of the new loan were utilized to pay off the previous line of credit. As of August 14, 2004, there is no amount outstanding under the new line of credit and the availability of such line is approximately $4 million at such date.

The new line of credit is collateralized by our investments in portfolio securities. The provisions of the new line of credit include a borrowing base that cannot exceed 10% of the total value of eligible portfolio securities. Interest on the new revolving line of credit is payable quarterly at a rate of .50% above the floating prime rate, adjusted daily. A facility fee of .25% per annum on the unused portion of the line of credit is payable quarterly in arrears, and we paid a commitment fee of $65,000 at the closing of the loan.

On April 8, 2004, we sold our interest in Strategic Holdings, Inc and SMIP, Inc. (“Strategic Materials”), and received proceeds of $13.8 million. A portion of the proceeds was used to pay off our existing borrowings under our line of credit and the promissory note payable. During the second quarter of 2004, we sold our interest in Alenco Holding Corporation (“Alenco”), received a cash distribution from Alenco Window Holdings, LLC (“AWHLLC”) and sold 868,022 shares of common stock of ENG. We received cash of $11.8 million from such sales and the distribution.

In the fourth quarter of 2003, we declared a dividend of $0.72 per share, of which $0.15 was considered a return of capital. We paid $2,287,194 in cash for this dividend in January, 2004, and issued 286,540 shares of common stock at $7.919 per share effective December 31, 2003.

Under certain circumstances, we may be called on to make follow-on investments in certain Portfolio Companies. As of June 30, 2004, we have committed to invest up to an additional $1.6 million in the two venture capital funds and one of our portfolio companies.

Net cash provided by operating activities was $ 57,191,918 and $2,331,336 for the six months ended June 30, 2004 and 2003, respectively. Approximately $11.1 million in estimated value of our investments are in the form of notes receivable from Portfolio Companies. However, only three of the Portfolio Companies are currently paying cash interest to us in accordance with their respective notes receivable, which aggregate $7,978,835 in fair value. Certain of the promissory notes provide that interest may be paid in kind or that the original issue discount may be accreted over the life of the notes, by adding such amounts to the principal of the notes.

Because of the nature and size of our portfolio investments, we periodically borrow funds to make qualifying investments to maintain our tax status as a RIC. During the six months ended June 30, 2004 and 2003, we borrowed such funds by utilizing a margin account with a securities brokerage firm. There is no assurance that such arrangement will be available in the future. If we are unable to borrow funds to make qualifying investments, we may no longer qualify as a RIC. We would then be subject to corporate income tax on our net investment income and realized capital gains, and distributions to stockholders would be subject to income tax as ordinary dividends.

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We have the ability to borrow funds and issue forms of senior securities representing indebtedness or stock, such as preferred stock, subject to certain restrictions. Net taxable investment income and net taxable realized gains from the sales of portfolio investments are intended to be distributed at least annually, to the extent such amounts are not reserved for payment of expenses and contingencies or to make follow-on or new investments. Pursuant to the restrictions in our existing line of credit, we are not allowed to incur additional indebtedness unless approved by the lender.

We reserve the right to retain net long-term capital gains in excess of net short-term capital losses for reinvestment or to pay contingencies and expenses. Such retained amounts, if any, will be taxable to us as long-term capital gains and stockholders will be able to claim their proportionate share of the federal income taxes paid by us on such gains as a credit against their own federal income tax liabilities. Stockholders will also be entitled to increase the adjusted tax basis of their Fund shares by the difference between their undistributed capital gains and their tax credit.

Results of Operations

Investment Income and Expense

Net investment income after all expenses amounted to $3,521,008 and $3,314,412 for the six months ended June 30, 2004 and 2003, respectively. Total income from portfolio securities was $4,771,995 for the six months ended June 30, 2004 and $5,221,346 for the comparable period in 2003.

The Management Company receives management fee compensation at an annual rate of 2% of the net assets of the Fund paid quarterly in arrears. Such fees amounted to $701,231 and $783,326 during the six months ended June 30, 2004 and 2003, respectively. The decrease in management fees during the six months ended June 30, 2004 was due to a decrease in net assets between the two periods.

Professional fees increased by $150,072 for the first six months of 2004 over the comparable period for 2003. This increase is primarily due to the legal fees incurred in connection with the refinancing of our line of credit and in responding to the SEC’s questions regarding the manner in which the officer option notes were settled during 2001.

Interest expense decreased to $263,713 for the first six months of 2004 from $523,347 in 2003 due to the payoff of the revolving line of credit. In addition, franchise taxes increased from $23,924 in 2003 to $81,665 in 2004 primarily due to the timing of the Texas franchise taxes.

Generally accepted accounting principles require that certain options issued by the Fund be accounted for using variable plan accounting. Such accounting resulted in non-cash compensation expense (benefit) of $(276,851) and $206,044 during the six months ended June 30, 2004 and 2003, respectively.

Realized Gains and Losses on Sales of Portfolio Securities

During the six months ended June 30, 2004, we realized a capital gain of $4,135,150. We sold 1,154,316 shares of ENGlobal, Inc. (“ENG”) common stock, realizing a capital loss of $119,803. We exchanged our investment in Turfgrass America, Inc. (“TAI”) for an investment in a new entity that acquired the assets and business of TAI, realizing a capital loss of $6,049,696. In the second quarter of 2004 we sold our interests in Alenco and Strategic Materials, and received a cash distribution from AWHLLC, realizing capital gains of $10,201,126. In addition, we realized a short term capital gain of $3,520 on our U.S. Treasury Bills.

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During the six months ended June 30, 2003, we realized a capital loss of $8,081,347 from the sale of securities of six Portfolio Companies. We received $197,986 for our remaining investment in Milam Enterprises, LLC, realizing a capital gain of $196,075. We received $2,406,398 from Doane PetCare Enterprises, Inc. for payment in full of our 15% promissory note, realizing a capital gain of $551,850 relating to the unamortized original issue discount. The Fund received $500,000 for its investment in FS Strategies, Inc., realizing a capital loss of $8,758,667. The Fund sold 4,432 shares of Weatherford International common stock for $183,005, realizing a capital loss of $73,800. We received $3,199 from ENG in payment for 3,332 shares of common stock, realizing a capital gain of $1,251 and we also realized a short-term capital gain of $1,944 from the sale of U.S. Treasury Bills.

Changes in Unrealized Appreciation/Depreciation of Portfolio Securities

Net unrealized depreciation on investments increased by $7,789,682 during the six months ended June 30, 2004 from $7,576,155 to $15,365,837. Such increase in unrealized depreciation is due primarily to the sale of Alenco and Strategic Materials, which transferred $9,939,384 of unrealized appreciation at December 31, 2003, to realized gains at June 30, 2004. Excluding the sale of Alenco and Strategic Materials, the net unrealized depreciation decreased by $2,149,702. Such decrease resulted from increases in the estimated fair value of six of our Portfolio Companies aggregating $9,364,702 and decreases in the estimated fair value of seven of our Portfolio Companies aggregating $7,215,000. The decrease in the estimated fair value of the Portfolio Companies is partially a result of the recapitalization dividend declared by Champion Window Holdings, Inc. in March 2004, from which the Fund received $3,525,000 in cash.

Net unrealized depreciation on investments decreased by $4,535,994 during the six months ended June 30, 2003 from $5,417,014 to $881,020. Such change resulted from increases in the estimated fair value of six of our Portfolio Companies aggregating $6,623,459, decreases in the estimated fair value of eleven of the Fund’s Portfolio Companies aggregating $11,426,899 and the transfer of $9,339,434 in net unrealized depreciation to net capital loss from the sale or disposition of investments in three of the Fund’s Portfolio Companies. The decrease in the estimated fair value of the Portfolio Companies was partially a result of the dividend declared by Champion Window Holdings, Inc. in June 2003, from which the Fund received $3,500,000 in cash.

Dividends