N-2/A 1 dn2a.htm FORM N-2/A Form N-2/A
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As filed with the Securities and Exchange Commission on June 5, 2008

Securities Act File No. 333-150403

 

 

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM N-2

REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933

(Check appropriate box or boxes)

 

Pre-Effective Amendment No. 2

Post-Effective Amendment No.     

HERCULES TECHNOLOGY GROWTH CAPITAL, INC.

(Exact name of Registrant as specified in charter)

 

400 Hamilton Avenue, Suite 310

Palo Alto, CA 94301

(Address of Principal Executive Offices)

 

Registrant’s Telephone Number, including Area Code: (650) 289-3060

 

Manuel A. Henriquez

Chief Executive Officer

Hercules Technology Growth Capital, Inc.

400 Hamilton Avenue, Suite 310

Palo Alto, CA 94301

(Name and address of agent for service)

 

COPIES TO:

Cynthia M. Krus

Steven B. Boehm

Sutherland Asbill & Brennan LLP

1275 Pennsylvania Avenue, N.W.

Washington, DC 20004

APPROXIMATE DATE OF PROPOSED PUBLIC OFFERING:

As soon as practicable after the effective date of this Registration Statement.

 

If any securities being registered on this form will be offered on a delayed or continuous basis in reliance on Rule 415 under the Securities Act of 1933, other than securities offered in connection with a dividend reinvestment plan, check the following box.  x

It is proposed that this filing will become effective (check appropriate box):  ¨  when declared effective pursuant to section 8(c).

CALCULATION OF REGISTRATION FEE UNDER THE SECURITIES ACT OF 1933

 
Title of Securities Being Registered         Amount
Being Registered(1)(3)    
        Proposed Maximum
Aggregate Offering Price(2)    
        Amount of
Registration Fee(4)

Common Stock, $0.001 par value per share

     10,200,000      $107,712,000      $4,233
 
(1) Pursuant to Rule 416, this registration statement also covers such additional shares of our common stock as may be issued by reason of stock splits, stock dividends or similar transactions.
(2) Estimated solely for purposes of calculating the amount of the registration fee pursuant to Rule 457(c) under the Securities Act of 1933, as amended, based upon the average of the high and low prices of our common stock as reported on the Nasdaq Global Select Market on April 15, 2008.
(3) In reliance upon Rule 429 under the Securities Act of 1933, this amount is in addition to the securities previously registered by the Registrant under a registration statement on Form N-2 (File No. 333-141828). All securities unsold under the prospectus contained in such prior Registration Statement (a total of 2,800,000 shares of common stock) are carried forward into this Registration Statement, and the prospectus contained as a part of this Registration Statement shall be deemed to be combined with the prospectus contained in the above-referenced registration statement, which has previously been filed.
(4) Previously paid $1,183.

 

 

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE SECURITIES AND EXCHANGE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.

 

 


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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

PROSPECTUS (Subject to Completion)

 

                , 2008

 

LOGO

 

13,000,000 Shares Common Stock

 

 

This prospectus relates to the offer, from time to time, of 13,000,000 shares of our common stock, par value $0.001 per share by us.

 

The shares of common stock may be offered at prices and terms to be described in one or more supplements to this prospectus.

 

We are a specialty finance company that provides debt and equity growth capital to technology-related and life sciences companies at all stages of development from seed and emerging growth to expansion and established stages of development, including select publicly listed companies and lower middle market companies. We primarily finance privately-held companies backed by leading venture capital and private equity firms and also may finance certain publicly-traded companies that lack access to public capital or are sensitive to equity ownership dilution as well as lower middle market companies. We source our investments through our principal office located in Silicon Valley, as well as additional offices in the Boston, Boulder, Chicago, Columbus, and San Diego areas. Our goal is to be the leading structured mezzanine capital provider of choice for venture capital and private equity backed technology-related and life sciences companies requiring sophisticated and customized financing solutions. We invest primarily in structured mezzanine debt and, to a lesser extent, in senior debt and equity.

 

Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity-related investments. We are an internally-managed, non-diversified closed-end investment company that has elected to be treated as a business development company under the Investment Company Act of 1940.

 

Our common stock is traded on the Nasdaq Global Select Market under the symbol “HTGC.” On May 30, 2008, the last reported sale price of a share of our common stock on the Nasdaq Global Select Market was $10.37.

 

 

 

An investment in our common stock may be speculative and involves risks including a heightened risk of total loss of investment. In addition, the companies in which we invest are subject to special risks. See “ Risk Factors” beginning on page 13 to read about risks that you should consider before investing in our common stock, including the risk of leverage.

 

Please read this prospectus before investing and keep it for future reference. It contains important information about us that a prospective investor ought to know before investing in our common stock. We file annual, quarterly and current reports, proxy statements and other information about us with the Securities and Exchange Commission. The information is available free of charge by contacting us at 400 Hamilton Avenue, Suite 310, Palo Alto, California 94301 or by telephone calling collect at (650) 289-3060 or on our website at www.herculestech.com. The SEC also maintains a website at www.sec.gov that contains such information.

 

 

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

This prospectus may not be used to consummate sales of shares of common stock unless accompanied by a prospectus supplement.

 

The date of this prospectus is                 , 2008


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You should rely only on the information contained in this prospectus. We have not authorized any dealer, salesperson or other person to provide you with different information or to make representations as to matters not stated in this prospectus. If anyone provides you with different or inconsistent information, you should not rely on it. This prospectus is not an offer to sell, or a solicitation of an offer to buy, any shares of common stock by any person in any jurisdiction where it is unlawful for that person to make such an offer or solicitation or to any person in any jurisdiction to whom it is unlawful to make such an offer or solicitation. The information in this prospectus is accurate only as of its date, and under no circumstances should the delivery of this prospectus or the sale of any common stock imply that the information in this prospectus is accurate as of any later date or that the affairs of Hercules Technology Growth Capital, Inc. have not changed since the date hereof. This prospectus will be updated to reflect material changes.

 

 

 

TABLE OF CONTENTS

 

     Page

Summary

   1

Fees and Expenses

   9

Selected Consolidated Financial Data

   11

Risk Factors

   13

Forward-Looking Statements; Market Data

   32

Use of Proceeds

   33

Price Range of Common Stock and Distributions

   34

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   37

Business

   60

Portfolio Companies

   73

Senior Securities

   94

Determination of Net Asset Value

   94

Management

   97

Control Persons and Principal Stockholders

   122

Certain Relationships and Related Transactions

   125

Certain United States Federal Income Tax Considerations

   127

Regulation

   135

Dividend Reinvestment Plan

   140

Description of Capital Stock

   141

Plan of Distribution

   148

Brokerage Allocation and Other Practices

   149

Custodian, Transfer and Dividend Paying Agent and Registrar

   149

Legal Matters

   149

Experts

   149

Available Information

   150

Index to Financial Statements

   F-1

 

 

 

Hercules Technology Growth Capital, Inc., our logo and other trademarks of Hercules Technology Growth Capital, Inc. mentioned in this prospectus are the property of Hercules Technology Growth Capital, Inc. All other trademarks or trade names referred to in this prospectus are the property of their respective owners.


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ABOUT THIS PROSPECTUS

 

This prospectus is part of a registration statement that we have filed with the Securities and Exchange Commission using the “shelf” registration process. Under the shelf registration process, which constitutes a delayed offering in reliance on Rule 415 under the Securities Act of 1933, as amended, we may offer, from time to time, up to 13,000,000 shares of our common stock on the terms to be determined at the time of the offering. Shares of our common stock may be offered at prices and on terms described in one or more supplements to this prospectus. This prospectus provides you with a general description of the shares of our common stock that we may offer. Each time we use this prospectus to offer shares of our common stock, we will provide a prospectus supplement that will contain specific information about the terms of that offering. A prospectus supplement may also add, update or change information contained in this prospectus. Please carefully read this prospectus and any such supplements together with the additional information described under “Where You Can Find Additional Information” in the “Prospectus Summary” and “Risk Factors” sections before you make an investment decision.

 

A prospectus supplement may also add to, update or change information contained in this prospectus.


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SUMMARY

 

This summary highlights some of the information in this prospectus and may not contain all of the information that is important to you. For a more complete understanding of this offering, we encourage you to read this entire prospectus and the documents that are referenced in this prospectus, together with any accompanying supplements. In this prospectus, unless the context otherwise requires, the “Company,” “Hercules Technology Growth Capital,” “we,” “us” and “our” refer to Hercules Technology Growth Capital, Inc. and our wholly-owned subsidiaries Hercules Technology II, L.P., Hercules Technology SBIC Management, LLC., Hydra Management LLC, Hydra Management Co., Inc. and Hercules Technology Management Co., Inc.

 

Our Company

 

We are a specialty finance company that provides debt and equity growth capital to technology-related and life sciences companies at all stages of development from seed and emerging growth to expansion and established stages of development, including select publicly listed companies and lower middle market companies. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity-related investments. We are an internally-managed, non-diversified closed-end investment company that has elected to be treated as a business development company under the Investment Company Act of 1940.

 

As of March 31, 2008 our total assets were approximately $548.9 million, of which, our investments comprised $530.8 million at fair value and $520.8 million at cost. Our investments at fair value were comprised of our debt investments, warrant portfolio and equity investments valued at approximately $479.9 million, $24.4 million and $26.5 million, respectively, or 87.4%, 4.4% and 4.8% of total assets, respectively. Our total investments at value in foreign companies were approximately $29.3 million or 5.3% of total assets at March 31, 2008. During the year ended December 31, 2007, we made debt commitments to 49 portfolio companies totaling $480.5 million and funded $355.5 million to 86 companies. For the three months ended March 31, 2008 we made debt commitments to five portfolio companies totaling $65 million and funded approximately $49.1 million to 12 portfolio companies. At March 31, 2008, we had unfunded contractual commitments of $128.4 million to 24 portfolio companies. In addition, as of March 31, 2008 we executed non-binding term sheets with 11 prospective portfolio companies, representing approximately $90.3 million in proposed future commitments.

 

Since inception through March 31, 2008, we have made debt and equity commitments in excess of $1.0 billion to our portfolio companies. During this same period we have incurred realized losses on loans to two portfolio companies of approximately $5.0 million.

 

We primarily finance privately-held companies backed by leading venture capital and private equity firms and also may invest in select publicly-traded companies that lack access to public capital or are sensitive to equity ownership dilution, as well as lower middle market companies. As of March 31, 2008, over 300 different venture capital firms sponsor our portfolio companies. Our principal executive office is located in Silicon Valley, and we have additional offices in the Boston, Boulder, Chicago, Columbus and San Diego areas. Our goal is to be the leading structured mezzanine capital provider of choice for venture capital and private equity backed technology-related and life sciences companies requiring sophisticated and customized financing solutions. Our strategy is to evaluate and invest in a broad range of ventures active in the technology and life science industries and to offer a full suite of capital products at all levels of the capital structure. We invest primarily in structured mezzanine debt and, to a lesser extent, in senior debt and equity investments. We use the term “structured mezzanine debt investment” to refer to any debt investment, such as a senior or subordinated secured loan, that is coupled with an equity component, including warrants, options or rights to purchase common or preferred stock. Our structured mezzanine debt investments will typically be secured by some or all of the assets of the portfolio company.

 

 

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We focus our investments in companies active in technology industry sub-sectors characterized by products or services that require advanced technologies, including computer software and hardware, networking systems, semiconductors, semiconductor capital equipment, information technology infrastructure or services, Internet consumer and business services, telecommunications, telecommunications equipment, media and life sciences. Within the life sciences sub-sector, we focus on medical devices, bio-pharmaceutical, drug discovery, drug delivery, health care services and information systems companies. We refer to all of these companies as “technology-related” companies and intend, under normal circumstances, to invest at least 80% of the value of our assets in such businesses.

 

Our primary business objectives are to increase our net income, net operating income and net asset value by investing in structured mezzanine debt and equity of venture capital and private equity backed technology-related companies with attractive current yields and the potential for equity appreciation and realized gains. Our structured debt investments typically include warrants or other equity interests, giving us the potential to realize equity-like returns on a portion of our investments. In some cases, we receive the right to make additional equity investments in our portfolio companies in connection with future equity financing rounds. Capital that we provide directly to venture capital and private equity backed technology-related companies is generally used for growth, and in select cases for acquisitions or recapitalizations.

 

Our portfolio is comprised of, and we anticipate that our portfolio will continue to be comprised of, investments in technology-related companies at various stages of their development. Consistent with regulatory requirements, we invest primarily in United States based companies and to a lesser extent in foreign companies. See “Regulation—Qualifying Assets.” To date, our emphasis has been primarily on private companies following or in connection with their first institutional round of equity financing, which we refer to as emerging-growth companies, private companies in later rounds of financing, which we refer to as expansion-stage companies, and private companies in one of their final rounds of equity financing prior to a liquidity event or select publicly-traded companies that lack access to public capital or are sensitive to equity ownership dilution, which we refer to as established-stage companies. Our recent investment emphasis has been primarily on expansion- and established-stage companies.

 

As of May 28, 2008, our investment professionals, including Manuel A. Henriquez, our co-founder, Chairman, President and Chief Executive Officer, is currently comprised of 25 professionals who have, on average, more than 15 years of experience in venture capital, structured finance, commercial lending or acquisition finance with the types of technology-related companies that we are targeting. We believe that we can leverage the experience and relationships of our management team to successfully identify attractive investment opportunities, underwrite prospective portfolio companies and structure customized financing solutions.

 

Our Market Opportunity

 

We believe that technology-related companies compete in one of the largest and most rapidly growing sectors of the U.S. economy and that continued growth is supported by ongoing innovation and performance improvements in technology products as well as the adoption of technology across virtually all industries in response to competitive pressures. We believe that an attractive market opportunity exists for a specialty finance company focused primarily on structured mezzanine investments in technology-related and life sciences companies for the following reasons:

 

   

Technology-related companies have generally been underserved by traditional lending sources;

 

   

Unfulfilled demand exists for structured debt financing to technology-related companies;

 

   

Structured mezzanine debt products are less dilutive and complement equity financing from venture capital and private equity funds; and

 

 

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Valuations currently assigned to technology-related companies in private financing rounds, while increasing in recent years, still provide a good opportunity for attractive capital returns.

 

Technology-Related Companies Underserved by Traditional Lenders. We believe many viable technology-related companies backed by financial sponsors have been unable to obtain sufficient growth financing from traditional lenders, including financial services companies such as commercial banks and finance companies, in part because traditional lenders have continued to consolidate and have adopted a more risk-averse approach to lending that has resulted in tightened credit standards in recent years. More importantly, we believe traditional lenders are typically unable to underwrite the risk associated with financial sponsor-backed emerging-growth or expansion-stage companies effectively.

 

The unique cash flow characteristics of many technology-related companies include significant research and development expenditures and high projected revenue growth thus often making such companies difficult to evaluate from a credit perspective. In addition, the balance sheets of emerging-growth and expansion-stage companies often include a disproportionately large amount of intellectual property assets, which can be difficult to value. Finally, the speed of innovation in technology and rapid shifts in consumer demand and market share add to the difficulty in evaluating technology-related companies.

 

Due to the difficulties described above, we believe traditional lenders are generally refraining from entering the structured mezzanine debt marketplace for emerging-growth and expansion-stage companies, instead preferring the risk-reward profile of senior debt. Traditional lenders generally do not have flexible product offerings that meet the needs of technology-related companies. The financing products offered by traditional lenders typically impose on borrowers many restrictive covenants and conditions, including limiting cash outflows and requiring a significant depository relationship to facilitate rapid liquidation.

 

Unfulfilled Demand for Structured Debt Financing to Technology-Related Companies. Private debt capital in the form of structured debt financing from specialty finance companies continues to be an important source of funding for technology-related companies. We believe that the level of demand for structured debt financing to emerging-growth and expansion-stage companies is a function of the level of annual venture equity investment activity. Currently, Dow Jones VentureOne reports that there are over 5,400 private, venture capital-backed companies, representing over $132.0 billion in cumulative investments. In 2007, venture capital-backed companies received, in approximately 2,648 transactions, equity financing in an aggregate amount of approximately $29.9 billion, representing an 8% increase over the preceding year, as reported by Dow Jones VentureOne. In addition, according to VentureOne, overall, the median round size in 2007 was $7.6 million, up from $7.0 million in 2006, and the highest annual median since 2000. For the third year in a row, equity investors are focusing more than a third of their investment activity on early-stage financings. Overall, seed- and first-round deals made up 38% of the deal flow in 2007, and later-stage deals made up roughly 50% of all capital invested. As a result, we believe a range of $23 billion to $28 billion in annual equity investments to venture-backed companies will be sustainable in future years.

 

We believe that demand for structured debt financing is currently unfulfilled, in part because historically the largest debt capital providers to technology-related companies exited the market during 2001. In addition, lending requirements of traditional lenders have become more stringent due to the credit and liquidity crisis that impacted certain financial institutions beginning in the summer of 2007 related to the sub-prime market, real estate market and consumer debt market, which we do not have exposure to as a financial lender. We therefore believe this is an opportune time to be active in the structured lending market for technology-related companies.

 

Structured Mezzanine Debt Products Complement Equity Financing From Venture Capital and Private Equity Funds. We believe that technology-related companies and their financial sponsors will continue to view structured debt securities as an attractive source of capital because it augments the capital provided by venture

 

 

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capital and private equity funds. We believe that our structured mezzanine debt products provide access to growth capital that otherwise may only be available through incremental investments by existing equity investors. As such, we provide portfolio companies and their financial sponsors with an opportunity to diversify their capital sources. Generally, we believe emerging-growth and expansion-stage companies target a portion of their capital to be debt in an attempt to achieve a higher valuation through internal growth. In addition, because financial sponsor-backed companies have recently been more mature prior to reaching a liquidity event, we believe our investments could provide the debt capital needed to grow or recapitalize during the extended period prior to liquidity events.

 

Lower Valuations for Private Technology-Related Companies. During the downturn in technology industries that began in 2000, the markets saw sharp and broad declines in valuations of venture capital and private equity-backed technology-related companies. According to Dow Jones VentureOne, median pre-money valuations for venture capital-backed companies in 2000 was $25.1 million declining to a low of $10.0 million in 2003. As of December 31, 2007 median pre-money valuations for venture capital-backed companies in 2007 was $16.0 million compared to $18.5 million in 2006. This decrease was attributed to lower valuations in certain areas such as medical software, information services, software and consumer products offset by increases in other industry segments such as health care services, retail, electronics and computers. We believe the valuations currently assigned to venture capital and private equity-backed technology-related companies in private financing rounds are still reasonably valued and should allow us to continue to build a portfolio of equity-related securities at attractive valuation levels.

 

Our Business Strategy

 

Our strategy to achieve our investment objective includes the following key elements:

 

Leverage the Experience and Industry Relationships of Our Management Team and Investment Professionals. We have assembled a team of experienced investment professionals with extensive experience as venture capitalists, commercial lenders, and originators of structured debt and equity investments in technology- related companies. Our investment professionals have, on average, more than 15 years of experience as equity investors in, and/or lenders to, technology-related companies. In addition, our team members have originated structured mezzanine investments in over 200 technology-related companies, representing over $2.0 billion in investments, and have developed a network of industry contacts with investors and other participants within the venture capital and private equity communities. In addition, members of our management team also have operational, research and development and finance experience with technology-related companies. We have established contacts with leading venture capital and private equity fund sponsors, public and private companies, research institutions and other industry participants, which should enable us to identify and attract well-positioned prospective portfolio companies.

 

We concentrate our investing activities in industries in which our investment professionals have investment experience. We believe that our focus on financing high growth venture capital-backed technology-related companies will enable us to leverage our expertise in structuring prospective investments, to assess the value of both tangible and intangible assets, to evaluate the business prospects and operating characteristics of technology-related companies and to identify and originate potentially attractive investments with these types of companies.

 

Mitigate Risk of Principal Loss and Build a Portfolio of Equity-Related Securities. We expect that our investments have the potential to produce attractive risk adjusted returns through current income, in the form of interest and fee income, as well as capital appreciation from equity-related securities. We believe that we can mitigate the risk of loss on our debt investments through the combination of loan principal amortization, cash

 

 

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interest payments, relatively short maturities, security interests in the assets of our portfolio companies, covenants requiring prospective portfolio companies to have certain amounts of available cash at the time of our investment and a venture capital or private equity firm’s continued support of a portfolio company at the time we make our investment.

 

In addition, our structured debt investments typically include warrants or other equity interests, giving us the potential to realize equity-like returns on a portion of our investment. We expect, in some cases, to receive the right to make additional equity investments in our portfolio companies in connection with future equity financing rounds. We believe these equity interests will create the potential for long-term capital gains in connection with the future liquidity events of these technology-related companies.

 

Provide Customized Financing Complementary to Financial Sponsors’ Capital. We offer a broad range of investment structures and possess expertise and experience to effectively structure and price investments in technology-related companies. Unlike many of our competitors that only invest in companies that fit a specific set of investment parameters, we have the flexibility to structure our investments to suit the particular needs of our portfolio companies. We offer customized financing solutions ranging from senior debt to equity capital, with a focus on structured mezzanine debt.

 

We use our relationships in the financial sponsor community to originate investment opportunities. Because venture capital and private equity funds typically invest solely in the equity securities of their portfolio companies, we believe that our debt investments will be viewed as an attractive source of capital, both by the portfolio company and by the portfolio company’s financial sponsor. In addition, we believe that many venture capital and private equity fund sponsors encourage their portfolio companies to use debt financing for a portion of their capital needs as a means of potentially enhancing equity returns, minimizing equity dilution and increasing valuations prior to a subsequent equity financing round or a liquidity event.

 

Invest at Various Stages of Development. We provide growth capital to technology-related companies at all stages of development, from emerging-growth companies, to expansion-stage companies and established stage companies. We believe that this provides us with a broader range of potential investment opportunities than those available to many of our competitors, who generally focus their investments on a particular stage in a company’s development. Because of the flexible structure of our investments and the extensive experience of our investment professionals, we believe we are well positioned to take advantage of these investment opportunities at all stages of prospective portfolio companies’ development.

 

Benefit from Our Efficient Organizational Structure. We believe that the perpetual nature of our corporate structure enables us to be a long-term partner for our portfolio companies, in contrast to traditional mezzanine and investment funds, which typically have a limited life. In addition, because of our access to the equity markets, we believe that we may benefit from a lower cost of capital than that available to private investment funds. We are not subject to requirements to return invested capital to investors nor do we have a finite investment horizon. Capital providers that are subject to such limitations are often required to seek a liquidity event more quickly than they otherwise might, which can result in a lower overall return on an investment.

 

Deal Sourcing Through Our Proprietary Database. We have developed a proprietary and comprehensive structured query language-based (SQL) database system to track various aspects of our investment process including sourcing, originations, transaction monitoring and post-investment performance. As of March 31, 2008, our proprietary SQL-based database system included over 3,800 technology-related companies and over 14,500 venture capital private equity sponsors/investors, as well as various other industry contacts. This proprietary SQL system allows us to maintain, cultivate and grow our industry relationships while providing us with comprehensive details on companies in the technology-related industries and their financial sponsors.

 

 

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Dividend Reinvestment Plan

 

We have adopted an opt-out dividend reinvestment plan through which distributions are paid to stockholders in the form of additional shares of our common stock, unless a stockholder elects to receive cash. See “Dividend Reinvestment Plan.” Those stockholders whose shares are held by a broker or other financial intermediary may receive distributions in cash by notifying their broker or other financial intermediary of their election.

 

Taxation

 

From incorporation through December 31, 2005, we were taxed as a corporation under Subchapter C of the Internal Revenue Code of 1986, as amended, which we refer to in this prospectus as the Code. We elected to be treated for federal income tax purposes as a regulated investment company (a “RIC”) under Subchapter M of the Code with the filing of our federal corporate income tax return for 2006, which election was effective as of January 1, 2006. As a RIC, we generally will not pay corporate-level federal income taxes on any ordinary income or capital gains that we distribute to our stockholders as dividends. See “Certain United States Federal Income Tax Considerations.” To obtain and maintain the federal income tax benefits of RIC status, we must meet specified source-of-income and asset diversification requirements and distribute annually an amount equal to at least 90% of the sum of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, out of assets legally available for distribution. See “Distributions.” There is no assurance that we will meet these tests and be eligible to make a RIC election. If we do not qualify or do not make a RIC election, we would be taxed as a C corporation.

 

Use of Proceeds

 

We intend to use the net proceeds from selling shares of common stock for general corporate purposes, which includes investing in debt and equity securities, repayment of indebtedness and other general corporate purposes. The supplement to this prospectus relating to an offering will more fully identify the use of proceeds from such offering. We will not receive any proceeds from the sale of the common stock by the selling holders.

 

Leverage

 

We borrow funds to make additional investments, and we have granted, and may in the future grant, a security interest in our assets to a lender in connection with any such borrowings, including any borrowings by any of our subsidiaries. We use this practice, which is known as “leverage,” to attempt to increase returns to our common stockholders. However, leverage involves significant risks. See “Risk Factors.” With certain limited exceptions, we are only allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing. Our asset coverage as of March 31, 2008 was approximately 748%. The amount of leverage that we employ will depend on our assessment of market and other factors at the time of any proposed borrowing.

 

We, through Hercules Funding Trust I, an affiliated statutory trust, have a securitization credit facility with a borrowing capacity of $250 million with Citigroup Global Markets Realty Corp. and Deutsche Bank Securities, Inc., which we refer to as the Credit Facility. Hercules Funding Trust I, together with Hercules Funding I LLC, a wholly owned subsidiary, function as vehicles to collateralize loans under our Credit Facility. As of March 31, 2008, we had approximately $72.9 million outstanding under the Credit Facility and approximately $61.5 million in available borrowing capacity. See “Management’s Discussion & Analysis of Financial Condition—Borrowings.” On May 7, 2008, we amended and renewed our Credit Facility with Citigroup and Deutsche Bank

 

 

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to provide for a borrowing capacity of $135.0 million and extending the expiration date to October 31, 2008. Under the terms of the agreement, we paid a renewal fee of approximately $1.3 million, interest on all borrowings was set at LIBOR plus a spread of 5.0%, and a fee of 2.50% that will be charged on any unused portion of the facility. The Credit Facility is collateralized by loans from our portfolio companies, and includes an advance rate of approximately 45% of eligible loans. The Credit Facility contains covenants that, among other things, require us to maintain a minimum net worth and to restrict the loans securing the Credit Facility to certain dollar amounts, to concentrations in certain geographic regions and industries, to certain loan grade classifications, to certain security interests, and to certain interest payment terms. We are also in preliminary discussions with other large national banks who are interested in potentially providing us with additional debt capital.

 

Hercules Technology II, L.P. (“HT II”), our wholly-owned subsidiary, is licensed as a Small Business Investment Company (“SBIC”) under the Small Business Investment Act of 1958. The SBIC regulations currently limit the amount that is available to borrow by any SBIC to $127.2 million, subject to periodic adjustments by the Small Business Administration (“SBA”). There is no assurance that we will draw up to the maximum limit available under the SBIC program. On April 5, 2007, we received an exemptive relief from the SEC that permits us to exclude the indebtedness that our wholly-owned subsidiary, HT II, which is qualified as a small business investment company, issues to the SBA from the 200% asset coverage requirement applicable to us. As of March 31, 2008, we had approximately $70.1 million outstanding under our SBA debenture and approximately $57.1 million available under the SBA program.

 

Distributions

 

As a RIC, we are required to distribute annually to our stockholders at least 90% of the sum of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any. We are not subject to corporate level income taxation on income we timely distribute to our stockholders as dividends. See “Certain Material United States Federal Income Tax Considerations.” We pay regular quarterly dividends based upon an estimate of annual taxable income available for distribution to shareholders and the amount of taxable income carried over from the prior year for distribution in the current year.

 

Principal Risk Factors

 

Investing in our common stock may be speculative and involves certain risks relating to our structure and our investment objective that you should consider before deciding whether to invest. In addition, we expect that our portfolio will continue to consist primarily of securities issued by privately-held technology-related companies, which generally require additional capital to become profitable. These investments may involve a high degree of business and financial risk, and they are generally illiquid. Our portfolio companies typically will require additional outside capital beyond our investment in order to succeed or to fully repay the amounts owed to us. A large number of entities compete for the same kind of investment opportunities as we seek.

 

We borrow funds to make our investments in portfolio companies. As a result, we are exposed to the risks of leverage, which may be considered a speculative investment technique. Borrowings magnify the potential for gain and loss on amounts invested and, therefore increase the risks associated with investing in our common stock. Also, we are subject to certain risks associated with valuing our portfolio, changing interest rates, accessing additional capital, fluctuating quarterly results, and operating in a regulated environment. See “Risk Factors” for a discussion of factors you should carefully consider before deciding whether to invest in our common stock.

 

 

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Certain Anti-Takeover Provisions

 

Our charter and bylaws, as well as certain statutes and regulations, contain provisions that may have the effect of discouraging a third party from making an acquisition proposal for our company. This could delay or prevent a transaction that could give our stockholders the opportunity to realize a premium over the price for their securities.

 

General Information

 

Our principal executive offices are located at 400 Hamilton Avenue, Suite 310, Palo Alto, California 94301, and our telephone number is (650) 289-3060. We also have offices in the Boston, Massachusetts; Boulder, Colorado; Chicago, Illinois; San Diego, California; and Columbus, Ohio areas. We maintain a website on the Internet at www.herculestech.com. Information contained in our website is not incorporated by reference into this prospectus, and you should not consider that information to be part of this prospectus.

 

We file annual, quarterly and current periodic reports, proxy statements and other information with the SEC under the Securities Exchange Act of 1934, which we refer to as the Exchange Act. This information is available at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information about the operation of the SEC’s public reference room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet website, at www.sec.gov, that contains reports, proxy and information statements, and other information regarding issuers, including us, who file documents electronically with the SEC.

 

 

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FEES AND EXPENSES

 

The following table is intended to assist you in understanding the various costs and expenses that an investor in our common stock will bear directly or indirectly. However, we caution you that some of the percentages indicated in the table below are estimates and may vary. Except where the context suggests otherwise, whenever this prospectus contains a reference to fees or expenses paid by “you” or “us” or that “we” will pay fees or expenses, stockholders will indirectly bear such fees or expenses as investors in Hercules Technology Growth Capital.

 

Stockholder Transaction Expenses (as a percentage of the public offering price):

  

Sales load (as a percentage of offering price)(1)

   —   %

Offering expenses

   —   %

Dividend reinvestment plan fees

   —   %
      

Total stockholder transaction expenses (as a percentage of the public offering price)

   —   %
      

Annual Expenses (as a percentage of net assets attributable to common stock):(2)

  

Operating expenses

   4.8 (3)(4)

Interest payments on borrowed funds

   3.1 %(5)

Fees paid in connection with borrowed funds

   .5 %(6)

Acquired fund fees and expenses(7)

   —   %
      

Total annual expenses

   8.4 %(8)
      

 

Example

 

The following example demonstrates the projected dollar amount of total cumulative expenses that would be incurred over various periods with respect to a hypothetical investment in our common stock. These amounts are based upon our payment of annual operating expenses at the levels set forth in the table above and assume no additional leverage.

 

     1 Year    3 Years    5 Years    10 Years

You would pay the following expenses on a $1,000 investment, assuming a 5% annual return

   $ 128.63    $ 278.05    $ 417.59    $ 727.43
                           

 

The example and the expenses in the tables above should not be considered a representation of our future expenses, and actual expenses may be greater or lesser than those shown. Moreover, while the example assumes, as required by the applicable rules of the SEC, a 5% annual return, our performance will vary and may result in a return greater or lesser than 5%. In addition, while the example assumes reinvestment of all dividends and distributions at net asset value, participants in our dividend reinvestment plan may receive shares valued at the market price in effect at that time. This price may be at, above or below net asset value. See “Dividend Reinvestment Plan” for additional information regarding our dividend reinvestment plan.

 

(1) In the event that the shares of common stock to which this prospectus relates are sold to or through underwriters, a corresponding prospectus supplement will disclose the applicable sales load. We will not pay any underwriting discount or commission, and we will not receive any of the proceeds from shares sold by the selling stockholders.
(2) “Average net assets attributable to common stock” equals estimated weighted average net assets for 2008 which is approximately $411 million.
(3) “Operating expenses” represent our estimated expenses for the year ending December 31, 2008 including income tax expense (benefit) including excise tax, excluding interest on indebtedness. This percentage for the year ended December 31, 2007 was 4.6%. See “Management’s Discussion and Analysis and Results of Operations,” “Management,” and “Compensation of Executive Officers and Directors.”

 

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(4) We do not have an investment adviser and are internally managed by our executive officers under the supervision of our Board of Directors. As a result, we do not pay investment advisory fees, but instead we pay the operating costs associated with employing investment management professionals.
(5) “Interest payments on borrowed funds” represents estimated annualized interest payments on borrowed funds for 2008. Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants and shares underlying the warrants collateralized under the Citigroup facility. As a fee and incentive to Citigroup for the extension of the Credit Facility, Hercules entered into a Warrant Participant Agreement with Citigroup in August 2005. Pursuant to the Warrant Participation Agreement, we granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants are included in collateral subsequent to the Credit Facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equals $3,750,000 (the “Maximum Participation Limit”). The obligations under the warrant participation agreement continue even after the Citigroup facility is terminated until the Maximum Participation Limit has been reached. During the year ended December 31, 2007, we recorded an additional liability and reduced the unrealized appreciation by approximately $609,000 to account for Citigroup’s participation in unrealized appreciation in the warrant portfolio. During the three months ended March 31, 2008 we reduced our realized gain by $56,000 and recorded an additional liability and reduced our unrealized appreciation by approximately $399,000 for Citigroup’s participation in unrealized appreciation in the warrant portfolio. We have paid Citigroup approximately $399,000 during the year ended December 31, 2007 and $680,000 since inception of the agreement under the warrant participation agreement thereby reducing our realized gains by that amount. The value of their participation right on unrealized gains in the related equity investments since inception of the agreement was approximately $1.1 million at March 31, 2008 and is included in accrued liabilities and reduces the unrealized gain we recognized at March 31, 2008. Based on our average borrowings for the year ended December 31, 2007 and the quarter ended March 31, 2008 and the amount of reduction we recorded for our realized and unrealized gains for the related periods, the additional cost of our borrowings as a result of the warrant participation agreement could be approximately 1.93% and 0.59%, respectively. There can be no assurances that the unrealized appreciation of the warrants will not be higher or lower in future periods due to fluctuations in the value of the warrants, thereby increasing or reducing the effect on the cost of borrowing.
(6) “Fees paid in connection with borrowed funds” represents estimated fees paid in connection with borrowed funds for 2008.
(7) For the year ended December 31, 2007, we did not have any investments in shares of Acquired Funds that are not consolidated and, as a result, we did not directly or indirectly incur any fees from Acquired Funds.
(8) “Total annual expenses” is the sum of “operating expenses,” “interest payments on borrowed funds” and “fees paid in connection with borrowed funds.”

 

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SELECTED CONSOLIDATED FINANCIAL DATA

 

The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” “Senior Securities” on page 85 and the consolidated financial statements and related notes included elsewhere herein. The selected balance sheet data as of the end of fiscal 2007, 2006, 2005 and the period from February 2, 2004 (commencement of operations) to December 31, 2004 presented below, and the selected income statement data for fiscal 2007, 2006, 2005 and the period from February 2, 2004 (commencement of operations) to December 31, 2004 have been derived from our audited financial statements included elsewhere herein, which have been audited by Ernst & Young LLP, an independent registered public accounting firm. The selected balance sheet data as of March 31, 2008 presented below and the selected income statement data for the fiscal quarter then ended have been derived from our unaudited financial statements included elsewhere herein. In the opinion of management, the quarterly financial information derived from unaudited financial information, reflects all adjustments (consisting only of normal recurring adjustments) which are necessary to present fairly the results for the interim period. The historical data are not necessarily indicative of results to be expected for any future period.

 

     Three Months Ended
March 31,
   For the Years Ended December 31,  
(In thousands, except per share amounts)    2008     2007    2007     2006     2005    Period Ending
February 2, 2004

(Commencement
of Operations) to
December 31, 2004
 
                   

Investment Income

              

Interest

   $ 14,239     $ 9,036    $ 48,757     $ 26,278     $ 9,791    $ 214  

Fees

     1,361       643      5,127       3,230       876      —    
                                              

Total Investment Income

     15,600       9,679    $ 53,884     $ 29,508       10,667      214  
                                              

Operating Expenses:

              

Interest

     1,851       686    $ 4,404     $ 5,770     $ 1,801    $ —    

Loan Fees

     382       266      1,290       810       1,098      —    

General and Administrative

     1,241       1,308      5,437       5,409       2,285      411  

Employee Compensation:

              

Compensation and Benefits

     2,799       1,940      9,135       5,779       3,706      1,165  

Stock-Based Compensation

     327       254      1,127       617       252      680  
                                              

Total Employee Compensation

     3,126       2,194    $ 10,262     $ 6,396     $ 3,958    $ 1,845  

Total Operating Expenses

     6,600       4,454    $ 21,393     $ 18,385     $ 9,142    $ 2,256  

Net Investment Income (Loss) Before Provision for Taxes and Investment Gains and Losses

     —         —      $ 32,491     $ 11,123     $ 1,525    $ (2,042 )

Provision for Income Taxes

     —         —        2       643       225      —    

Net Investment Income (Loss)

     9,000       5,225      32,489       10,480       1,270      (2,041 )

Net Realized Gain (Loss) on Investments

     2,958       290      2,791       (1,604 )     482      —    

Provision for Excise Tax

     —         —        (139 )     —         —        —    

Net Increase in Unrealized Appreciation on Investments

     (921 )     816      7,268       2,508       353      —    
                                              

Net Increase and Unrealized Gains

     2,037       1,106      9,920       904       835      —    

Net Increase in Net Assets Resulting from Operations

   $ 11,037     $ 6,331    $ 42,409     $ 11,384     $ 2,105    $ (2,041 )

Cash Dividends Declared per Common Share

   $ 0.30     $ 0.30    $ 1.20     $ 0.90     $ 0.33    $ —    

 

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    March 31,
2008
  As of December 31,
(In thousands, except per share amounts)     2007   2006   2005   Period Ending
February 2, 2004

(Commencement of
Operations)

to December 31, 2004
    (unaudited)    

Balance Sheet Data:

         

Investments, at Value

  $ 530,763   $ 529,972   $ 283,234   $ 176,673   $ 16,700

Cash and Cash Equivalents

    13,804     7,856     16,404     15,362     8,678

Total Assets

    548,944     541,943     301,142     193,648     25,233

Total Liabilities

    146,510     141,206     45,729     79,296     25,078

Total Net Assets

    402,434     400,737     255,413     114,352  

Other Data:

         

Total Debt Investments, at Value

  $ 479,857   $ 482,123   $ 266,724   $ 166,646   $ 16,700

Total Warrant Investments, at Value

    24,360     21,646     8,441     5,160     —  

Total Equity Investments, at Value

    26,546     26,203     8,069     4,867     —  

Unfunded Commitments

    128,396     130,602     55,500     30,200     5,000

Net Asset value Per Share(1)

  $ 12.28   $ 12.31   $ 11.65   $ 11.67   $ 12.18

 

(1) Based on common shares outstanding at period end.

 

The following tables set forth certain quarterly financial information for each of the nine quarters up to and ending March 31, 2008. This information was derived from our unaudited consolidated financial statements. Results for any quarter are not necessarily indicative of results for the full year or for any future quarter.

 

     Quarter Ended
(In thousands, except per share amounts)    3/31/07    6/30/07    9/30/07    12/31/07    3/31/08
      

Total investment income

   $ 9,679    $ 13,275    $ 15,141    $ 15,790    $ 15,600

Net investment income (loss) before provision for income taxes and investment gains and losses

     5,225      7,240      10,044      9,981      9,000

Net investment income (loss)

     6,331      8,270      7,178      20,632      11,037

Net investment income per common share (basic)

   $ 0.28    $ 0.33    $ 0.22    $ 0.63    $ 0.28
     Quarter Ended     
     3/31/06    6/30/06    9/30/06    12/31/06     

Total investment income

   $ 6,487    $ 6,788    $ 7,544    $ 8,689   

Net investment income (loss) before provision for income taxes and investment gains and losses

     2,046      2,468      3,117      3,492   

Net investment income (loss)

     2,505      3,366      1,573      3,940   

Net investment income per common share (basic)

   $ 0.25    $ 0.26    $ 0.12    $ 0.23   

 

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RISK FACTORS

 

Investing in our common stock may be speculative and involves a high degree of risk. Before you invest in shares of our common stock, you should be aware of various risks, including those described below. You should carefully consider these risks, together with all of the other information included in this prospectus, before you decide whether to make an investment in our common stock. The risks set forth below are not the only risks we face. If any of the following risks occur, our business, financial condition and results of operations could be materially adversely affected. In such case, our net asset value and the trading price of our common stock could decline, and you may lose all or part of your investment.

 

Risks Related to our Business and Structure

 

We have a limited operating history as a business development company, which may affect our ability to manage our business and may impair your ability to assess our prospects.

 

We were incorporated in December 2003 and commenced investment operations in September 2004. We are subject to all of the business risks and uncertainties associated with any new business enterprise, including the risk that we will not achieve our investment objective and that the value of our common stock could decline substantially. We have limited operating history as a business development company and as a RIC. As a result, we have limited operating results under these regulatory frameworks that can demonstrate to you either their effect on the business or our ability to manage the business within these frameworks. See “Regulation” and “Certain United States Federal Income Tax Considerations.” If we fail to maintain our status as a business development company or fail to qualify as a RIC, our operating flexibility and results of operations would be significantly affected.

 

We are dependent upon key management personnel for our future success, particularly Manuel A. Henriquez, and if we are not able to hire and retain qualified personnel, or if we lose any member of our senior management team, our ability to implement our business strategy could be significantly harmed.

 

We depend upon the members of our senior management, particularly Mr. Henriquez, as well as other key personnel for the identification, final selection, structuring, closing and monitoring of our investments. These employees have critical industry experience and relationships on which we rely to implement our business plan. If we lose the services of Mr. Henriquez, or of any other senior management members, we may not be able to operate the business as we expect, and our ability to compete could be harmed, which could cause our operating results to suffer. We believe our future success will depend, in part, on our ability to identify, attract and retain sufficient numbers of highly skilled employees. If we do not succeed in identifying, attracting and retaining such personnel, we may not be able to operate our business as we expect.

 

Our business model depends to a significant extent upon strong referral relationships with venture capital and private equity fund sponsors, and our inability to develop or maintain these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.

 

We expect that members of our management team will maintain their relationships with venture capital and private equity firms, and we will rely to a significant extent upon these relationships to provide us with our deal flow. If we fail to maintain our existing relationships or to develop new relationships with other firms or sources of investment opportunities, then we will not be able to grow our investment portfolio. In addition, persons with whom members of our management team have relationships are not obligated to provide us with investment opportunities and, therefore, there is no assurance that such relationships will lead to the origination of debt or other investments.

 

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We operate in a highly competitive market for investment opportunities, and we may not be able to compete effectively.

 

A large number of entities compete with us to make the types of investments that we plan to make in prospective portfolio companies. We compete with a large number of venture capital and private equity firms, as well as with other investment funds, investment banks and other sources of financing, including traditional financial services companies such as commercial banks and finance companies. Many of our competitors are substantially larger and have considerably greater financial, technical, marketing and other resources than we do. For example, some competitors may have a lower cost of funds and/or access to funding sources that are not available to us. This may enable some competitors to make commercial loans with interest rates that are comparable to or lower than the rates that we typically offer. We may lose prospective portfolio companies if we do not match competitors’ pricing, terms and structure. If we do match competitors’ pricing, terms or structure, we may experience decreased net interest income and increased risk of credit losses. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments, establish more relationships and build their market shares. Furthermore, many potential competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a business development company or that the Code would impose on us as a RIC. If we are not able to compete effectively, our business, financial condition, and results of operations will be adversely affected. As a result of this competition, there can be no assurance that we will be able to identify and take advantage of attractive investment opportunities that we identify, or that we will be able to fully invest our available capital.

 

Because we intend to distribute substantially all of our income to our stockholders as long as we are treated as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow will be impaired.

 

In order to satisfy the tax requirements applicable to a RIC, to avoid payment of excise taxes and to minimize or avoid payment of income taxes, we intend as a RIC to distribute to our stockholders substantially all of our ordinary income and realized net capital gains except for certain realized net long-term capital gains, some or all of which we currently intend to retain, pay applicable income taxes with respect thereto and elect to treat as deemed distributions to our stockholders. As a business development company, we generally are required to meet a coverage ratio of total assets to total borrowings and other senior securities, which includes all of our borrowings and any preferred stock that we may issue in the future, of at least 200%. This requirement limits the amount that we may borrow. Because we will continue to need capital to grow our loan and investment portfolio, this limitation may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so. While we expect to be able to borrow and to issue additional debt and equity securities, we cannot assure you that debt and equity financing will be available to us on favorable terms, or at all, and debt financings may be restricted by the terms of any of our outstanding borrowings. In addition, as a business development company, we generally are not permitted to issue equity securities priced below net asset value without stockholder approval and approval of our independent directors. We have received such approval from our independent directors and received stockholder approval at our Annual Meeting on May 29, 2008. See “Determination of Net Asset Value.” If additional funds are not available to us, we could be forced to curtail or cease new lending and investment activities, and our net asset value could decline.

 

Because we borrow money, there could be increased risk in investing in our company.

 

Lenders have fixed dollar claims on our assets that are superior to the claims of stockholders, and we have granted, and may in the future grant, lenders a security interest in our assets in connection with borrowings. In the case of a liquidation event, those lenders would receive proceeds before our stockholders. In addition, borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in our securities. Leverage is generally considered a speculative investment technique. If the value of our assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more than it otherwise would have had we not leveraged. Conversely, if the value of our assets decreases, leveraging would cause the net asset value attributable to our

 

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common stock to decline more than it otherwise would have had we not leveraged. Similarly, any increase in our revenue in excess of interest expense on our borrowed funds would cause our net income to increase more than it would without the leverage. Any decrease in our revenue would cause our net income to decline more than it would have had we not borrowed funds and could negatively affect our ability to make distributions on common stock. Our ability to service any debt that we incur will depend largely on our financial performance and will be subject to prevailing economic conditions and competitive pressures. We and, indirectly our stockholders will bear the cost associated with our leverage activity. Our Credit Facility contains financial and operating covenants that could restrict our business activities, including our ability to declare dividends if we default under certain provisions.

 

As of March 31, 2008, we had outstanding indebtedness of $72.9 million pursuant to our securitized Credit Facility. If our portfolio of investments fails to provide adequate returns and we are unable to otherwise raise funds, we may be unable to make interest or principal payments on our indebtedness as they become due. In addition, we had approximately $70.1 million outstanding under our SBA debenture. We expect, in the future, to borrow from, and issue senior debt securities to, banks, insurance companies and other lenders, including additional borrowings pursuant to the Credit Facility. See “Management’s Discussion and Analysis of Financial Condition—Borrowings.”

 

As a business development company, we generally are required to meet a coverage ratio of total assets to total borrowings and other senior securities, which include all of our borrowings and any preferred stock that we may issue in the future, of at least 200%. If this ratio declines below 200%, we may not be able to incur additional debt and may need to sell a portion of our investments to repay some debt when it is disadvantageous to do so, and we may not be able to make distributions.

 

Illustration. The following table illustrates the effect of leverage on returns from an investment in our common stock assuming various annual returns, net of expenses. The calculations in the table below are hypothetical and actual returns may be higher or lower than those appearing in the table below.

 

     Assumed Return on Our Portfolio
(Net of Expenses)
 
     (10)%     (5)%     0%     5%     10%  

Corresponding return to stockholder(1)

   (36.57 )%   (20.49 )%   (4.41 )%   11.67 %   27.75 %

 

(1) Assumes $820 million in total assets, $250 million in debt outstanding, $411 million in stockholders’ equity, and an average cost of funds of 4.5%, which is the approximate cost of funds of the Credit Facility for the period ended March 31, 2008. Actual interest payments may be different.

 

Because most of our investments typically are not in publicly-traded securities, there is uncertainty regarding the value of our investments, which could adversely affect the determination of our net asset value.

 

At March 31, 2008, portfolio investments, 99% of which are valued at fair value by the Board of Directors, were approximately 97% of our total assets. We expect our investments to continue to consist primarily of securities issued by privately-held companies, the fair value of which is not readily determinable. In addition, we are not permitted to maintain a general reserve for anticipated loan losses. Instead, we are required by the 1940 Act to specifically value each investment and record an unrealized appreciation or depreciation for any asset that we believe has increased or decreased in value. There is no single standard for determining fair value in good faith. We value these securities at fair value as determined in good faith by our Board of Directors, based on the recommendations of our Board of Directors’ Valuation Committee. The Valuation Committee utilizes its best judgment in arriving at the fair value of these securities. 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 the types of investments we make. However, the Board of Directors retains ultimate authority as to the appropriate valuation of each investment. Because such valuations are

 

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inherently uncertain and may be based on estimates, our determinations of fair value may differ materially from the values that would be assessed if a ready market for these securities existed. We adjust quarterly the valuation of our portfolio to reflect the Board of Directors’ determination of the fair value of each investment in our portfolio. Any changes in fair value are recorded in our statement of operations as net change in unrealized appreciation or depreciation. Our net asset value could be adversely affected if our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon the disposal of such securities.

 

Beginning in the quarter ended March 31, 2008, we adopted the provisions of Statement No. 157, Fair Value Measurements, on a prospective basis. Adoption of this statement did not have a material effect on our consolidated financial statements for the first quarter of 2008. However, the impact on our consolidated financial statements in the periods subsequent to the period of adoption cannot be determined at this time as it will be influenced by the estimates of fair value for those periods, the number and amount of investments we originate, acquire or exit and the effect of any additional guidance or any changes in the interpretation of this statement. See Note 1 to our Consolidated Financial Statements.

 

Our financial results could be negatively affected if a significant portfolio investment fails to perform as expected.

 

Our total investment in companies may be significant individually or in the aggregate. As a result, if a significant investment in one or more companies fails to perform as expected, our financial results could be more negatively affected and the magnitude of the loss could be more significant than if we had made smaller investments in more companies. There were no investments with a fair value greater than 5% of net assets at March 31, 2008.

 

Regulations governing our operations as a business development company affect our ability to, and the manner in which, we raise additional capital, which may expose us to risks.

 

Our business will require a substantial amount of capital. We may acquire additional capital from the issuance of senior securities, including borrowings, securitization transactions or other indebtedness, or the issuance of additional shares of our common stock. However, we may not be able to raise additional capital in the future on favorable terms or at all. We may issue debt securities, other evidences of indebtedness or preferred stock, and we may borrow money from banks or other financial institutions, which we refer to collectively as “senior securities,” up to the maximum amount permitted by the 1940 Act. The 1940 Act permits us to issue senior securities in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after each issuance of senior securities. Our ability to pay dividends or issue additional senior securities would be restricted if our asset coverage ratio were not at least 200%. If the value of our assets declines, we may be unable to satisfy this test. If that happens, we may be required to liquidate a portion of our investments and repay a portion of our indebtedness at a time when such sales may be disadvantageous. As a result of issuing senior securities, we would also be exposed to typical risks associated with leverage, including an increased risk of loss. If we issue preferred stock, the preferred stock would rank “senior” to common stock in our capital structure, preferred stockholders would have separate voting rights and might have rights, preferences, or privileges more favorable than those of our common stockholders and the issuance of preferred stock could have the effect of delaying, deferring, or preventing a transaction or a change of control that might involve a premium price for holders of our common stock or otherwise be in your best interest.

 

To the extent that we are constrained in our ability to issue debt or other senior securities, we will depend on issuances of common stock to finance operations. Other than in certain limited situations such as rights offerings, as a business development company, we are generally not able to issue our common stock at a price below net asset value without first obtaining required approvals from our stockholders and our independent directors. We have received such approval from our independent directors and received stockholder approval at our Annual Meeting on May 29, 2008. See “Determination of Net Asset Value.” If we raise additional funds by issuing more

 

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common stock or senior securities convertible into, or exchangeable for, our common stock, then the percentage ownership of our stockholders at that time will decrease, and you might experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on favorable terms or at all.

 

In addition to issuing securities to raise capital as described above, we anticipate that, in the future, we may securitize our loans to generate cash for funding new investments. An inability to successfully securitize our loan portfolio could limit our ability to grow our business and fully execute our business strategy.

 

When we are a debt or minority equity investor in a portfolio company, we may not be in a position to control the entity, and management of the company may make decisions that could decrease the value of our portfolio holdings.

 

We make both debt and minority equity investments; therefore, we are subject to the risk that a portfolio company may make business decisions with which we disagree, and the stockholders and management of such company may take risks or otherwise act in ways that do not serve our interests. As a result, a portfolio company may make decisions that could decrease the value of our portfolio holdings.

 

If we do not invest a sufficient portion of our assets in qualifying assets, we could fail to qualify as a business development company or be precluded from investing according to our current business strategy.

 

As a business development company, we may not acquire any assets other than “qualifying assets” unless, at the time of and after giving effect to such acquisition, at least 70% of our total assets are qualifying assets. See “Regulation.”

 

We believe that most of the senior and mezzanine loans we make will constitute qualifying assets. However, we may be precluded from investing in what we believe are attractive investments if such investments are not qualifying assets for purposes of the 1940 Act. If we do not invest a sufficient portion of our assets in qualifying assets, we could lose our status as a business development company, which would have a material adverse effect on our business, financial condition and results of operations. Similarly, these rules could prevent us from making follow-on investments in existing portfolio companies (which could result in the dilution of our position) or could require us to dispose of investments at inappropriate times in order to comply with the 1940 Act. If we need to dispose of such investments quickly, it would be difficult to dispose of such investments on favorable terms. For example, we may have difficulty in finding a buyer and, even if we do find a buyer, we may have to sell the investments at a substantial loss.

 

We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income.

 

In accordance with generally accepted accounting principles and tax requirements, we include in income certain amounts that we have not yet received in cash, such as contracted payment-in-kind interest, which represents contractual interest added to a loan balance and due at the end of such loan’s term. In addition to the cash yields received on our loans, in some instances, certain loans may also include any of the following:

end-of-term payments, exit fees, balloon payment fees or prepayment fees (“other deferred payments”). We must include in taxable income each year a portion of contracted payment-in-kind interest or other deferred payments that accrues over the life of the obligations as original issue discount or other income accrual even though we may not have received any cash payment during the year of accrual. Any warrants that we receive in connection with our debt investments will generally be valued as part of the negotiation process with the particular portfolio company. As a result, a portion of the aggregate purchase price for the debt investments and warrants will be allocated to the warrants that we receive. This will generally result in the associated debt investments being treated as issued with original issue discount for tax purposes. A portion of such original issue discount must be accrued and included in our taxable income each year over the life of the debt investment even though we may

 

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not receive any cash payment with respect to such income in the year of accrual. We also may be required to include in income certain other amounts that we will not receive in cash.

 

Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the year of accrual, we may be required to distribute such income to our stockholders in order to satisfy the annual distribution requirements applicable to RICs even though we may not have received any corresponding cash amount with respect to such income. As a result, we may have difficulty meeting the annual distribution requirements necessary to maintain our status as RIC unless we are able to obtain cash from other sources. Accordingly, we may have to, among other things, sell some of our investments at times and/or at prices we would not consider advantageous, raise additional debt or equity capital or forgo new investment opportunities in order to make the necessary distributions. If we are not able to obtain cash from other sources in order to make the necessary distributions, we may fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax on all of our income. See “Certain United States Federal Income Tax Considerations—Taxation as a Regulated Investment Company.”

 

There is a risk that you may not receive distributions or that our distributions may not grow over time.

 

We intend to make distributions on a quarterly basis to our stockholders. We cannot assure you that we will achieve investment results, or our business may not perform in a manner that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. In addition, due to the asset coverage test applicable to us as a business development company, we may be limited in our ability to make distributions. Also, our credit facility limits our ability to declare dividends if we default under certain provisions.

 

If we are unable to manage our future growth effectively, we may be unable to achieve our investment objective, which could adversely affect our financial condition and results of operations and cause the value of your investment to decline.

 

Our ability to achieve our investment objective will depend on our ability to sustain growth. Sustaining growth will depend, in turn, on our senior management team’s ability to identify, evaluate, finance and invest in suitable companies that meet our investment criteria. Accomplishing this result on a cost-effective basis is largely a function of our marketing capabilities, our management of the investment process, our ability to provide efficient services and our access to financing sources on acceptable terms. Failure to manage our future growth effectively could have a material adverse effect on our business, financial condition and results of operations.

 

Our quarterly and annual operating results are subject to fluctuation as a result of the nature of our business, and if we fail to achieve our investment objective, the net asset value of our common stock may decline.

 

We could experience fluctuations in our quarterly and annual operating results due to a number of factors, some of which are beyond our control, including, but not limited to, the interest rate payable on the debt securities that we acquire, the default rate on such securities, the level of our expenses, variations in investment origination volume, variations in fee income earned, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.

 

In addition, any of these factors could negatively impact our ability to achieve our investment objectives, which may cause our net asset value of our common stock to decline.

 

Fluctuations in interest rates may adversely affect our profitability.

 

A portion of our income will depend upon the difference between the rate at which we borrow funds and the interest rate on the debt securities in which we invest. Because we will borrow money to make investments, our

 

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net investment income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. Typically, we anticipate that our interest-earning investments will accrue and pay interest at fixed rates, and that our interest-bearing liabilities will accrue interest at variable rates. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. We anticipate using a combination of equity and long-term and short-term borrowings to finance our investment activities.

 

A significant increase in market interest rates could harm our ability to attract new portfolio companies and originate new loans and investments. We expect that a significant percentage of our initial investments in debt securities will be at fixed rates. However, in the event that we make investments in debt securities at variable rates, a significant increase in market interest rates could also result in an increase in our non-performing assets and a decrease in the value of our portfolio because our floating-rate loan portfolio companies may be unable to meet higher payment obligations. In periods of rising interest rates, our cost of funds would increase, resulting in a decrease in our net investment income. In addition, a decrease in interest rates may reduce net income, because new investments may be made at lower rates despite the increased demand for our capital that the decrease in interest rates may produce. We may, but will not be required to, hedge against the risk of adverse movement in interest rates in our short-term and long-term borrowings relative to our portfolio of assets. If we engage in hedging activities, it may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition, and results of operations.

 

If we are unable to continue to borrow money in order to leverage our equity capital, then our ability to make new investments and to execute our business plan will be impaired.

 

As of May 28, 2008, we had outstanding borrowings of $180.0 million under the Credit Facility and SBA debenture and $82.2 available borrowing capacity under these facilities. There can be no assurance that we will be successful in obtaining any additional debt capital on terms acceptable to us or at all. If we are unable to obtain debt capital, then our equity investors will not benefit from the potential for increased returns on equity resulting from leverage to the extent that our investment strategy is successful.

 

In addition, the terms of available financing may place limits on our financial and operating flexibility. If we are unable to obtain sufficient capital in the future, we may:

 

   

be forced to reduce our operations;

 

   

not be able to expand or acquire complementary businesses; and

 

   

not be able to develop new services or otherwise respond to changing business conditions or competitive pressures.

 

It is likely that the terms of any long-term or revolving credit or warehouse facility we may enter into in the future could constrain our ability to grow our business.

 

On May 7, 2008, the Company renewed its Credit Facility with Citigroup and Deutsche Bank providing for a borrowing capacity of $135 million and extending the expiration date to October 31, 2008. See Note 12 to our consolidated financial statements. We expect to enter into additional revolving credit or warehouse facilities in the future. While there can be no assurance that we will be able to borrow from banks or other financial institutions, we expect that we will, at some time in the future, obtain a long-term or revolving credit facility or a warehouse facility. The current lenders have, and any future lender or lenders will have fixed dollar claims on our assets that are senior to the claims of our stockholders and, thus, will have a preference over our stockholders with respect to our assets. In addition, we may grant a security interest in our assets in connection with any such borrowing. We expect such a facility to contain customary default provisions such as a minimum net worth amount, a profitability test, and a restriction on changing our business and loan quality standards. An event of

 

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default under any credit facility would likely result, among other things, in termination of the availability of further funds under that facility and an accelerated maturity date for all amounts outstanding under the facility, which would likely disrupt our business and, potentially, the business of the portfolio companies whose loans that we financed through the facility. This could reduce our revenues and, by delaying any cash payment allowed to us under our facility until the lender has been paid in full, reduce our liquidity and cash flow and impair our ability to grow our business and maintain our status as a RIC.

 

Our cost of borrowing is increased by the warrant participation agreement we have with one of our lenders. In addition, our realized gains are reduced by amounts paid pursuant to the warrant participation agreement.

 

Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants collateralized under the Credit Facility. Pursuant to the warrant participation agreement, we granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants are included in collateral subsequent to the Credit Facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equals $3,750,000 (the “Maximum Participation Limit”). The obligations under the warrant participation agreement continue even after the Credit Facility is terminated until the Maximum Participation Limit has been reached.

 

During the year ended December 31, 2007, we reduced our realized gain by approximately $400,000 for Citigroup’s participation in the gain on sale of an equity security and we recorded an additional liability and reduced our unrealized appreciation by a net amount of approximately $609,000 for Citigroup’s participation in unrealized appreciation in the warrant portfolio. During the three months ended March 31, 2008 we recorded an additional liability and reduced our unrealized appreciation by approximately $399,000 for Citigroup’s participation in unrealized appreciation in the warrant portfolio. Since inception of the agreement, we have paid Citigroup approximately $680,000 under the warrant participation agreement thereby reducing our realized gains. In addition, our realized gains will be reduced by the amounts owed to Citigroup under the warrant participation agreement. The value of Citigroup’s participation right on unrealized appreciation in the related equity investments since inception of the agreement was approximately $1.1 million at March 31, 2008 and is included in accrued liabilities and reduces the unrealized appreciation recognized by us at March 31, 2008. Citigroup’s rights under the warrant participation agreement increase our cost of borrowing and reduce our realized gains.

 

If we are unable to satisfy Code requirements for qualification as a RIC, then we will be subject to corporate-level income tax, which would adversely affect our results of operations and financial condition.

 

We elected to be treated as a RIC for federal income tax purposes with the filing of our federal corporate income tax return for 2006. We will not qualify for the tax treatment allowable to RICs if we are unable to comply with the source of income, diversification and distribution requirements contained in Subchapter M of the Code, or if we fail to maintain our election to be regulated as a business development company under the 1940 Act. If we fail to qualify for the federal income tax benefits allowable to RICs for any reason and remain or become subject to a corporate-level income tax, the resulting taxes could substantially reduce our net assets, the amount of income available for distribution to our stockholders and the actual amount of our distributions. Such a failure would have a material adverse effect on us, the net asset value of our common stock and the total return, if any, obtainable from your investment in our common stock. Any net operating losses that we incur in periods during which we qualify as a RIC will not offset net capital gains (i.e., net realized long-term capital gains in excess of net realized short-term capital losses) that we are otherwise required to distribute, and we cannot pass such net operating losses through to our stockholders. In addition, net operating losses that we carry over to a taxable year in which we qualify as a RIC normally cannot offset ordinary income or capital gains.

 

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One of our wholly-owned subsidiaries is licensed by the U.S. Small Business Administration, and as a result, we will be subject to SBA regulations.

 

Our wholly-owned subsidiary HT II is licensed to act as an SBIC and is regulated by the SBA. Under current SBA regulations, a licensed SBIC can provide capital to those entities that have a tangible net worth not exceeding $18.0 million and an average annual net income after Federal income taxes not exceeding $6.0 million for the two most recent fiscal years. In addition, a licensed SBIC must devote 20.0% of its investment activity to those entities that have a tangible net worth not exceeding $6.0 million and an average annual net income after Federal income taxes not exceeding $2.0 million for the two most recent fiscal years. The SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on factors such as the number of employees and gross sales. The SBA regulations permit licensed SBICs to make long term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services. The SBA also places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBA requirements may cause HT II to forego attractive investment opportunities that are not permitted under SBA regulations.

 

Further, the SBA regulations require that a licensed SBIC be periodically examined and audited by the SBA to determine its compliance with the relevant SBA regulations. The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10.0% or more of a class of capital stock of a licensed SBIC. If HT II fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit HT II’s use of debentures, declare outstanding debentures immediately due and payable, and/or limit HT II from making new investments. Such actions by the SBA would, in turn, negatively affect us because HT II is our wholly owned subsidiary.

 

Changes in laws or regulations governing our business could negatively affect the profitability of our operations.

 

Changes in the laws or regulations, or the interpretations of the laws and regulations, which govern business development companies, small business investment companies, RICs or non-depository commercial lenders could significantly affect our operations and our cost of doing business. We are subject to federal, state and local laws and regulations and are subject to judicial and administrative decisions that affect our operations, including our loan originations, maximum interest rates, fees and other charges, disclosures to portfolio companies, the terms of secured transactions, collection and foreclosure procedures, and other trade practices. If these laws, regulations or decisions change, or if we expand our business into jurisdictions that have adopted more stringent requirements than those in which we currently conduct business, then we may have to incur significant expenses in order to comply or we may have to restrict our operations. In addition, if we do not comply with applicable laws, regulations and decisions, then we may lose licenses needed for the conduct of our business and be subject to civil fines and criminal penalties, any of which could have a material adverse effect upon our business results of operations or financial condition.

 

Current market conditions have impacted debt and equity capital markets in the United States.

 

The debt and equity capital markets in the United States have been impacted by significant write-offs in the financial services sector relating to subprime mortgages and the re-pricing of credit risk in the broadly syndicated market, among other things. These events, along with the deterioration of the housing market, have led to worsening general economic conditions, which have impacted the broader financial and credit markets and have reduced the availability of debt and equity capital for the market as a whole and financial firms in particular. We and other commercial finance companies have previously utilized the securitization market to finance some investment activities. Due to the current dislocation of the securitization market, which we believe may continue for an extended period of time, we and other companies in the commercial finance sector may have to access

 

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alternative debt markets in order to grow. The debt capital that will be available may be at a higher cost, and terms and conditions may be less favorable which could negatively effect our financial performance and results.

 

We may currently be in a period of capital markets disruption and slowing economic growth or recession.

 

We believe that in 2007 and into 2008, the U.S. capital markets entered into a period of disruption as evidenced by increasing spreads between the yields realized on riskier debt securities and those realized on risk-free securities and a lack of liquidity in parts of the debt capital markets. We believe the United States and other countries may also be in a period of slowing economic growth or a recession. This period may increase the probability that these risks could negatively impact us.

 

Any unrealized losses we experience on our investment portfolio may be an indication of future realized losses, which could reduce our income available for distribution.

 

As a BDC, we are required to carry our investments at market value or, if no market value is ascertainable, at fair value as determined in good faith by or under the direction of our Board of Directors. Decreases in the market values or fair values of our investments will be recorded as unrealized depreciation. Any unrealized losses in our investment portfolio could be an indication of a portfolio company’s inability to meet its repayment obligations to us with respect to the affected investments. This could result in realized losses in the future and ultimately in reductions of our income available for distribution in future periods.

 

Results may fluctuate and may not be indicative of future performance.

 

Our operating results may fluctuate and, therefore, you should not rely on current or historical period results to be indicative of our performance in future reporting periods. Factors that could cause operating results to fluctuate include, but are not limited to, variations in the investment origination volume and fee income earned, changes in the accrual status of our loans and debt securities, variations in timing of prepayments, variations in and the timing of the recognition of net realized gains or losses and changes in unrealized appreciation or depreciation, the level of our expenses, the degree to which we encounter competition in our markets, and general economic conditions.

 

Risks Related to Our Investments

 

Our investments are concentrated in a limited number of technology-related companies, which subjects us to the risk of significant loss if any of these companies default on their obligations under any of their debt securities that we hold, or if any of the technology-related industry sectors experience a downturn.

 

We have invested and intend to continue investing in a limited number of technology-related companies. A consequence of this limited number of investments is that the aggregate returns we realize may be significantly adversely affected if a small number of investments perform poorly or if we need to write down the value of any one investment. Beyond the asset diversification requirements to which we will be subject as a RIC, we do not have fixed guidelines for diversification or limitations on the size of our investments in any one portfolio company and our investments could be concentrated in relatively few issuers. In addition, we have invested in and intend to continue investing, under normal circumstances, at least 80% of the value of our total assets (including the amount of any borrowings for investment purposes) in technology-related and life-science companies. As a result, a downturn in technology-related and life-science industry sectors could materially adversely affect us.

 

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Our investments may be concentrated in portfolio companies that may have limited operating histories and financial resources.

 

We expect that our portfolio will continue to consist of investments that may have relatively limited operating histories. These companies may be particularly vulnerable to economic downturns, may have more limited access to capital and higher funding costs, may have a weaker financial position and may need more capital to expand or compete. These businesses also may experience substantial variations in operating results. They may face intense competition, including from companies with greater financial, technical and marketing resources. Furthermore, some of these companies do business in regulated industries and could be affected by changes in government regulation. Accordingly, these factors could impair their cash flow or result in other events, such as bankruptcy, which could limit their ability to repay their obligations to us, and may adversely affect the return on, or the recovery of, our investment in these companies. We cannot assure you that any of our investments in our portfolio companies will be successful. Our portfolio companies compete with larger, established companies with greater access to, and resources for, further development in these new technologies. We may lose our entire investment in any or all of our portfolio companies.

 

Our investment strategy focuses on technology-related and life-science companies, which are subject to many risks, including volatility, intense competition, shortened product life cycles and periodic downturns, and you could lose all or part of your investment.

 

We have invested and will continue investing primarily in technology-related and life-science companies, many of which may have narrow product lines and small market shares, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as to general economic downturns. The revenues, income (or losses), and valuations of technology-related and life-science companies can and often do fluctuate suddenly and dramatically. In addition, technology-related markets are generally characterized by abrupt business cycles and intense competition. Beginning in mid-2000, there was substantial excess production capacity and a significant slowdown in many technology-related industries. This overcapacity, together with a cyclical economic downturn, resulted in substantial decreases in the market capitalization of many technology-related and life-science companies. While such valuations have recovered to some extent, such decreases in market capitalization may occur again, and any future decreases in technology-related and life-science company valuations may be substantial and may not be temporary in nature. Therefore, our portfolio companies may face considerably more risk of loss than do companies in other industry sectors.

 

Because of rapid technological change, the average selling prices of products and some services provided by technology-related and life-science companies have historically decreased over their productive lives. As a result, the average selling prices of products and services offered by technology-related and life-science companies may decrease over time, which could adversely affect their operating results, their ability to meet obligations under their debt securities and the value of their equity securities. This could, in turn, materially adversely affect our business, financial condition and results of operations.

 

We have invested in and may continue investing in technology-related and life-science companies that do not have venture capital or private equity firms as equity investors, and these companies may entail a higher risk of loss than do companies with institutional equity investors, which could increase the risk of loss of your investment.

 

Our portfolio companies will often require substantial additional equity financing to satisfy their continuing working capital and other cash requirements and, in most instances, to service the interest and principal payments on our investment. Portfolio companies that do not have venture capital or private equity investors may be unable to raise any additional capital to satisfy their obligations or to raise sufficient additional capital to reach the next stage of development. Portfolio companies that do not have venture capital or private equity investors may be less financially sophisticated and may not have access to independent members to serve on their boards, which means that they may be less successful than portfolio companies sponsored by venture capital or private equity

 

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firms. Accordingly, financing these types of companies may entail a higher risk of loss than would financing companies that are sponsored by venture capital or private equity firms.

 

Economic recessions or downturns could impair the ability of our portfolio companies to repay loans, which, in turn, could increase our non-performing assets, decrease the value of our portfolio, reduce our volume of new loans and harm our operating results, which might have an adverse effect on our results of operations.

 

Many of our portfolio companies may be susceptible to economic slowdowns or recessions and may be unable to repay our loans during such periods. Therefore, our non-performing assets are likely to increase and the value of our portfolio is likely to decrease during such periods. Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments. Economic slowdowns or recessions could lead to financial losses in our portfolio and a decrease in revenues, net income and assets. Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us.

 

A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of the portfolio company’s loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize the portfolio company’s ability to meet its obligations under the debt securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company. In addition, if a portfolio company goes bankrupt, even though we may have structured our investment as senior debt or secured debt, depending on the facts and circumstances, including the extent to which we actually provided significant “managerial assistance,” if any, to that portfolio company, a bankruptcy court might re-characterize our debt holding and subordinate all or a portion of our claim to that of other creditors. These events could harm our financial condition and operating results.

 

We do not control our portfolio companies. These portfolio companies may face intense competition, including competition from companies with greater financial resources, more extensive research and development, manufacturing, marketing and service capabilities and greater number of qualified and experienced managerial and technical personnel. They may need additional financing which they are unable to secure and which we are unable or unwilling to provide, or they may be subject to adverse developments unrelated to the technologies they acquire.

 

The inability of our portfolio companies to commercialize their technologies or create or develop commercially viable products or businesses would have a negative impact on our investment returns.

 

The possibility that our portfolio companies will not be able to commercialize their technology, products or business concepts presents significant risks to the value of our investment. Additionally, although some of our portfolio companies may already have a commercially successful product or product line when we invest, technology-related and life-science products and services often have a more limited market- or life-span than have products in other industries. Thus, the ultimate success of these companies often depends on their ability to continually innovate, or raise additional capital, in increasingly competitive markets. Their inability to do so could affect our investment return. In addition, the intellectual property held by our portfolio companies often represents a substantial portion of the collateral, if any, securing our investments. We cannot assure you that any of our portfolio companies will successfully acquire or develop any new technologies, or that the intellectual property the companies currently hold will remain viable. Even if our portfolio companies are able to develop commercially viable products, the market for new products and services is highly competitive and rapidly changing. Neither our portfolio companies nor we have any control over the pace of technology development. Commercial success is difficult to predict, and the marketing efforts of our portfolio companies may not be successful.

 

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An investment strategy focused primarily on privately-held companies presents certain challenges, including the lack of available information about these companies, a dependence on the talents and efforts of only a few key portfolio company personnel and a greater vulnerability to economic downturns.

 

We invest primarily in privately-held companies. Generally, very little public information exists about these companies, and we are required to rely on the ability of our management team to obtain adequate information to evaluate the potential returns from investing in these companies. If we are unable to uncover all material information about these companies, then we may not make a fully informed investment decision, and we may not receive the expected return on our investment or lose some or all of the money invested in these companies. Also, privately-held companies frequently have less diverse product lines and a smaller market presence than do larger competitors. Privately-held companies are, thus, generally more vulnerable to economic downturns and may experience more substantial variations in operating results than do larger competitors. These factors could affect our investment returns.

 

In addition, our success depends, in large part, upon the abilities of the key management personnel of our portfolio companies, who are responsible for the day-to-day operations of our portfolio companies. Competition for qualified personnel is intense at any stage of a company’s development, and high turnover of personnel is common in technology-related companies. The loss of one or more key managers can hinder or delay a company’s implementation of its business plan and harm its financial condition. Our portfolio companies may not be able to attract and retain qualified managers and personnel. Any inability to do so may negatively impact our investment returns.

 

If our portfolio companies are unable to protect their intellectual property rights, then our business and prospects could be harmed. If our portfolio companies are required to devote significant resources to protecting their intellectual property rights, then the value of our investment could be reduced.

 

Our future success and competitive position depend in part upon the ability of our portfolio companies to obtain and maintain proprietary technology used in their products and services, which will often represent a significant portion of the collateral, if any, securing our investment. The portfolio companies will rely, in part, on patent, trade secret and trademark law to protect that technology, but competitors may misappropriate their intellectual property, and disputes as to ownership of intellectual property may arise. Portfolio companies may, from time to time, be required to institute litigation in order to enforce their patents, copyrights or other intellectual property rights, to protect their trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. Such litigation could result in substantial costs and diversion of resources. Similarly, if a portfolio company is found to infringe upon or misappropriate a third party’s patent or other proprietary rights, that portfolio company could be required to pay damages to such third party, alter its own products or processes, obtain a license from the third party and/or cease activities utilizing such proprietary rights, including making or selling products utilizing such proprietary rights. Any of the foregoing events could negatively affect both the portfolio company’s ability to service our debt investment and the value of any related debt and equity securities that we own, as well as any collateral securing our investment.

 

We may not be able to realize our entire investment on equipment-based loans in the case of default.

 

We may, from time to time, provide loans that will be collateralized only by equipment of the portfolio company. If the portfolio company defaults on the loan our sole recourse would be to take possession of the underlying equipment to satisfy the outstanding debt. The residual value of the equipment at the time we would take possession may not be sufficient to satisfy the outstanding debt and we could experience a loss on the disposition of the equipment.

 

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Our investments in foreign securities may involve significant risks in addition to the risks inherent in U.S. investments.

 

Our investment strategy contemplates that a portion of our investments may be in securities of foreign companies. Investing in foreign companies may expose us to additional risks not typically associated with investing in U.S. companies. These risks include changes in exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the U.S., higher transaction costs, less government supervision of exchanges, brokers and issuers, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility.

 

Some of our portfolio companies may need additional capital, which may not be readily available.

 

Our portfolio companies will often require substantial additional equity financing to satisfy their continuing working capital and other requirements, and in most instances to service the interest and principal payments on our investment. Each round of venture financing is typically intended to provide a company with only enough capital to reach the next stage of development. We cannot predict the circumstances or market conditions under which our portfolio companies will seek additional capital. It is possible that one or more of our portfolio companies will not be able to raise additional financing or may be able to do so only at a price or on terms unfavorable to us, either of which would negatively impact our investment returns. Some of these companies may be unable to obtain sufficient financing from private investors, public capital markets or traditional lenders. Accordingly, financing these types of companies may entail a higher risk of loss than would financing companies that are able to utilize traditional credit sources.

 

We may be unable or decide not to make additional cash investments in our portfolio companies which could result in our losing our initial investment if the portfolio company fails.

 

We may have to make additional cash investments in our portfolio companies to protect our overall investment value in the particular company. We retain the discretion to make any additional investments as our management determines. The failure to make such additional investments may jeopardize the continued viability of a portfolio company, and our initial (and subsequent) investments. Moreover, additional investments may limit the number of companies in which we can make initial investments. In determining whether to make an additional investment our management will exercise its business judgment and apply criteria similar to those used when making the initial investment. We cannot assure you that we will have sufficient funds to make any necessary additional investments, which could adversely affect our success and result in the loss of a substantial portion or all of our investment in a portfolio company.

 

If our investments do not meet our performance expectations, you may not receive distributions.

 

We intend to make distributions on a quarterly basis to our stockholders. We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, due to the asset coverage test applicable to us as a business development company, we may be limited in our ability to make distributions. See “Regulation.” Also, restrictions and provisions in any future credit facilities may limit our ability to make distributions. As a RIC, if we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including failure to obtain, or possible loss of, the federal income tax benefits allowable to RICs. See “Certain United States Federal Income Tax Considerations—Taxation as a Regulated Investment Company.” We cannot assure you that you will receive distributions at a particular level or at all.

 

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Any unrealized depreciation that we experience on our loan portfolio may be an indication of future realized losses, which could reduce our income available for distribution.

 

As a business development company, we are required to carry our investments at market value or, if no market value is ascertainable, at the fair value as determined in good faith by our Board of Directors in accordance with procedures approved by our Board of Directors. Decreases in the market values or fair values of our investments will be recorded as unrealized depreciation. Any unrealized depreciation in our loan portfolio could be an indication of a portfolio company’s inability to meet its repayment obligations to us with respect to the affected loans. This could result in realized losses in the future and ultimately in reductions of our income available for distribution in future periods.

 

The lack of liquidity in our investments may adversely affect our business and, if we need to sell any of our investments, we may not be able to do so at a favorable price. As a result, we may suffer losses.

 

We generally invest in debt securities with maturities of two to seven years, with an expected average term of three years and hold such investments until maturity, and we do not expect that our related holdings of equity securities will provide us with liquidity opportunities in the near-term. We invest and expect to continue investing in companies whose securities have no established trading market and whose securities are and will be subject to legal and other restrictions on resale or whose securities are and will be less liquid than are publicly-traded securities. The illiquidity of these investments may make it difficult for us to sell these investments when desired. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we had previously recorded these investments. As a result, we do not expect to achieve liquidity in our investments in the near-term. However, to maintain our qualification as a business development company and as a RIC, we may have to dispose of investments if we do not satisfy one or more of the applicable criteria under the respective regulatory frameworks. Our investments are usually subject to contractual or legal restrictions on resale, or are otherwise illiquid, because there is usually no established trading market for such investments. The illiquidity of most of our investments may make it difficult for us to dispose of the investments at a favorable price and, as a result, we may suffer losses.

 

If the assets securing the loans that we make decrease in value, then we may lack sufficient collateral to cover losses.

 

We believe that our portfolio companies generally will be able to repay our loans from their available capital, from future capital-raising transactions, or from cash flow from operations. However, to attempt to mitigate credit risks, we will typically take a security interest in the available assets of these portfolio companies, including the equity interests of their subsidiaries and, in some cases, the equity interests of our portfolio companies held by their stockholders. In many cases, our loans will include a period of interest-only payments. There is a risk that the collateral securing our loans may decrease in value over time, may be difficult to sell in a timely manner, may be difficult to appraise and may fluctuate in value based upon the success of the business and market conditions, including as a result of the inability of a portfolio company to raise additional capital. In some circumstances, our lien could be subordinated to claims of other creditors. Additionally, a deterioration in a portfolio company’s financial condition and prospects, including its inability to raise additional capital, may be accompanied by a deterioration in the value of the collateral for the loan. Moreover, in the case of some of our structured mezzanine debt, we may not have a first lien position on the collateral. Consequently, the fact that a loan is secured does not guarantee that we will receive principal and interest payments according to the loan’s terms, or that we will be able to collect on the loan should we be forced to enforce our remedies. In addition, because we invest in technology-related companies, a substantial portion of the assets securing our investment may be in the form of intellectual property, if any, inventory and equipment and, to a lesser extent, cash and accounts receivable. Intellectual property, if any, that is securing our loan could lose value if, among other things, the company’s rights to the intellectual property are challenged or if the company’s license to the intellectual property is revoked or expires. Inventory may not be adequate to secure our loan if our valuation of the inventory at the time that we made the loan was not accurate or if there is a reduction in the demand for the inventory.

 

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Similarly, any equipment securing our loan may not provide us with the anticipated security if there are changes in technology or advances in new equipment that render the particular equipment obsolete or of limited value, or if the company fails to adequately maintain or repair the equipment. Any one or more of the preceding factors could materially impair our ability to recover principal in a foreclosure.

 

Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.

 

We invest primarily in debt securities issued by our portfolio companies. In some cases, portfolio companies will be permitted to have other debt that ranks equally with, or senior to, the debt securities in which we invest. Such debt instruments may provide that the holders thereof are entitled to receive payment of interest or principal on or before the dates on which we are entitled to receive payments in respect of the debt securities in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution in respect of our investment. After repaying such senior creditors, such portfolio company might not have any remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with debt securities in which we invest, we would have to share on a pari passu basis any distributions with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy. In addition, we would not be in a position to control any portfolio company by investing in its debt securities. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such companies, as representatives of the holders of their common equity, may take risks or otherwise act in ways that do not best serve our interests as debt investors.

 

Our equity investments are highly speculative, and we may not realize gains from these investments. If our equity investments do not generate gains, then the return on our invested capital will be lower than it would otherwise be, which could result in a decline in the value of shares of our common stock.

 

When we invest in debt securities, we generally expect to acquire warrants or other equity securities as well. Our goal is ultimately to dispose of these equity interests and realize gains upon disposition of such interests. We cannot predict or control the timing of liquidity events of our portfolio companies. Over time, the gains that we realize on these equity interests may offset, to some extent, losses that we experience on defaults under debt securities that we hold. However, the equity interests that we receive may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses that we experience.

 

We do not control any of our portfolio companies and therefore our portfolio companies may make decisions with which we disagree.

 

We do not control any of our portfolio companies, even though we may have board observation rights and our debt agreements may contain certain restrictive covenants. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such company, as representatives of the holders of their common equity, may take risks or otherwise act in ways that do not serve our interests as debt investors.

 

Prepayments of our debt investments by our portfolio companies could adversely impact our results of operations and reduce our return on equity.

 

We are subject to the risk that the investments we make in our portfolio companies may be repaid prior to maturity. When this occurs, we will generally reinvest these proceeds in temporary investments, pending their future investment in new portfolio companies. These temporary investments will typically have substantially lower yields than the debt being prepaid and we could experience significant delays in reinvesting these amounts.

 

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Any future investment in a new portfolio company may also be at lower yields than the debt that was repaid. As a result, our results of operations could be materially adversely affected if one or more of our portfolio companies elects to prepay amounts owed to us. Additionally, prepayments could negatively impact our return on equity, which could result in a decline in the market price of our common stock.

 

We may not realize gains from our equity investments.

 

When we invest in debt securities, we generally expect to acquire warrants or other equity securities as well. However, the equity interests we receive may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience.

 

Our financial results could be negatively affected if we are unable to recover our principal investment as a result of a negative pledge on the intellectual property of our portfolio companies.

 

In some cases, we collateralize our investments by obtaining a first priority security interest in a portfolio companies’ assets, which may include their intellectual property. In other cases, we may obtain a first priority security interest in a portion of a portfolio company’s assets and a negative pledge covering a company’s intellectual property and a first priority security interest in the proceeds from such intellectual property. In the case of a negative pledge, the portfolio company cannot encumber or pledge their intellectual property without our permission. In the event of a default on a loan, the intellectual property of the portfolio company will most likely be liquidated to provide proceeds to pay the creditors of the company. As a result, a negative pledge may affect our ability to fully recover our principal investment. In addition, there can be no assurance that our security interest in the proceeds of the intellectual property will be enforceable in a court of law or bankruptcy court.

 

At March 31, 2008, approximately 33 portfolio company loans were secured by a first priority security in all of the assets of the portfolio company, 43 portfolio company loans were prohibited from pledging or encumbering their intellectual property and one portfolio company was secured by a second lien position.

 

We may choose to waive or defer enforcement of covenants in the debt securities held in our portfolio, which may cause us to lose all or part of our investment in these companies.

 

We structure the debt investments in our portfolio companies to include business and financial covenants placing affirmative and negative obligations on the operation of the company’s business and its financial condition. However, from time to time we may elect to waive breaches of these covenants, including our right to payment, or waive or defer enforcement of remedies, such as acceleration of obligations or foreclosure on collateral, depending upon the financial condition and prospects of the particular portfolio company. These actions may reduce the likelihood of our receiving the full amount of future payments of interest or principal and be accompanied by a deterioration in the value of the underlying collateral as many of these companies may have limited financial resources, may be unable to meet future obligations and may go bankrupt. This could negatively impact our ability to pay dividends and cause the loss of all or part of your investment.

 

Risks Related to an Offering of Our Shares

 

Our common stock price may be volatile and may decrease substantially.

 

The trading price of our common stock following an offering may fluctuate substantially. The price of the common stock that will prevail in the market after an offering may be higher or lower than the price you paid and the liquidity of our common stock may be limited, in each case depending on many factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include, but are not limited to, the following:

 

   

price and volume fluctuations in the overall stock market from time to time;

 

 

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significant volatility in the market price and trading volume of securities of RICs, business development companies or other financial services companies;

 

   

any inability to deploy or invest our capital;

 

   

fluctuations in interest rates;

 

   

any shortfall in revenue or net income or any increase in losses from levels expected by investors or securities analysts;

 

   

operating performance of companies comparable to us;

 

   

changes in regulatory policies or tax guidelines with respect to RICs or business development companies;

 

   

losing RIC status;

 

   

actual or anticipated changes in our earnings or fluctuations in our operating results, or changes in the expectations of securities analysts;

 

   

changes in the value of our portfolio of investments;

 

   

realized losses in investments in our portfolio companies;

 

   

general economic conditions and trends;

 

   

loss of a major funding source; or

 

   

departures of key personnel.

 

In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been brought against that company. Due to the potential volatility of our stock price, we may be the target of securities litigation in the future. Securities litigation could result in substantial costs and could divert management’s attention and resources from our business.

 

We may be unable to invest the net proceeds raised from an offering on acceptable terms, which would harm our financial condition and operating results.

 

Until we identify investments for our portfolio, we intend to invest the net proceeds from an offering in cash, cash equivalents, U.S. government securities or high-quality debt securities. We cannot assure you that we will be able to complete investments that meet our investment criteria or that any investment we complete using the proceeds from an offering will produce a sufficient return. Moreover, because we may not have identified all investments at the time of an offering, we will have broad authority to invest the net proceeds of an offering. We will not receive any proceeds from an offering by the selling holders.

 

Investing in shares of our common stock may involve an above average degree of risk.

 

The investments we make in accordance with our investment objective may result in a higher amount of risk, volatility or loss of principal than alternative investment options. Our investments in portfolio companies may be highly speculative and aggressive, and therefore, an investment in our common stock may not be suitable for investors with lower risk tolerance.

 

We cannot assure you that the market price of our common stock will not decline.

 

We cannot predict the price at which our common stock will trade. Shares of closed-end investment companies have in the past frequently traded at discounts to their net asset values and our stock may also be discounted in the market. This characteristic of closed-end investment companies is separate and distinct from the risk that our net asset value per share may decline. We cannot predict whether shares of our common stock

 

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will trade above, at or below our net asset value. See “Price Range of Common Stock and Distributions.” The risk of loss associated with this characteristic of closed-end investment companies may be greater for investors expecting to sell shares of common stock purchased in this offering soon after the offering. In addition, if our common stock trades below its net asset value, we will generally not be able to issue additional shares of our common stock at its market price without first obtaining the approval for such issuance from our stockholders and our independent directors. We have received such approval from our independent directors and received stockholder approval at our Annual Meeting on May 29, 2008. See “Determination of Net Asset Value.”

 

Provisions of the Maryland General Corporation Law, and of our charter and bylaws, could deter takeover attempts and have an adverse impact on the price of our common stock.

 

The Maryland General Corporation Law and our charter and bylaws contain provisions that may have the effect of discouraging, delaying, or making difficult a change in control of our company or the removal of our incumbent directors. We will be covered by the Business Combination Act of the Maryland General Corporation Law to the extent that such statute is not superseded by applicable requirements of the 1940 Act. However, our Board of Directors has adopted a resolution exempting from the Business Combination Act any business combination between us and any person to the extent that such business combination receives the prior approval of our board, including a majority of our directors who are not interested persons as defined in the 1940 Act. Our Board of Directors has already adopted a resolution exempting from the Business Combination Act any business combination between us and certain investment funds managed by JMP Asset Management, LLC and certain investment funds managed by Farallon Capital Management, L.L.C., and we have agreed with such investment funds that we will not alter or repeal such board resolution prior to the date that is two years after such investment funds cease to own at least 10% of our outstanding common stock in a manner that would make the Business Combination Act applicable to acquisitions of our stock by such investment funds without the written consent of such investment funds. In addition, our bylaws contain a provision exempting from the Control Share Acquisition Act any and all acquisitions by any person of shares of our stock. We have agreed with certain investment funds managed by JMP Asset Management, LLC and certain investment funds managed by Farallon Capital Management, L.L.C. that we will not repeal or amend such provision of our bylaws in a manner that would make the Control Share Acquisition Act applicable to acquisitions of our stock by such investment funds without the written consent of such investment funds prior to the date that is two years after such investment funds cease to own at least 10% of our outstanding common stock. If the applicable board resolution is repealed following such period of time or if our board does not otherwise approve a business combination, the Business Combination Act and the Control Share Acquisition Act (if we amend our bylaws to be subject to that Act) may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer.

 

Under our charter, our Board of Directors is divided into three classes serving staggered terms, which will make it more difficult for a hostile bidder to acquire control of us. In addition, our Board of Directors may, without stockholder action, authorize the issuance of shares of stock in one or more classes or series, including preferred stock. See “Description of Capital Stock.” Subject to compliance with the 1940 Act, our Board of Directors may, without stockholder action, amend our charter to increase the number of shares of stock of any class or series that we have authority to issue. The existence of these provisions, among others, may have a negative impact on the price of our common stock and may discourage third party bids for ownership of our company. These provisions may prevent any premiums being offered to you for shares of our common stock.

 

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FORWARD-LOOKING STATEMENTS; MARKET DATA

 

The matters discussed in this prospectus, as well as in future oral and written statements by management of Hercules Technology Growth Capital, that are forward-looking statements are based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. Important assumptions include our ability to originate new investments, achieve certain margins and levels of profitability, the availability of additional capital, and the ability to maintain certain debt to asset ratios. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this prospectus should not be regarded as a representation by us that our plans or objectives will be achieved. The forward-looking statements contained in this prospectus include statements as to:

 

   

our future operating results;

 

   

our business prospects and the prospects of our prospective portfolio companies;

 

   

the impact of investments that we expect to make;

 

   

our informal relationships with third parties;

 

   

the dependence of our future success on the general economy and its impact on the industries in which we invest;

 

   

the ability of our portfolio companies to achieve their objectives;

 

   

our expected financings and investments;

 

   

our regulatory structure and tax status;

 

   

our ability to operate as a business development company and a RIC;

 

   

the adequacy of our cash resources and working capital; and

 

   

the timing of cash flows, if any, from the operations of our portfolio companies.

 

For a discussion of factors that could cause our actual results to differ from forward-looking statements contained in this prospectus, please see the discussion under “Risk Factors.” You should not place undue reliance on these forward-looking statements. The forward-looking statements made in this prospectus relate only to events as of the date on which the statements are made.

 

This prospectus contains third-party estimates and data regarding valuations of venture capital-backed companies. This data was reported by Dow Jones VentureOne, an independent venture capital industry research company which we refer to as VentureOne. VentureOne is commonly relied upon as an information source in the venture capital industry. Although we have not independently verified any such data, we believe that the industry information contained in such releases and data tables and included in this prospectus is reliable.

 

We have compiled certain industry estimates presented in this prospectus from internally generated information and data. While we believe our estimates are reliable, they have not been verified by any independent sources. The estimates are based on a number of assumptions, including increasing investment in venture capital and private equity-backed companies. Actual results may differ from projections and estimates, and this market may not grow at the rates projected, or at all. If this market fails to grow at projected rates, our business and the market price of our common stock could be materially adversely affected.

 

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USE OF PROCEEDS

 

We intend to use the net proceeds from selling shares of common stock for general corporate purposes, which include investing in debt and equity securities, repayment of indebtedness and other general corporate purposes. The supplement to this prospectus relating to an offering will more fully identify the use of proceeds from such offering. We will not receive any proceeds from the sale of common stock by the selling stockholders.

 

We anticipate that substantially all of the net proceeds from any offering of our shares of common stock will be used as described above within twelve months, but in no event longer than two years. Pending such uses and investments, we will invest the net proceeds primarily in cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment. Our ability to achieve our investment objective may be limited to the extent that the net proceeds of any offering, pending full investment, are held in lower yielding short-term instruments.

 

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PRICE RANGE OF COMMON STOCK AND DISTRIBUTIONS

 

Our common stock is traded on the Nasdaq Global Select Market under the symbol “HTGC.” We completed the initial public offer of our common stock in June 2005 at a price of $13.00 per share. Prior to such date, there was no public market for our common stock.

 

The following table sets forth the range of high and low sales prices of our common stock as reported on the Nasdaq Global Select Market and the dividends declared by us for each fiscal quarter since our initial public offer. The stock quotations are interdealer quotations and do not include markups, markdowns or commissions.

 

          Price Range    Premium/
Discount
of High Sales
Price to NAV
    Premium/
Discount
of Low Sales
Price to NAV
    Cash
Dividend
per Share(2)
     NAV(1)    High(3)    Low(3)       

2005

               

Second quarter (June 9, 2005 through June 30, 2005)

   $ 11.55    $ 13.19    $ 12.45    114.2 %   107.8 %     —  

Third quarter

   $ 11.71    $ 14.41    $ 11.90    123.1 %   101.6 %   $ 0.025

Fourth quarter

   $ 11.67    $ 12.68    $ 9.71    108.7 %   83.2 %   $ 0.300

2006

               

First quarter

   $ 11.63    $ 11.99    $ 10.50    103.1 %   90.3 %   $ 0.300

Second quarter

   $ 11.24    $ 12.53    $ 10.88    111.5 %   96.8 %   $ 0.300

Third quarter

   $ 11.06    $ 12.90    $ 11.11    116.6 %   100.5 %   $ 0.300

Fourth quarter

   $ 11.65    $ 14.25    $ 12.50    122.3 %   107.3 %   $ 0.300

2007

               

First quarter

   $ 11.68    $ 14.50    $ 12.77    124.1 %   109.3 %   $ 0.300

Second quarter

   $ 12.05    $ 14.71    $ 12.80    122.1 %   106.2 %   $ 0.300

Third quarter

   $ 11.97    $ 14.02    $ 11.32    117.1 %   94.6 %   $ 0.300

Fourth quarter

   $ 12.31    $ 13.60    $ 10.87    110.5 %   88.3 %   $ 0.300

2008

               

First quarter

     12.28    $ 12.75    $ 9.59    103.8 %   78.1 %   $ 0.340

Second quarter

     *    $ 11.32    $ 9.96    *     *       —  

 

(1) Net asset value per share is generally determined as of the last day in the relevant quarter and therefore may not reflect the net asset value per share on the date of the high and low sales prices. The net asset values shown are based on outstanding shares at the end of each period.
(2) Represents the dividend declared in the specified quarter. As of the date of this prospectus, no dividend has been declared for the first quarter of 2008.

(3)

The high and low price for the second quarter of 2008 reflects the period from April 1 to May 30 of 2008.

 * Net asset value has not yet been calculated for this period.

 

The last reported price for our common stock on May 30, 2008 was $10.37 per share.

 

Shares of business development companies may trade at a market price that is less than the value of the net assets attributable to those shares. The possibility that our shares of common stock will trade at a discount from net asset value or at premiums that are unsustainable over the long term are separate and distinct from the risk that our net asset value will decrease. At times, our shares of common stock have traded at a premium to net asset value and at times our shares of common stock have traded at a discount to the net assets attributable to those shares. It is not possible to predict whether the shares offered hereby will trade at, above, or below net asset value.

 

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Dividends

 

The following table summarizes our dividends declared and paid on all shares, including restricted stock, to date:

 

Date Declared

   Record Date    Payment Date    Amount Per Share

October 27, 2005

   November 1, 2005    November 17, 2005    $ 0.025

December 9, 2005

   January 6, 2006    January 27, 2006      0.300

April 3, 2006

   April 10, 2006    May 5, 2006      0.300

July 19, 2006

   July 31, 2006    August 28, 2006      0.300

October 16, 2006

   November 6, 2006    December 1, 2006      0.300

February 7, 2007

   February 19, 2007    March 19, 2007      0.300

May 3, 2007

   May 16, 2007    June 18, 2007      0.300

August 2, 2007

   August 16, 2007    September 17, 2007      0.300

November 1, 2007

   November 16, 2007    December 17, 2007      0.300

February 7, 2008

   February 15, 2008    March 17, 2008      0.300

May 8, 2008

   May 16, 2008    June 16, 2008      0.340
            
         $ 3.065
            

 

Distributions in excess of our current and accumulated earnings and profits would be treated first as a return of capital to the extent of the stockholder’s tax basis, and any remaining distributions would be treated as a capital gain. The determination of the tax attributes of our distributions is made annually as of the end of our fiscal year based upon its taxable income for the full year and distributions paid for the full year, therefore a determination made on a quarterly basis may not be representative of the actual tax attributes of our distributions for a full year. If the company had determined the attributes of its distributions year-to-date as of March 31, 2008, approximately $0.30 or 100% would be from ordinary income and earnings spilled over from 2007, however there can be no certainty to shareholders that this determination is representative of what the tax attributes of its 2008 distributions to shareholders will actually be. During 2007, we distributed $1.20 per share to our shareholders of which 100% was deemed to be a distribution of income and is considered ordinary income to our shareholders in 2007.

 

We intend to distribute quarterly dividends to our stockholders. In order to avoid certain excise taxes imposed on RICs, we currently intend to distribute during each calendar year an amount at least equal to the sum of (1) 98% of our ordinary income for the calendar year, (2) 98% of our capital gains in excess of capital losses for the one year period ending on October 31 of the calendar year, and (3) any ordinary income and net capital gains for the preceding year that were not distributed during such year. We will not be subject to excise taxes on amounts on which we are required to pay corporate income tax (such as retained net capital gains). In order to obtain the tax benefits applicable to RICs, we will be required to distribute to our stockholders with respect to each taxable year at least 90% of our ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses.

 

We currently intend to retain for investment some or all of our net capital gains (that is, the excess of our realized net long-term capital gains over our realized net short-term capital losses) and to make deemed distributions to our stockholders of any retained net capital gains. If this happens, you will be treated as if you received an actual distribution of the capital gains we retain and then reinvested the net after-tax proceeds in our common stock. You also may be eligible to claim a tax credit (or, in certain circumstances, a tax refund) equal to your allocable share of the tax we paid on the capital gains deemed distributed to you. Please refer to “Certain United States Federal Income Tax Considerations” for further information regarding the consequences of our retention of net capital gains. To the extent that we do not retain all of our net capital gains, we will make actual distributions to our stockholders of such gains.

 

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We can offer no assurance that we will achieve results that will permit the payment of any cash distributions and, if we issue senior securities, we will be prohibited from making distributions if doing so causes us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or if distributions are limited by the terms of any of our borrowings. See “Regulation.”

 

We maintain an “opt-out” dividend reinvestment plan for our common stockholders. As a result, if we declare a dividend, cash dividends will be automatically reinvested in additional shares of our common stock unless the stockholder specifically “opts out” of the dividend reinvestment plan and chooses to receive cash dividends. See “Dividend Reinvestment Plan.”

 

Our ability to make distributions will be limited by the asset coverage requirements under the 1940 Act. For a more detailed discussion, see “Regulation.”

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with our consolidated financial statements and related notes and other financial information appearing elsewhere in this report. In addition to historical information, the following discussion and other parts of this report contain forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated by such forward-looking information due to the factors discussed under “Risk Factors” and “Forward-Looking Statements; Market Data” appearing elsewhere herein.

 

Overview

 

We are a specialty finance company that provides debt and equity growth capital to technology-related and life-science companies at all stages of development from seed and emerging growth to expansion and established stages of development. We primarily finance privately-held companies backed by leading venture capital and private equity firms, and may also finance select publicly listed companies and lower middle market companies. As of March 31, 2008, over 300 different venture capital firms sponsor our portfolio companies.

 

Our principal office is located in the Silicon Valley and we have additional offices in the Boston, Boulder, Chicago, Columbus and San Diego areas. Our goal is to be the leading structured mezzanine capital provider of choice for venture capital and private equity backed technology-related companies requiring sophisticated and customized financing solutions. Our strategy is to evaluate and invest in a broad range of companies active in the technology and life science industries and to offer a full suite of growth capital products up and down the capital structure. We invest primarily in structured mezzanine debt and, to a lesser extent, in senior debt and equity investments. We use the term “structured mezzanine debt investment” to refer to any debt investment, such as a senior or subordinated secured loan, that is coupled with an equity component, including warrants, options or rights to purchase common or preferred stock. Our structured mezzanine debt investments will typically be secured by some or all of the assets of the portfolio company.

 

Our investment objective is to maximize our portfolio total return by generating current income from our debt investments and capital appreciation from our equity-related investments. We are an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company under the 1940 Act. As a business development company, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in “qualifying assets,” including securities of private U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less.

 

From incorporation through December 31, 2005, we were taxed as a corporation under Subchapter C of the Code. We are treated for federal income tax purposes as a RIC under Subchapter M of the Code as of January 1, 2006. To qualify for the benefits allowable to a RIC, we must, among other things, meet certain source-of-income and asset diversification and income distribution requirements. Pursuant to this election, we generally will not have to pay corporate-level taxes on any income that we distribute to our stockholders. However, such an election and qualification to be treated as a RIC requires that we comply with certain requirements contained in Subchapter M of the Code. For example, a RIC must meet certain requirements, including source-of-income, asset diversification and income distribution requirements. The income source requirement mandates that we receive 90% or more of our income from qualified earnings, typically referred to as “good income.” Qualified earnings may exclude such income as management fees received in connection with our SBIC or other potential outside managed funds and certain other fees.

 

Our portfolio is comprised of, and we anticipate that our portfolio will continue to be comprised of, investments primarily in technology-related companies at various stages of their development. Consistent with

 

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regulatory requirements, we invest primarily in United States based companies and to a lesser extent in foreign companies. During 2007, our investing emphasis has been primarily on private companies following or in connection with a subsequent institutional round of equity financing, which we refer to as expansion-stage companies and private companies in later rounds of financing and certain public companies, which we refer to as established-stage companies. We have also historically focused our investment activities in private companies following or in connection with the first institutional round of financing, which we refer to as emerging-growth companies.

 

Portfolio and Investment Activity

 

As of March 31, 2008 our total assets were approximately $548.9 million. The total value of our investment portfolio was approximately $520.8 million at cost and $530.8 million at fair value at March 31, 2008, as compared to $519.5 million at cost and $530.0 million at fair value at December 31, 2007. Our investments at fair value were comprised of our debt investments, warrant portfolio and equity investments valued at approximately $479.9 million, $24.4 million and $26.5 million, respectively, or 87.4%, 4.4% and 4.8% of total assets, respectively. Our total investments at value in foreign companies were approximately $29.3 million or 5.3% of total assets at March 31, 2008. During the three months ended March 31, 2008, we made debt commitments to five portfolio companies totaling $65 million and funded approximately $49.1 million to 12 companies. We also made an equity commitment of $250,000 to one portfolio company and made equity investments in two portfolio companies totaling $700,000 during the three months ended March 31, 2008, bringing total equity investments at fair value to approximately $26.5 million at March 31, 2008. The fair value of our warrant portfolio at March 31, 2008 and 2007, was $24.4 million and $10.5 million respectively. At March 31, 2008, we had unfunded contractual commitments of $128.4 million to 24 portfolio companies. In addition, we executed non-binding term sheets with 11 prospective portfolio companies, representing approximately $90.3 million in proposed future commitments.

 

We receive payments in our loan portfolio based on scheduled amortization of the outstanding balances. In addition, we receive repayments of some of our loans prior to their scheduled maturity date. The frequency or volume of these repayments may fluctuate significantly from period to period. During the three month period ending March 31, 2008, we received normal principal repayments of $21 million, and early repayments and working line of credit paydowns totaling $27.9 million. Total portfolio investment activity (exclusive of unearned income) as of the three month period ended March 31, 2008 was as follows:

 

(in millions)    March 31,
2008
 

Beginning Portfolio

   $ 530.0  

Purchase of investments

     49.1  

Equity Investments

     0.7  

Principal payments received on investments

     (21.0 )

Early pay-offs and recoveries

     (27.9 )

Proceeds from sale of investments

     (3.7 )

Accretion of loan discounts and paid-in-kind principal

     1.2  

Net realized and unrealized change in investments

     2.4  
        

Ending Portfolio

   $ 530.8  
        

 

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The following table shows the fair value of our portfolio of investments by asset class as of March 31, 2008 and December 31, 2007 (excluding unearned income):

 

     March 31, 2008     December 31, 2007  
(in thousands)    Investments at Fair
Value
   Percentage of Total
Portfolio
    Investments at Fair
Value
   Percentage of Total
Portfolio
 

Senior debt with warrants

   $ 432,037    81.4 %   $ 429,760    81.1 %

Senior debt

     59,700    11.2 %     61,483    11.6 %

Preferred stock

     24,546    4.6 %     23,265    4.4 %

Senior debt-second lien with warrants

     12,057    2.3 %     12,078    2.3 %

Common Stock

     2,000    0.4 %     2,938    0.5 %

Subordinated debt with warrants

     422    0.1 %     448    0.1 %
                          
   $ 530,763    100.0 %   $ 529,972    100.0 %
                          

 

A summary of the company’s investment portfolio at value by geographic location is as follows:

 

     March 31, 2008     December 31, 2007  
(in thousands)    Investments at Fair
Value
   Percentage of Total
Portfolio
    Investments at Fair
Value
   Percentage of Total
Portfolio
 

United States

   $ 501,439    94.5 %   $ 512,724    96.8 %

Canada

     15,950    3.0 %     15,001    2.8 %

Israel

     13,374    2.5 %     2,247    0.4 %
                          
   $ 530,763    100.0 %   $ 529,972    100.0 %
                          

 

Our portfolio companies are primarily privately held expansion-and established-stage companies in the biopharmaceutical, communications and networking, consumer and business products, electronics and computers, energy, information services, internet consumer and business services, medical devices, semiconductor and software industry sectors. These sectors are characterized by high margins, high growth rates, consolidation and product and market extension opportunities. Value is often vested in intangible assets and intellectual property.

 

The largest companies vary from year to year as new loans are recorded and loans pay off. Loan revenue, consisting of interest, fees, and recognition of gains on equity interests, can fluctuate dramatically when a loan is paid off or a related equity interest is sold. Revenue recognition in any given year can be highly concentrated among several portfolio companies. For the quarter ended March 31, 2008 and the year ended December 31, 2007, our ten largest portfolio companies represented approximately 33.1% and 33.7% of the total fair value of our investments, respectively. At March 31, 2008 and December 31, 2007, we had five and three investments, respectively, that represented 5% or more of the fair value of our investments. At March 31, 2008, we had five equity investments representing approximately 50.0% of the total fair value of our equity investments, and each represented 5% or more of the total fair value of such investments. At December 31, 2007, we had five equity investments which represented 50% of the total fair value of its equity investments, and each represented 5% or more of the total fair value of such investments.

 

At March 31, 2008, we had investments in two portfolio companies deemed to be Affiliates. One investment is a non-income producing equity investment and one portfolio company became an Affiliate on December 17, 2007 upon a restructure of the company. Income derived from these investments was less than $38,000 since these investments became Affiliates. At March 31, 2007, none of the Company’s investments were deemed to be Affiliates. No realized gains or losses related to Affiliates were recognized during the three-month period ended March 31, 2008 or 2007.

 

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The following table shows the fair value of our portfolio by industry sector at March 31, 2008 and December 31, 2007 (excluding unearned income):

 

     March 31, 2008     December 31, 2007  
(in thousands)    Investments at Fair
Value
   Percentage of Total
Portfolio
    Investments at Fair
Value
   Percentage of Total
Portfolio
 

Communications & networking

   $ 116,477    21.9 %   $ 114,014    21.5 %

Drug discovery

     90,092    17.0 %     95,294    18.0 %

Information services

     65,038    12.3 %     58,464    11.0 %

Electronics & computer hardware

     50,192    9.5 %     50,953    9.6 %

Specialty pharmaceuticals

     43,651    8.2 %     45,646    8.6 %

Software

     34,705    6.5 %     38,963    7.4 %

Semiconductors

     24,214    4.6 %     25,501    4.8 %

Drug delivery

     22,806    4.3 %     22,725    4.3 %

Biotechnology tools

     19,095    3.6 %     9,714    1.8 %

Internet consumer & business services

     17,181    3.2 %     16,918    3.2 %

Therapeutic

     13,572    2.6 %     12,853    2.4 %

Media/Content/Info

     12,132    2.3 %     7,193    1.4 %

Surgical Devices

     7,748    1.5 %     16,821    3.2 %

Energy

     6,573    1.2 %     7,016    1.3 %

Consumer & business products

     5,471    1.0 %     2,817    0.5 %

Diagnostic

     1,816    0.3 %     2,316    0.5 %

Advanced Specialty Materials & Chemicals

     —      0.0 %     2,764    0.5 %
                          
   $ 530,763    100.0 %   $ 529,972    100.0 %
                          

 

We use an investment grading system, which grades each debt investment on a scale of 1 to 5, to characterize and monitor our expected level of risk on the debt investments in our portfolio with 1 being the highest quality. The following table shows the distribution of our outstanding debt investments on the 1 to 5 investment grading scale at fair value as of March 31, 2008 and December 31, 2007:

 

     March 31, 2008     December 31, 2007  
(in thousands)    Investments at Fair
Value
   Percentage of Total
Portfolio
    Investments at Fair
Value
   Percentage of Total
Portfolio
 
Investment Grading           

1

   $ 18,657    3.9 %   $ 27,678    5.7 %

2

     353,955    73.7       341,598    70.9  

3

     98,698    20.6       103,380    21.4  

4

     8,547    1.8       9,467    2.0  

5

     —      —         —      —    
                          
   $ 479,257    100.00 %   $
 
 
482,123
   100.00 %
                          

 

As of March 31, 2008, our investments had a weighted average investment grading of 2.21 as compared to 2.20 at December 31, 2007. Our policy is to reduce the grading on our portfolio companies as they approach the point in time when they will require additional equity capital. Additionally, we may downgrade our portfolio companies if they are not meeting our financing criteria and their respective business plans. Various companies in our portfolio will require additional funding in the near term or have not met their business plans and have therefore been downgraded until their funding is complete or their operations improve. At March 31, 2008,

 

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19 portfolio companies were graded 3 and three portfolio companies were graded 4, as compared to 15 and three portfolio companies, respectively, at December 31, 2007.

 

We target total returns on our debt investments, including warrant gains, of between 20% and 35%, and target an annual investment yield on debt investments ranging from 11% to 15%, excluding warrants. The effective yield on our debt investments during the year was 12.8% and was attributed in part to interest charges and fees related to loan restructurings and acceleration of fee income recognition from early loan repayments. The overall weighted average yield to maturity of our loan obligations was approximately 12.64% at March 31, 2008, decreased slightly compared to 12.7% at December 31, 2007, attributed to increased investments to both expansion- and established-stage companies and asset based financing offered to more mature companies seeking revolver type financing solutions. The weighted average yield to maturity is computed using the interest rates in effect at the inception of each of the loans, and includes amortization of the loan facility fees, commitment fees and market premiums or discounts over the expected life of the debt investments, weighted by their respective costs when averaged and based on the assumption that all contractual loan commitments have been fully funded and held to maturity.

 

We generate revenue in the form of interest income, primarily from our investments in debt securities, and commitment and facility fees. Fees generated in connection with our debt investments are recognized over the life of the loan or, in some cases, recognized as earned. In addition, we generate revenue in the form of capital gains, if any, on warrants or other equity-related securities that we acquire from our portfolio companies. Our investments generally range from $1.0 million to $30.0 million, with an average initial principal balance of between $1.0 million and $15.0 million. We typically charge our portfolio companies facility fees ranging between 0.5% and 2.5% of committed capital. Our debt investments have a term of between two and seven years and typically bear interest at a rate ranging from Prime rate to 14.0% (based on current interest rate conditions). In addition to the cash yields received on our loans, in some instances, our loans may also include any of the following: end-of-term payments, exit fees, balloon payment fees, PIK provisions, prepayment fees, and diligence fees, which may be required to be included in income prior to receipt. Back-end fees charged are generally up to 10% of the committed capital amount of a loan.

 

With our debt investments, we typically secure the right to co-invest in the next equity financing round of our portfolio companies. In most cases, we collateralize our investments by obtaining security interests in our portfolio companies’ assets, which may include their intellectual property. In other cases, we may obtain a negative pledge covering a company’s intellectual property. At March 31, 2008, approximately 33 portfolio company loans were secured by a first priority security in all of the assets of the portfolio company, 43 portfolio company loans were prohibited from pledging or encumbering their intellectual property and one portfolio company was secured by a second lien position. Interest on debt securities is generally payable monthly, with amortization of principal typically occurring over the term of the security for emerging-growth, expansion-stage and established-stage companies. In addition, certain loans may include an interest-only period ranging from three to eighteen months for emerging-growth and expansion-stage companies and longer for established-stage companies. In limited instances in which we choose to defer amortization of the loan for a period of time from the date of the initial investment, the principal amount of the debt securities and any accrued but unpaid interest become due at the maturity date.

 

Our mezzanine debt investments also generally have equity enhancement features, typically in the form of warrants or other equity-related securities designed to provide us with an opportunity for capital appreciation. As of March 31, 2008, we have received warrants in connection with the majority of our debt investments in each portfolio company, and have realized gains on 12 warrant positions since inception. During the three-month period ended March 31, 2008, we realized gains of approximately $3.1 million from the sale of common stock of one advanced specialty materials and chemicals company and approximately $400,000 from the acquisition of one software company and one medical device and equipment company. We recognized realized losses in the first quarter of 2008 of approximately $566,000 on the acquisition of one semiconductor company.

 

Our warrant coverage generally ranges from 3% to 20% of the principal amount invested in a portfolio company, with a strike price equal to the most recent equity financing round. We currently hold warrants in

 

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83 portfolio companies, with a fair value of approximately $24.4 million included in the investment portfolio of $530.8 million. The fair value of the warrant portfolio has increased by $13.8 million or 131% as compared to the fair value of $10.5 million at March 31, 2008. These warrant holdings would allow us to invest approximately $51.8 million if such warrants are exercised. However, these warrants may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our warrant interests.

 

Results of Operations

 

Comparison of the Three Months Ended March 31, 2008 and 2007

 

Operating Income

 

Interest income totaled approximately $14.2 million for the three-month period ended March 31, 2008, compared with $9.0 million for the three month period ended March 31, 2007. Income from commitment, facility and loan related fees totaled approximately $1.4 million and $643,000 for the three-month periods ended March 31, 2008 and 2007, respectively. The increases in interest income and income from commitment, facility and loan related fees are the result of higher average loan balances outstanding due to origination activity and yield from the related investments. At March 31, 2008, we had approximately $7.0 million of deferred revenue related to commitment and facility fees, as compared to approximately $4.3 million as of March 31, 2007.

 

Operating Expenses

 

Operating expenses totaled approximately $6.6 million and $4.5 million during the three-month periods ended March 31, 2008 and 2007, respectively. Operating expenses for the three-month periods ended March 31, 2008 and 2007 included interest expense, loan fees and unused commitment fees of approximately $2.2 million and $952,000, respectively. The 135.0% increase in these expenses relates to higher average outstanding debt balance of $139.3 million in the first quarter of 2008 as compared to $38.2 million in the first quarter of 2007 and higher fees for our SBA debenture. Employee compensation and benefits were approximately $2.8 million and $1.9 million during the three-month periods ended March 31, 2008 and 2007, respectively. The increase in compensation expense was primarily attributable to office expansion in new markets, an increase in our headcount from 29 employees at March 31, 2007 to 45 employees at March 31, 2008 and increases in salaries and bonuses from March 31, 2007 to March 31, 2008. General and administrative expenses which include legal and accounting fees, insurance premiums, rent and various other expenses decreased to $1.2 million from $1.3 million during the first quarter of 2007 primarily due to lower compensation expense for our Board of Directors. In addition, we incurred approximately $327,000 of stock-based compensation expense in the first quarter of 2008 as compared to $254,000 in the first quarter of 2007. The increase was due to additional option grants made to employees in the first quarter of 2008.

 

Net Investment Income Before Income Tax Expense and Investment Gains and Losses

 

Net investment income before provision for income tax expense for the three-months ended March 31, 2008 totaled $9.0 million as compared with net investment income before provision for income tax expense in the first quarter of 2007 of approximately $5.2 million. The changes are made up of the items described above under “Operating Income” and “Operating Expenses.”

 

Net Investment Realized Gains and Losses and Unrealized Appreciation and Depreciation

 

Realized gains or losses are measured by the difference between the net proceeds from the repayment or sale and the cost basis of the investment without regard to unrealized appreciation or depreciation previously recognized, and include investments charged off during the period, net of recoveries. Net change in unrealized appreciation or depreciation primarily reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.

 

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During the three-month period ended March 31, 2008, we generated realized gains totaling approximately $3.1 million from the sale of common stock of one advanced specialty materials and chemicals company and approximately $400,000 from the acquisition of one software company and one medical device and equipment company. We recognized realized losses in the first quarter of 2008 of approximately $566,000 on the acquisition of one semiconductor company. During the three-months ended March 31, 2007, we generated a net realized gain totaling approximately $290,000 due to the sale of equity and warrants in one portfolio company. A summary of realized and unrealized gains and losses for the three-month periods ended March 31, 2008 and 2007 is as follows:

 

($ in millions)    March 31, 2008     March 31, 2007

Realized gains

     3.5       0.3

Realized losses

     (0.5 )     —  
              

Net realized gains

   $ 3.0     $ 0.3
              

 

During the three-month period ended March 31, 2008, net unrealized investment depreciation totaled approximately $921,000 and the net unrealized appreciation during the three-month period ended March 31, 2007 was $816,000. The net unrealized appreciation and depreciation of investments is based on portfolio asset valuations determined in good faith by our Board of Directors. During the quarter ended March 31, 2008, we revised the marketability discount we apply to our private company warrants. As a result of the revision to the discounts applied to the warrants we recognized unrealized appreciation of approximately $5.3 million during the quarter. As of March 31, 2008, the net unrealized investment appreciation recognized by the company was reduced by approximately $1.1 million for a warrant participation agreement with Citigroup. For a more detailed discussion, see the discussion set forth under Note 3 to the consolidated financial statements. The following table itemizes the change in net unrealized appreciation (depreciation) of investments for the three-month period ended March 31, 2008:

 

     March 31,
2008
 
($ in thousands)    Companies    Amount  

Gross unrealized appreciation on portfolio investments

   56    $ 5,378  

Gross unrealized depreciation on portfolio investments

   26      (3,798 )

Reversal of prior period net unrealized appreciation upon a realization

        (2,150 )

Citigroup Warrant Participation

        (351 )
           

Net unrealized appreciation/(depreciation) on portfolio investments

      $ (921 )
           

 

We anticipate that we will achieve eight to 10 exit events during 2008. As of March 31, 2008, three portfolio companies have achieved liquidity events.

 

Income and Excise Taxes

 

We account for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, which requires that deferred income taxes be determined based upon the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax law. Valuation allowances are used to reduce deferred tax assets to the amount likely to be realized.

 

We elected to be treated as a RIC under Subchapter M of the Code with the filing of our 2006 federal income tax return. Such election and qualification to be treated as a RIC requires that we comply with certain requirements contained in Subchapter M of the Code. Provided we continue to qualify as a RIC, our income generally will not be subject to federal income or excise taxes to the extent we make the requisite distributions to stockholders.

 

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If we do not distribute at least 98% of our annual taxable income in the year earned, we will generally be required to pay an excise tax equal to 4% of the amount by which 98% of our annual taxable income exceeds the distributions from such taxable income during the year earned. To the extent that we determine that our estimated current year annual taxable income will be in excess of estimated current year dividend distributions from such taxable income, we accrue excise taxes on estimated excess taxable income as taxable income is earned using an annual effective excise tax rate. The annual effective excise tax rate is determined by dividing the estimated annual excise tax by the estimated annual taxable income.

 

At December 31, 2007, we had excess taxable income of $4.2 million available for distribution to shareholders in 2008. Excess taxable income for 2007 represents ordinary income and capital gains.

 

In accordance with regulated investment company distribution rules, we are required to declare current year dividends to be paid from carried over excess taxable income from 2007 before we file our 2007 tax return in September, 2008, and we must pay such dividends by December 31, 2008.

 

Net Increase in Net Assets Resulting from Operations and Earnings Per Share

 

For the three-months ended March 31, 2008, net income totaled approximately $11.0 million compared to net income of approximately $6.3 million for the three-months ended March 31, 2007. These changes are made up of the items previously described.

 

Basic and fully diluted net income per share was $0.34 for the three-months ended March 31, 2008 as compared to a basic and fully diluted income per share of $0.28 and $0.27, respectively, for the three-months ended March 31, 2007.

 

Comparison of periods ended December 31, 2007 and 2006

 

Operating Income

 

Interest income totaled approximately $48.8 million and $26.3 million for 2007 and 2006, respectively. The increase in interest income was directly related to increases in origination activity as net investments at fair value grew by $246.8 million during 2007. In 2007 and 2006, interest income included approximately $1.8 million and $713,000 of income from accrued exit fees. Income from commitment, facility and loan related fees totaled approximately $5.1 million and $3.2 million for 2007 and 2006, respectively. At December 31, 2007 and 2006, we had approximately $6.6 million and $3.5 million of deferred income related to commitment and facility fees, respectively.

 

Operating Expenses

 

Operating expenses totaled approximately $21.4 million and $18.4 million during 2007 and 2006, respectively. Operating expenses for the years ended December 31, 2007 and 2006 included interest expense, loan fees and unused commitment fees of approximately $5.7 million and $6.6 million, respectively. The 13.5% decrease in interest expense was primarily due to a lower average debt balance of $66.3 million in 2007 as compared to $70.7 million in 2006. The weighted average cost of debt was approximately 6.5% at December 31, 2007 as compared to 6.7% at December 31, 2006 which primarily reflects a lower LIBOR rate under our Credit Facility. Employee compensation and benefits were approximately $9.1 million and $5.8 million during 2007 and 2006, respectively. The increase in employee compensation and benefits is due to increased number of employees from 26 to 38 and bonuses of approximately $3.7 million accrued in 2007 as compared to an accrual of $2.2 million in 2006. General and administrative expenses include legal and accounting fees, insurance premiums, rent and various other expenses totaling $5.4 million in both 2007 and 2006. We incurred approximately $1.1 million of stock-based compensation expense in 2007 as compared to $618,000 in 2006 due to additional option grants made in 2007. We anticipate that operating expenses will increase over the next twelve months as we continue to incur higher interest expense on higher average outstanding debt balances, increase the number of our employees to support our growth and incur

 

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additional expenses related to being a public company, including expenses related to continued compliance requirements under the Sarbanes-Oxley Act.

 

Net Investment Income Before Income Tax Expense and Investment Gains and Losses

 

Net investment income before income tax expense for the year ended December 31, 2007 totaled $32.5 million as compared with a net investment income before income tax expense in 2006 of approximately $11.1 million. The changes are made up of the items described above under “Operating Income” and “Operating Expenses.”

 

Net Investment Realized Gains and Losses and Unrealized Appreciation and Depreciation

 

Realized gains or losses are measured by the difference between the net proceeds from the repayment or sale and the cost basis of the investment without regard to unrealized appreciation or depreciation previously recognized, and include investments charged off during the period, net of recoveries. Net change in unrealized appreciation or depreciation primarily reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.

 

In 2007, we generated realized gains totaling approximately $3.6 million from the sale of common stock of two communications and networking companies, two internet consumer and business services companies and three biopharmaceutical companies. We recognized realized losses in 2007 of approximately $800,000 on the disposition of warrants in six portfolio companies. We recognized a realized gain of approximately $3.3 million during the year ended December 31, 2006 from the sale of common stock of one communications and networking company, one internet consumer and business services company and two biopharmaceutical companies. We recognized realized losses in 2006 of approximately $4.9 million on the disposition of loans to two portfolio companies. A summary of realized and unrealized gains and losses for the years end December 31, 2007 and 2006 is as follows:

 

(in millions)    December 31,
2007
    December 31,
2006
 

Realized gains

   $ 3.6     $ 3.3  

Realized losses

     (0.8 )     (4.9 )
                

Net realized gains (losses)

   $ 2.8     $ (1.6 )
                

 

For the years ended December 31, 2007 and 2006, net unrealized investment appreciation totaled approximately $7.3 million and $2.5 million, respectively. The year to year increase is primarily attributable to the increased number of companies in the portfolio. The net unrealized appreciation and depreciation of investments is based on portfolio asset valuations determined in good faith by our Board of Directors. As of December 31, 2007, the net unrealized investment appreciation recognized by the company was reduced by approximately $690,000 for a warrant participation agreement with Citigroup. For a more detailed discussion, see the discussion set forth under “Borrowings” below. The following table itemizes the change in net unrealized appreciation (depreciation) of investments for 2007 and 2006:

 

     2007     2006  
($ in millions)    Companies    Amount     Companies    Amount  

Gross unrealized appreciation on portfolio investments

   59    $ 17.7     11    $ 4.9  

Gross unrealized depreciation on portfolio investments

   25      (9.4 )   41      (1.6 )

Reversal of prior period net unrealized appreciation upon a realization

        (0.3 )        (0.4 )

Citigroup Warrant Participation

        (0.7 )        (0.4 )
                      

Net unrealized appreciation/(depreciation) on portfolio investments

      $ 7.3        $ 2.5  
                      

 

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During 2007, we achieved thirteen liquidity events from our portfolio companies. Ten portfolio companies were acquired and three portfolio companies completed initial public offerings.

 

Income and Excise Taxes

 

We account for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, which requires that deferred income taxes be determined based upon the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax law. Valuation allowances are used to reduce deferred tax assets to the amount likely to be realized.

 

Through December 31, 2005 we were taxed under Subchapter C of the Code. We elected to be treated as a RIC under Subchapter M of the Code with the filing of our 2006 federal income tax return. Provided we continue to qualify as a RIC, our income generally will not be subject to federal income or excise taxes to the extent we make the requisite distributions to stockholders. At December 31, 2007, we elected to pay an excise tax of approximately $139,000 on approximately $4.3 million of undistributed earnings from operations and capital gains that we intend to distribute in 2008. See “Business—Certain United States Federal Income Tax Considerations.”

 

During 2007, we distributed $1.20 per share to our shareholders, of which 100% was deemed to be a distribution of income and is considered ordinary income to our shareholders in 2007.

 

Net Increase in Net Assets Resulting from Operations and Earnings Per Share

 

For the year ended December 31, 2007 net income totaled approximately $42.4 million compared to net income of approximately $11.4 million for the period ended December 31, 2006. These changes are made up of the items previously described.

 

Basic and fully diluted net income per share was $1.50 and $1.49, respectively, for the year ended December 31, 2007, compared to basic net income per share of $0.85 and fully diluted net income per share of $0.84 for the year ended December 31, 2006.

 

Comparison of periods ended December 31, 2006 and 2005

 

Operating Income

 

Interest income totaled approximately $26.3 million and $9.8 million for 2006 and 2005, respectively. In 2006 and 2005, interest income included approximately $713,000 and $351,000 of income from accrued exit fees, respectively. Income from commitment and facility fees totaled approximately $3.2 million and $876,000 for 2006 and 2005, respectively. The increase in both interest and fee income was directly related to increases in origination activity, as net investments at fair value grew by $106.5 million during 2006. At December 31, 2006 and 2005, we had approximately $3.4 million and $2.7 million of deferred income related to commitment and facility fees.

 

Operating Expenses

 

Operating expenses totaled approximately $18.4 million and $9.1 million during 2006 and 2005, respectively. Operating expenses for 2006 and 2005 included interest expense, loan fees and unused commitment fees under our Bridge Loan Credit Facility and the Credit Facility of approximately $6.6 million and $2.9 million, respectively. The increase in interest expense was due to a higher average debt balance of $70.7 million in 2006, as compared to $20.3 million in 2005. Employee compensation and benefits were approximately $5.8 million and $3.7 million during 2006 and 2005, respectively. The increase in employee

 

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compensation and benefits is due to an increased number of employees from 19 to 26, and bonuses of approximately $2.2 million accrued in 2006. General and administrative expenses increased to $5.4 million in 2006 from $2.3 million in 2005 primarily due to increased Board of Directors costs, legal expenses, professional service costs related to our status as a public company and the creation of our SBIC subsidiaries, as well as increased expenses associated with operating a business development company. In addition, we incurred approximately $618,000 of stock-based compensation expense in 2006 as compared to $252,000 in 2005. The increase in stock-based compensation expense was due to the additional stock option grants made in 2006.

 

Net Investment Income Before Income Tax Expense and Investment Gains and Losses

 

Net investment income before income tax expense for the year ended December 31, 2006 totaled $11.1 million as compared with a net investment income before income tax expense in 2005 of approximately $1.5 million. This change is made up of the items described above.

 

Net Investment Gains

 

In 2006, we generated realized gains totaling approximately $3.3 million from the sale of common stock of one communications and networking company, one internet consumer and business services company and two biopharmaceutical companies. We recognized realized losses in 2006 of approximately $4.9 million on the disposition of loans to two portfolio companies. We recognized a realized gain of approximately $482,000 during the year ended December 31, 2005 from the sale of common stock of one biopharmaceutical portfolio company. During 2006, we reversed approximately $162,000 of net unrealized appreciation to realized gains. For the year ended December 31, 2006, net unrealized investment appreciation totaled approximately $2.5 million. The net unrealized appreciation and depreciation of investments is based on portfolio asset valuations determined in good faith by our Board of Directors, based on the recommendations of the Valuation Committee. For the year ended December 31, 2006, we recognized approximately $4.9 million of gross unrealized appreciation on 11 of our portfolio companies and approximately $1.6 million of gross unrealized depreciation on 41 of our portfolio companies. As of December 31, 2006, the net unrealized investment appreciation recognized by the company was reduced by approximately $377,000 for a warrant participation agreement with Citigroup. For a more detailed discussion, see “Borrowings” below.

 

Income Taxes

 

Through December 31, 2005 we were taxed under Subchapter C of the Code and recorded a tax expense of $255,000 for 2005. We elected to be treated as a RIC under Subchapter M of the Code with the filing of our 2006 federal income tax return, which election was effective as of January 1, 2006. Provided we continue to qualify as a RIC, our income generally will not be subject to federal income or excise tax to the extent we make the requisite distributions to stockholders. We have distributed and currently intend to distribute sufficient dividends to eliminate our investment company taxable income for 2006. As such, no provision for Federal or state income taxes related to operations in 2006 was required. At December 31, 2005, the Company had a deferred tax asset of approximately $1,454,000, which was adjusted through operations during the first quarter of 2006. Upon the determination that Hercules would qualify as a regulated investment company, any remaining deferred tax asset was reversed. The Company elected to recognize all of its net built-in gains at the time of the conversion to a RIC and paid tax on the built-in gain with the filing of its 2005 tax return. In making this election, the portfolio was marked to market at the time of the RIC election and the Company paid approximately $294,000 in Federal and State tax on the resulting taxable gain. In addition, upon completion of the 2005 tax returns, we recorded an additional tax benefit of approximately $345,000. To qualify as a RIC we were required by December 31, 2006 to distribute our earnings and profits while we were taxable as a C corporation. During 2006, we distributed $1.20 per share to our shareholders of which approximately $0.09 was deemed to be a distribution of these accumulated earnings and profits, $0.97 was deemed to be a distribution of 2006 income and $0.14 was a return of capital. The distribution of our income and our accumulated earnings and profits is considered ordinary income to our shareholders in 2006.

 

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Net Increase in Net Assets Resulting from Operations and Earnings Per Share

 

For the year ended December 31, 2006 net income totaled approximately $11.4 million, compared to net income of approximately $2.1 million for the period ended December 31, 2005. These changes are made up of the items previously described.

 

Basic net income per share was $0.85 and fully diluted net income per share was $0.84 per share for the year ended December 31, 2006, compared to basic and diluted net income per share of $0.30 per share for the period ended December 31, 2005. The net income per share for 2006 was affected by an increase in the weighted average shares outstanding of approximately 6.4 million shares and 6.5 million shares on a basic and diluted basis, respectively, as compared to 2005.

 

Financial Condition, Liquidity and Capital Resources

 

For the three month period ended March 31, 2008

 

At March 31, 2008, we had approximately $13.8 million in cash and cash equivalents and available borrowing capacity of approximately $177.1 million under our Credit Facility and approximately $57.1 million available under the SBA program, subject to existing terms and advance rates. We primarily invest cash on hand in interest bearing deposit accounts.

 

For the quarter ended March 31, 2008, net cash provided by operating activities totaled approximately $7.4 million as compared to net cash used in operating activities of approximately $54.4 million for the quarter ended March 31, 2007. This change was primarily due to a decrease of approximately $30.4 million in the purchase of investments in our portfolio to $49.8 million offset by $48.9 million of principal payments in the first quarter 2008 as compared $80.2 million used for investment in our portfolio companies offset by $21.9 million in principal repayments in the first quarter of 2007. Cash used in investing activities for the quarter ended March 31, 2008 totaled approximately $247,000 and was primarily used for the purchase of capital equipment. Net cash used in financing activities totaled $1.2 million for the quarter ended March 31, 2008 and was primarily comprised of net borrowings of $8.7 million offset by a cash dividend payment of $9.8 million. In the quarter ended March 31, 2007, we received approximately $13.6 million in net proceeds from the sale of common stock, $72.0 million of net credit facility borrowings and made cash dividend payments of $6.1 million.

 

As of March 31, 2008, net assets totaled $402.4 million, with a net asset value per share of $12.28. We intend to generate additional cash primarily from equity capital, future borrowings as well as cash flows from operations, including income earned from investments in our portfolio companies and, to a lesser extent, from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less. Our primary use of funds will be investments in portfolio companies and cash distributions to holders of our common stock. After we have used our current capital resources, we expect to raise additional capital to support our future growth through future equity offerings, issuances of senior securities and/or future borrowings, to the extent permitted by the 1940 Act. As a result of the exemptive relief we received related to our SBA debt, we are able to exceed the 1:1 leverage ratio required by the 1940 Act. In order to fully leverage the Company, we would need to obtain additional credit. There can be no assurances that we will seek to, or be successful in, leveraging the Company further.

 

As required by the 1940 Act, our asset coverage must be at least 200% after each issuance of senior securities. Our asset coverage as of March 31, 2008 was approximately 748%.

 

We anticipate that we will continue to fund our investment activities through a combination of debt and additional equity capital over the next year. As of March 31, 2008, we had $72.9 million outstanding under the Credit Facility and approximately $70.1 million under the SBA program. As of March 31, 2008, there were $273.5 million of loans in the collateral pool and, based on eligible loans in the pool and existing advance rates, we have access to approximately $61.5 million of borrowing capacity available under our $250.0 million

 

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securitized credit facility. In addition, Citigroup has an equity participation right of 10% of the realized gains on warrants collateralized under the Credit Facility. However, no additional warrants are included in collateral subsequent to the facility amendment on May 2, 2007. See Note 3 to the consolidated financial statements for discussion of the participation right. We anticipate that portfolio fundings entered into in succeeding periods will allow us to utilize the full borrowing capacity of the Credit Facility.

 

At March 31, 2008 and December 31, 2007, we had the following borrowing capacity and outstandings:

 

     March 31, 2008    December 31, 2007
(in thousands)    Facility Amount    Amount
Outstanding
   Facility Amount    Amount
Outstanding

Credit Facility

   $ 250,000    $ 72,900    $ 250,000    $ 79,200

SBA Debenture

     127,200      70,050      127,200      55,050
                           

Total

   $ 377,200    $ 142,950    $ 377,200    $ 134,250
                           

 

On September 27, 2006, HT II received a license to operate as a Small Business Investment Company under the SBIC program and is able to borrow funds from the SBA against eligible previously approved investments and additional contributions to regulatory capital. We have a committment from the SBA permitting us to draw up to $127.2 million from the SBA, subject to certain regulatory requirements. At March 31, 2008, we had a net investment of $63.6 million in HT II, and there are investments in 34 companies with a fair value of approximately $137.5 million. The Company is the sole limited partner of HT II and Hercules Technology SBIC Management, LLC (“HTM”), another wholly-owned subsidiary of the Company, is the general partner of HT II.

 

For the year ended December 31, 2007

 

At December 31, 2007, we had approximately $7.9 million in cash and cash equivalents and available borrowing capacity of approximately $170.8 million under our Credit Facility and approximately $72.1 million available under the SBA program, subject to existing terms and advance rates. We primarily invest cash on hand in interest bearing deposit accounts.

 

For the year ended December 31, 2007, net cash used in operating activities totaled approximately $201.1 million as compared to $91.3 million in 2006. This increase was due primarily due to $368.1 million used for investments in our portfolio companies offset by proceeds of $128.7 million in principal repayments, as compared to $87.5 million in principal repayments offset by $196.0 million used for investments in 2006. Cash used in investing activities for the year ended December 31, 2007 totaled approximately $34,000 and was used for the purchase of capital equipment offset by a reduction in other long-term assets. Net cash provided by financing activities totaled $192.5 million for the year ended December 31, 2007. In 2007, we received approximately $131.4 million in net proceeds from the sale of common stock, and made cash dividend payments of $30.0 million. During the year ended December 31, 2007, we borrowed a net $38.2 million under our Credit Facility and borrowed $55.1 million of SBA debentures.

 

As of December 31, 2007, net assets totaled $400.7 million, with a net asset value per share of $12.31. We intend to generate additional cash primarily from equity capital, future borrowings as well as cash flows from operations, including income earned from investments in our portfolio companies and, to a lesser extent, from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less. Our primary use of funds will be investments in portfolio companies and cash distributions to holders of our common stock. After we have used our current capital resources, we expect to raise additional capital to support our future growth through future equity offerings, issuances of senior securities and/or future borrowings, to the extent permitted by the 1940 Act.

 

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As required by the 1940 Act, our asset coverage must be at least 200% after each issuance of senior securities. Our asset coverage as of December 31, 2007 was approximately 675%.

 

We anticipate that we will continue to fund our investment activities through a combination of debt and additional equity capital over the next year. As of December 31, 2007, we had $79.2 million outstanding under the Credit Facility and approximately $55.1 million under the SBA program. Through March 30, 2007, advances under the Credit Facility carried interest at one-month LIBOR plus 165 basis points. On March 30, 2007, the interest on all borrowings was reduced to LIBOR plus a spread of 1.20%. On May 2, 2007, we amended the Credit Facility to extend the expiration date to May 1, 2008, increased the borrowing capacity under the facility to $250 million, and included Deutsche Bank Securities Inc. as a participant along with Citigroup Markets Realty Corp. The credit facility is a one year facility and is renewable on May 1, 2008 with an interest rate of LIBOR plus a spread of 1.20%. We intend to initiate renewal negotiations on the Credit Facility in the first quarter of 2008. We paid a structuring fee of $375,000 which will be expensed ratably through maturity. As of December 31, 2007, there were $242.8 million of loans in the collateral pool and, based on eligible loans in the pool and existing advance rates, we have access to approximately $131.3 million of borrowing capacity available under our $250.0 million securitized credit facility. In addition, Citigroup has an equity participation right of 10% of the realized gains on warrants collateralized under the Credit Facility. However, no additional warrants are included in collateral subsequent to the facility amendment on May 2, 2007. See Note 3 to the consolidated financial statements for discussion of the participation right. We anticipate that portfolio fundings entered into in succeeding periods will allow us to utilize the full borrowing capacity of the Credit Facility.

 

At December 31, 2007 and December 31, 2006, we had the following borrowing capacity and outstandings:

 

     December 31, 2007    December 31, 2006
($ in thousands)    Facility
Amount
   Amount
Outstanding
   Facility
Amount
   Amount
Outstanding

Credit Facility

   $ 250,000    $ 79,200    $ 150,000    $ 41,000

SBA Debenture

     127,200      55,050      —        —  
                           

Total

   $ 377,200    $ 134,250    $ 150,000    $ 41,000
                           

 

On September 27, 2006, HT II received a license to operate as a Small Business Investment Company under the SBIC program and is able to borrow funds from the SBA against eligible previously approved investments and additional contributions to regulatory capital. On July 31, 2007, we received approval from the SBA to increase our leverage by approximately $77.0 million to a total of $127.2 million, subject to certain regulatory requirements. At December 31, 2007, we had a net investment of $63.6 million in HT II, and there are investments in 30 companies with a fair value of approximately $124.6 million. The Company is the sole limited partner of HT II and HTM is the general partner of HT II.

 

Current Market Conditions

 

The debt and equity capital markets in the United States have been impacted by significant write-offs in the financial services sector relating to subprime mortgages and the re-pricing of credit risk in the broadly syndicated market, among other things. These events, along with the deterioration of the housing market, have led to worsening general economic conditions, which have impacted the broader financial and credit markets and have reduced the availability of debt and equity capital for the market as a whole and financial firms in particular. We and other commercial finance companies have previously utilized the securitization market to finance some investment activities. Due to the current dislocation of the securitization market, which we believe may continue for an extended period of time, we and other companies in the commercial finance sector may have to access alternative debt markets in order to grow. The debt capital that will be available may be at a higher cost, and terms and conditions may be less favorable which could negatively effect our financial performance and results.

 

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Off Balance Sheet Arrangements

 

In the normal course of business, we are party to financial instruments with off-balance sheet risk. These consist primarily of unfunded commitments to extend credit, in the form of loans, to our portfolio companies. Unfunded commitments to provide funds to portfolio companies will not be reflected on our balance sheet. Our unfunded commitments may be significant from time to time. As of March 31, 2008, we had unfunded commitments of approximately $128.4 million. These commitments will be subject to the same underwriting and ongoing portfolio maintenance as are the on-balance sheet financial instruments that we hold. Since these commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.

 

Contractual Obligations

 

The following table shows our contractual obligations as of March 31, 2008:

 

(in thousands)    Payments due by period

Contractual Obligations(1)

   Total    Less than 1 year (2)(3)    1-3 years    4-5 years    After 5 years

Borrowings (4)

   $ 142,950    $ 72,900    $ —      $ —      $ 70,050

Operating Lease Obligations

     3,913      841      2,102      970      —  
                                  

Total

   $ 146,863    $ 73,741    $ 2,102    $ 970    $ 70,050
                                  

 

(1) Excludes commitments to extend credit to our portfolio companies.
(2) Borrowings under our Credit Facility are listed based on the contractual maturity of the facility. Actual repayments could differ significantly due to prepayments by our existing portfolio companies, modifications of our current agreements with our existing portfolio companies and modification of the credit facility.
(3) We also have a warrant participation agreement with Citigroup as discussed below.
(4) Includes borrowings under our Credit Facility and the SBA debentures.

 

Borrowings

 

We, through Hercules Funding Trust I, an affiliated statutory trust, have a Credit Facility with Citigroup Global Markets Realty Corp. and Deutsche Bank Securities Inc. The Credit Facility is a one year facility and is renewable on May 1, 2008 with an interest rate of LIBOR plus a spread of 1.20% and borrowing capacity of $250 million. We intend to initiate renewal negotiations on the Credit Facility in the first quarter of 2008. See Note 12, “Subsequent Events” to our Consolidated Financial Statements included in Item 1. We paid a structuring fee of $375,000 which will be expensed ratably through maturity. At March 31, 2008, we had $72.9 million outstanding under the Credit Facility.

 

The Credit Facility is collateralized by loans from our portfolio companies, and includes an advance rate of approximately 55% of eligible loans. The Credit Facility contains covenants that, among other things, require us to maintain a minimum net worth and to restrict the loans securing the Credit Facility to certain dollar amounts, to concentrations in certain geographic regions and industries, to certain loan grade classifications, to certain security interests, and to certain interest payment terms. Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants collateralized under the Credit Facility. Pursuant to the warrant participation agreement, we granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants are included in collateral subsequent to the facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equals $3,750,000 (the “Maximum Participation Limit”). The Obligations under the warrant participation agreement continue even after the Credit Facility is terminated until the Maximum Participation Limit has been reached. During the three-month period ended March 31, 2008, we recorded an additional liability and reduced the unrealized gains by approximately $399,000 to account for Citigroup’s participation in unrealized gains in the warrant

 

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portfolio. The value of their participation right on unrealized gains in the related equity investments since inception of the agreement was approximately $1.1 million at March 31, 2008 and is included in accrued liabilities and reduces the unrealized gain we recognized at March 31, 2008. Since inception of the agreement, we have paid Citigroup approximately $680,000 under the warrant participation agreement, thereby reducing our realized gains by that amount.

 

At March 31, 2008, we, through our special purpose entity (“SPE”), had transferred pools of loans and warrants with a fair value of approximately $273.5 million to Hercules Funding Trust I and had drawn approximately $72.9 million under the Credit Facility. Transfers of loans have not met the requirements of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, for sales treatment and are, therefore, treated as secured borrowings, with the transferred loans remaining as investments and the related liability recorded in borrowings. The average debt outstanding under the Credit Facility for the quarter ended March 31, 2008 was approximately $77.3 million and the average interest rate was approximately 4.5%, excluding facility fees.

 

On May 7, 2008, we amended and renewed our Credit Facility with Citigroup and Deutsche Bank providing for a borrowing capacity of $135.0 million and extending the expiration date to October 31, 2008. Under the terms of the agreement, we paid a renewal fee of approximately $1.3 million, interest on all borrowings was set at LIBOR plus a spread of 5.0%, and a fee of 2.50% that will be charged on any unused portion of the facility. The Credit Facility is collateralized by loans from our portfolio companies, and includes an advance rate of approximately 45% of eligible loans. The Credit Facility contains covenants that, among other things, require us to maintain a minimum net worth and to restrict the loans securing the Credit Facility to certain dollar amounts, to concentrations in certain geographic regions and industries, to certain loan grade classifications, to certain security interests, and to certain interest payment terms.

 

At March 31, 2008, we had excess capacity of approximately $177.0 million on our $250.0 million line of Credit Facility. As such, we made the decision to decrease the amount of our Credit Facility to mitigate the adverse impact on earnings for the cost related to the renewal and unused fees. We believe our relationships with our existing partners and other credit providers will allow us the flexibility to expand the facility as needed in the short-term.

 

We plan to aggregate pools of funded loans using the Credit Facility or other conduits that we may seek until a sufficiently large pool of funded loans is created which can then be securitized at a later date. We expect that any loans included in a securitization facility may be securitized on a non-recourse basis with respect to the credit losses on the loans. There can be no assurance that we will be able to complete this securitization strategy, or that it will be successful. See Business—Capital Structure.

 

In January 2005, we formed HT II and HTM. HT II is licensed as a SBIC. HT II borrows funds from the SBA against eligible investments and additional deposits to regulatory capital. Under the Small Business Investment Act and current SBA policy applicable to SBICs, an SBIC can have outstanding at any time SBA guaranteed debentures up to twice the amount of its regulatory Capital. As of March 31, 2008, the maximum statutory limit on the dollar amount of outstanding SBA guaranteed debentures issued by a single SBIC is $127.2 million, subject to periodic adjustments by the SBA. With $63.6 million of regulatory capital as of March 31, 2008, HT II has the current capacity to issue up to a total of $127.2 million of SBA guaranteed debentures. Currently, HT II has paid commitment fees of approximately $1.3 million and has a commitment from the SBA to issue a total of $127.2 million of SBA guaranteed debentures, of which approximately $70.1 million are outstanding and $57.1 million is available as of March 31, 2008. There is no assurance that HT II will draw up to the maximum limit available under the SBIC program.

 

As of March 31, 2008, assets held by HT II represented approximately 26.5% of the total assets of the Company.

 

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SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the two most recent fiscal years. In addition, SBICs must devote 20% of their investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services.

 

Through our wholly-owned subsidiary HT II, we plan to provide long-term loans to qualifying small businesses, and in connection therewith, make equity investments. HT II is periodically examined and audited by the SBA’s staff to determine its compliance with SBIC regulations. As of March 31, 2008, HT II could draw up to $127.2 million of leverage from the SBA subject to SBA regulations. Borrowings under the program are charged interest based on ten year treasury rates plus a spread and the rates are generally set for a pool of debentures issued by the SBA in six month periods. The rate for the $12.0 million of borrowings originated from March 13, 2007 to September 10, 2007 was set by the SBA as announced on September 26, 2007 at 5.528%. The rate for the $58.1 million borrowings made after September 10, 2007 through March 13, 2008 was set by the SBA as announced on March 26, 2008 at 5.471%. In addition, the SBA charges an annual fee that is set annually, depending on the Federal fiscal year the leverage commitment was delegated by the SBA, regardless of the date that the leverage was drawn by the SBIC. The 2008 and 2007 annual fee has been set at 0.906%. Interest payments are payable semi-annually and there are no principal payments required on these issues prior to maturity. Debentures under the SBA generally mature ten years after being borrowed.

 

Dividends

 

The following table summarizes our dividends declared and paid on all shares, including restricted stock, to date:

 

Date Declared

  

Record Date

  

Payment Date

   Amount Per Share
October 27, 2005    November 1, 2005    November 17, 2005    $ 0.025
December 9, 2005    January 6, 2006    January 27, 2006      0.300
April 3, 2006    April 10, 2006    May 5, 2006      0.300
July 19, 2006    July 31, 2006    August 28, 2006      0.300
October 16, 2006    November 6, 2006    December 1, 2006      0.300
February 7, 2007    February 19, 2007    March 19, 2007      0.300
May 3, 2007    May 16, 2007    June 18, 2007      0.300
August 2, 2007    August 16, 2007    September 17, 2007      0.300
November 1, 2007    November 16, 2007    December 17, 2007      0.300
February 7, 2008    February 15, 2008    March 17, 2008      0.300
May 8, 2008    May 16, 2008    June 16, 2008      0.340
            
         $ 3.065
            

 

On May 8, 2008, we announced that our Board of Directors approved a dividend of $0.34 per share to shareholders of record as of May 16, 2008 and payable on June 16, 2008. Distributions in excess of our current and accumulated earnings and profits would be treated first as a return of capital to the extent of the stockholder’s tax basis, and any remaining distributions would be treated as a capital gain. The determination of the tax attributes of our distributions is made annually as of the end of our fiscal year based upon its taxable income for the full year and distributions paid for the full year, therefore a determination made on a quarterly basis may not be representative of the actual tax attributes of our distributions for a full year. If we determined

 

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the tax attributes of its distributions year-to-date as of March 31, 2008, $0.30 or 100.0% would be from ordinary income and spill-over earnings from 2007, however there can be no certainty to stockholders that this determination is representative of what the tax attributes of its 2007 distributions to stockholders will actually be.

 

Each year a statement on Form 1099-DIV identifying the source of the distribution (i.e., paid from ordinary income, paid from net capital gains on the sale of securities, and/or a return of paid-in-capital surplus which is a nontaxable distribution) is mailed to our stockholders. To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a tax return of capital to our stockholders.

 

We operate to qualify to be taxed as a RIC under the Code. Generally, a RIC is entitled to deduct dividends it pays to its shareholders from its income to determine “taxable income.” Taxable income includes our taxable interest, dividend and fee income, as well as taxable net capital gains. Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation, as gains or losses are not included in taxable income until they are realized. In addition, gains realized for financial reporting purposes may differ from gains included in taxable income as a result of our election to recognize gains using installment sale treatment, which generally results in the deferment of gains for tax purposes until notes or other amounts, including amounts held in escrow, received as consideration from the sale of investments are collected in cash. Taxable income includes non-cash income, such as changes in accrued and reinvested interest and dividends, which includes contractual payment-in-kind interest, and the amortization of discounts and fees. Cash collections of income resulting from contractual PIK interest or the amortization of discounts and fees generally occur upon the repayment of the loans or debt securities that include such items. Non-cash taxable income is reduced by non-cash expenses, such as realized losses and depreciation and amortization expense.

 

We have distributed and currently intend to distribute sufficient dividends to eliminate taxable income. We are subject to a nondeductible federal excise tax if we do not distribute at least 98% of our capital gain net income for each one year period ending on October 31. At December 31, 2007 we recorded a provision for excise tax of approximately $139,000 on income and capital gains of approximately $4.3 million to be distributed in 2008. The maximum amount of excess taxable income that may be carried over for distribution in the next year under the Code is the total amount of dividends paid in the following year, subject to certain declaration and payment guidelines.

 

The table below shows the detail of our distributions for the years ended December 31, 2007 and 2006:

 

     December 31,
2007
    December 31,
2006
 

Ordinary income

   $ 1.20    100.0 %   $ 0.97    80.8 %

Accumulated earnings and profits

     —      —         0.09    7.5 %

Return of capital

     —      —         0.14    11.7 %
                          

Total

   $ 1.20    100.0 %     1.20    100.0 %
                          

 

On February 7, 2008, the Board of Directors declared a dividend of $0.30 per share to shareholders of record as of February 15, 2008 and payable on March 17, 2008.

 

Critical Accounting Policies

 

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and revenues and expenses during the period reported. On an ongoing basis, our management evaluates its estimates and assumptions, which are based on historical experience and on various other assumptions that we believe to be reasonable under the

 

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circumstances. Actual results could differ from those estimates. Changes in our estimates and assumptions could materially impact our results of operations and financial condition.

 

Valuation of Portfolio Investments. The most significant estimate inherent in the preparation of our consolidated financial statements is the valuation of investments and the related amounts of unrealized appreciation and depreciation of investments recorded. As a business development company, we invest primarily in illiquid securities, including debt and equity-related securities of private companies. Our investments are generally subject to some restrictions on resale and generally have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation process requires an analysis of various factors. Our valuation methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.

 

At March 31, 2008, approximately 97% of our total assets represented investments in portfolio companies of which greater than 99% are valued at fair value by the Board of Directors. Value, as defined in Section 2(a) (41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the Board of Directors. Since there is typically no readily available market value for the investments in our portfolio, we value substantially all of our investments at fair value as determined in good faith by our board pursuant to a valuation policy and a consistent valuation process in accordance with the provisions of SFAS No. 157, Fair Value Measurement (“SFAS 157”) and the 1940 Act. Due to the inherent uncertainty in determining the fair value of investments that do not have a readily available market value, the fair value of our investments determined in good faith by our board may differ significantly from the value that would have been used had a ready market existed for such investments, and the differences could be material.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, outlines a fair value hierarchy based on inputs used to measure fair value and enhances disclosure requirements for fair value measurements. SFAS 157 does not change existing guidance as to whether or not an instrument is carried at fair value. The Company adopted SFAS 157 effective January 1, 2008. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

 

Consistent with SFAS 157, we determine fair value to be the amount for which an investment could be exchanged in a current sale, which assumes an orderly disposition over a reasonable period of time between willing parties other than in a forced or liquidation sale. Our valuation policy considers the fact that no ready market exists for substantially all of the securities in which it invests. In accordance with SFAS 157, the Company has considered the principal market, or the market in which the Company exits its portfolio investments with the greatest volume and level of activity. SFAS 157 requires that the portfolio investment is assumed to be sold in the principal market to market participants, or in the absence of a principal market, the most advantageous market. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable, and willing and able to transact.

 

Determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment, although our valuation policy is intended to provide a constant basis for determining the fair value of portfolio investments. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses. Instead, we must determine the fair value of each individual investment on a quarterly basis. We will record unrealized depreciation on investments when we believe that an investment has decreased in value, including where collection of a loan or realization of an equity security is doubtful. Conversely, where appropriate, we will record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and, therefore, that our investment has also appreciated in value.

 

As a business development company, we invest primarily in illiquid securities including debt and equity-related securities of private companies. Our investments are generally subject to some restrictions on resale and

 

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generally have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation process requires an analysis of various factors. Our valuation methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.

 

Estimating fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. We determine fair value to be the amount for which an investment could be exchanged in a current sale, which assumes an orderly disposition over a reasonable period of time between willing parties other than in a forced or liquidation sale. Our valuation policy considers the fact that no ready market exists for substantially all of the securities in which it invests. Fair value established in good faith by the Board of Directors may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

 

When originating a debt instrument, the Company generally receives warrants or other equity-related securities from the borrower. The Company determines the cost basis of the warrants or other equity-related securities received based upon their respective fair values on the date of receipt in proportion to the total fair value of the debt and warrants or other equity-related securities received. Any resulting discount on the loan from recordation of the warrant or other equity instruments is accreted into interest income over the life of the loan.

 

At each reporting date, privately held debt and equity securities are valued based on an analysis of various factors including, but not limited to, the portfolio company’s operating performance and financial condition and general market conditions that could impact the valuation. When an external event occurs, such as a purchase transaction, public offering, or subsequent equity sale, the pricing indicated by that external event is utilized to corroborate the Company’s valuation of the debt and equity securities. The Company periodically reviews the valuation of its portfolio companies that have not been involved in a qualifying external event to determine if the enterprise value of the portfolio company may have increased or decreased since the last valuation measurement date. The Company may consider, but is not limited to, industry valuation methods such as price to enterprise value or price to equity ratios, discounted cash flow, valuation comparisons to comparable public companies or other industry benchmarks in its evaluation of the fair value of its investment.

 

An unrealized loss is recorded when an investment has decreased in value, including: where collection of a loan is doubtful, there is an adverse change in the underlying collateral or operational performance, there is a change in the borrower’s ability to pay, or there are other factors that lead to a determination of a lower valuation for the debt or equity security. Conversely, unrealized appreciation is recorded when the investment has appreciated in value. Securities that are traded in the over the counter markets or on a stock exchange will be valued at the prevailing bid price at period end. The Board of Directors estimates the fair value of warrants and other equity-related securities in good faith using a Black-Scholes pricing model and consideration of the issuer’s earnings, sales to third parties of similar securities, the comparison to publicly traded securities, and other factors.

 

All investments recorded at fair value are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:

 

Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets at the measurement date. The types of assets carried at Level 1 fair value generally are equities listed in active markets.

 

Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset in connection with market data at the measurement date and for the extent of the instrument’s anticipated life. Fair valued assets that are generally included in this category are warrants held in a public company.

 

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Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing the asset at the measurement date. It includes prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. Generally, assets carried at fair value and included in this category are the debt investments and warrants held in a private company. For loan and debt securities, we have performed a yield analysis assuming a hypothetical current sale of the security. The yield analysis considers changes in interest rates and changes in leverage levels of the portfolio company as compared to the market interest rates and leverage levels. Assuming the credit quality of the portfolio company remains stable, we will use the value determined by the yield analysis as the fair value for that security.

 

We will record unrealized depreciation on investments when we determine that the fair value of a security is less than its cost basis, and will record unrealized appreciation when we determine that the fair value is greater than its cost basis.

 

Income Recognition. Interest income is recorded on the accrual basis and is recognized as earned in accordance with the contractual terms of the loan agreement to the extent that such amounts are expected to be collected. Original Issue Discount, (“OID”), initially represents the value of detachable equity warrants obtained in conjunction with the acquisition of debt securities and is accreted into interest income over the term of the loan as a yield enhancement. When a loan becomes 90 days or more past due, or if management otherwise does not expect the portfolio company to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and cease recognizing interest income on that loan until all principal has been paid. However, we may make exceptions to this policy if the investment has sufficient collateral value and is in the process of collection. As of March 31, 2008 we had one loan on non-accrual status with a fair value of approximately $2.6 million. There were no loans on non-accrual status as of March 31, 2007.

 

Paid-In-Kind and End of Term Income. Contractual paid-in-kind (“PIK”) interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. We will generally cease accruing PIK interest if there is insufficient value to support the accrual or we do not expect the portfolio company to be able to pay all principal and interest due. In addition, we may also be entitled to an end-of-term payment that we amortize into income over the life of the loan. To maintain our status as a RIC, PIK and end-of-term income must be paid out to stockholders in the form of dividends even though we have not yet collected the cash. Amounts necessary to pay these dividends may come from available cash or the liquidation of certain investments. For the three months ended March 31, 2008, approximately $186,000 in PIK income was recorded. There was no PIK income recorded during the three months ended March 31, 2007.

 

Fee Income. Fee income, generally collected in advance, includes loan commitment and facility fees for due diligence and structuring, as well as fees for transaction services and management services rendered by us to portfolio companies and other third parties. Loan and commitment fees are amortized into income over the contractual life of the loan. Management fees are generally recognized as income when the services are rendered. Loan origination fees are capitalized and then amortized into interest income using the effective interest rate method. In certain loan arrangements, warrants or other equity interests are received from the borrower as additional origination fees.

 

Stock-Based Compensation. We have issued and may, from time to time, issue additional stock options to employees under our 2004 Equity Incentive Plan. We follow Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payments (“FAS 123R”), to account for stock options granted. Under FAS 123R, compensation expense associated with stock-based compensation is measured at the grant date based on the fair value of the award and is recognized.

 

Federal Income Taxes. We intend to operate so as to qualify to be taxed as a RIC under Subchapter M of the Code and, as such, will not be subject to federal income tax on the portion of our taxable income and gains distributed to stockholders. To qualify as a RIC, we are required to distribute at least 90% of our investment

 

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company taxable income, as defined by the Code. We will be subject to a non-deductible federal excise tax if we do not distribute at least 98% of our taxable ordinary income for each calendar year, 98% of our capital gain net income for each 1 year period ending on October 31, and 100% of any previously undistributed taxable ordinary income and capital gain net income. At December 31, 2007 we recorded a liability for excise tax of approximately $139,000 on income and capital gains of approximately $4.3 million to be distributed in 2008.

 

Because federal income tax regulations differ from accounting principles generally accepted in the United States, distributions in accordance with tax regulations may differ from net investment income and realized gains recognized for financial reporting purposes. Differences may be permanent or temporary. Permanent differences are reclassified among capital accounts in the financial statement to reflect their tax character. Temporary differences arise when certain items of income, expense, gain or loss are recognized at some time in the future. Differences in classification may also result from the treatment of short-term gains as ordinary income for tax purposes.

 

Recent Accounting Pronouncements

 

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted the provisions of FIN 48 on January 1, 2007. The implementation of FIN 48 did not result in any unrecognized tax benefits in the accompanying financial statements.

 

In September 2006, the FASB issued Statement on Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”). This standard clarifies the definition of fair value for financial reporting, establishes a framework for measuring fair value and requires additional disclosures about the use of fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. As of December 31, 2007, the Company is evaluating the impact of FAS 157 on its financial position and results of operations but does not believe the adoption of FAS 157 will impact the amounts reported in the financial statements. However, additional disclosures will be required about the inputs used to develop the measurements of fair value and the effect of certain of the measurements reported in the statement of operations for a fiscal period.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”). Among other requirements, FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. FAS 159 is effective for the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact of FAS 159 on its financial position and results of operations.

 

Recent Developments

 

On May 8, 2008 the Board of Directors declared a dividend of $0.34 per share for the first quarter, payable on June 16, 2008 to shareholders of record as of May 16, 2008.

 

On May 7, 2008, the Company amended and renewed its Credit Facility with Citigroup and Deutsche Bank providing for a borrowing capacity of $135.0 million and extending the expiration date to October 31, 2008. Under the terms of the agreement, the Company paid a renewal fee of approximately $1.3 million, interest on all borrowings was set at LIBOR plus a spread of 5.0%, and a fee of 2.50% that will be charged on any unused

 

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portion of the facility. The Credit Facility is collateralized by loans from the Company’s portfolio companies, and includes an advance rate of approximately 45% of eligible loans. The Credit Facility contains covenants that, among other things, require the Company to maintain a minimum net worth and to restrict the loans securing the Credit Facility to certain dollar amounts, to concentrations in certain geographic regions and industries, to certain loan grade classifications, to certain security interests, and to certain interest payment terms. The Company is also in preliminary discussions with other large national banks who are interested in potentially providing us with additional debt capital.

 

On April 22, 2008, GlaxoSmithKline announced that the company has entered into a definitive agreement with Sirtris Pharmaceuticals to acquire the company for approximately $720 million through a cash tender offer of $22.50 per share. The acquisition has been approved by the board of directors of each company and is subject to customary closing conditions, including the tender of at least a majority of Sirtris’ shares and clearance under the Hart-Scott-Rodino Antitrust Improvements Act. The parties anticipate that the tender offer will be commenced in early May and close in the second quarter of 2008. Upon the closing of the acquisition, the Company anticipates a realized gain of approximately $2.2 million, or $0.07 per share.

 

On May 7, 2008, Gomez, Inc. announced that it has filed a registration statement with the SEC relating to a proposed initial public offering of shares of its common stock.

 

Quantitative and Qualitative Disclosures about Market Risk

 

We are subject to financial market risks, including changes in interest rates. As of March 31, 2008, approximately 48% of our portfolio loans were at fixed rates and 52% of our loans were at variable rates. Over time additional investments may be at variable rates. We may, in the future, hedge against interest rate fluctuations by using standard hedging instruments such as futures, options, and forward contracts. While hedging activities may insulate us against changes in interest rates, they may also limit our ability to participate in the benefits of lower interest rates with respect to our borrowed funds and higher interest rates with respect to our portfolio of investments. Interest rates on our borrowings are based primarily on LIBOR. Borrowings under our SBA program are fixed at the ten-year treasury every March and September for borrowings of the preceding six months. At March 31, 2008, the borrowing rate under the Credit Facility was LIBOR plus a spread of 1.20%. The borrowing rate under the SBA facility for approximately $12.0 million of fixed rate borrowings was approximately 5.5% and the rate for the $58.1 million borrowings made after September 10, 2007 through March 13, 2008 was set by the SBA as announced on March 26, 2008 at 5.471%. In addition, the SBA charges an annual fee of 0.906%.

 

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BUSINESS

 

We are a specialty finance company that provides debt and equity growth capital to technology-related and life-science companies at all stages of development from seed and emerging growth to expansion and established stages of development, including select publicly listed companies and lower middle market companies. We primarily finance privately-held companies backed by leading venture capital and private equity firms and also may finance certain select publicly-traded companies that lack access to public capital or are sensitive to equity ownership dilution as well as lower middle market companies. We source our investments through our principal office located in Silicon Valley, as well as our additional offices in the Boston, Boulder, Chicago, Columbus, and San Diego areas.

 

Our goal is to be the leading structured mezzanine capital provider of choice for venture capital and private equity-backed technology-related and life science companies requiring sophisticated and customized financing solutions. Our strategy is to evaluate and invest in a broad range of companies active in the technology and life science industries and to offer a full suite of growth capital products at all levels of the capital structure. We invest primarily in structured mezzanine debt and, to a lesser extent, in senior debt and equity investments. We use the term “structured mezzanine debt investment” to refer to any debt investment, such as a senior or subordinated secured loan, that is coupled with an equity component, including warrants, options or rights to purchase common or preferred stock. Our structured mezzanine debt investments will typically be secured by some or all of the assets of the portfolio company.

 

We focus our investments in companies active in the technology industry sub-sectors characterized by products or services that require advanced technologies, including computer software and hardware, networking systems, semiconductors, semiconductor capital equipment, information technology infrastructure or services, Internet consumer and business services, telecommunications, telecommunications equipment, renewable or alternative energy, media and life sciences. Within the life sciences sub-sector, we focus on medical devices, bio-pharmaceutical, drug discovery, drug delivery, health care services and information systems companies. We refer to all of these companies as “technology-related” companies and intend, under normal circumstances, to invest at least 80% of the value of our assets in such businesses.

 

Our primary business objectives are to increase our net income, net operating income and net asset value by investing in structured mezzanine debt and equity of venture capital and private equity backed technology-related companies with attractive current yields and the potential for equity appreciation and realized gains. Our structured debt investments typically include warrants or other equity interests, giving us the potential to realize equity-like returns on a portion of our investments. In some cases, we receive the right to make additional equity investments in our portfolio companies in connection with future equity financing rounds. Capital that we provide directly to venture capital and private equity backed technology-related companies is generally used for growth and in select cases for acquisitions or recapitalizations.

 

Our portfolio is comprised of, and we anticipate that our portfolio will continue to be comprised of, investments in technology-related companies at various stages of their development. Consistent with regulatory requirements, we invest primarily in United States based companies and to a lesser extent in foreign companies. To date, our emphasis has been on private companies following or in connection with their first institutional round of equity financing, which we refer to as emerging-growth companies, private companies in later rounds of financing, which we refer to as expansion-stage companies and in private companies in one of their final rounds of equity financing prior to a liquidity event or select publicly-traded companies that lack access to public capital or are sensitive to equity ownership dilution, which we refer to as established-stage companies.

 

Corporate History and Offices

 

We are a Maryland Corporation formed in December 2003 that began investment operations in September 2004. We are an internally managed, non-diversified, closed-end investment company that has elected to be

 

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treated as a business development company under the Investment Company Act of 1940 Act. As a business development company, we are required to meet various regulatory tests. A business development company is required to invest at least 70% of its total assets in “qualifying assets,” including securities of private U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less. A business development company also must meet a coverage ratio of total net assets to total senior securities, which include all of our borrowings (including accrued interest payable) except for debentures issued by the SBA, and any preferred stock we may issue in the future, of at least 200%. See “Business—Regulation as a Business Development Company.”

 

From incorporation through December 31, 2005, we were taxed as a corporation under Subchapter C of the Code. We have elected to be treated for federal income tax purposes as a regulated investment company, or “RIC,” under the Code. In order to continue to qualify as a RIC for federal income tax purposes, we must meet certain requirements, including certain minimum distribution requirements. See “Business—Certain United States Federal Income Tax Considerations.”

 

Our principal executive offices are located at 400 Hamilton Avenue, Suite 310, Palo Alto, California 94301 and our telephone number is (650) 289-3060. We also have additional offices in the Boston, Boulder, Chicago, Columbus, and San Diego areas. We maintain a website on the Internet at www.herculestech.com. Information contained in our website is not incorporated by reference into this Annual Report, and you should not consider that information as part of this Annual Report. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and our current reports on Form 8-K, as well as any amendments to those reports, are available free of charge through our website as soon as reasonably practicable after we file them with, or furnish them to, the Securities and Exchange Commission (“SEC”). These reports are also available on the SEC’s website at www.sec.gov.

 

Our Market Opportunity

 

We believe that technology-related companies compete in one of the largest and most rapidly growing sectors of the U.S. economy and that continued growth is supported by ongoing innovation and performance improvements in technology products as well as the adoption of technology across virtually all industries in response to competitive pressures. We believe that an attractive market opportunity exists for a specialty finance company focused primarily on structured mezzanine investments in technology-related companies for the following reasons:

 

   

Technology-related companies have generally been underserved by traditional lending sources;

 

   

Unfulfilled demand exists for structured debt financing to technology-related companies;

 

   

Structured mezzanine debt products are less dilutive and complement equity financing from venture capital and private equity funds; and

 

   

Valuations currently assigned to technology-related companies in private financing rounds, while increasing in recent years, still provide a good opportunity for attractive capital returns.

 

Technology-Related Companies Underserved by Traditional Lenders. We believe many viable technology-related companies backed by financial sponsors have been unable to obtain sufficient growth financing from traditional lenders, including financial services companies such as commercial banks and finance companies, in part because traditional lenders have continued to consolidate and have adopted a more risk-averse approach to lending that has resulted in tightened credit standards in recent years. More importantly, we believe traditional lenders are typically unable to underwrite the risk associated with financial sponsor-backed emerging-growth or expansion-stage companies effectively.

 

The unique cash flow characteristics of many technology-related companies include significant research and development expenditures and high projected revenue growth thus often making such companies difficult to

 

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evaluate from a credit perspective. In addition, the balance sheets of emerging-growth and expansion-stage companies often include a disproportionately large amount of intellectual property assets, which can be difficult to value. Finally, the speed of innovation in technology and rapid shifts in consumer demand and market share add to the difficulty in evaluating technology-related companies.

 

Due to the difficulties described above, we believe traditional lenders are generally refraining from entering the structured mezzanine debt marketplace for emerging-growth and expansion-stage companies, instead preferring the risk-reward profile of senior debt. Traditional lenders generally do not have flexible product offerings that meet the needs of technology-related companies. The financing products offered by traditional lenders typically impose on borrowers many restrictive covenants and conditions, including limiting cash outflows and requiring a significant depository relationship to facilitate rapid liquidation.

 

Unfulfilled Demand for Structured Debt Financing to Technology-Related Companies. Private debt capital in the form of structured debt financing from specialty finance companies continues to be an important source of funding for technology-related companies. We believe that the level of demand for structured debt financing to emerging-growth and expansion-stage companies is a function of the level of annual venture equity investment activity. In 2007, venture capital-backed companies received, in approximately 2,648 transactions, equity financing in an aggregate amount of approximately $29.9 billion, representing an 8% increase over the preceding year, as reported by Dow Jones VentureOne. In addition, overall, the median round size in 2007 was $7.6 million, up from $7.0 million in 2006, and the highest annual median since 2000. For the third year in a row, equity investors are focusing more than a third of their investment activity on early-stage financings. Overall, seed- and first-round deals made up 38% of the deal flow in 2007, and later-stage deals made up roughly 50% of all capital invested. As a result, we believe a range of $23 billion to $28 billion in annual equity investments to venture-backed companies will be sustainable in future years.

 

We believe that demand for structured debt financing is currently under served, in part because historically the largest debt capital providers to technology-related companies exited the market during 2001. In addition, lending requirements of traditional lenders have recently become more stringent due to the credit and liquidity crisis that impacted certain financial institutions beginning in the summer of 2007 related to the sub-prime market, real estate market and consumer debt market, which we do not have exposure to as a financial lender. We therefore believe this is an opportune time to be active in the structured lending market for technology-related companies.

 

Structured Mezzanine Debt Products Complement Equity Financing From Venture Capital and Private Equity Funds. We believe that technology-related companies and their financial sponsors will continue to view structured debt securities as an attractive source of capital because it augments the capital provided by venture capital and private equity funds. We believe that our structured mezzanine debt products provide access to growth capital that otherwise may only be available through incremental investments by existing equity investors. As such, we provide portfolio companies and their financial sponsors with an opportunity to diversify their capital sources. Generally, we believe emerging-growth and expansion-stage companies target a portion of their capital to be debt in an attempt to achieve a higher valuation through internal growth. In addition, because financial sponsor-backed companies have recently been more mature prior to reaching a liquidity event, we believe our investments could provide the debt capital needed to grow or recapitalize during the extended period prior to liquidity events.

 

Lower Valuations for Private Technology-Related Companies. During the downturn in technology industries that began in 2000, the markets saw sharp and broad declines in valuations of venture capital and private equity-backed technology-related companies. According to Dow Jones VentureOne, median pre-money valuations for venture capital-backed companies in 2000 was $25.0 million declining to a low of $10.0 million in 2003. As of December 31, 2007 median pre-money valuations for venture capital-backed companies in 2007 was $16.0 million compared to $18.5 million in 2006. This decrease was attributed to lower valuations in certain areas such as medical software, information services, software and consumer products offset by increases in

 

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other industry segments such as health care services, retail, electronics and computers. We believe the valuations currently assigned to venture capital and private equity-backed technology-related companies in private financing rounds are still reasonably valued and should allow us to continue to build a portfolio of equity-related securities at attractive valuation levels.

 

Our Business Strategy

 

Our strategy to achieve our investment objective includes the following key elements:

 

Leverage the Experience and Industry Relationships of Our Management Team and Investment Professionals. We have assembled a team of experienced investment professionals with extensive experience as venture capitalists, commercial lenders, and originators of structured debt and equity investments in technology-related companies. Our investment professionals have, on average, more than 15 years of experience as equity investors in, and/or lenders to, technology-related companies. In addition, our team members have originated structured mezzanine investments in over 200 technology-related companies, representing over $2.0 billion in investments, and have developed a network of industry contacts with investors and other participants within the venture capital and private equity communities. In addition, members of our management team also have operational, research and development and finance experience with technology-related companies. We have established contacts with leading venture capital and private equity fund sponsors, public and private companies, research institutions and other industry participants, which should enable us to identify and attract well-positioned prospective portfolio companies.

 

We concentrate our investing activities in industries in which our investment professionals have investment experience. We believe that our focus on financing high growth venture capital-backed technology-related companies will enable us to leverage our expertise in structuring prospective investments, to assess the value of both tangible and intangible assets, to evaluate the business prospects and operating characteristics of technology-related companies and to identify and originate potentially attractive investments with these types of companies.

 

Mitigate Risk of Principal Loss and Build a Portfolio of Equity-Related Securities. We expect that our investments have the potential to produce attractive risk adjusted returns through current income, in the form of interest and fee income, as well as capital appreciation from equity-related securities. We believe that we can mitigate the risk of loss on our debt investments through the combination of loan principal amortization, cash interest payments, relatively short maturities, security interests in the assets of our portfolio companies, covenants requiring prospective portfolio companies to have certain amounts of available cash at the time of our investment and the continued support from a venture capital or private equity firm at the time we make our investment.

 

In addition, our structured debt investments typically include warrants or other equity interests, giving us the potential to realize equity-like returns on a portion of our investment. In addition, we expect, in some cases, to receive the right to make additional equity investments in our portfolio companies in connection with future equity financing rounds. We believe these equity interests will create the potential for meaningful long-term capital gains in connection with the future liquidity events of these technology-related companies.

 

Provide Customized Financing Complementary to Financial Sponsors’ Capital. We offer a broad range of investment structures and possess expertise and experience to effectively structure and price investments in technology-related companies. Unlike many of our competitors that only invest in companies that fit a specific set of investment parameters, we have the flexibility to structure our investments to suit the particular needs of our portfolio companies. We offer customized financing solutions ranging from senior debt to equity capital, with a focus on structured mezzanine debt.

 

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We use our relationships in the financial sponsor community to originate investment opportunities. Because venture capital and private equity funds typically invest solely in the equity securities of their portfolio companies, we believe that our debt investments will be viewed as an attractive source of capital, both by the portfolio company and by the portfolio company’s financial sponsor. In addition, we believe that many venture capital and private equity fund sponsors encourage their portfolio companies to use debt financing for a portion of their capital needs as a means of potentially enhancing equity returns, minimizing equity dilution and increasing valuations prior to a subsequent equity financing round or a liquidity event.

 

Invest at Various Stages of Development. We provide growth capital to technology-related companies at all stages of development, from emerging-growth companies, to expansion-stage companies and established-stage companies. We believe that this provides us with a broader range of potential investment opportunities than those available to many of our competitors, who generally focus their investments on a particular stage in a company’s development. Because of the flexible structure of our investments and the extensive experience of our investment professionals, we believe we are well positioned to take advantage of these investment opportunities at all stages of prospective portfolio companies’ development.

 

Benefit from Our Efficient Organizational Structure. We believe that the perpetual nature of our corporate structure enables us to be a long-term partner for our portfolio companies in contrast to traditional mezzanine and investment funds, which typically have a limited life. In addition, because of our access to the equity markets, we believe that we may benefit from a lower cost of capital than that available to private investment funds. We are not subject to requirements to return invested capital to investors nor do we have a finite investment horizon. Capital providers that are subject to such limitations are often required to seek a liquidity event more quickly than they otherwise might, which can result in a lower overall return on an investment.

 

Deal Sourcing Through Our Proprietary Database. We have developed a proprietary and comprehensive structured query language-based (SQL) database system to track various aspects of our investment process including sourcing, originations, transaction monitoring and post-investment performance. As of March 31, 2008, our proprietary SQL-based database system included over 15,300 technology-related companies and over 4,200 venture capital private equity sponsors/investors, as well as various other industry contacts. This proprietary SQL system allows us to maintain, cultivate and grow our industry relationships while providing us with comprehensive details on companies in the technology-related industries and their financial sponsors.

 

Our Investments and Operations

 

We invest in debt securities and, to a lesser extent, equity securities, with a particular emphasis on structured mezzanine debt.

 

We generally seek to invest in companies that have been operating for at least six to 12 months prior to the date of our investment. We anticipate that such entities may, at the time of investment, be generating revenues or will have a business plan that anticipates generation of revenues within 24 to 48 months. Further, we anticipate that on the date of our investment we will obtain a lien on available assets, which may or may not include intellectual property, and these companies will have sufficient cash on their balance sheet to amortize their debt for at least six to 15 months following our investment. We generally require that a prospective portfolio company, in addition to having sufficient capital to support leverage, demonstrate an operating plan capable of generating cash flows or raising the additional capital necessary to cover its operating expenses and service its debt.

 

We expect that our investments will generally range from $1.0 million to $30.0 million. Our debt investments generally have an average initial principal balance of between $1.0 million and $15.0 million and have maturities of two to seven years, with an expected average term of three years. We typically structure our debt securities to provide for amortization of principal over the life of the loan, but may include an interest-only

 

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period of 3 to 18 months for emerging growth and expansion-stage companies and longer for established-stage companies, and our loans will be collateralized by a security interest in the borrower’s assets, although we may not have the first claim on these assets and the assets may not include intellectual property. Our debt investments carry fixed or variable contractual interest rates typically ranging from Prime rate to 14.0%. In addition to the cash yields received on our loans, in some instances, certain loans may also include any of the following: end of term payments, exit fees, balloon payment fees, success fees, payment-in-kind (“PIK”) provisions or prepayment fees, which we may be required to include in income prior to receipt. We also generate revenue in the form of commitment and facility fees.

 

In addition, the majority of our venture capital-backed companies structured mezzanine debt investments generally have equity enhancement features, typically in the form of warrants or other equity-related securities designed to provide us with an opportunity for potential capital appreciation. The warrants typically will be immediately exercisable upon issuance and generally will remain exercisable for the lesser of seven years or three years after an initial public offering. The exercise prices for the warrants varies from nominal exercise prices to exercise prices that are at or above the current fair market value of the equity for which we receive warrants. We may structure warrants to provide minority rights provisions and put rights upon the occurrence of certain events. We generally target a total annualized return (including interest, fees and value of warrants) of 12% to 25% for our debt investments.

 

Typically, our debt and equity investments take one of the following forms:

 

   

Structured Mezzanine Debt. We seek to invest a majority of our assets in structured mezzanine debt of prospective portfolio companies. Traditional “mezzanine” debt is a layer of high-coupon financing between debt and equity that most commonly takes the form of subordinated debt coupled with warrants, combining the cash flow and risk characteristics of both senior debt and equity. However, our structured mezzanine investments may be the only debt capital on the balance sheet of our portfolio companies, and in many cases we have a first priority security interest in all of our portfolio company’s assets, or in certain investments we review a negative pledge on intellectual property. Our structured mezzanine debt investments typically have maturities of between two and seven years, with full amortization for emerging-growth or expansion-stage companies and longer deferred amortization for select established-stage companies. Our structured mezzanine debt investments generally carry a contractual interest rate between Prime rate and 14% and may include an additional end-of-term payment, are in an amount between $3.0 million and $25.0 million with an average initial principal balance of between $3.0 million and $15.0 million (although this investment size may vary proportionately as the size of our capital base changes) and have an average term of three years. In some cases we collateralize our investments by obtaining security interests in our portfolio companies’ assets, which may include their intellectual property. In other cases we may prohibit a company from pledging or otherwise encumbering their intellectual property. We may structure our mezzanine debt investments with restrictive affirmative and negative covenants, default penalties, prepayment penalties, lien protection, equity calls, change-in-control provisions or board observation rights.

 

   

Senior Debt. We seek to invest a limited portion of our assets in senior debt. Senior debt may be collateralized by accounts receivable and/or inventory financing of prospective portfolio companies. Senior debt has a senior position with respect to a borrower’s scheduled interest and principal payments and holds a first priority security interest in the assets pledged as collateral. Senior debt also may impose covenants on a borrower with regard to cash flows and changes in capital structure, among other items. Our senior debt investments carry a contractual interest rate between Prime rate and 12%, are in an amount between $1.0 million and $7.0 million with an average initial principal balance of $3.0 million, and have an average term of under three years. We generally collateralize our investments by obtaining security interests in our portfolio companies’ assets, which may include their intellectual property. In other cases we may obtain a negative pledge covering a company’s intellectual property. Our senior loans, in certain instances, may be tied to the financing of specific assets. In connection with a senior debt investment, we may also provide the borrower with a working capital line-of-credit that will carry

 

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an interest rate ranging from the Prime rate to 12%, generally maturing in one to two years, and will be secured by accounts receivable and/or inventory. In connection with a senior debt investment, we may also provide the borrower with a working capital line-of-credit at fixed rates or variable rates based on the Prime rate or LIBOR plus a spread, generally maturing in one or two years, and will be secured by accounts receivable and / or inventory.

 

   

Equipment Loans. We intend to invest a limited portion of our assets in equipment-based loans to early-stage prospective portfolio companies. Equipment-based loans are secured by a first priority security interest in the assets financed. These loans are generally for amounts up to $3.0 million, carry a contractual interest rate between Prime and Prime plus 400 basis points, and have an average term between three and four years. Equipment loans may also include end of term payments.

 

   

Equity-Related Securities. The equity-related securities we hold consist primarily of warrants or other equity interests generally obtained in connection with our structured debt investments. In addition to the warrants received as a part of a structured debt financing, we typically receive the right to make equity investments in a portfolio company in connection with the next equity financing round for that company. We may also on certain debt investments have the right to convert a portion of the debt investment into equity. These rights will provide us with the opportunity to further enhance our returns over time through opportunistic equity investments in our portfolio companies. These equity-related investments are typically in the form of preferred or common equity and may be structured with a dividend yield, providing us with a current return, and with customary anti-dilution protection and preemptive rights. In the future, we may achieve liquidity through a merger or acquisition of a portfolio company, a public offering of a portfolio company’s stock or by exercising our right, if any, to require a portfolio company to buy back the equity-related securities we hold. We may also make stand alone direct equity investments into portfolio companies in which we may not have any debt investment in the company.

 

A comparison of the typical features of our various investment alternatives is set forth in the chart below.

 

    Senior Debt   Structured Mezzanine
Debt
  Equipment Loans   Equity Securities
         

Typical Structure

  Term or revolving debt   Term debt with warrants   Term debt with warrants   Preferred stock or

common stock

         

Investment Horizon

  Usually under 3 years   Long term, ranging from 2

to 7 years, with an average

of 3 years

  Ranging from 3 to 4

years

  Long term
         

Ranking/Security

  Senior/First lien   Senior or junior lien   Secured by underlying

equipment

  None/unsecured
         

Covenants

  Generally borrowing base

and financial

  Less restrictive;

Mostly financial;

Maintenance-based

  None   None
         

Risk Tolerance

  Low   Medium/High   High   High
         

Coupon/Dividend

  Cash pay—floating or

fixed rate

  Cash pay—fixed and

floating rate; Payment-in-

kind in limited cases

  Cash pay-floating or

fixed rate and may

include Payment-in-kind  

  Generally none
         

Customization or Flexibility

  Little to none   More flexible   Little to none   Flexible
         

Equity Dilution

  None to low   Low   Low   High

 

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Investment Criteria

 

We have identified several criteria that we believe are important in achieving our investment objective with respect to prospective portfolio companies. These criteria, while not inclusive, provide general guidelines for our investment decisions.

 

Portfolio Composition. While we generally focus our investments in venture capital and private equity-backed technology-related companies, we seek to diversify across various financial sponsors as well as across various stages of companies’ development and various technology industry sub-sectors and geographies.

 

Continuing Support from One or More Financial Sponsors. We generally invest in companies in which one or more established financial sponsors have previously invested and continue to make a contribution to the management of the business. We believe that having established financial sponsors with meaningful commitments to the business is a key characteristic of a prospective portfolio company. In addition, we look for representatives of one or more financial sponsors to maintain seats on the Board of Directors of a prospective portfolio company as an indication of such commitment.

 

Company Stage of Development. While we invest in companies at various stages of development, we generally require that prospective portfolio companies be beyond the seed stage of development and generally have received or anticipate to have commitments for their first institutional round of equity financing. We expect a prospective portfolio company to demonstrate progress in its product development or demonstrate a path towards its ability to commence revenue generation or increase its revenues and operating cash flow over time. The anticipated growth rate of a prospective portfolio company is a key factor in determining the value that we ascribe to any warrants or other equity securities that we may acquire in connection with an investment in debt securities.

 

Operating Plan. We generally require that a prospective portfolio company, in addition to having sufficient access to capital to support leverage, demonstrate an operating plan capable of generating cash flows or the ability to raise the additional capital necessary to cover its operating expenses and service its debt for a specific period. Specifically, we require that a prospective portfolio company demonstrate at the time of our proposed investment that it has cash on its balance sheet, or is in the process of completing a financing so that it will have cash on its balance sheet, sufficient to support its operations for a minimum of 6 to 15 months.

 

Security Interest. In many instances we seek a first priority security interest in all of the portfolio company’s tangible and intangible assets as collateral for our debt investment, subject in some cases to permitted exceptions. In other cases we may prohibit a company from pledging or otherwise encumbering their intellectual property. Although we do not intend to operate as an asset-based lender, the estimated liquidation value of the assets, if any, collateralizing the debt securities that we hold is an important factor in our credit analysis and subject to assumptions that may change over the life of the investment. We evaluate both tangible assets, such as accounts receivable, inventory and equipment, and intangible assets, such as intellectual property, customer lists, networks and databases.

 

Covenants. Our investments may include one or more of the following covenants; cross-default and material adverse change provisions, require the portfolio company to provide periodic financial reports and operating metrics and will typically limit the portfolio company’s ability to incur additional debt, sell assets, dividend recapture, engage in transactions with affiliates and consummate an extraordinary transaction, such as a merger or recapitalization without our consent. In addition, we may require other performance or financial based covenants, as we deem appropriate.

 

Exit Strategy. Prior to making a debt investment that is accompanied by an equity-related security in a prospective portfolio company, we analyze the potential for that company to increase the liquidity of its equity through a future event that would enable us to realize appreciation in the value of our equity interest. Liquidity

 

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events may include an initial public offering, a private sale of our equity interest to a third party, a merger or an acquisition of the company or a purchase of our equity position by the company or one of its stockholders.

 

Investment Process

 

We have organized our management team around the four key elements of our investment process:

 

   

Origination;

 

   

Underwriting;

 

   

Documentation; and

 

   

Loan and Compliance Administration.

 

Our investment process is summarized in the following chart:

 

LOGO

 

Origination

 

The origination process for our investments includes sourcing, screening, preliminary due diligence and deal structuring and negotiation, all leading to an executed non-binding term sheet. Our investment origination team, which consists of 21 investment professionals, is headed by our Senior Managing Directors of Technology and Life Science, and our Chief Executive Officer. The origination team is responsible for sourcing potential investment opportunities and members of the investment origination team use their extensive relationships with various leading financial sponsors, management contacts within technology-related companies, trade sources, technology conferences and various publications to source prospective portfolio companies. Our investment origination team is divided into technology and life-sciences sub-teams to better source potential portfolio companies.

 

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In addition, we have developed a proprietary and comprehensive SQL-based database system to track various aspects of our investment process including sourcing, originations, transaction monitoring and post- investment performance. As of March 31, 2008, our proprietary SQL-based database system included over 15,300 technology-related companies and over 4,200 venture capital private equity sponsors/investors, as well as various other industry contacts. This proprietary SQL system allows our origination team to maintain, cultivate and grow our industry relationships while providing our origination team with comprehensive details on companies in the technology-related industries and their financial sponsors.

 

If a prospective portfolio company generally meets certain underwriting criteria, we perform preliminary due diligence, which may include high level company and technology assessments, evaluation of its financial sponsors’ support, market analysis, competitive analysis, evaluation of select management, risk analysis and transaction size, pricing, return analysis and structure analysis. If the preliminary due diligence is satisfactory, and the origination team recommends moving forward, we then structure, negotiate and execute a non-binding term sheet with the potential portfolio company. Upon execution of a term sheet, the investment opportunity moves to the underwriting process to complete formal due diligence review and approval.

 

Underwriting

 

The underwriting review includes formal due diligence and approval of the proposed investment in the portfolio company.

 

Due Diligence. Our due diligence on a prospective investment is typically completed by two or more investment professionals which we define as the underwriting team. The underwriting team for a proposed investment consists of the deal sponsor who possesses specific industry knowledge and is responsible for originating and managing the transaction, other investment professional(s) who perform due diligence, credit and corporate financial analyses and, as needed, our Chief Legal Officer. To ensure consistent underwriting, we generally use our standardized due diligence methodologies, which include due diligence on financial performance and credit risk as well as an analysis of the operations and the legal and applicable regulatory framework of a prospective portfolio company. The members of the underwriting team work together to conduct due diligence and understand the relationships among the prospective portfolio company’s business plan, operations and financial performance.

 

As part of our evaluation of a proposed investment, the underwriting team prepares an investment memorandum for presentation to the investment committee. In preparing the investment memorandum, the underwriting team typically interviews with select key management of the company and select financial sponsors and assembles information necessary to the investment decision. If and when appropriate, the investment professionals may also contact industry experts and customers, vendors or, in some cases, competitors of the company.

 

Approval Process. The sponsoring managing director or principal presents the investment memorandum to our investment committee for consideration. The unanimous approval of our investment committee is required before we proceed with any investment. The members of our investment committee are our Chief Executive Officer, our Chief Legal Officer and our Chief Financial Officer. The investment committee generally meets weekly and more frequently on an as-needed basis. Our investment committee process is generally the same at our wholly-owned subsidiary Hercules Technology II, L.P. (“HT II”) except that our two Senior Managing Directors are also members of the committee. The senior Managing Directors abstain from voting with respect to investments they originate.

 

Documentation

 

Our documentation group, headed by our Chief Legal Officer, administers the front-end documentation process for our loans. This group is responsible for documenting the term sheet approved by the investment

 

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committee to memorialize the transaction with a portfolio company. This group negotiates loan documentation and, subject to the approval of the Chief Legal Officer and/or the Associate General Counsel, final documents are prepared for execution by all parties. The documentation group generally uses the services of external law firms to complete the necessary documentation.

 

Loan and Compliance Administration

 

Our loan and compliance administration group, headed by our Chief Financial Officer, administers loans and tracks covenant compliance, if applicable, of our investments and oversees periodic reviews of our critical functions to ensure adherence with our internal policies and procedures. After funding of a loan in accordance with the investment committee’s approval, the loan is recorded in our loan administration software and our SQL-based database system. The loan and compliance administration group is also responsible for ensuring timely interest and principal payments and collateral management and advises the investment committee on the financial performance and trends of each portfolio company, including any covenant violations that occur, to aid us in assessing the appropriate course of action for each portfolio company and evaluating overall portfolio quality. In addition, the loan and compliance administration group advises the investment committee and the Valuation Committee of the board, accordingly, regarding the credit and investment grading for each portfolio company as well as changes in the value of collateral that may occur.

 

The loan and compliance administration group monitors our portfolio companies in order to determine whether the companies are meeting our financing criteria and their respective business plans and also monitors the financial trends of each portfolio company from its monthly or quarterly financial statements to assess the appropriate course of action for each company and to evaluate overall portfolio quality. In addition, our management team closely monitors the status and performance of each individual company through our SQL-based database system and periodic contact with our portfolio companies’ management teams and their respective financial sponsors.

 

Credit and Investment Grading System. Our loan and compliance administration group uses an investment grading system to characterize and monitor our outstanding loans. Our loan and compliance administration group monitors and, when appropriate, recommends changes to investment grading. Our investment committee reviews the recommendations and/or changes to the investment grading, which are submitted on a quarterly basis to the Valuation Committee and our Board of Directors for approval.

 

From time to time we will identify investments that require closer monitoring or become workout assets. We develop a workout strategy for workout assets and our investment committee monitors the progress against the strategy. We will incur losses from our investing activities, however we work with our troubled portfolio companies in order to recover as much of our investments as is practicable.

 

We use the following investment grading system approved by our Board of Directors:

 

  Grade 1. Loans involve the least amount of risk in our portfolio. The borrower is performing above expectations, and the trends and risk profile is generally favorable.

 

  Grade 2. The borrower is performing as expected and the risk profile is neutral to favorable. All new loans are initially graded 2.

 

  Grade 3. The borrower may be performing below expectations, and the loan’s risk has increased materially since origination. We increase procedures to monitor a borrower that may have limited amounts of cash remaining on the balance sheet, is approaching its next equity capital raise within the next three to six months, or if the estimated fair value of the enterprise may be lower than when the loan was originated. We will generally lower the loan grade to a level 3 even if the company is performing in accordance to plan as it approaches the need to raise additional cash to fund its operations. Once the borrower closes its new equity capital raise, we may increase the loan grade back to grade 2.

 

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  Grade 4. The borrower is performing materially below expectations, and the loan risk has substantially increased since origination. Loans graded 4 may experience some partial loss or full return of principal but are expected to realize some loss of interest which is not anticipated to be repaid in full, which, to the extent not already reflected, may require the fair value of the loan to be reduced to the amount we anticipate will be recovered. Grade 4 investments are closely monitored.

 

  Grade 5. The borrower is in workout, materially performing below expectations and a significant risk of principal loss is probable. Loans graded 5 will experience some partial principal loss or full loss of remaining principal outstanding is expected. Grade 5 loans will require the fair value of the loans be reduced to the amount, if any, we anticipate will be recovered.

 

At March 31, 2008, our investments had a weighted average investment grading of 2.21.

 

Managerial Assistance

 

As a business development company, we offer, and provide upon request, managerial assistance to our portfolio companies. This assistance could involve, among other things, monitoring the operations of our portfolio companies, participating in board and management meetings, consulting with and advising officers of portfolio companies and providing other organizational and financial guidance. We may receive fees for these services.

 

Asset Management

 

We may engage in the asset management business by providing investment advisory services to funds that may be formed in the future. Such funds may focus on our lower yielding assets, such as senior debt, equipment based only financing or equity only funding. We may contribute assets currently in our portfolio to the extent that our management and Board of Directors deems it appropriate. We may, from time to time, serve as the investment manager of such funds and may receive management and other fees for such services. Such funds may have overlapping investment objectives and may invest in asset classes similar to those targeted by us.

 

Competition

 

Our primary competitors provide financing to prospective portfolio companies and include non-bank financial institutions, federally or state chartered banks, venture debt funds, financial institutions, venture capital funds, private equity funds, investment funds and investment banks. Many of these entities have greater financial and managerial resources than we have, and the 1940 Act imposes certain regulatory restrictions on us as a business development company to which many of our competitors are not subject. However, we believe that few of our competitors possess the expertise to properly structure and price debt investments to venture capital and private equity backed technology-related companies. We believe that our specialization in financing technology-related companies will enable us to assess the value of intellectual property assets, evaluate the business prospects and operating characteristics of prospective portfolio companies and, as a result, identify investment opportunities that produce attractive risk-adjusted returns. For additional information concerning the competitive risks we face, see “Risk Factors—Risks Related to our Business and Structure—We operate in a highly competitive market for investment opportunities, and we may not be able to compete effectively.”

 

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Legal Proceedings

 

As of March 31, 2008, we were not a party to any legal proceedings. However, from time to time, we may be party to certain legal proceedings incidental to the normal course of our business including the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.

 

Corporate Structure

 

We are a Maryland corporation and an internally-managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company under the 1940 Act. HT II, our wholly-owned subsidiary, is licensed under the Small Business Investment Act of 1958 as a Small Business Investment Company. HTM, another wholly-owned subsidiary, functions as the general partner of our subsidiary HT II. Hercules Funding I LLC, our wholly owned subsidiary, and Hercules Funding Trust I function as vehicles to collateralize loans under our Credit Facility. In December 2006, we established Hydra Management LLC and Hydra Management Co., Inc. an investment manager and an investment management company, respectively. In April 2008, we established Hercules Technology Management Co., Inc., an investment manager.

 

Our principal executive offices are located at 400 Hamilton Avenue, Suite 310, Palo Alto, California 94301. We also have offices in: Boston, Massachusetts; Boulder, Colorado; Chicago, Illinois; Columbus, Ohio; and San Diego, California.

 

Employees

 

As of May 30, 2008, we had 39 employees, including 25 investment and portfolio management professionals all of whom have extensive prior experience working on financing transactions for technology-related companies. We intend to expand our management team, financial analyst group and operational personnel to support our growing portfolio of companies. We may also hire additional managing directors if our business indicates the need to expand the team to take advantage of growing market opportunities.

 

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PORTFOLIO COMPANIES

 

The following tables set forth certain information as of March 31, 2008 regarding each portfolio company in which we had a debt or equity investment. The general terms of our loans and other investments are described in “Business—Our Investments.” We offer to make available significant managerial assistance to our portfolio companies. In addition, we may receive rights to observe the Board of Directors’ meetings of our portfolio companies.

 

Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

Acceleron Pharmaceuticals, Inc. (0.68%)*(4)

 

Drug Discovery

  

Senior Debt

     

24 Emily Street

    

Matures June 2009

     

Cambridge, MA 02139

    

Interest rate 10.25%

    $ 2,889   $ 2,889
    

Preferred Stock Warrants

  1.67 %     69     707
    

Preferred Stock Warrants

  0.65 %     35     130

Acceleron Pharmaceuticals, Inc. (0.33%)

    

Preferred Series A Stock

  1.71 %     1,243     1,805
                  

Total Acceleron Pharmaceuticals, Inc.

           4,236     5,531

Aveo Pharmaceuticals, Inc. (2.02%)(4)

 

Drug Discovery

  

Senior Debt

     

75 Sidney Street 4th Floor

    

Matures September 2009

     

Cambridge, MA 02139

    

Interest rate 10.75%

      10,845     10,845
    

Preferred Stock Warrants

  10.18 %     144     193
    

Preferred Stock Warrants

  3.39 %     46     72
                  

Total Aveo Pharmaceuticals, Inc.

           11,035     11,110

Elixir Pharmaceuticals, Inc. (2.42%)(4)

 

Drug Discovery

  

Senior Debt

     

One Kendall Square Building 1000, 5th Floor

    

Matures June 2010

     

Cambridge, MA 02139

    

Interest rate Prime + 2.45%

      12,829     12,829
    

Preferred Stock Warrants

  1.47 %     217     453
                  

Total Elixir Pharmaceuticals, Inc.

           13,046     13,282

EpiCept Corporation (1.11%)(4)

 

Drug Discovery

  

Senior Debt

     

777 Old Saw Mill River Road

    

Matures August 2009

     

Tarrytown, NY 10591

    

Interest rate 11.70%

      5,989     5,989
    

Common Stock Warrants

  0.69 %     423     128
                  

Total EpiCept Corporation

           6,412     6,117

Horizon Therapeutics, Inc. (0.22%)

 

Drug Discovery

  

Senior Debt

     

533 Bryant Street

    

Matures April 2011

      1,038     1,038

Palo Alto, CA 94301

    

Interest rate 8.75%

      1,038     1,038
    

Preferred Stock Warrants

  1.56 %     179     183
                  

Total Horizon Therapeutics, Inc.

           1,217     1,221

Inotek Pharmaceuticals Corp. (0.27%)

 

Drug Discovery

  

Preferred Stock

  6.17 %     1,500     1,500

100 Cummings Drive

          

Beverly, MA 019 15

          
                  

Total Inotek Pharmaceuticals Corp.

           1,500     1,500

Memory Pharmaceticals Corp. (2.52%)(4)

 

Drug Discovery

  

Senior Debt

     

100 Phillips Parkway

    

Matures December 2010

     

Montvale, NJ 07645

    

Interest rate 11.45%

      13,731     13,731
    

Common Stock Warrants

  0.83 %     1,751     131
                  

Total Memory Pharmaceticals Corp.

           15,482     13,862

Merrimack Pharmaceuticals, Inc. (0.21%)(4)

 

Drug Discovery

  

Convertible Senior Debt

     

101 Binney Street

    

Matures October 2008

     

Cambridge, MA 02142

    

Interest rate 11.15%

      572     572
    

Preferred Stock Warrants

  3.60 %     155     575

Merrimack Pharmaceuticals, Inc. (0.51%)

    

Preferred Series E Stock

  3.65 %     2,000     2,787
                  

Total Merrimack Pharmaceuticals, Inc.

           2,727     3,934

Neosil, Inc. (1.08%)

 

Drug Discovery

  

Senior Debt

     

5980 Horton St. Suite 525

    

Matures May 2010

     

Emeryville, CA 94608

    

Interest rate 10.75%

      5,742     5,742
    

Preferred Stock Warrants

  1.53 %     83     208
                  

Total Neosil, Inc.

           5,825     5,950

 

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Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

Paratek Pharmaceuticals, Inc. (0.27%)(4)

 

Drug Discovery

  

Senior Debt

     

75 Kneeland Street

    

Matures June 2008

     

Boston, MA 02111

    

Interest rate 11.10%

    1,490   1,490
    

Preferred Stock Warrants

  18.53 %   137   —  

Paratek Pharmaceuticals, Inc. (0.18%)

    

Preferred Stock

  2.44 %   1,000   1,000
              

Total Paratek Pharmaceuticals, Inc.

         2,627   2,490

Portola Pharmaceuticals, Inc. (2.78%)(4)

 

Drug Discovery

  

Senior Debt

     

270 E Grand Ave

    

Matures September 2010

     

South San Francisco, CA 94080

    

Interest rate Prime + 1.75%

    14,904   14,904
    

Preferred Stock Warrants

  1.43 %   152   339
              

Total Portola Pharmaceuticals, Inc.

         15,056   15,243

Sirtris Pharmaceuticals, Inc. (1.66%)(4)

 

Drug Discovery

  

Senior Debt

     

790 Memorial Drive

    

Matures April 2011

     

Cambridge, MA 02139

    

Interest rate 10.60%

    8,451   8,451
    

Common Stock Warrants

  2.22 %   89   668

Sirtris Pharmaceuticals, Inc. (0.13%)

    

Common Stock

  1.30 %   500   736
              

Total Sirtris Pharmaceuticals, Inc.

         9,040   9,855
              

Total Drug Discovery (16.39%)

         88,203   90,095
              

E-band Communications, Inc. (0.36%)(6)

 

Communications &

  

Preferred Stock

  20.00 %   2,000   2,000

9745 Businesspark Ave.

 

Networking

        

San Diego, CA 92131

          
              

Total E-Band Communications, Inc.

         2,000   2,000

IKANO Communications, Inc. (3.43%)(4)

 

Communications &

  

Senior Debt

     

265 East 100 South, Ste 245

 

Networking

  

Matures March 2011

     

Salt Lake City, UT 84111

    

Interest rate 11.00%

    18,384   18,384
    

Preferred Stock Warrants

  0.04 %   45   188
    

Preferred Stock Warrants

  0.07 %   72   286
              

Total IKANO Communications, Inc.

         18,501   18,858

Neonova Holding Company (1.64%)

 

Communications &

  

Senior Debt

     

1000 Perimeter Park Drive, Suite K

 

Networking

  

Matures September 2012

     

Morrisville, NC 27560

    

Interest rate Prime + 3.25%

    8,906   8,906
    

Preferred Stock Warrants

  2.17 %   94   93

Neonova Holding Company (0.05%)

    

Preferred Stock

  1.92 %   250   250
              

Total Neonova Holding Company

         9,250   9,249

Ping Identity Corporation (0.25%)(4)

 

Communications &

  

Senior Debt

     

1099 18th Street Suite 2950

 

Networking

  

Matures June 2009

     

Denver, CO 80202

    

Interest rate 11.50%

    1,360   1,360
    

Preferred Stock Warrants

  3.35 %   52   5
              

Total Ping Identity Corporation

         1,412   1,365

Purcell Systems, Inc. (1.51%)

 

Communications &

  

Senior Debt

     

16125 East Euclid Ave.

 

Networking

  

Matures June 2009

    2,002   2,002

Spokane, WA 99216

    

Interest rate Prime + 3.50%

    2,002   2,002
    

Revolving Line of Credit

     
    

Matures June 2008

     
    

Interest rate Prime + 2.00%

    6,000   6,000
    

Preferred Stock Warrants

  2.59 %   123   260
              

Total Purcell Systems, Inc.

         8,125   8,262

Rivulet Communications, Inc. (0.54%)(4)

 

Communications &

  

Senior Debt

     

75 Rochester Avenue

 

Networking

  

Matures September 2009

     

Portsmouth, NH 03801

    

Interest rate 10.60%

    2,954   2,954
    

Preferred Stock Warrants

  2.59 %   51   —  

Rivulet Communications, Inc. (0.05%)

    

Preferred Stock

  2.31 %   250   250
              

Total Rivulet Communications, Inc.

         3,255   3,204

 

74


Table of Contents

Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

Seven Networks, Inc. (1.97%)(4)

 

Communications &

  

Senior Debt

     

901 Marshall St.

 

Networking

  

Matures April 2010

     

Redwood City, CA 94063

    

Interest rate Prime + 3.75%

    8,405   8,405
    

Revolving Line of Credit

     
    

Matures April 2008

     
    

Interest rate Prime + 3.00%

    2,000   2,000
    

Preferred Stock Warrants

  6.04 %   174   437
              

Total Seven Networks, Inc.

         10,579   10,842

Simpler Networks Corp. (0.47%)(4)

 

Communications &

  

Senior Debt

     

90 Washington Valley Road

 

Networking

  

Matures July 2009

     

Bedminster, NJ 07921

    

Interest rate 11.75%

    4,058   2,558
    

Preferred Stock Warrants

  5.90 %   160   —  

Simpler Networks Corp. (0.00%)

    

Preferred Stock

  1.96 %   500   —  
              

Total Simpler Networks Corp.

         4,718   2,558

Stoke, Inc. (0.43%)

 

Communications &

  

Senior Debt

     

5403 Betsy Ross Dr.

 

Networking

  

Matures August 2010

     

Santa Clara, CA 94043

    

Interest rate 10.55%

    2,208   2,208
    

Preferred Stock Warrants

  1.87 %   53   127
              

Total Stoke, Inc.

         2,261   2,335

Tectura Corporation (3.78%)(4)

 

Communications &

  

Senior Debt

     

333 Twin Dolphin Drive, Suite 750

 

Networking

  

Matures March 2012

     

Redwood City, CA 94065

    

Interest rate LIBOR + 6.15%

    8,643   8,643
    

Revolving Line of Credit

     
    

Matures March 2008

     
    

Interest rate LIBOR + 5.15%

    12,000   12,000
    

Preferred Stock Warrants

  18.24 %   51   104
              

Total Tectura Corporation

         20,694   20,747

Teleflip, Inc. (0.00%)

 

Communications &

  

Senior Debt

     

2425 Olympic Blvd. Suite 520

 

Networking

  

Matures May 2010

     

Santa Monica, CA 90404

    

Interest rate Prime + 2.75%

    930   —  
    

Preferred Stock Warrants

  2.51 %   11   —  
              

Total Teleflip, Inc.

         941   —  

Wireless Channels, Inc. (2.20%)

 

Communications &

  

Senior Debt—Second Lien

     

7101 S. Fulton St. #200

 

Networking

  

Matures April 2010

     

Centenial, CO 80112

    

Interest rate Prime + 4.25%

    1,570   1,570
    

Senior Debt—Second Lien

     
    

Matures April 2010

     
    

Interest rate Prime + 4.25%

    10,147   10,147
    

Preferred Stock Warrants

  4.47 %   155   340
              

Total Wireless Channels, Inc.

         11,872   12,057

Zayo Bandwith, Inc. (4.55%)(4)

 

Communications &

  

Senior Debt

     

950 Spruce St.

 

Networking

  

Matures April 2013

     

Louisville, CO 80027

    

Interest rate Prime + 3.50%

    25,000   25,000
              

Total Zayo Bandwith, Inc.

         25,000   25,000
              

Total Communications & Networking (21.23%)

       118,608   116,477
              

Atrenta, Inc. (0.63%)(4)

 

Software

  

Senior Debt

     

2077 Gateway Place Suite 300

    

Matures June 2009

     

San Jose, CA 95110

    

Interest rate 11.50%

    3,108   3,108
    

Preferred Stock Warrants

  5.40 %   102   250
    

Preferred Stock Warrants

  1.77 %   34   82

Atrenta, Inc. (0.05%)

    

Preferred Stock

  1.56 %   250   250
              

Total Atrenta, Inc.

         3,494   3,690

Blurb, Inc. (0.42%)

 

Software

  

Senior Debt

     

580 California St Suite 300

    

Matures December 2009

     

San Francisco, CA 94104

    

Interest rate 9.55%

    2,293   2,293
    

Preferred Stock Warrants

  0.62 %   25   34
              

Total Blurb, Inc.

         2,318   2,327

 

75


Table of Contents

Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

Bullhorn, Inc. (0.18%)

 

Software

  

Senior Debt

     

33-41 Farnsworth, 5th Floor

    

Matures March 2010

     

Boston, MA 02210

    

Interest rate Prime + 3.75%

    963   963
    

Preferred Stock Warrants

  8.54 %   43   53
              

Total Bullhorn, Inc.

         1,006   1,016

Cittio, Inc. (0.18%)

 

Software

  

Senior Debt

     

80 Tehama St.

    

Matures April 2010

     

San Francisco, CA 94105

    

Interest rate 11.00%

    1,000   1,000
              

Total Cittio, Inc.

         1,000   1,000

Forescout Technologies, Inc. (0.43%)(4)

 

Software

  

Senior Debt

     

10001 De Anza Blvd., Suite 220

    

Matures August 2009

     

Cupertino, CA 95014

    

Interest rate 11.15%

    1,671   1,671
    

Revolving Line of Credit

     
    

Matures August 2007

     
    

Interest rate Prime + 1.49%

    500   500
    

Preferred Stock Warrants

  3.06 %   99   176
              

Total Forescout Technologies, Inc.

         2,270   2,347

GameLogic, Inc. (0.56%)(4)

 

Software

  

Senior Debt

     

139 Main street 5th floor

    

Matures December 2009

     

Boston, MA 02142

    

Interest rate Prime + 4.125%

    2,947   2,947
    

Preferred Stock Warrants

  1.54 %   92   139
              

Total GameLogic, Inc.

         3,039   3,086

Gomez, Inc. (0.09%)(4)

 

Software

  

Preferred Stock Warrants

  4.35 %   35   491

610 Lincoln Street

          

Waltham, MA 02451

          
              

Total Gomez, Inc.

         35   491

HighRoads, Inc. (0.01%)(4)

 

Software

  

Preferred Stock Warrants

  3.18 %   44   71

150 Presidential Way

          

Woburn, MA 01801

          
              

Total HighRoads, Inc.

         44   71

Intelliden, Inc. (0.40%)

 

Software

  

Senior Debt

     

90 South Cascade Avenue

    

Matures February 2010

     

Colorado Springs, CO 80903

    

Interest rate 13.20%

    2,122   2,122
    

Preferred Stock Warrants

  0.94 %   18   77
              

Total Intelliden, Inc.

         2,140   2,199

Oatsystems, Inc. (0.69%)(4)

 

Software

  

Senior Debt

     

265 Winter St.

    

Matures September 2009

     

Waltham, MA 02451

    

Interest rate 11.00%

    3,768   3,768
    

Preferred Stock Warrants

  5.45 %   67   1
              

Total Oatsystems, Inc.

         3,835   3,769

Proficiency, Inc. (0.27%)(5)(6)

 

Software

  

Senior Debt

     

880 Winter St. Suite 320

    

Matures July 2008

     

Waltham, MA 02415

    

Interest rate 12.00%

    1,497   1,497
    

Preferred Stock Warrants

  9.27 %   96   —  

Proficiency, Inc. (0.14%)

    

Preferred Stock

  25.91 %   2,750   750
              

Total Proficiency, Inc.

         4,343   2,247

PSS Systems, Inc. (0.65%)(4)

 

Software

  

Senior Debt

     

2471 East Bayshore Road, Suite 600

    

Matures March 2010

     

Palo Alto, CA 94303

    

Interest rate 10.74%

    3,467   3,467
    

Preferred Stock Warrants

  1.48 %   51   108
              

Total PSS Systems, Inc.

         3,518   3,575

 

76


Table of Contents

Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

Savvion, Inc. (1.14%)(4)

 

Software

  

Senior Debt

     

5104 Old Ironsides Drive, Suite 205

    

Matures March 200

     

Santa Clara, CA 95054

    

Interest rate Prime + 3.45%

    1,043   1,043
    

Revolving Line of Credit

     
    

Matures March 2008

     
    

Interest rate Prime + 3.45%

    3,188   3,188
    

Revolving Line of Credit

     
    

Matures March 2008

     
    

Interest rate Prime + 2.00%

    1,797   1,797
    

Preferred Stock Warrants

  5.59 %   52   251
              

Total Savvion, Inc.

         6,080   6,279

Sportvision, Inc. (0.01%)

 

Software

  

Preferred Stock Warrants

  1.89 %   39   59

4619 N. Ravenswood

          

Chicago, IL 60640

          
              

Total Sportvision, Inc.

         39   59

Talisma Corp. (0.08%)(4)

 

Software

  

Preferred Stock Warrants

  1.47 %   49   422

10900 N.E. 4th Street, Suite 1510

          

Bellevue, WA 98004-5841

          
              

Total Talisma Corp.

         49   422

WildTangent, Inc. (0.39%)

 

Software

  

Senior Debt

     

18578 NE 67th Court, Building 5

    

Matures March 2011

     

Redmond, WA 98052

    

Interest rate 9.65%

    1,788   1,788
    

Preferred Stock Warrants

  6.31 %   238   339
              

Total WildTangent, Inc.

         2,026   2,127
              

Total Software (6.32%)

         35,236   34,705
              

Agami Systems, Inc. (0.84%)(4)

 

Electronics &

  

Senior Debt

     

1269 Innsbruck Drive

 

Computer

  

Matures August 2009

     

Sunnyvale, CA 94089

 

Hardware

  

Interest rate 11.00%

    4,394   4,394
    

Preferred Stock Warrants

  1.88 %   86   218
              

Total Agami Systems, Inc.

         4,480   4,612

Luminus Devices, Inc. (2.18%)(4)

 

Electronics &

  

Senior Debt

     

175 New Boston Street Suite A

 

Computer

  

Matures August 2009

     

Woburn, MA 01801

 

Hardware

  

Interest rate 12.8750%

    11,354   11,354
    

Preferred Stock Warrants

  0.43 %   183   135
    

Preferred Stock Warrants

  0.21 %   84   74
    

Preferred Stock Warrants

  1.45 %   334   420
              

Total Luminus Devices, Inc.

         11,955   11,983

Maxvision Holding, LLC. (2.05%)(4)

 

Electronics &

  

Senior Debt

     

495 Production Ave.

 

Computer

  

Matures April 2012

     

Huntsville, AL 35758

 

Hardware

  

Interest rate Prime + 5.50%

    4,956   4,956
    

Senior Debt

     
    

Matures April 2012

     
    

Interest rate Prime + 2.25%

    5,500   5,500
    

Revolving Line of Credit

     
    

Matures September 2012

     
    

Interest rate Prime +2.25%

    821   821

Maxvision Holding, LLC. (0.01%) (4)

    

Preferred Stock

  1.25 %   81   81
              

Total Maxvision Holding, LLC

         11,358   11,358

NetEffect, Inc. (0.43%)

 

Electronics &

  

Senior Debt

     

9211 Waterford Centre Blvd. Ste 100

 

Computer

  

Matures May 2010

     

Austin, TX 78758

 

Hardware

  

Interest rate 11.95%

    2,244   2,244
    

Preferred Stock Warrants

  0.55 %   47   120
              

Total NetEffect, Inc.

         2,291   2,364

Shocking Technologies, Inc. (0.05%)

 

Electronics &

  

Senior Debt

     

2161 Otoole Ave.

 

Computer

  

Matures December 2010

     

San Jose, CA 95138

 

Hardware

  

Interest rate 9.75%

    192   192
    

Preferred Stock Warrants

  2.74 %   63   95
              

Total Shocking Technologies, Inc.

         255   287

 

77


Table of Contents

Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

SiCortex, Inc. (1.83%)

 

Electronics &

  

Senior Debt

     

Three Clock Tower Place, Suite 210

 

Computer

  

Matures December 2010

     

Maynard, MA 01754

 

Hardware

  

Interest rate 10.95%

    9,615   9,615
    

Preferred Stock Warrants

  4.15 %   164   446
              

Total SiCortex, Inc.

         9,779   10,061

Spatial Photonics, Inc. (0.71%)(4)

 

Electronics &

  

Senior Debt

     

618 West California Avenue

 

Computer

  

Matures May 2011

     

Sunnyvale, CA 94086

 

Hardware

  

Interest rate 10.75%

    3,634   3,634
    

Preferred Stock Warrants

  1.83 %   130   274

Spatial Photonics, Inc. (0.09%)

    

Preferred Stock

  1.89 %   500   500
              

Total Spatial Photonics Inc.

         4,264   4,408

VeriWave, Inc. (0.88%)

 

Electronics &

  

Senior Debt

     

8770 SW Nimbus Ave. Suite B

 

Computer

  

Matures May 2010

     

Beaverton, OR 97008

 

Hardware

  

Interest rate 10.75%

    3,710   3,710
    

Revolving Line of Credit

     
    

Matures May 2008

     
    

Interest rate Prime +1.00%

    990   990
    

Preferred Stock Warrants

  3.55 %   54   128
              

Total VeriWave, Inc.

         4,754   4,828

ViDeOnline Communications, Inc. (0.05%)(4)

 

Electronics &

  

Preferred Stock Warrants

  2.56 %   298   289

656 Bair Island Road, Suite 108

 

Computer

        

Redwood City, CA 94063

 

Hardware

        
              

Total ViDeOnline Communications, Inc.

         298   289
              

Total Electronics & Computer Hardware (9.12%)

       49,434   50,190
              

Aegerion Pharmaceuticals, Inc. (1.66%)(4)

 

Specialty

  

Senior Debt

     

1140 Route 22 East, Suite 304

 

Pharmaceuticals

  

Matures August 2010

     

Bridgewater, NJ 08807

    

Interest rate Prime + 2.50%

    8,877   8,877
    

Preferred Stock Warrants

  0.58 %   69   237

Aegerion Pharmaceuticals, Inc. (0.18%)(4)

    

Preferred Stock

  5.37 %   1,000   1,000
              

Total Aegerion Pharmaceuticals, Inc.

         9,946   10,114

Panacos Pharmaceuticals, Inc. (3.55%)(4)

 

Specialty

  

Senior Debt

     

134 Coolidge Ave.

 

Pharmaceuticals

  

Matures January 2011

     

Watertown, MA 02472

    

Interest rate 11.20%

    19,332   19,332
    

Common Stock Warrants

  1.20 %   876   132

Panacos Pharmaceuticals, Inc. (0.03%)

    

Common Stock

  0.37 %   410   140
              

Total Panacos Pharmaceuticals, Inc.

         20,618   19,604

Quatrx Pharmaceuticals Company (2.40%)(4)

 

Specialty

  

Senior Debt

     

777 East Eisenhower Pkwy Suite 100

 

Pharmaceuticals

  

Matures January 2010

     

Ann Arbor, MI 48108

    

Interest rate Prime + 3.00%

    13,038   13,038
    

Preferred Stock Warrants

  2.89 %   220   144

Quatrx Pharmaceuticals Company (0.14%)

    

Preferred Stock

  2.23 %   750   750
              

Total Quatrx Pharmaceuticals Company

         14,008   13,932
              

Total Specialty Pharmaceuticals (7.96%)

         44,572   43,650
              

Annie’s, Inc. (0.73%)

 

Consumer &

  

Senior Debt

     

564 Gateway Drive

 

Business

  

Matures April 2011

     

Napa, CA 94558

 

Products

  

Interest rate LIBOR + 6.50%

    3,679   3,679
    

Preferred Stock Warrants

  1.79 %   321   323
              

Total Annie’s, Inc.

         4,000   4,002

BabyUniverse, Inc. (0.03%)(4)

 

Consumer &

  

Common Stock

  0.15 %   267   145

150 South US Highway One, Ste 500

 

Business

        

Jupiter, FL 33477

 

Products

        
              

Total BabyUniverse, Inc.

         267   145

Market Force Information, Inc. (0.01%)(4)

 

Consumer &

  

Preferred Stock Warrants

  1.21 %   24   53

1877 Broadway, Suite 200

 

Business

        

Boulder, CO 80302

 

Products

        

Market Force Information, Inc. (0.09%)

    

Preferred Stock

  1.57 %   500   500
              

Total Market Force Information, Inc.

         524   553

 

78


Table of Contents

Portfolio Company

 

Industry

  

Type of Investment(1)

  Percentage
of Class
Held on a
Fully
Diluted
Basis
    Cost(2)   Value(3)

Wageworks, Inc. (0.10%)(4)

 

Consumer &

  

Preferred Stock Warrants

  6.72 %   252   562

1100 Park Place 4th Floor

 

Business

        

San Mateo, CA 94403

 

Products

        

Wageworks, Inc. (0.04%)

    

Preferred Stock

  1.64 %   250   209
              

Total Wageworks, Inc.

         502   771
              

Total Consumer & Business Products (1.00%)

         5,293   5,471
              

Custom One Design, Inc. (0.19%)

 

Semiconductors

  

Senior Debt

     

10 Corey St.

    

Matures September 2010

     

Melrose, MA 02176

    

Interest rate 11.50%

    985   985
    

Common Stock Warrants

  1.11 %   18   53
              

Total Custom One Design, Inc.

         1,003   1,038

iWatt Inc. (0.84%)(4)

 

Semiconductors

  

Senior Debt

     

90 Albright Way

    

Matures September 2009

     

Los Gatos, CA 95032-1827

    

Interest rate Prime + 2.75%

    1,130   1,130
    

Revolving Line of Credit

     
    

Matures September 2007

     
    

Interest rate Prime + 1.75%