RAND CAPITAL CORP - Annual Report: 2006 (Form 10-K)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

Commission file number: 001-08205

 

Rand Capital Corporation

(Exact Name of Registrant as specified in its Charter)

 

 

(716) 853-0802

(Registrant’s Telephone No. Including Area Code)

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.10 par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 under the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form  10-K  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 under the Exchange Act.

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the registrant’s outstanding common stock held by non-affiliates of the registrant as of June 30, 2006 was approximately $5,833,738 based upon the last sale price as quoted by NASDAQ Capital Market on such date.

 

As of March 16, 2007 there were 5,718,934 shares of the registrant’s common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Corporation’s definitive proxy statement for the Annual Meeting of Stockholders to be held on April 26, 2007 are incorporated by reference into certain sections of Part III herein.

 

 

RAND CAPITAL CORPORATION
TABLE OF CONTENTS FOR FORM 10-K

 

 

Rand Capital Corporation (“Rand” or “Corporation”) was incorporated under the law of New York on February 24, 1969. Beginning in 1971, Rand operated as a publicly traded, closed-end, diversified management company that was registered under Section 8(b) of the Investment Company Act of 1940 (the “1940 Act”). On August 16, 2001, Rand filed an election to be treated as a business development company (“BDC”) under the 1940 Act, which became effective on the date of filing. On January 16, 2002, Rand formed a wholly-owned subsidiary, Rand Capital SBIC, L.P., (“Rand SBIC”) for the purpose of operating it as a small business investment company. At the same time, Rand organized another wholly owned subsidiary, Rand Capital Management, LLC (“Rand Management”), as a Delaware limited liability company, to act as the general partner of Rand SBIC. Rand transferred $5 million in cash to Rand SBIC to serve as “regulatory capital” in January 2002 and on August 16, 2002, Rand received notification that its Small Business Investment Company (“SBIC”) application had been approved and Rand SBIC had been licensed by the Small Business Administration (“SBA”). The following discussion will include Rand, Rand SBIC and Rand Management (collectively, the “Corporation”).

 

Throughout the Corporation’s history, its principal business has been to make venture capital investments in small to medium sized companies that are engaged in the exploitation of new or unique products or services with a sustainable competitive advantage typically in New York and its surrounding states. The Corporation’s principal investment objective is to achieve long-term capital appreciation while maintaining a current cash flow from its debenture instruments. The Corporation invests in a mixture of debenture and equity instruments. The debt securities most often have an equity piece attached to the debenture in the form of stock, warrants or options to acquire stock or the right to convert the debt securities into stock. Rand SBIC was the primary investment vehicle in 2005 and 2006 and it is anticipated that will continue to be the case in 2007. Consistent with its status as a BDC and the purposes of the regulatory framework for BDC’s under the 1940 Act, the Corporation provides managerial assistance, often in the form of a board of director’s seat, to the portfolio companies in which it invests.

 

The Corporation operates as an internally managed investment company whereby its officers and employees conduct its operations under the general supervision of its Board of Directors. It has not elected to qualify to be taxed as a regulated investment company as defined under Subchapter M of the Internal Revenue Code.

 

The Corporation’s website is www.randcapital.com. The Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, charters for the Corporation’s committees and other reports filed with the Securities and Exchange Commission (“SEC”) are available through the Corporation’s website.

 

Regulation as a BDC

 

Although the 1940 Act exempts a BDC from registration under that Act, it contains significant limitations on the operations of BDC’s. Among other things, the 1940 Act contains prohibitions and restrictions relating to transactions between a BDC and its affiliates, principal underwriters and affiliates of its affiliates or underwriters, and it requires that a majority of the BDC’s directors be persons other than “interested persons,” as defined under the 1940 Act. The 1940 Act also prohibits a BDC from changing the nature of its business so as to cease to be, or to withdraw its election as, a BDC unless so authorized by a vote of the holders of a majority of its outstanding voting securities. BDC’s are not required to maintain fundamental investment policies relating to diversification and concentration of investments within a single industry. More specifically, in order to qualify as a BDC, a company must:

 

(1) be a domestic company;

 

(2) have registered a class of its equity securities or have filed a registration statement with the Commission pursuant to Section 12 of the Securities Exchange Act of 1934;

 

(3) operate for the purpose of investing in the securities of certain types of portfolio companies, namely immature or emerging companies and businesses suffering or just recovering from financial distress;

 

(4) extend significant managerial assistance to such portfolio companies; and

 

(5) have a majority of “disinterested” directors (as defined in the 1940 Act). Generally, a BDC must be primarily engaged in the business of furnishing capital and providing managerial expertise to companies that do not have ready access to capital through conventional financial channels. Such portfolio companies are termed “eligible portfolio companies.”

 

An eligible portfolio company is, generally, a private domestic operating company, or a public domestic operating company whose securities are not listed on a national securities exchange. In addition, any small business investment company that is licensed by the Small Business Administration and that is a wholly owned subsidiary of a BDC is an eligible portfolio company.

 

The 1940 Act prohibits or restricts companies subject to the 1940 Act from investing in certain types of companies, such as brokerage firms, insurance companies, investment banking firms and investment companies. Moreover, the 1940 Act limits the type of assets that BDCs may acquire to “qualifying assets” and certain assets necessary for its operations (such as office furniture, equipment and facilities) if, at the time of acquisition, less than 70% of the value of the BDC’s assets consist of qualifying assets. Qualifying assets include: (1) securities of companies that were eligible portfolio companies at the time the BDC acquired their securities; (2) securities of bankrupt or insolvent companies that were eligible at the time of the BDC’s initial acquisition of their securities but are no longer eligible, provided that the BDC has maintained a substantial portion of its initial investment in those companies; (3) securities received in exchange for or distributed in or with respect to any of the foregoing; and (4) cash items, government securities and high-quality short-term debt. The 1940 Act also places restrictions on the nature of the transactions in which, and the persons from whom, securities can be purchased in order for the securities to be considered qualifying assets. These restrictions include limiting purchases to transactions not involving a public offering and acquiring securities from the portfolio company or its officers, directors, or affiliates.

 

A BDC is permitted to invest in the securities of public companies and other investments that are not qualifying assets, but those kinds of investments may not exceed 30% of the BDC’s total asset value at the time of the investment.

 

A BDC must make significant managerial assistance available to the issuers of eligible portfolio securities in which it invests. Making available significant managerial assistance means, among other things, any arrangement whereby the BDC, through its directors, officers or employees, offers to provide, and, if accepted does provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company.

 

SBIC Subsidiary

 

On January 16, 2002, Rand formed two wholly-owned subsidiaries, Rand SBIC and Rand Management. On August 16, 2002, Rand received notification that its Small Business Investment Company application had been approved and licensed by the Small Business Administration. The approval allows Rand SBIC to obtain loans up to two times its initial $5 million of regulatory capital from the SBA for purposes of making new investment’s in portfolio companies.

 

Rand formed Rand SBIC as a subsidiary for the purpose of causing it to be licensed as a small business investment company (“SBIC”) under the Small Business Investment Act of 1958 (the “SBA Act”) by the Small Business Administration (the “SBA”), in order to have access to various forms of leverage provided by the SBA to SBIC’s.

 

On May 28, 2002, the Corporation filed an Exemption Application with the SEC seeking an order under Sections 6(c), 12(d)(1)(J), 57(c), and 57(i) of, and Rule 17d-1 under, the 1940 Act for exemptions from the application of Sections 2(a)(3), 2(a)(19), 12(d)(1), 18(a), 21(b), 57(a)(1), (2), (3), and (4), and 61(a) of the 1940 Act to certain aspects of its operations. The application also seeks an order under Section 12(h) of the Securities Exchange Act of 1934 Act (the “Exchange Act”) for an exemption from separate reporting requirements for Rand

SBIC under Section 13(a) of the Exchange Act. In general, the Corporation’s applications seek orders that would permit:

 

 

Since the filing of its original Application for Exemption, Rand has maintained discussions with the staff of the Division of Investment Management of the SEC concerning Rand’s application. The principal substantive issue in these discussions has been the structure of Rand SBIC as a limited partnership. Rand SBIC must meet the requirements of the SBA for licensed SBICs, and at the same time Rand SBIC must meet the requirements of the SEC that apply to BDCs.

 

When Rand formed Rand SBIC in 2002, it formed Rand SBIC as a limited partnership because that was the organizational form that the SBA strongly encouraged for all new entities seeking licenses as SBICs, and Rand formed Rand SBIC in a manner that was consistent with the SBA’s model limited partnership forms for licensed SBICs. In that structure, the general partner of Rand SBIC is Rand Management, a limited liability company whose managers are the principal executive officers of Rand.

 

Under the rules and interpretations of the SEC applicable to BDCs, if a BDC is structured in limited partnership form, then it must have general partners who serve as a board of directors, or a general partner with very limited authority and a separate board of directors, and all of the persons who serve on the board of directors must be natural persons and a majority of them must not be “interested persons” of the BDC. Since the managers of Rand Management are the principal executive officers of Rand, and since both Rand Management and Rand SBIC are wholly owned by Rand, Rand believes that the Board of Directors of Rand is the functional equivalent of a board of directors for both Rand Management and Rand SBIC. Nevertheless, the staff of the Division of Investment Management of the SEC has expressed the view that if Rand SBIC is to be operated as a limited partnership BDC in compliance with the 1940 Act, then the organizational documents of Rand SBIC must specifically provide that it will have a board of directors consisting of natural persons, a majority of whom are not “interested persons.”

 

In discussions between Rand and the SBA, the SBA has recently indicated that if Rand SBIC is reorganized as a corporation whose directors are directors of Rand, it will continue to permit Rand SBIC to be licensed as an SBIC. Accordingly, Rand is currently in negotiations with the SEC and the SBA concerning the reorganization of Rand SBIC as a wholly owned corporate subsidiary of Rand whose board of directors will be comprised of directors of Rand, a majority of whom will not be “interested persons” of Rand or Rand SBIC, and concerning the licensing of the new corporate subsidiary as an SBIC. Based on the current status of these negotiations, Rand does not expect that either the reorganization process or the subsequent operations of Rand SBIC as a corporation will result in any material change in the operations of Rand SBIC. Once the reorganization is completed, Rand expects to make an appropriate amendment to its Exemption Application to the SEC, and it believes that it will receive exemptions necessary for its operation of Rand SBIC as a BDC.

 

Rand operates Rand SBIC through Rand Management for the same investment purposes, and with investments in similar kinds of securities, as Rand. Rand SBIC’s operations are consolidated with those of Rand for both financial reporting and tax purposes.

 

Regulation of SBIC Subsidiary

 

Lending Restrictions

 

The SBA licenses SBICs as part of a program designed to stimulate the flow of private debt and/or equity capital to small businesses. SBICs use funds borrowed from the SBA, together with their own capital, to provide loans to, and make equity investments in, concerns that (a) do not have a net worth in excess of $18 million and do not have average net income after U.S. federal income taxes for the two years preceding any date of determination of more than $6 million, or (b) meet size standards set by the SBA that are measured by either annual receipts or number of employees, depending on the industry in which the concerns are primarily engaged. The types and dollar amounts of the loans and other investments an SBIC that is a BDC may make are limited by the 1940 Act, the SBA Act and SBA regulations. The SBA is authorized to examine the operations of SBICs, and an SBIC’s ability to obtain funds from the SBA is also governed by SBA regulations.

 

In addition, at the end of each fiscal year, an SBIC must have at least 20% (in total dollars) invested in “Smaller Enterprises”. The SBA defines “Smaller Enterprises” as concerns that (a) do not have a net worth in excess of $6 million and have average net income after U.S. federal income taxes for the preceding two years no greater than $2 million, or (b) meet size standards set by the SBA that are measured by either annual receipts or number of employees, depending on the industry in which the concerns are primarily engaged.

 

SBICs may invest directly in the equity of their portfolio companies, but they may not become a general partner of a non-incorporated entity or otherwise become jointly or severally liable for the general obligations of a non-incorporated entity. An SBIC may acquire options or warrants in its portfolio companies, and the options or warrants may have redemption provisions, subject to certain restrictions.

 

SBA Leverage

 

The SBA raises capital to enable it to provide funds to SBICs by guaranteeing certificates or bonds that are pooled and sold to purchasers of the government guaranteed securities. The amount of funds that the SBA may lend to SBICs is determined by annual Congressional appropriations.

 

In order to obtain SBA borrowings, also known as leverage, an SBIC must demonstrate its need to the SBA. To demonstrate need, an SBIC must invest 50% of its Leverageable Capital (defined as Regulatory Capital less unfunded commitments and federal funds) and any outstanding SBA leverage. Other requirements include compliance with SBA regulations, adequacy of capital, and meeting liquidity standards. An SBIC’s license entitles an SBIC to apply for SBA leverage, but does not assure that it will be available, or if available, that it will be available at the level of the relevant matching ratio. Availability depends on the SBIC’s continued regulatory compliance and sufficient SBA funds being available when the SBIC applies to draw down SBA leverage. Under the provisions of the SBIC regulations, the Corporation may apply for the SBA’s conditional commitment to reserve a specific amount of leverage for future use. The Corporation may then apply to draw down leverage against the commitment. All SBIC’s must obtain a leverage commitment in order to draw leverage from the SBA. Commitments expire on September 30 of the fourth full fiscal year following issuance and require the payment of a fee equal to 1 percent of the total commitment at the time of issuance. An additional fee equal to 2 percent of the amount drawn is deducted at the time of each draw.

 

The Corporation paid $100,000 to the SBA to reserve $10,000,000 of its approved debenture leverage. The leverage commitment expires on September 30, 2008. The fees were paid in two installments of $50,000 each in July 2003 and in August 2004. These fees were 1% of the face amount of the leverage reserved under the commitment. The fee represents a partial prepayment of the SBA’s nonrefundable 3% leverage fee. As of December 31, 2006, Rand SBIC had drawn $8,100,000 in leverage from the SBA.

 

SBA debentures are issued with 10-year maturities. Interest only is payable semi-annually until maturity. Ten-year SBA debentures may be prepaid with a penalty during the first 5 years, and then are pre-payable without penalty. Rand initially capitalized Rand SBIC with $5 million in Regulatory Capital. Rand SBIC was approved to obtain SBA leverage at a 2:1 matching ratio, resulting in a total capital pool eligible for investment of $15 million. The Corporation expects to use Rand SBIC as its primary investment vehicle.

 

Employees

 

As of December 31, 2006, the Corporation had four employees.

 

The Corporation is Subject to Risks Created by the Valuation of its Portfolio Investments

 

There is typically no public market for equity securities of the small privately held companies in which the Corporation invests. As a result, the valuations of the equity securities in the Corporation’s portfolio are stated at fair value as determined by the good faith estimate of the Corporation’s Board of Directors in accordance with the established SBA valuation policy. In the absence of a readily ascertainable market value, the estimated value of the Corporation’s portfolio of securities may differ significantly, favorably or unfavorably, from the values that would be placed on the portfolio if a ready market for the equity securities existed. Any changes in estimated value are recorded in the statement of operations as “Net (increase) decrease in unrealized appreciation.”

 

The Corporation’s Portfolio Investments are Illiquid

 

Most of the investments of the Corporation are or will be either equity securities acquired directly from small companies or subordinated debt securities. The Corporation’s portfolio of equity and debt securities is, and will usually be, subject to restrictions on resale or otherwise have no established trading market. The illiquidity of most of the Corporation’s portfolio may adversely affect the ability of the Corporation to dispose of the securities at times when it may be advantageous for the Corporation to liquidate investments.

 

Investing in Private Companies involves a High Degree of Risk

 

The Corporation typically invests a substantial portion of its assets in small and medium sized private companies. These private businesses may be thinly capitalized, unproven companies with risky technologies, may lack management depth, and may not have attained profitability. Because of the speculative nature and the lack of a public market for these investments, there is significantly greater risk of loss than is the case with traditional investment securities. The Corporation expects that some of its venture capital investments will be a complete loss or will be unprofitable and that some will appear to be likely to become successful but never realize their potential. The Corporation has been risk seeking rather than risk averse in its approach to venture capital and other investments.

 

Even if the Corporation’s portfolio companies are able to develop commercially viable products, the market for new products and services is highly competitive and rapidly changing. Commercial success is difficult to predict and the marketing efforts of the portfolio companies may not be successful.

 

Investing in the Corporation’s Shares May be Inappropriate for the Investor’s Risk Tolerance

 

The Corporation’s investments, in accordance with its investment objective and principal strategies, result in a greater than average amount of risk and volatility and may well result in loss of principal. Its investments in portfolio companies are highly speculative and aggressive and, therefore, an investment in its shares may not be suitable for investors for whom such risk is inappropriate. Neither the Corporation’s investments nor an investment in the Corporation is intended to constitute a balanced investment program.

 

The Corporation is Subject to Risks Created by its Regulated Environment

 

The Corporation is regulated by the SBA and the SEC. Changes in the laws or regulations that govern SBICs and BDCs could significantly affect the Corporation’s business. Regulations and laws may be changed periodically, and the interpretations of the relevant regulations and laws are also subject to change. Any change in the regulations and laws governing the Corporation’s business could have a material impact on its financial condition or its results of operations. Moreover, the laws and regulations that govern BDCs and SBICs may place conflicting demands on the manner in which the Corporation operates, and the resolution of those conflicts may restrict or otherwise adversely affect the operations of the Corporation.

 

The Corporation is Subject to Risks Created by Borrowing Funds from the SBA

 

The Corporation’s Leverageable Capital may include large amounts of debt securities issued through the SBA, and all of the debentures will have fixed interest rates. Until and unless the Corporation is able to invest substantially all of the proceeds from debentures at annualized interest or other rates of return that substantially exceed annualized interest rates that Rand SBIC must pay the SBA, the Corporation’s operating results may be adversely affected which may, in turn, depress the market price of the Corporation’s common stock.

 

The Corporation is Dependent Upon Key Management Personnel for Future Success

 

The Corporation is dependent on the diligence and skill of its two senior officers, Allen F. Grum and Daniel P. Penberthy for the selection, structuring, closing and monitoring of its investments. The future success of the Corporation depends to a significant extent on the continued service and coordination of its senior management team. The departure of either of its executive officers could materially adversely affect its ability to implement its business strategy. The Corporation does not maintain key man life insurance on any of its officers or employees.

 

The Corporation Operates in a Competitive Market for Investment Opportunities

 

The Corporation faces competition in its investing activities from many entities including other SBIC’s, private venture capital funds, investment affiliates of large companies, wealthy individuals and other domestic or foreign investors. The competition is not limited to entities that operate in the same geographical area as the Corporation. As a regulated BDC, the Corporation is required to disclose quarterly and annually the name and business description of portfolio companies and the value of its portfolio securities. Most of its competitors are not subject to this disclosure requirement. The Corporation’s obligation to disclose this information could hinder its ability to invest in certain portfolio companies. Additionally, other regulations, current and future, may make the Corporation less attractive as a potential investor to a given portfolio company than a private venture capital fund.

 

Fluctuations of Quarterly Results

 

The Corporation’s quarterly operating results could fluctuate significantly as a result of a number of factors. These factors include, among others, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which portfolio companies encounter competition in their markets, and general economic conditions. As a result of these factors, results for any one quarter should not be relied upon as being indicative of performance in future quarters.

 

Rand maintains its offices at 2200 Rand Building, Buffalo, New York 14203, where it leases approximately 1,300 square feet of office space pursuant to a lease agreement that expires December 31, 2010. Rand believes that its leased facilities are adequate to support its current staff and expected future needs.

 

None

 

Not applicable

 

Rand’s common stock, par value $0.10 per share (“Common Stock”), is traded on the NASDAQ Small Cap Market (“NASDAQ”) under the symbol “RAND.” The following table sets forth, for the periods indicated, the range of high and low sales prices per share as reported by NASDAQ:

 

 

 

Rand did not sell any securities during the period covered by this report that were not registered under the Securities Act. Rand has not paid any cash dividends in its most recent two fiscal years, and it has no intention of paying cash dividends in the coming fiscal year.

 

Profit Sharing and Stock Option Plans

 

In July 2001, the shareholders of the Corporation authorized the establishment of an Employee Stock Option Plan (the “Plan”). The Plan provides for an award of options to purchase up to 200,000 common shares to eligible employees. In 2002, the Corporation placed the Plan on inactive status as it developed a new profit sharing plan for the Corporation’s employees in connection with the establishment of its SBIC subsidiary. As of December 31, 2006, no stock options had been awarded under the Plan. Because Section 57(n) of the 1940 Act prohibits maintenance of a profit sharing plan for the officers and employees of a BDC where any option, warrant or right is outstanding under an executive compensation plan, no options will be granted under the Plan while any profit sharing plan is in effect with respect to the Corporation.

 

In 2002, the Corporation established a non-equity incentive Profit Sharing Plan for its executive officers in accordance with Section 57(n) of the Investment Company Act of 1940 (the “1940 Act”). The profit sharing plan provides for incentive compensation to the named executive officers based on a stated percentage of net realized capital gains and unrealized depreciation of Rand SBIC. There have been no accruals for, nor contributions to, the Profit Sharing Plan since the Plan inception in 2002.

 

On March 16, 2007 the Corporation had a total of 1,116 shareholders, which included 111 record holders of its common stock, and an estimated 1,005 shareholders with shares beneficially owned in nominee name or under clearinghouse positions of brokerage firms or banks.

 

On October 18, 2001 the Board of Directors authorized the repurchase of up to 5% of the Corporation’s outstanding stock through purchases on the open market which was extended through October 26, 2007. During 2003 and 2002 the Corporation purchased 44,100 shares for a total cost of $47,206, which were placed in the treasury. No shares were repurchased during the years ended December 31, 2006, 2005 or 2004.

Company Performance Graph

 

The following graph shows a five-year comparison of cumulative total shareholder returns for the Company’s common stock, the NASDAQ Market Index, and a Peer Group Index, assuming a base index of $100 at the end of 2001. The cumulative total return for each annual period within the five years presented is measured by dividing (1) the sum of (A) the cumulative amount of dividends for the measurement period, assuming dividend investment, and (B) the difference between share prices at the end and at the beginning of the measurement period by (2) the share price at the beginning of the measurement period.

 

COMPARE 5-YEAR CUMULATIVE TOTAL RETURN
AMONG RAND CAPITAL, INC.,
NASDAQ MARKET AND PEER GROUP INDEX

 

 

ASSUMES $100 INVESTED ON DEC. 31, 2001
ASSUMES DIVIDENDS REINVESTED
FISCAL YEAR ENDING DEC. 31, 2006

 

COMPARISON OF CUMULATIVE TOTAL RETURN OF ONE OR MORE
COMPANIES, PEER GROUPS, INDUSTRY INDEXES AND/OR BROAD MARKETS

 

FISCAL YEAR ENDING

 

 

The Peer Group is made up of the following:

Ameritrans Capital Corp (NasdaqCM:AMTC)

Brantley Capital Corp (OTC:BBDC.pk)

Capital Southwest Corp (NasdaqGM:CSWC)

Equus Total Return Inc (NYSE:EQS)

Gladstone Investment CP (NasdaqGS:GAIN)

Harris & Harris Group (NasdaqGM:TINY)

Macc Private Equities Inc (NasdaqCM:MACC)

MCG Capital Corporation (NasdaqGS:MCGC)

MVC Capital Inc (NYSE:MVC)

 

The Peer Group was selected in good faith by the Corporation and contains nine business development companies or other funds believed by the Corporation to have similar investment objectives to those of the Corporation.

 

The performance graph information provided above will not be deemed to be “soliciting material” or “filed” with the Securities and Exchange Commission or subject to Regulations 14A or 14C, or to the liabilities of section 18 of the Securities Exchange Act, unless in the future the Corporation specifically requests that the information be treated as soliciting material or specifically incorporates it by reference into any filing under the Securities Act or the Securities Exchange Act.

 

The following table provides selected consolidated financial data of the Corporation for the periods indicated. You should read the selected financial data set forth below in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and with our consolidated financial statements and related notes appearing elsewhere in this report.

 

Balance Sheet Data as of December 31:

 

 

Operating Data for the year ended December 31:

 

 

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our financial statements and related notes included elsewhere in this report.

 

Forward Looking Statements

 

Statements included in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this document that do not relate to present or historical conditions are “forward-looking statements” within the meaning of that term in Section 27A of the Securities Act of 1933, and in Section 21F of the Securities Exchange Act of 1934. Additional oral or written forward-looking statements may be made by the Corporation from time to time, and those statements may be included in documents that are filed with the Securities and Exchange Commission. Such forward-looking statements involve risks and uncertainties that could cause results or outcomes to differ materially from those expressed in the forward-looking statements. Forward-looking statements may include, without limitation, statements relating to the Corporation’s plans, strategies, objectives, expectations and intentions and are intended to be made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “believes,” “forecasts,” “intends,” “possible,” “expects,” “estimates,” “anticipates,” or “plans” and similar expressions are intended to identify forward-looking statements. Among the important factors on which such statements are based are assumptions concerning the state of the national economy and the local markets in which the Corporation’s portfolio companies operate, the state of the securities markets in which the securities of the Corporation’s portfolio company trade or could be traded, liquidity within the national financial markets, and inflation. Forward-looking statements are also subject to the risks and uncertainties described under the caption “Risk Factors” contained in Part I, Item 1A, which is incorporated herein by reference.

 

There may be other factors that we have not identified that affect the likelihood that the forward-looking statements may prove to be accurate. Further, any forward-looking statement speaks only as of the date it is made and, except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of anticipated or unanticipated events or circumstances. New factors emerge from time to time that may cause our business not to develop as we expect, and we cannot predict all of them.

 

Overview

 

The following discussion includes Rand Capital Corporation (“Rand”), Rand Capital SBIC, L.P., (“Rand SBIC”), and Rand Capital Management, LLC (“Rand Management”), (collectively the “Corporation”), its financial position and results of operations.

 

Rand is incorporated under the laws of New York and is regulated under the 1940 Act as a business development company (“BDC”). In addition, a wholly-owned subsidiary, Rand SBIC is regulated as a Small Business Investment Company (“SBIC”) by the Small Business Administration (“SBA”). The Corporation anticipates that most, if not all, of its investments in the next year will be originated through the SBIC subsidiary.

 

The Corporation’s primary business is making investments in companies, usually in the form of subordinated debt, membership interests or preferred or common stock. The investment focus is usually on small and medium-sized companies that meet certain criteria, including:

 

1) a qualified and experienced management team

 

2) a new or unique product or service with a sustainable competitive advantage

 

3) a potential for growth in revenue and cash flow

 

4) a potential to realize appreciation in an equity position, if any.

 

The Corporation makes investments in portfolio companies that typically range from $500,000 to $1,000,000 and it invests either directly in the equity of a company through equity shares or through a debt instrument. The debt

instruments generally have a maturity of not more than five years and usually have detachable equity warrants. Interest is either paid currently or deferred.

 

The management team of the Corporation identifies investment opportunities. Throughout the Corporation’s history it has established a large network of investment referral relationships. Investment proposals may, however, come to the Corporation from many other sources, and may include unsolicited proposals from the public and referrals from banks, lawyers, accountants and other members of the financial community. The Corporation believes that its reputation in the community and experience provide a competitive advantage in originating qualified new investments.

 

In a typical private financing, the management team of the Corporation will review, analyze, and confirm, through due diligence, the business plan and operations of the potential portfolio company. Additionally, the Corporation will become familiar with the portfolio company’s industry and competitive landscape and may conduct additional reference checks with customers and suppliers of the portfolio company.

 

Following an initial investment in a portfolio company, the Corporation may be requested to make follow-on investments in the company. Follow-on investments may be made to take advantage of warrants or other preferential rights granted to the Corporation or otherwise to increase or maintain the Corporation’s position in a promising portfolio company. The Corporation may also be called upon to provide an additional investment to a portfolio company in order for that company to fully implement its business plans, to develop a new line of business or to recover from unexpected business problems. Follow-on investments in a portfolio company are evaluated individually and may be subject to regulatory restrictions.

 

The Corporation will exit its investments generally through the maturation of the debt security or when a liquidity event takes place, such as the sale, recapitalization, or initial public offering of a portfolio company. The method and timing of the disposition of the Corporation’s portfolio investments can be critical to the realization of maximum total return. The Corporation generally expects to dispose of its equity securities through the private sales of securities to other investors or through an outright sale of the company or a merger. The Corporation anticipates its debentures will be repaid with interest and hopes to realize further appreciation from the warrants or other equity type instruments it receives in connection with the origination of the debenture. The Corporation anticipates generating cash for new investments and operating expenses through SBA leverage draw downs, and interest and principal payments from its portfolio concerns.

 

2006 Highlights and Outlook

 

The Corporation’s net asset value increased $1.42 as of December 31, 2006, closing the year at $2.93 per share. The net asset value increased 94%, from $1.51 at December 31, 2005. This was the fourth consecutive quarterly increase in net assets for the Corporation during 2006. At December 31, 2006, the Corporation’s total investment portfolio was valued at $23 million, which exceeds its cost basis of $14 million, reflecting $9 million in net unrealized appreciation.

 

The Corporation’s valuation policy provides that valuations may be adjusted for a subsequent equity financing with new investors. In accordance with this policy, during the fourth quarter of 2006, the Corporation recognized unrealized appreciation of $7.76 million on its investment in Innov-X Systems, Inc. (Innov-X) and $2.8 million in unrealized appreciation on its investment in Synacor, Inc. (Synacor). During the year, it also recognized $189,000 in unrealized appreciation in Carolina Skiff LLC (Carolina Skiff) and $452,000 in unrealized depreciation in WineIsIt.com, Corp.

 

In addition, during 2006 the Corporation recognized a $3.45 gain on the sale of two portfolio securities, liquidating its position in Minrad International, Inc. for a total realized gain of $1.25 million for the year and selling a portion of its Innov-X shares as part of a new investor financing, recognizing a realized gain of $2.28 million.

 

The growth in net assets, combined with the realized gains recognized in 2006, resulted in the Corporation’s stock surging from trading at a discount to net asset value and a low price of $1.09 in the fourth quarter of 2005 to a high price of $3.55 in the fourth quarter of 2006 which represents a premium to the net asset value.

 

During 2006 the Corporation also realized $1,326,962 in total investment income, an increase of $590,000 from the $736,573 of investment income in 2005. The 80% increase is attributable to growth in dividends and interest from portfolio companies, primarily occurring during the third and fourth quarters of 2006

 

Dividend and other investment income grew primarily because of higher Limited Liability Corporation (LLC) distributions from companies in the portfolio that have improving operational trends, in particular Gemcor II, LLC (Gemcor), Topps Meat Company LLC (Topps), and Carolina Skiff. Gemcor designs and sells automatic riveting machines to manufacturers of airframes, missile bodies, space system accessories, and other aerospace equipment. Topps is a 66 year old manufacturer and supplier of premium frozen meat products. Carolina Skiff is a leading manufacturer of affordable fishing and recreational boats. LLC dividends can fluctuate based on portfolio companies’ profitability and the timing of distributions.

 

Also during 2006 certain portfolio companies repaid some or all of their outstanding debenture instruments, including: Innov-X, Synacor, Concentrix Corporation, Ramsco, New Monarch Machine Tool, Inc., Gemcor and APF Group, Inc.. These repayments will impact future earnings by reducing interest income in 2007 and future periods.

 

The cash balance at December 31, 2006 was $4.3 million which was $3.1 million higher than at the end of 2005. The increase was primarily due to portfolio investment repayments and loan repayments. In addition, the Corporation has $1.9 million of outstanding leverage available from the Small Business Administration (SBA) for future investment. The cash availability will provide sufficient liquidity to fund the Corporation’s deal flow in 2007.

 

While the business of many portfolio companies is strengthening, in terms of employee growth, increase in revenue, and strengthening EBITDA or net income position, it remains difficult to forecast when future exits will happen, or if the portfolio companies will have sufficient capital to remain viable while their respective markets mature.

 

Critical Accounting Policies

 

The Corporation prepares its financial statements in accordance with United States generally accepted accounting principles (GAAP), which requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities. For a summary of all significant accounting policies, including critical accounting policies, see Note 1 to the consolidated financial statements in Item 8.

 

The increasing complexity of the business environment and applicable authoritative accounting guidance require the Corporation to closely monitor its accounting policies and procedures. The Corporation has identified two critical accounting policies that require significant judgment. The following summary of critical accounting policies is intended to enhance your ability to assess the Corporation’s financial condition and results of operations and the potential volatility due to changes in estimates.

 

Valuation of Investments

 

The most significant estimate inherent in the preparation of the Corporation’s consolidated financial statements is the valuation of its investments and the related unrealized appreciation or depreciation. The Corporation has adopted the SBA’s valuation guidelines for SBICs, which describe the policies and procedures used in valuing investments.

 

Investments are valued in accordance with the Corporation’s established valuation policy and are stated at fair value as determined in good faith by the management of the Corporation and submitted to the Board of Directors for approval. There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment while employing a consistently applied valuation process for investments. The Board of Directors considers fair value to be the amount which the Corporation may reasonably expect to receive for portfolio securities when sold on the valuation date. The Corporation analyzes and values each individual investment on a quarterly basis, and records unrealized depreciation for an investment that it believes has become impaired, including where collection of a loan or realization of an equity security is doubtful. Conversely, the Corporation will record unrealized appreciation if it believes that the underlying portfolio company has appreciated in value and, therefore, its equity security has also

appreciated in value. These estimated fair values may differ from the values that would have been used had a ready market for the investments existed and these differences could be material if our assumptions and judgments differ from results of actual liquidation events.

 

In the valuation process, the Corporation uses financial information received monthly, quarterly, and annually from its portfolio companies, which includes both audited and unaudited financial statements, annual projections and budgets prepared by the portfolio company and other financial and non-financial business information supplied by the portfolio companies’ management. This information is used to determine financial condition, performance, and valuation of the portfolio investments. The valuation may be reduced if a company’s performance and potential have significantly deteriorated. If the factors which led to the reduction in valuation are overcome, the valuation may be restored.

 

Another key factor used in valuing equity investments is recent arms-length equity transactions with unrelated new investors entered into by the portfolio company that the Corporation utilizes to form a basis for its underlying value. Many times the terms of these equity transactions may not be identical to the equity transactions between the portfolio company and the Corporation, and the impact of the discrepancy in transaction terms on the market value of the portfolio company may be difficult or impossible to quantify.

 

Any changes in estimated fair value are recorded in our statement of operations as “Net increase (decrease) in unrealized appreciation.”

 

Revenue Recognition (Interest Income)

 

Interest income generally is recognized on the accrual basis except where the investment is in default or otherwise presumed to be in doubt. In such cases, interest is recognized at the time of receipt. A reserve for possible losses on interest receivable is maintained when appropriate. Certain investments of the Corporation are structured to provide a deferred interest period when interest is not currently due.

 

Rand SBIC’s interest accrual is also regulated by the SBA’s “Accounting Standards and Financial Reporting Requirements for Small Business Investment Companies”. Under these rules interest income cannot be recognized if collection is doubtful, and a 100% reserve must be established. The collection of interest is presumed to be in doubt when there is substantial doubt about a portfolio company’s ability to continue as a going concern or the loan is in default more than 120 days. Management also utilizes other qualitative and quantitative measures to determine the value of a portfolio investment and the collectability of any accrued interest.

 

Recent Accounting Pronouncements

 

In June 2006 the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”. This Interpretation clarifies that management is expected to evaluate an income tax position taken or expected to be taken for the likelihood of realization before recording any amounts for such position in the financial statements. FIN 48 also requires expanded disclosure with respect to income tax positions taken that are not certain to be realized. This Interpretation is effective for fiscal years beginning after December 15, 2006, and will require management to evaluate every open tax position that exists in every jurisdiction on the date of initial adoption. Certain disclosures are required in Form 10-Q in the period of adoption of FIN 48 which would be the March 31, 2007 Form 10-Q.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. SFAS No. 157 requires companies to disclose the fair value of their financial instruments according to a fair value hierarchy as defined in the standard. Additionally, companies are required to provide enhanced disclosure regarding financial instruments in one of the categories (level 3), including a reconciliation of the beginning and ending balances separately for each major category of assets and liabilities. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 will have an impact on the Company’s consolidated financial statements from a disclosure standpoint.

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements”. Due to diversity in practice

among registrants, SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether financial statement restatement is necessary. SAB 108 is effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 did not have an impact on the Company’s consolidated financial statements.

 

Financial Condition

 

Overview:

 

 

The Corporation’s financial condition is dependent on the success of its portfolio holdings. It has invested a substantial portion of its assets in small to medium-sized companies. The following summarizes the Corporation’s investment portfolio at the year-ends indicated.

 

 

The increase in investments, at cost, is comprised of the following:

 

 

 

The Corporation borrowed $900,000 in leverage from the SBA during the year ended December 31, 2006 and the total owed to the SBA for Leverage Payable at December 31, 2006 was $8,100,000. These debentures bear a fixed interest rate and an annual fee, averaging 5.9%, payable semi-annually. The debenture principal is repayable in full 10 years from issuance.

 

Net asset value per share (NAV) was $2.93 per share at December 31, 2006 versus $1.51 per share at December 31, 2005.

 

The Corporation’s total investments at fair value, whose fair value have been estimated by the Board of Directors, approximated 141% of net assets at December 31, 2006 and 155% of net assets at December 31, 2005.

 

Cash and cash equivalents approximated 26% of net assets at December 31, 2006 compared to 14% at December 31, 2005.

 

The effect of the realized gains and the change in unrealized appreciation on investments resulted in a net change in the net deferred tax (liability) asset from an $846,000 deferred tax asset at December 31, 2005 to a net deferred tax liability of $(3,808,000) at December 31, 2006.

 

Results of Operations

 

Investment Income

 

The Corporation’s investment objective is to achieve long-term capital appreciation on its equity investments while maintaining a current cash flow from its debenture and pass through equity instruments. Therefore, the Corporation will invest in a mixture of debenture and equity instruments, which will provide a current return on a portion of the investment portfolio. The equity features contained in our investment portfolio are structured to realize capital appreciation over the long-term and may not necessarily generate current income in the form of dividends or interest. In addition, the Corporation earns interest income from investing its idle funds in money market instruments held at high grade financial institutions.

 

Comparison of the years ended December 31, 2006 and 2005

 

 

Interest from portfolio companies — The increase in portfolio interest income is attributable to the fact that there has been an increase in the number of investments that provide the Corporation with current income. The blended rate of the debenture investments originated out of the Corporation during the last two fiscal years is approximately 10.7%.

 

After reviewing the portfolio companies’ performance and the circumstances surrounding the investments, the Corporation has ceased accruing interest income on the following investment instruments:

 

 

Interest from other investments — The increase in interest income is primarily due to higher cash balances and higher yields on these cash balances. The higher cash balances are a result of portfolio investment repayments and sales of portfolio companies’ equity instruments and draw downs on the SBA leverage.

 

Dividend and other investment income — Dividend income is comprised of distributions from Limited Liability Companies (LLC’s) in which the Corporation has invested. The Corporation’s investment agreements with certain LLC companies require the entities to distribute funds to the Corporation for payment of income taxes on its allocable share of the entities’ profits. These dividends will fluctuate based upon the profitability of the entities and the timing of the distributions. Dividend income for the year ended December 31, 2006 consisted of distributions from Gemcor II, LLC (Gemcor) for $375,372, Topps for $37,334, Carolina Skiff LLC (Carolina Skiff) for $18,416 and Vanguard Modular Building Systems (Vanguard) for $1,174.

 

Dividend income for the year ended December 31, 2005 consisted of distributions from Gemcor for $51,500, Topps for $28,174, Carolina Skiff for $14,082 and Vanguard for $1,174.

 

Other income — Other income consists of the revenue associated with the amortization of financing fees charged to the portfolio companies upon successful closing of Rand SBIC financing. The SBA regulations limit the amount of fees that can be charged to a portfolio company, and the Corporation typically charges 1% to 3% to the portfolio concerns. These fees are amortized ratably over the life of the instrument associated with the fees. The unamortized fees are carried on the balance sheet under “Deferred revenue”. In addition, other income includes fees charged by the Corporation to its portfolio companies for attendance at the portfolio companies’ board meetings.

 

The increase in other income is due to the fact that two of the Corporation’s portfolio companies, Concentrix and Innov-X, paid off their debenture instruments early and therefore the remaining unamortized closing fees of $12,000 from Concentrix and $6,800 from Innov-X were brought into income. In addition, the Corporation charged Concentrix an $18,000 prepayment penalty fee that was included in other income. The annualized financing fee income based on the existing portfolio will average $20,000 annually in 2007 and less than $11,000 annually thereafter, based on the deferred revenue balance at December 31, 2006. In addition the board attendance income amounted to $9,000 for the year ended December 31, 2006 and $7,000 for year ended December 31, 2005.

 

Comparison of the years ended December 31, 2005 and 2004

 

 

Interest from portfolio companies — Portfolio interest income decreased $52,081 for the year ended December 31, 2005 as compared to the same period in the prior year. This is attributable to the fact that the Corporation ceased accruing interest on two WineIsIt.com (Wineisit) debt instruments in January 2005 in anticipation of a restructuring of the Wineisit balance sheet. The total interest recognized from these two Wineisit notes for the year ended December 31, 2004 was $73,009. During 2005 this portfolio company experienced a decline in business performance and therefore the restructuring has been delayed. These two notes are technically in default due to nonpayment of principal and interest and the Corporation has revised their valuation. See further discussion on this valuation change in the section labeled “Net Change in Unrealized Appreciation/Depreciation of Investments”.

 

The current period decrease in portfolio income can also be attributed to the fact that the portfolio income for the year ended December 31, 2004 included $62,703 of income on a $900,000 convertible note from Somerset. This note had stopped accruing interest in September 2003 because it was in default and the Corporation had established a 100% reserve for the total accrued interest of $122,914. In April 2004 Somerset became current on the note, therefore the Corporation recognized all past due interest in the first quarter of 2004.

 

Interest from other investments — The increase in interest income is primarily due to higher yields on cash balances.

 

Dividend and other investment income — Dividend income for the year ended December 31, 2005 consisted of distributions from Gemcor for $51,500, Topps for $28,174, Carolina Skiff for $14,082 and Vanguard for $1,174.

 

Dividend income for the year ended December 31, 2004 was comprised of distributions from Topps for $35,195, Carolina Skiff for $28,384 and Vanguard for $1,244.

 

Other income — Other income for the year ended December 31, 2005 decreased slightly. The decrease in financing amortization revenue can be attributed to the fact that several fees became fully amortized in early 2005 due to the instrument maturing. The annualized financing fee income based on the existing portfolio will average $29,000 annually in 2006 and 2007 and less than $10,000 annually thereafter, based on the deferred revenue balance at December 31, 2005. In addition the board attendance income amounted to $7,000 for the year ended December 31, 2005 and $0 for year ended December 31, 2004.

 

Operating Expenses

 

Comparison of the years ended December 31, 2006 and 2005

 

 

Operating expenses predominately consist of interest expense on SBA debentures, employee compensation and benefits, directors’ fees, shareholder related costs, office expenses, professional fees, and expenses related to identifying and reviewing investment opportunities. The increase in operating expenses during the year ended December 31, 2006 can be primarily attributed to the 70.4% or $195,239 increase in SBA interest expense. The SBA interest expense was $472,526 for the year ended December 31, 2006 and $277,287 for the year ended December 31, 2005. The Corporation has borrowed $8,100,000 from the SBA as of December 31, 2006 at an average borrowing rate, including surcharges, of approximately 5.9%. Interest costs will continue to increase in 2007 and beyond as the

Corporation continues to draw down SBA leverage up to the maximum approved leverage of $10 million. This interest is paid on a semi-annual basis.

 

In addition, salary expense grew 20.4% or $81,727 from $400,340 for the year ended December 31, 2005 to $482,067 for the year ended December 31, 2006. This increase is due to the officer pay increases and the fact that the executive officer bonuses increased by $50,000 in 2006. Professional fees were $116,068 and $96,917 for the years ended December 31, 2006 and 2005, respectively. This represents an increase of 20% which can be attributed to the escalating legal, audit and tax costs due to the increasingly more complex regulatory environment in which the Corporation operates.

 

Comparison of the years ended December 31, 2005 and 2004

 

 

Operating expenses increased $365,034 or 40.5% during the year ended December 31, 2005 as compared to the same period in the prior year. The increase in operating expenses can mainly be attributed to the establishment of a bad debt reserve for $114,870 on Vanguard, and a 158.2% increase in SBA interest expense.

 

The Corporation’s management reviewed the interest receivable from Vanguard and believed that the collectibilty of this receivable was in doubt and therefore reserved for all of the receivable balance. The portfolio company continued to perform well and was then investigating sale opportunities. The Corporation ceased accruing interest revenue on this instrument in 2003.

 

The SBA borrowings increased $3,700,000 during the year ended December 31, 2005 and the SBA interest expense increased $169,880 from $107,407 for the year ended December 31, 2004 to $277,287 for the year ended December 31, 2005. The SBA borrowing rates, which included an SBA annual charge, averaged 5.8% in 2005. The SBA annual charge during 2005 decreased from 0.887% to 0.855%. The 2004 SBA borrowing rates averaged 5.4% and the overall combined SBA borrowing rate on the $7,200,000 outstanding leverage at December 31, 2004 was 5.6%. Interest costs will continue to increase in 2006 and beyond as the Corporation continues to draw down SBA leverage up to the maximum approved leverage of $10 million.

 

Increases in salaries and professional costs contributed to the remaining increase in operating expense during the year ended December 31, 2005. Professional fees increased $33,323 or 52.4% during the year ended December 31, 2005 due to the additional accounting and legal expenses related to the increasingly more complex regulatory environment in which the Corporation operates.

 

Net Realized Gains and Losses on Investments

 

Comparison of the years ended December 31, 2006 and 2005

 

 

During the year ended December 31, 2006, the Corporation sold a portion of its shares in Innov-X and recognized a realized gain of $2,280,682 on the sale. A portion of the proceeds from the sale of Innov-X is an escrow receivable in the amount of $711,249 which is expected to be collected in early 2008. This escrow receivable is included in the other asset line on the financial statements.

 

Furthermore, the Corporation sold its remaining 677,981 shares of Minrad during 2006 and recognized a gain of $1,256,759. The average sales price of Minrad was $3.26/share and the basis of the stock was $1.36/share. The Corporation incurred $33,899 in broker transaction fees that were netted against the realized gain. In addition, the Corporation sold its interest in Vanguard during 2006 and recognized an ($81,000) loss on the disposition.

 

During the year ended December 31, 2005, the Corporation recognized a realized loss of ($382,353) on its investment in D’Lisi Food Systems, Inc. (D’Lisi).

 

Comparison of the years ended December 31, 2005 and 2004

 

 

During the year ended December 31, 2005, the Corporation realized a loss of ($382,353) on its investment in D’Lisi. The D’Lisi investment of $400,000 was written down to zero in the third quarter of 2004 due to the fact that it filed for bankruptcy protection on August 13, 2004. The final bankruptcy proceeds were distributed in July 2005 and resulted in a realized loss of ($382,353).

 

During the year ended December 31, 2004, the Corporation realized a $32,956 gain on the sale of the remaining Advanced Digital Information Corporation (ADIC) stock. In addition, the Corporation realized a ($6,229) loss on its investment in Clearview Cable.

 

Net Change in Unrealized Appreciation/(Depreciation) of Investments

 

For the years ended December 31, 2006 and 2005

 

 

The Corporation recorded a net increase in unrealized appreciation on investments of $9,958,053 during the year ended December 31, 2006, as compared to an increase of $244,020 during the year ended December 31, 2005. The increase in unrealized appreciation (depreciation) on investments of $9,958,053 is due to the following valuation changes made by the Corporation:

 

 

In accordance with its valuation policy, the Corporation increased the value of its holdings in Innov-X and Synacor based on significant equity financings at higher valuations by new non-strategic outside investors for each of these portfolio companies.

 

Additionally the Corporation recognized appreciation on its equity investment in Carolina Skiff based on the improving financial condition of this portfolio company since the Corporation’s first investments. Per the Corporation’s valuation policy, a portfolio company can be valued based on a very conservative financial measure if the portfolio company has been self-financing and has had positive cash flow from operations for at least the past two fiscal years.

 

The Corporation liquidated its holdings in Minrad and Vanguard during 2006 and therefore any unrealized appreciation (depreciation) was reclassified to a realized gain (loss).

 

The WineIsIt and G-Tec investments were revalued during the year ended December 31, 2006 after a review by the Corporation’s management which identified that the business of each of these portfolio companies had

deteriorated since the time of the original funding, as compared to their original plan. The portfolio companies remain in operation and are developing new business strategies.

 

The USTec valuation was based on a subsequent event that occurred in January 2007 where the portfolio company was sold and the Corporation recognized a loss.

 

For the years ended December 31, 2005 and 2004

 

 

The Corporation recorded a decrease in unrealized depreciation on investments before income tax expense of $244,020 during the year ended December 31, 2005, as compared to an increase of $(206,737) during the year ended December 31, 2004. The decrease in unrealized depreciation on investments during the year ended December 31, 2005 is due to the following valuation changes made by the Corporation:

 

 

The Corporation recognized appreciation on its equity investments in Topps and Carolina Skiff based on the improving financial condition of these portfolio companies since the Corporation’s first investments. Per the Corporation’s valuation policy, a portfolio company can be valued based on a very conservative financial measure if the portfolio company has been self-financing and has had positive cash flow from operations for at least the past two fiscal years.

 

The Corporation recognized appreciation of $272,000 on its 667,981 shares of Minrad. Minrad is traded under the symbol BUF on the Amex stock exchange. The Corporation’s Minrad shares were restricted under SEC Rule 144. During the year ended December 31, 2005, Minrad’s securities traded between $1.25 and $7.00 per share. The Corporation’s policy is to record the valuation of our publicly held securities on a “mark to market” basis. The Minrad’s shares were therefore valued at $1.65 per share at December 31, 2005, which was the average closing price for the last three trading days of the year.

 

Kionix was revalued during the second quarter of 2005 due to the fact that the portfolio company failed to achieve certain performance milestones, therefore changing the liquidation preferences of the Series A and B securities. This caused the Corporation to reprice its shares in Kionix from $0.35/share to $0.25/share.

 

The WineIsIt investment was revalued during the year ended December 31, 2005 after a review by management which identified that Wineisit’s business had deteriorated since the time of the original funding, as compared to their original plan.

 

The Corporation’s investment in Vanguard was written down to $135,000 during the year ended December 31, 2005 based on a financial review of the portfolio company.

 

The Ultrascan and Somerset investment valuations were adjusted based on recent rounds of financing that lowered the per share prices.

 

Photonics is a public stock (NASDAQ symbol: PHPG.OB) and is marked to market at the end of each quarter.

 

All of these value adjustments were done in accordance with the Corporation’s established valuation policy.

 

Net Increase (decrease) in Net Assets from Operations

 

The Corporation accounts for its operations under U.S. generally accepted accounting principles for investment companies. The principal measure of its financial performance is “net increase (decrease) in net assets from operations” on its consolidated statements of operations. During the year ended December 31, 2006, the net increase was $8,166,471, as compared to net decreases in net assets from operations of ($411,120) in 2005 and ($211,434) in 2004.

 

The net increase in net assets from operations for the year ended December 31, 2006 is due to the $9,431,273 net realized and unrealized gain on investments. The net decrease in net assets from operations in 2005 can primarily be attributed to the net investment loss of ($175,179), a realized loss on investments of ($382,353) and an unrealized gain on investments after tax of 146,412. The 2004 decrease is primarily due to the net investment loss of ($112,384) and the increase in unrealized depreciation after tax of ($125,777).

 

Liquidity and Capital Resources

 

The Corporation’s principal objective is to achieve capital appreciation. Therefore, a significant portion of the investment portfolio is structured to maximize the potential for capital appreciation and certain of the Corporation’s portfolio investments may be structured to provide little or no current yield in the form of dividends or interest payments.

 

As of December 31, 2006, the Corporation’s total liquidity, consisting of cash and cash equivalents, was $4,299,852.

 

Net cash used in operating activities has averaged approximately $345,000 over the last three years and management anticipates cash will continue to be utilized at similar levels. The cash flow may fluctuate based on possible expenses associated with compliance with new regulations.

 

The Corporation realized approximately $2,500,000 in net cash flow from investing activities in fiscal 2006. The Corporation has experienced an average net use of cash in the investing activities of approximately $3 million over the two years prior. The Corporation will generally use cash in investing activities as it builds its portfolio utilizing its available SBA financing and proceeds from prior liquidations of portfolio investments. The Corporation anticipates that it will continue to make new investments and may experience a net use of cash over the next two years. In addition, significant liquidating events within the Corporation’s investment portfolio are difficult to determine with any certainty.

 

As of December 31, 2006 the Corporation had paid $100,000 to the SBA to reserve its approved $10,000,000 leverage. The leverage commitment expires on September 30, 2008. The Corporation has drawn down $8,100,000 of this leverage as of December 31, 2006. Management expects that it will not be necessary to draw down the SBA leverage in 2007, and the large cash balance and expected investment payoffs will be adequate to fund new investments and operating activities. It is anticipated that the remaining $1,900,000 in SBA leverage will be drawn down in fiscal year 2008 prior to the expiration of the commitment and will be available to fund operations and new investments.

 

Management believes that the cash and cash equivalents at December 31, 2006, coupled with the anticipated additional SBIC leverage draw downs and interest and dividend payments on its portfolio investments, will provide the Corporation with the liquidity necessary to fund operations over the next twelve months.

 

The following table summarizes the cash to be received over the next five years from portfolio companies based on contractual obligations as of December 31, 2006. These payments represent scheduled principal and interest payments that are contained in the investment documents of each portfolio company.

 

 

The preceding table only includes debenture instruments and does not include any equity investments which may provide additional proceeds upon exit of these securities.

 

Disclosure of Contractual Obligations

 

The following table shows the Corporation’s contractual obligations at December 31, 2006. The Corporation does not have any capital lease obligations or other long-term liabilities reflected on its balance sheet.

 

 

The Corporation’s investment activities contain elements of risk. The portion of the Corporation’s investment portfolio consisting of equity and debt securities in private companies is subject to valuation risk. Because there is typically no public market for the equity and equity-linked debt securities in which it invests, the valuation of the equity interests in the portfolio is stated at “fair value” as determined in good faith by the Board of Directors in accordance with the Corporation’s investment valuation policy. (The discussion of valuation policy contained in the “Notes to Schedule of Portfolio Investments” in the consolidated financial statements contained in Item 8 of this report is hereby incorporated herein by reference.) In the absence of a readily ascertainable market value, the estimated value of the Corporation’s portfolio may differ significantly from the values that would be placed on the portfolio if a ready market for the investments existed. Any changes in valuation are recorded in the Corporation’s consolidated statement of operations as “Net unrealized appreciation (depreciation) on investments.”

 

At times a portion of the Corporation’s portfolio may include marketable securities traded in the over-the-counter market. In addition, there may be a portion of the Corporation’s portfolio for which no regular trading market exists. In order to realize the full value of a security, the market must trade in an orderly fashion or a willing purchaser must be available when a sale is to be made. Should an economic or other event occur that would not allow the markets to trade in an orderly fashion, the Corporation may not be able to realize the fair value of its marketable investments or other investments in a timely manner.

 

As of December 31, 2006, the Corporation did not have any off-balance sheet investments or hedging investments.

 

The following consolidated financial statements and consolidated supplemental schedule of the Corporation and report of independent auditors thereon are set forth below:

 

Statements of Financial Position as of December 31, 2006 and 2005

 

Statements of Operations for the three years in the period ended December 31, 2006

 

Statements of Changes in Net Assets for the three years in the period ended December 31, 2006

 

Statements of Cash Flows for the three years in the period ended December 31, 2006

 

Schedule of Portfolio Investments as of December 31, 2006

 

Schedules of Selected Per Share Data and Ratios for the five years in the period ended December 31, 2006

 

Notes to the Consolidated Financial Statements

 

Supplemental Schedule of Consolidated Changes in Investments at Cost and Realized Gain for the year ended December 31, 2006

 

Report of Independent Registered Public Accounting Firm

RAND CAPITAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
December 31,

 

 

See accompanying notes

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

For The Years Ended December 31, 2006, 2005 and 2004

 

 

See accompanying notes

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS

For The Years Ended December 31, 2006, 2005 and 2004

 

 

See accompanying notes.

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

For The Years Ended December 31, 2006, 2005 and 2004

 

 

See accompanying notes

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED SCHEDULE OF PORTFOLIO INVESTMENTS

December 31, 2006

 

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED SCHEDULE OF PORTFOLIO INVESTMENTS

December 31, 2006 – (Continued)

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED SCHEDULE OF PORTFOLIO INVESTMENTS

December 31, 2006 – (Continued)

 

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED SCHEDULE OF PORTFOLIO INVESTMENTS

December 31, 2006 – (Continued)

Notes to Consolidated Schedule of Portfolio Investments

 

 

 

 

 

 

 

 

RAND CAPITAL CORPORATION AND SUBSIDIARIES

 

SCHEDULES OF SELECTED PER SHARE DATA AND RATIOS
For the Five Years Ended December 31, 2006, 2005, 2004, 2003 and 2002

 

Selected data for each share of capital stock outstanding throughout the five most current years is as follows: