-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, IwtLEKNsiqG0Ep8jA7hVkbax1nkJUAmY1yEVrPY0utkDs1mUhYRk3gtfUb9h8oLE gz3J5dIOa6KK/1KdCL5vFQ== 0001024739-98-000327.txt : 19980331 0001024739-98-000327.hdr.sgml : 19980331 ACCESSION NUMBER: 0001024739-98-000327 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19931231 FILED AS OF DATE: 19980330 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMERICAN CAPITAL STRATEGIES LTD CENTRAL INDEX KEY: 0000817473 STANDARD INDUSTRIAL CLASSIFICATION: [] IRS NUMBER: 521451377 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 814-00149 FILM NUMBER: 98577629 BUSINESS ADDRESS: STREET 1: 3 BETHESDA METRO CENTER STREET 2: SUITE 860 CITY: BETHESDA STATE: MD ZIP: 20814 BUSINESS PHONE: 3019516122 MAIL ADDRESS: STREET 1: 3 BETHESDA METRO CENTER STREET 2: SUITE 860 CITY: BETHESDA STATE: MD ZIP: 20814 10-K 1 ANNUAL REPORT As filed with the Securities and Exchange Commission on March __, 1998 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K --------- (Mark One) [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998; or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____ to ____ Commission file number __________ --------------------- AMERICAN CAPITAL STRATEGIES, LTD.
3 Bethesda Metro Center Suite 860 Delaware Bethesda, Maryland 20814 52-1451377 -------- --------------------------------------- ---------- (State or other jurisdiction of (Address of principal executive offices) (I.R.S. Employer incorporation or organization) Identification No.)
Registrant's telephone number, including area code: (301) 951-6122 Securities registered pursuant to Section 12(b) of the Act: Not Applicable Securities registered pursuant to section 12(g) of the Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- Common Stock, $0.01 par value Nasdaq Stock Market per share Indicate by check mark whether the registrant (1) has filed all report to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter earlier period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ]. No [ ]. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] On March 26, 1998, the aggregate market value of the Registrant's common stock held by nonaffiliates of the Registrant was approximately $[180,000,000] based upon a closing price of the Registrant's common stock of $22.88per share as reported on the NASDQ National Market System on that date. (For this computation, the registrant has excluded the market value of all shares of its Common Stock reported as beneficially owned by executive officers and directors of the registrant and certain other stockholders; such an exclusion shall not be deemed to constitute an admission that any such person is an "affiliate" of the registrant.) . On March 26, 1997, there were 11,068,767 shares of the Registrant's common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE. The Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 14, 1998 is incorporated by reference into certain sections of Part III herein. Certain exhibits previously filed with the Securities and Exchange Commission are incorporated by reference into Part IV of this report. ================================================================================ PART I ITEM 1. BUSINESS OF THE COMPANY BACKGROUND American Capital Strategies, Ltd., a Delaware corporation (the "Company"), was incorporated in 1986 to provide financial advisory services to and invest in small and medium sized businesses. On August 29, 1997, the Company completed an initial public offering ("IPO") of 10,382,437 shares of its common stock ("Common Stock") and became a non-diversified, closed end investment company that has elected to be treated as a business development company ("BDC") under the Investment Company Act of 1940, as amended ("1940 Act"). On October 1, 1997, the company began operations so as to qualify to be taxed as a regulated investment company (RIC) as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code of 1986 as amended (the "Code"). As contemplated by these transactions, the Company materially changed its business plan and format from structuring and arranging financing for buyout transactions on a fee for services basis to primarily being a lender to and investor in small and medium sized companies. The Company continues to provides financial advisory services to businesses through ACS Capital Investments Corporation ("CIC"), a wholly-owned subsidiary. The Company had established itself as a leading firm in structuring and obtaining funding for management and employee buyouts of subsidiaries, divisions and product lines being divested by larger corporations through the use of an employee stock ownership plans ("ESOPs"). From its formation in 1986 through the IPO, the Company arranged 29 financing transactions aggregating over $400 million. BUSINESS The Company is a buyout and specialty finance company that is principally engaged in providing senior debt, subordinated debt and equity to companies in need of capital for employee buyouts, management buyouts, growth, acquisitions, liquidity and restructuring. The Company invests up to $20 million in each transaction and through its subsidiary, CIC, will arrange and secure capital for larger transactions. The Company's primary business objectives are to increase its net operating income and net asset value by investing its assets in senior debt, subordinated debt with detachable warrants and equity of small to medium sized businesses with attractive current yields and potential for equity appreciation. The Company's loans typically range from $1 million to $20 million, mature in five to ten years, and require monthly or quarterly interest payments at variable rates based on the prime rate plus a margin. The Company prices its debt and equity investments based on its analysis of each transaction. As of December 31, 1997 the weighted average effective interest on the Company's debt investments was 14.5% and dividend rate on the Company's preferred stock investment was 15% The Company also invests in common stock which may not provide a current yield but would share in the appreciation of the investment. At December 31, 1997, common stock investments represented 6.0% of the Company's portfolio and common stock investments excluding CIC was 7.6% of the Company's investment in non-publicly traded securities. The Company expects common stock investments to represent the smallest percentage of its portfolio. The Company's equity interests in small and medium sized businesses are purchased with the goal of disposing of such interests and realizing a gain within three to seven years. The opportunity to realize such gain may occur if the business recapitalizes its equity, either through a sale to new owners or makes a public offering of its equity. The Company generally does not have the right to require that a business undergo an initial public offering by registering securities under the Securities Act of 1933, but the Company generally does have the right to sell its equity interests in a public offering by the business to the extent permitted by underwriters. 1 In most cases, the Company also receives the right to require the business to purchase the warrants or stock held by the Company ("Put Rights") under various circumstances including, typically, the repayment of the Company's loans or debt securities. When no public offering is available, the Company may use its Put Rights to dispose of its equity interest in a business, although the Company's ability to exercise Put Rights may be limited or nonexistent if a business is illiquid. The Company makes available significant managerial assistance to its portfolio companies. Such assistance typically involves closely monitoring the operations of the company, participating in its board and management meetings, being available for consultation with its officers and providing organizational and financial guidance. Providing assistance to its borrowers serves as a control for the Company as well as provides an opportunity for the Company to assist in maximizing the operations of the borrower. Prior to the IPO, the Company established itself as a leading firm in structuring and obtaining funding for management and employee buyouts of subsidiaries, divisions and product lines being divested by larger corporations through the use of an ESOP. The selling entities have included Sunbeam Corporation, the U.S. Office of Personnel Management, American Premier Underwriters, Inc. (formerly Penn Central Corporation), Campbell Soup Company, Union Carbide Corporation, National Forge Company, Inc., Air Products Company, Ampco-Pittsburgh Corporation and British Petroleum Company. In most of the ESOP transactions structured by the Company, the employees agree to restructure their wages and benefits so that overall cash compensation is reduced while contributions of stock are made to an ESOP. The resulting company is structured so that the fair market value of stock contributed to the ESOP can be deducted from corporate income before paying taxes. Restructuring employee compensation together with the ESOP tax advantages has the effect of improving the cash flow of the ESOP company. The Company believes that its ESOP knowledge and experience and its ability to fund transactions positions the Company favorably in the market place. 2 The Company continues providing financial advisory services and structuring of transactions through its wholly-owned subsidiary CIC. The typical advisory engagement includes a monthly retainer and a performance fee contingent upon closing of the transaction or event which is the subject of the engagement. Management believes that future growth of CIC is attainable through adding additional professionals, by gaining additional market share and by realizing the benefits of what is expected to be an increasing client base, which should expand as a result of its relationship with the Company. The Company believes that, through the structuring and advisory business, it has established an extensive referral network comprised of venture capitalists, investment bankers, attorneys, commercial bankers and business and financial brokers. CIC is continuing the relationships with the referral network and the Company utilizes the referral network and CIC's client base as its primary sources of investment opportunities. LENDING AND INVESTMENT DECISION CRITERIA The Company reviews certain criteria in order to make investment decisions. The criteria listed below provide a general guide for the Company's lending and investment decisions, although not all criteria are required to be favorable in order for the Company to make an investment. Operating History. The Company focuses on target companies that have stable operating histories and are profitable or near profitable at existing operating levels. The Company reviews the target companies ability to service and repay debt based on its historical results of operations. The Company does not expect to lend or invest in start-up or other early stage companies. Growth. In addition to generating sufficient cash flow to service its debt, a potential recipient of the Company's financing generally is required to establish its ability to grow its cash flow. Anticipated growth will be a key factor in determining the value ascribed to any warrants and equity interests acquired by the Company. Liquidation Value of Assets. Although the Company does not operate as an asset-based lender, liquidation value of the assets collateralizing the Company's loans is an important factor in each credit decision. Emphasis is placed both on tangible assets (accounts receivable, inventory, plant, property and equipment) as well as intangible assets such as customer lists, networks, databases and recurring revenue streams. Experienced Management Team. The Company requires that each borrower have or promptly obtain a management team that is experienced and properly incentivized through a significant ownership interest in the borrower. The Company requires that a potential recipient of the Company's financing have a management team who have demonstrated the ability to execute the company's objectives and implement its business plan. 3 Exit Strategy. Prior to making an investment, the Company analyzes the potential for the target company to experience a liquidity event that will allow the Company to realize value for its equity position. Liquidity events include, among other things, an initial public offering, a private sale of the Company's financial interest, a sale of the company, or a purchase by the company or one of its stockholders of the Company's equity position. OPERATIONS Marketing and Origination Process. The Company and CIC have thirteen professionals responsible for originating loans and investments and providing financial assistance to small and medium sized businesses and intends to hire an additional five professionals by year end. To originate financing opportunities, these professionals use an extensive referral network comprised of venture capitalists, investment bankers, unions, attorneys, accountants, commercial bankers, unions, business brokers and prospective or existing ESOP companies. The Company also has an extensive set of internet sites that it uses to attract financing opportunities. Approval Process. The Company's financial professionals review informational packages in search of potential financing opportunities and conduct a due diligence investigation of each applicant that passes an initial screening process. This due diligence investigation generally includes one or more on-site visits, a review of the company's historical and prospective financial information, interviews with management, employees, customers and vendors of the applicant, and background checks and research on the applicant's product, service or particular industry. Upon completion of the due diligence investigation, the financial professional creates a profile summarizing the target company's historical financial statements, industry and management team and analyzing its conformity to the Company's general investment criteria. The financial professional then presents this profile to the Company's Credit Committee, which is comprised of David Gladstone, Malon Wilkus and Adam Blumenthal, the Chairman, President and Executive Vice President, respectively, of the Company. The Company's Credit Committee and the Company's Board of Directors must approve each financing. Support Services. A commercial bank provides certain loan accounting and administrative services for the Company's investments and also acts as the custodian of the Company's portfolio assets pursuant to and in accordance with the 1940 Act. COMPETITION The Company's primary competitors include financial institutions and venture capital firms and other nontraditional lenders. Many of these entities have greater financial and managerial resources than the Company. Nevertheless, the Company believes that it competes effectively with these entities through, among other means, its responsiveness to the needs of its customers and its flexibility in structuring transactions. 4 EMPLOYEES As of March 20, 1998, the Company had twenty-two employees, thirteen of whom are professionals working on financings for small and medium sized businesses. The Company believes that its relations with its employees are excellent. The Company intends to continue maintaining a relatively low overhead by outsourcing many functions not directly related to marketing or underwriting its investments and the executive management of the Company. THE COMPANY'S OPERATIONS AS A BDC AND RIC As a BDC, the Company may not acquire any asset other than Qualifying Assets unless, at the time the acquisition is made, Qualifying Assets represent at least 70% of the value of the Company's total assets. The principal categories of Qualifying Assets relevant to the business of the Company are the following: (i) securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer is an eligible portfolio company. An eligible portfolio company is defined as any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than a small business investment company wholly-owned by the BDC and (c) does not have any class of publicly-traded securities with respect to which a broker may extend credit; (ii) securities received in exchange for or distributed with respect to securities described above, or pursuant to the exercise of options, warrants or rights relating to such securities; and (iii) cash, cash items, Government securities, or high quality debt securities maturing in one year or less from the time of investment. The Company may not change the nature of its business so as to cease to be, or withdraw its election as, a BDC unless authorized by vote of a majority, as defined in the 1940 Act, of the Company's shares. Since the Company made its BDC election, it has not made any substantial change in its structure or in the nature of its business. The Company operates so as to qualify as a RIC under the Internal Revenue Code of 1986 as amended. Generally in order to qualify as a RIC, the Company must distribute to shareholders in a timely manner, at least 90% of its "investment company taxable income" and 98% of its capital gain net income as defined by the code. The Company must derive at least 90% of its gross income from dividends, interest, payments with respect to securities loans, gain from the sale of stock or other securities, or other income derived with respect to its business of investing in such stock or securities as defined by the code. Additionally, the Company must diversify its holdings so that (i) at least 50% of the value of the Company's assets consists of cash, cash items, government securities and other securities if such other securities of any one issuer do not represent more than 5% of the Company's assets and 10% of the outstanding voting securities of the issuer and (ii) no more than 25% of the value of the Company's assets are invested in the securities of one issuer (other than U.S. government securities), or of two or more issuers that are controlled by the Company and are engaged in the same or similar or related trades or businesses. 5 TEMPORARY INVESTMENTS Pending investment in other types of Qualifying Assets, the Company has invested its otherwise uninvested cash primarily in cash, cash items, government securities, agency paper or high quality debt securities maturing in one year or less from the time of investment in such high quality debt investments ("Temporary Investments") so that at least seventy percent (70%) of its assets are Qualifying Assets. Typically, the Company invests in U.S. Treasury bills or in repurchase obligations of a "primary dealer" in government securities (as designated by the Federal Reserve Bank of New York) or of any other dealer whose credit has been established to the satisfaction of the Board of Directors. There is no percentage restriction on the proportion of the Company's assets that may be invested in such repurchase agreements. A repurchase agreement involves the purchase by an investor, such as the Company, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed upon future date and at a price which is greater than the purchase price by an amount that reflects an agreed-upon interest rate. Such interest rate is effective for the period of time during which the investor's money is invested in the arrangement and is related to current market interest rates rather than the coupon rate on the purchased security. The Company requires the continual maintenance by its custodian or the correspondent in its account with the Federal Reserve/Treasury Book Entry System of underlying securities in an amount at least equal to the repurchase price. If the seller were to default on its repurchase obligation, the Company might suffer a loss to the extent that the proceeds from the sale of the underlying securities were less than the repurchase price. A seller's bankruptcy could delay or prevent a sale of the underlying securities. LEVERAGE For the purpose of making investments other than Temporary Investments and to take advantage of favorable interest rates, the Company intends to issue in the future senior debt securities, up to the maximum amount permitted by the 1940 Act, which currently permits the Company, as a BDC, to issue senior debt securities and preferred stock (collectively, "Senior Securities") in amounts such that the Company's asset coverage, as defined in the 1940 Act, is at least 200% after each issuance of Senior Securities. Such indebtedness may also be incurred for the purpose of effecting share repurchases. As a result, the Company would become exposed to the risks of leverage. Although the Company has no current intention to do so, it has retained the right to issue preferred stock. As permitted by the 1940 Act, the Company may, in addition, borrow amounts up to five percent (5%) of its total assets for temporary or emergency purposes. 6 ITEM 2. PROPERTIES Neither the Company nor any of its subsidiaries owns any real estate or other physical properties materially important to the operation of the Company or any of its subsidiaries. The Company leases an aggregate of approximately 10,000 square feet of office space in four locations for terms ranging up to seven years. ITEM 3. LEGAL PROCEEDINGS Although the Company may, from time to time, be involved in litigation and claims arising out of its operations in the normal course of business, as of December 31, 1997, the Company was not presently a party to any material legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year ended December 31, 1997, there were no matters submitted to a vote of the Company's security holders through the solicitation of proxies or otherwise. 7 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Since the IPO the Company has distributed and currently intends to continue to distribute 90% of its net operating income and net realized short-term capital gains, if any, on a quarterly basis to its stockholders. Net realized long-term capital gains may be retained to supplement the Company's equity capital and support growth in its portfolio, unless the Board of Directors determines in certain cases to make a distribution. There is no assurance that the Company will achieve investment results or maintain a tax status that will permit any specified level of cash distributions or year-to-year increases in cash distributions. The Common Stock is quoted on the Nasdaq Stock Market under the symbol ACAS. As of March 25, 1998, the Company had 49 stockholders of record and approximately 1300 beneficial owners. The following table sets forth the range of high and low bid prices of the Company's Common Stock as reported on the Nasdaq Stock Market and the dividends declared by the Company for the period from August 29, 1997, when public trading of the Common Stock commenced, through March 25, 1998.
BID PRICE --------- DIVIDEND HIGH LOW DECLARED ---- --- -------- 1997 Third Quarter (beginning August 29, 1997) . . $20.25 $18.50 $.00 Fourth Quarter. . . . . . . . . . . . . . . . 20.75 16.50 .21 1998 First Quarter (through March 25, 1998). . . . 22.25 17.25 .25
8 ITEM 6. SELECTED FINANCIAL DATA [Furnish the information required by Item 301 of Regulation S-K.] ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION [Furnish the information required in Item 303 of Regulation S-K.] ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK [Furnish the information required by Item 305 of Regulation S-K.] ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA [Furnish the financial statements meeting the requirements of Regulation S-X, except ss. 210.3-05 and Article 11 thereof, and the supplementary financial information required by Item 302 of Regulation S-K. Financial statements of the registrant and its subsidiaries consolidated (as required by Rule 14a-3(b)) shall be filed under this Item. Other financial statements and schedules required under Regulation S-X may be filed as "Financial Statement Schedules" pursuant to Item 13, Exhibits, Financial Statement Schedules, and Reports on Form 8-K, of this Form.] ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE [Furnish the information required by Item 302 of Regulation S-K.] 9 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information in response to this Item is incorporated herein by reference to the information provided in the Company's Proxy Statement for its Annual Meeting of Shareholders to be held May 14, 1998 (the "1998 Proxy Statement") under the heading "Directors and Executive Officers of the Registrant." ITEM 11. EXECUTIVE COMPENSATION Information in response to this Item is incorporated herein by reference to the information provided in the 1998 Proxy Statement under the heading "Compensation of Directors and Executive Officers." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in response to this Item is incorporated herein by reference to the information provided in the 1998 Proxy Statement under the heading "Security Ownership of Management and Certain Beneficial Owners." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to this Item is incorporated herein by reference to the information provided in the 1998 Proxy Statement under the heading "Certain Transactions." 10 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K [(a) List the following: (1) all financial statements; (2) financial statement schedules required by Item 8 and paragraph (d) below; and (3) those exhibits required by Item 601 of Regulation S-K and paragraph (c) below. Identify in the list each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form pursuant to Item 149c) of this report (b) State whether any reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) File as exhibits those exhibits required by Item 601 of Regulation S-K. (d) Registrants shall file, as financial statement schedules to this Form, the financial statements required by Regulation S-X which are excluded from the annual report to shareholders by Rule 14a-3(b), including: (1) separate financial statements of subsidiaries not consolidated and fifty percent or less owned persons; (2) separate financial statements of affiliates whose securities are pledged as collateral; and (3) schedules.] 11 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN CAPITAL STRATEGIES, LTD. By: /s/ John R. Erickson -------------------------- John R. Erickson Chief Financial Officer (Principal Financial and Accounting Officer) Date: March 31, 1998 12 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name Title Date - ---- ----- ---- /s/ David J. Gladstone Chairman and Director March __, 1998 - ---------------------- David J. Gladstone /s/ Malon Wilkus President and Director March __, 1998 - ---------------- Malon Wilkus /s/ Adam Blumenthal Executive Vice President March __, 1998 - ------------------- and Director Adam Blumenthal /s/ John Erickson Vice President and Chief March __, 1998 - ----------------- Financial Officer John Erickson /s/ Stephen L. Hester Vice President and General March __, 1998 - --------------------- Counsel Stephen L. Hester /s/ Roland Cline Vice President March __, 1998 - ---------------- Roland Cline /s/ Robert L. Allbritton Director March __, 1998 - ------------------------ Robert L. Allbritton /s/ Landon Butler Director March __, 1998 - ----------------- Landon Butler /s/ Neil M. Hahl Director March __, 1998 - ---------------- Neil M. Hahl /s/ Phillip R. Harper Director March __, 1998 - --------------------- Phillip R. Harper /s/ Stan Lundine Director March __, 1998 - ---------------- Stan Lundine /s/ Stephen P. Walko Director March __, 1998 - -------------------- Stephen P. Walko
13 EXHIBIT INDEX
Exhibit Description ------- ----------- 3.1 American Capital Strategies, Ltd. Second Amended and Restated Certificate of Incorporation. Incorporated herein by reference to Exhibit 2.a of the Pre-Effective Amendment Number 1 to the Registration Statement on Form N-2 (File No. 333-29943) filed on August 12, 1997. 3.2 American Capital Strategies, Ltd. 1997 Stock Option Plan. Incorporated herein by reference to Exhibit i.2 of the Pre-Effective Amendment Number 1 to the Registration Statement on Form N-2 (File No. 333-29943) filed on August 12, 1997. 4 Instruments defining rights of security holders, including indentures. 9 Voting Trust Agreement. 10 Material Contracts. 11 Statement regarding computation of per share earnings. 12 Statement regarding computation of ratios. 13 Annual Report. 18 Letter regarding change in accounting principles. 21 Subsidiaries of the registrant. 22 Published report regarding matters submitted to vote of security holders. 23 Consents of experts and counsel [Where the opinion of the expert or counsel has been incorporated by reference into a previously filed Securities Act registration statement]. 24 Power of Attorney. 27 Financial Data Schedule.
14 EX-13 2 ANNUAL REPORT EXHIBIT 13 - -------------------------------------------------------------------------------- Dear Shareholders We would like to extend our warmest welcome to you as shareholders of American Capital Strategies. It has been a momentous year. You have entrusted us with $155 million of your capital and we want to convey our commitment and responsibility to executing our business plan and rewarding your trust. We wish each of you could be with us to share the excitement in our organization. It is an excitement bred of seeing long-cherished goals achieved. It is an excitement fed by the strong reception our capital strategies have had from the entrepreneurs, managers and employees who provide the vitality to America's economic heartland. And it is an excitement shared both by the many seasoned professionals who have devoted a decade or more to the development of American Capital, and by the select group of extraordinary people we have had the privilege of hiring since last August. With the capital you have entrusted to us, American Capital is providing senior debt, subordinated debt and equity to some of the most dynamic small and medium sized businesses in America. In the seven months since our IPO, we have executed our strategy by: o Reviewing nearly $1 billion of financing opportunities, o Investing and committing just under $70 million in senior debt, subordinated debt and equity to nine outstanding companies, o Funding three add-on acquisitions, o Capitalizing three buyouts, and o Committing funds to and raising additional financing for a major employee buyout. Over the past thirteen years, American Capital has arranged funding for more than $400 million of transactions, while becoming a national leader in structuring and funding employee and management buyouts. Over that time, we became acutely aware of a tremendous gap in the financial markets for sophisticated, flexible, long-term capital for the small and medium businesses who give the American economy its vibrancy and resilience. We worked intimately with managers and employees who were tough, determined, creative and tested. Often they were in industries that were out of favor--manufacturers in the so-called rust belt or in our large inner cities, or which had a unionized workforce. Sometimes they were corporate stepchildren, declared "non-core" for the grand corporate strategy du jour, but with a core of managers and employees who knew they could be dynamic independent businesses. Sometimes they were small, solid, and ambitious, small fry seeking to eat larger fish. Always, they were under the radar screen of the great liquidity and capital machine we refer to as "Wall Street." For twelve years, we solved financial problems for such companies. We invested in them and presented them to conventional capital markets. After financing them, we often became their partners, served on their boards, and saw them thrive. We became intimate with a gap in the capital markets so dramatic that it cried out to be filled. Our companies were dynamic. Their capital sources were moribund and often failed to provide adequate financing to fuel their growth. Regulations and industry consolidation make it uneconomical for banks to meet their needs. Pension funds and insurance companies are generally not sources of capital for this market due to the sophisticated structuring and uniqueness of each transaction coupled with an average investment size which is smaller than their appetite. Venture capital firms, are frequently established as finite life organizations requiring quick exit strategies that do not mesh with the long-term plans of these businesses. Private equity funds tend to have an appetite for one specific tier of financing and cannot meet all of the needs of a small and medium sized business. Everywhere we turned, we saw structural problems and gaps in the availability of financing. Our capital strategies fill the gaps and serve the needs of these dynamic companies. We approach our transactions with the mindset of a principal and underwrite it with a rigor unmatched in the industry because we believe in making strategic investments rather than simply churning capital. The companies we invest in work directly with our principals, who are talented individuals with exceptional achievements in finance and investment banking. As a result of this detailed diligence, we are willing to place long-term, patient capital, to take mezzanine or equity risks for appropriate returns, or to act quickly to finance an entire transaction--senior, subdebt, and equity--where speed and certainty are critical to closing. Because of our ability to fill the gaps and our expertise in structuring transactions, many existing financial institutions and financial advisors see us as partners. Commercial banks, venture capital firms and private equity funds come to us for capital, advice and expertise. Our organization is excited because the business plan that we talked to you about at the time of the IPO is being executed and well received. We now have more than six months experience as a public company and are very pleased with our performance. We have quickly and very judiciously invested $55 million and are working to finalize a $15 million investment in the near future. Additionally, the pipeline of new investment opportunities continues to fill and we are confident in our ability to deliver outstanding results. We have expanded our Bethesda, New York City and San Francisco offices and are planning to open additional offices and staff them with highly dedicated and experienced principals and associates. We strongly believe that the success of our business starts with our people and that we offer an exciting opportunity for everyone at American Capital. In closing, we would like to thank all of the employee owners of American Capital whose energy and efforts have made this fine organization, our outstanding board of directors for their advice and counsel and of course we want to thank you, our shareholders, for the support and confidence you have in us. Sincerely, /s/ David Gladstone - ------------------- David Gladstone Chairman of the Board /s/ Malon Wilkus - ---------------- Malon Wilkus President /s/ Adam Blumenthal - ------------------- Adam Blumenthal Executive Vice President - -------------------------------------------------------------------------------- CORPORATE INFORMATION CORPORATE HEADQUARTERS - ---------------------- 3 Bethesda Metro Center Ste. 860 Bethesda, Maryland 20814 (301) 951-6122 STOCK EXCHANGE LISTING - ---------------------- ria for quality typography have not changed with the application of computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, character design and of computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, character design and TRANSFER AGENT AND REGISTRAR - ---------------------------- judge typography. This copy is not intended to be read. It is merely a representation of what the text of this piece may look like set in this type size nology. Legibility, style. of computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, character design and FINANCIAL PUBLICATIONS - ---------------------- The criteria for quality typography have not changed with the application of computers and state of the art technology. Legibility,image clarity, consistent letter and word spacing, character design and consistent letter and word spacing, characterlayout remain the basic qualities by of computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, character design and DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN - ------------------- which we judge This copy is not intended to be read. It is merely a representation of what the text of this piece may look like consistent letter and onsistent letter and word spacing,set in this type size and style. The criteria for quality of computers and state of the art technology. Legibility, image clarity, consistent INVESTOR INQUIRES - ----------------- raphy have not changed with the application of computers and state of the art technology. Legibility,image clarity, consistent letter and word spacing, character design and layout remain the basic qualities by which we judge typography.of computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, character design and ADUITORS - -------- This copy is not intended to be read. It is merely a representation of what the text of this piece may look like set in this type size and sistent letter and word spacing, characterconsistent letter of computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, character design and LEGAL COUNSEL - ------------- and word spacing, chtypography. It is merely a representation PRICE RANGE OF COMMON STOCK AND DIVIDENDS - ------------- of what the text of this piece may look like set in this type size and style. The criteria for quality typography have not changed with the applicaof computers and state of the art technology. Legibility, image clarity, consistent letter and word spacing, AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Corporate Profile American Capital Strategies is a buyout and specialty finance company with capital resources exceeding $150 million. ACAS provides senior debt, subordinated debt and equity to companies in need of capital for employee or management buyouts, growth, acquisitions, liquidity and restructuring. ACAS invests $1 to $20 million in businesses that typically have sales in excess of $10 million. ACAS does not provide startup financing. American Capital Strategies was founded in 1985 and completed its initial public offering in August 1997. Its shares are traded on the NASDAQ stock market under the symbol ACAS. American Capital Strategies is headquartered in Bethesda, Maryland with offices in Boston, New York, Pittsburgh, San Francisco, and Savannah. Companies interested in learning more about American Capital Strategies and its unique and flexible financing should visit the ACAS website at www.AmericanCapital.com. American Capital Strategies Selected Stock Prices $25 $20 $15 $10 $5 $0 IPO 12/31/97 3/23/98 [Graph Omitted] 1 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Selected Financial Data The selected financial data should be read in conjunction with the Company's financial statements and notes thereto. As discussed in Notes 1 and 2, the Company completed an initial public offering of its common stock on August 29, 1997 and on October 1, 1997 began to operate so as to qualify to be taxed as a RIC. As a result of the changes, the financial results of the Company for periods prior to October 1, 1997 are not comparable to periods commencing October 1, 1997 and are not expected to be representative of the financial results of the Company in the future.
Three Months Nine Months Ended Ended Year Ended December 31, December 31, September 30, ------------------------------------------- 1997 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- ---- Total operating income ............ $ 2,796,667 $ 2,900,801 $2,746,422 $2,705,632 $2,498,231 $1,882,158 Total operating expenses .......... 551,061 2,651,029 2,861,697 2,927,709 2,605,758 1,659,172 ------------ ------------ ---------- ---------- ---------- ---------- Operating income (loss) before equity in earnings of unconsolidated operating subsidiary ..................... 2,245,606 249,772 (115,275) (222,077) (107,527) 222,986 Equity in earnings of unconsolidated operating subsidiary ..................... 24,213 -- -- -- -- -- ------------ ------------ ---------- ---------- ---------- ---------- Net operating income (loss) ...... 2,269,819 249,772 (115,275) (222,077) (107,527) 222,986 Change in unrealized appreciation on investments .... 167,573 5,321,421 483,665 370,696 956,294 (61,660) Realized gain (loss) on investments ................. -- -- -- 66,148 (22,784) -- ------------ ------------ ---------- ---------- ---------- ---------- Income before income taxes ....... 2,437,392 5,571,193 368,390 214,767 825,983 161,326 Provision for income taxes ....... -- 2,128,610 159,251 57,381 421,664 (2,458) ------------ ------------ ---------- ---------- ---------- ---------- Net increase in shareholders' equity resulting from operations .................... 2,437,392 3,442,583 209,139 157,386 404,319 163,784 ------------ ------------ ---------- ---------- ---------- ---------- Per share data: Cash dividends ................ $ 0.21 Net operating income Basic ........ $ 0.21 Diluted ...... $ 0.20 Net increase in shareholders' equity resulting from operations Basic ........ $ 0.22 Diluted ...... $ 0.21 Total assets .................... 150,705,354 154,322,393 5,432,265 4,382,994 3,930,365 2,821,611 Total shareholders' equity ...... 150,651,900 150,538,951 3,371,651 2,945,659 2,571,446 1,850,509
2 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations All statements contained herein that are not historical facts including, but not limited to, statements regarding anticipated activity are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: changes in the economic conditions in which the Company operates negatively impacting the financial resources of the Company; certain of the Company's competitors with substantially greater financial resources than the Company reducing the number of suitable investment opportunities offered to the Company or reducing the yield necessary to consummate the investment; increased costs related to compliance with laws, including environmental laws; general business and economic conditions and other risk factors described in the Company's report filed from time to time with the Securities and Exchange Commission. The Company cautions readers not to place undue reliance on any such forward looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act 1995 and, as such, speak only as of the date made. The following analysis of the financial condition and results of operations of the Company should be read in conjunction with the Company's financial statements and the notes therein. As discussed in Notes 1 and 2, the Company completed an initial public offering (IPO) of its common stock on August 29, 1997 and on October 1, 1997 began to operate so as to qualify to be taxed as a regulated investment company (RIC). After the IPO, the Company changed its primary business plan and format from structuring and arranging financing for buyout transactions on a fee for services basis to being a lender to and investor in small and medium sized businesses. As a result of the changes, the Company's predominant source of operating income has changed from financial performance and advisory fees to interest and dividends earned from investing the Company's assets in debt and equity of businesses. Additionally, pursuant to RIC accounting requirements, effective October 1, 1997, the Company's accounting for its operating subsidiary, ACS Capital Investment Corp. (CIC), changed from a consolidated basis to the equity method. The financial results of the Company for the periods through September 30, 1997 are not comparable to periods commencing October 1, 1997 and are not expected to be representative of the financial results of the Company in the future. Accordingly, those periods are discussed separately. Results of Operations The Company's financial performance as reflected in its Statements of Operations is composed of four primary elements. The first element is "Net operating income (loss)," which for periods prior to October 1, 1997 (Pre-RIC) is the difference between the Company's revenue earned from arranging commercial loans for small and medium sized businesses and other financial advisory work and its total operating expenses including ESOP contributions, depreciation and interest expense. For periods prior to October 1, 1997, ESOP contributions represented a significant component of total operating expenses. All required contributions to the Company's ESOP have been made by the Company, and further contributions will be made at the discretion of the Company's Board of Directors. Net operating income (loss) for periods commencing October 1, 1997 (Post-RIC) is primarily the interest and dividends earned from investing in debt and equity securities and the equity in earnings of unconsolidated operating subsidiary less the operating expenses of the Company. The second element is "Change in unrealized appreciation of investments," which is the net change in the fair value of the Company's portfolio assets at the end of the period compared with their fair values at the beginning of the period or their stated costs, as appropriate. The third element is "Realized gain on investments," which reflects the difference between the proceeds from a sale or maturity of a portfolio investment and the cost at which the investment was carried on the Company's balance sheet. The fourth element is "Provision for income taxes," which reflects a statutory tax rate applied to the Company's GAAP pretax income for pre-RICperiods. Actual taxes paid have historically been lower than the provision primarily due to the temporary difference of the unrealized appreciation of investments which has resulted in a deferred tax liability on the Company's balance sheet. For post-RIC periods, the Company intends to operate so as to qualify to be taxed as a RIC. As long as the Company qualifies as a RIC, it will be able to take a deduction against its otherwise taxable income for certain dividends it pays, allowing it to substantially reduce or eliminate its corporate-level tax liability. As a result, the provisions for income taxes for post-RIC periods are expected to be minimal. As discussed above, as a RIC, the Company is required to account for investments in operating subsidiaries under the equity method, regardless of ownership interest. Accordingly, the Company's investment in CIC, which prior to RIC status was consolidated, is presented on the equity method effective October 1, 1997. Therefore, commencing on October 1, 1997, and consistent with the equity method of accounting, the portfolio companies owned by CIC are not reported separately by the Company. 3 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Three months ended December 31, 1997 Operating results for the three months ended December 31, 1997 (post-RIC) are summarized as follows: Three Months Ended December 31, 1997 ----------------- Operating income ........................................... $2,796,667 Operating expenses ......................................... 551,061 Equity in earnings of unconsolidated operating subsidiary ..................................... 24,213 ---------- Net operating income ....................................... 2,269,819 Change in unrealized appreciation of investments ........................................... 167,573 ---------- Net increase in shareholders' equity resulting from operations ................................ $2,437,392 ========== Total operating income consisted of approximately $700,000 in loan processing fees and $200,000 in interest on non- publicly traded securities and $1.9 million in interest on government agency securities and overnight repurchase agreements. The loan fees were earned as a result of closing three investments in private companies totaling $20.5 million during the period. Operating expenses for the period consisted of $243,000 in salaries and benefits and $308,000 in general and administrative expenses. Equity in earnings of unconsolidated operating subsidiary represents CIC's results including the portfolio companies. For the three months ended December 31, 1997, CIC's results included $414,000 of operating income, $987,000 of operating expenses, $605,000 of unrealized appreciation of investment and $8,000 in tax provisions. The change in unrealized appreciation of investments as discussed in Note 2 to the financial statements is determined by the Company's Board of Directors. The change in unrealized appreciation of investments for the three month period is $167,000 which consists of an increase of $52,000 in the valuation of the government agency securities and an increase of $115,000 in the valuation of the investments in private companies. Nine months ended September 30, 1997 compared to nine months ended September 30, 1996 Nine Months Ended September 30, 1997 1996 ---- ---- Operating income .......................... $ 2,900,801 $ 1,757,972 Operating expenses ........................ 2,651,029 1,921,195 ----------- ----------- Net operating income (loss) ............... 249,772 (163,223) Change in unrealized appreciation of investments ............. 5,321,421 441,081 Provision for income taxes ................ 2,128,610 109,223 ----------- ----------- Net increase in shareholders' equity resulting from operations .............................. $ 3,442,583 $ 168,635 =========== =========== Total operating income was $2.9 million for the nine months ended September 30, 1997, compared to $1.8 million for the nine months ended September 30, 1996, a 65.0% increase. Financial advisory fees were $1.1 million and $1.3 million for the nine months ended September 30, 1997 and 1996, respectively. The decline in financial advisory fees was attributable to a relative increase in management attention to engagements producing financial performance fees, and to the IPO. Financial performance fees were $798,000 and $241,000 for the nine months ended September 30, 1997 and 1996, respectively. The increase in financial performance fees was associated with the Company's successful completion of an engagement to advise the Allied Pilots Association on the structuring of an employee option plan at American Airlines. Other operating income was $428,000 and $265,000 for the nine months ended September 30, 1997 and 1996, respectively. The increase in other operating income was attributable to a higher level of expense reimbursement for the Company. Included in total operating revenue for the nine months ended September 30, 1997 was interest income earned on investment securities and overnight repurchase agreements of $553,000. 4 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Total operating expenses for the nine months ended September 30, 1997 and 1996 were $2.7 million and $1.9 million, respectively, an increase of 38.0%. Salaries and benefits for the nine months ended September 30, 1997 and 1996, were $1.2 million and $935,000, respectively, a 30.6% increase which was predominantly associated with increased levels of staffing. General and administrative expenses for the nine months ended September 30, 1997 and 1996, were $1.5 million and $772,000, respectively, a 96.1% increase primarily associated with the increased use of consultants by the Company. The increase in other expenses is attributable to a variety of expenses associated with potential transactions. For the nine months ended September 30, 1997 and 1996, interest expense was $60,000 and $21,000, respectively. The increase in interest expense relates to the Company's increased levels of working capital for the period in 1997 prior to the initial public offering. During the nine months ended September 30, 1997, the Company changed its evaluation of collectibility of a receivable from Martino's Bakery, Inc. due to Martino's improved financial condition, restructuring of repayment terms, and subsequent payment history. Therefore, the Company recorded a reversal in its provision for doubtful accounts totaling $177,000. During the nine months ended September 30, 1996, the Company had accrued $164,000 as a provision for doubtful accounts related to two companies, one of which was Martino's Bakery, Inc. For the nine months ended September 30, 1997 and 1996, the Company recorded net increases in unrealized appreciation of investments in its portfolio companies of $5.3 million and $441,000, respectively. Included in unrealized appreciation of investments during the first nine months of 1997 was $4.4 million associated with the acquisition of Biddeford Textile Company, formerly the blanket operation of the electric blanket manufacturing division of Sunbeam Products, Inc. Also included in unrealized appreciation of investments during the first nine months of 1997 was appreciation of $731,000 associated with the Company's investment in Mobile Tool International, Inc., appreciation of $356,000 associated with Four S Baking Company, Inc., and depreciation of $138,000 associated with Martino's Bakery, Inc. The following table sets forth the components of unrealized appreciation of investments for the nine months ended September 30, 1997 and 1996: Nine Months Ended September 30, 1997 1996 ---- ---- Government Securities ...................... $ (26,720) -- Erie Forge and Steel, Inc. ................. $ -- $152,930 Four S Baking Company, Inc. ................ 355,675 (54,000) Indiana Steel & Wire Corporation ........... -- 6,792 Martino's Bakery, Inc. ..................... (138,250) 143,459 Mobile Tool International, Inc. ............ 731,111 191,900 Biddeford Textile Corporation .............. 4,399,605 -- ----------- -------- Change in Unrealized Appreciation of Investments ........................... $ 5,321,421 $441,081 =========== ======== The Company recorded provisions for income taxes for the nine months ended September 30, 1997 and 1996 of $2.1 million and $109,000, respectively. Unrealized appreciation (depreciation) of investments does not affect the actual tax paid by the Company. However, under GAAP, the Company provides for income taxes based on its GAAP pretax income, which includes unrealized appreciation (depreciation) of investments. Actual income taxes paid may differ substantially from the provision for income taxes. The Company accounted for this difference by recognition of the deferred tax liability shown on the balance sheet. Years ended December 31, 1996 and 1995 Year Ended December 31, 1996 1995 ---- ---- Operating income ............................. $2,746,422 $2,705,632 Operating expense excluding ESOP contribution .......................... 2,645,814 2,710,882 ESOP contribution ............................ 215,883 216,827 ---------- ---------- Total operating expense ...................... 2,861,697 2,927,709 ---------- ---------- Net operating loss before investment activity ........................ (115,275) (222,077) Change in unrealized appreciation of investments ............................. 483,665 370,696 Realized gain on investments ................. -- 66,148 Provision for income taxes ................... 159,251 57,381 ---------- ---------- Net increase in shareholders' equity resulting from operations .................. $ 209,139 $ 157,386 ========== ========== 5 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Operating income consists predominantly of financial advisory fees, which are hourly or periodic fees earned by the Company for providing advice and analysis to small and medium sized businesses, and financial performance fees, which are fees earned on a contingent basis for structuring, financing, or executing transactions. During 1996, financial advisory fees and financial performance fees constituted 86.9% of total revenue; during 1995, financial advisory fees and financial performance fees constituted 90.1% of total revenue. During each of the years ended December 31, 1996 and 1995, the Company earned operating income of $2.7 million. Other components of operating income consisted primarily of expense reimbursements. Total operating expenses at the Company were $2.862 million in 1996, a 2.3% decrease from $2.928 million in 1995. Salaries and benefits, excluding ESOP contributions, were $1.5 million in 1995 and declined 28.1% to $1.1 million in 1996. The reduction in salaries and benefits is the result of an increased use of outside consultants in the Company's financial advisory work and the reduction in bonuses in 1996. General and administrative and other expenses increased 51% from $.9 million in 1995, to $1.3 million in 1996. The increased use of consultants was the primary reason for the increase in general and administrative expenses from 1995 to 1996. The Company's interest expense was $33,000 in 1996 and $37,000 in 1995. Interest expense is primarily associated with credit facilities used by the Company to support its working capital requirements and, beginning in 1996, to finance a portion of its investments in small and medium sized businesses. The Company's total borrowings under these facilities were approximately $430,000 at December 31, 1996 and $161,000 at December 31, 1995. In addition, the Company had a note payable to its President in the amount of $74,000 at December 31, 1996 and $66,000 at December 31, 1995. During 1995 and 1996, the Company has paid interest on its debt obligations to unrelated parties at rates ranging from 1.5% above the lender's base rate of interest to 3% above such rate. The rate of interest on the Company's note payable to its President is 4% above the prime rate of interest. The Company made ESOP contributions of $216,000 in 1996 and $217,000 in 1995. These contributions represent an allocation of the preferred stock held by the ESOP to the Company's employees which preferred stock was converted into common stock on a one for one basis on July 28, 1997. As a result, these contributions did not result in a cash outflow from the Company. These contributions were deductible for tax purposes and served to reduce the Company's tax obligations. At December 31, 1996, unearned ESOP shares totaled $117,000, and the Company's obligation to make further contributions to the ESOP was limited to that amount. When an investment is sold, disposed of, or liquidated, the difference between the ultimate value realized on the investment and its cost is shown as a realized gain or loss on the investment. The Company realized a gain of $66,000 in 1995 on the sale of an investment in a portfolio company. For the years ended December 31, 1996 and 1995, the Company recorded net increases in unrealized appreciation of investments of $484,000 and $371,000, respectively. Unrealized appreciation represents the periodic increases and decreases in the fair market value of the investments in the Company's portfolio. Fair market value is determined by the Board of Directors of the Company, taking into account recent independent third party valuations of these investments. The following chart sets forth the components of Change in unrealized appreciation of investments for the years ended December 31, 1996 and 1995: Year Ended December 31, 1996 1995 ---- ---- Erie Forge and Steel, Inc. ................... $203,808 $(208,937) Four S Baking Company, Inc. .................. (81,000) 499,250 Indiana Steel & Wire Corporation ............. 9,057 (5,719) Martino's Bakery, Inc. ....................... 156,500 (18,250) Mobile Tool International, Inc. .............. 195,300 170,500 The C.M. Kemp Manufacturing Company(1) ................................. -- (66,148) -------- --------- Change in Unrealized Appreciation of Investments ............................. $483,665 $ 370,696 ======== ========= - ---------- (1) The Company's investment in the C.M. Kemp Manufacturing Company (Kemp) was sold in 1995 for a gain over the original cost of the investment. The Company had recorded unrealized appreciation in the amount of this gain prior to the sale and, thus, at the time of sale, Kemp was sold for the value at which it was then reflected on the Company's balance sheet. The Company then recorded depreciation of $66,000 in 1995 to reverse the unrealized appreciation and recognize the realized appreciation associated with the sale of Kemp. 6 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) During 1996 and 1995, the Company was taxed as a C Corporation. Unrealized appreciation (depreciation) of investments does not affect the actual tax paid by the Company. However, under GAAP, the Company provides for income taxes based on its GAAP pretax income, which includes unrealized appreciation (depreciation) of investments. The Company accounted for this difference by recognition of deferred tax provisions of $159,000 in 1996 and $57,000 in 1995. Financial Condition, Liquidity, and Capital Resources The Company received proceeds of $143.6 million in connection with its IPO which was completed on August 29, 1997. At December 31, 1997, the Company had $8.9 million in cash and cash equivalents and $112.8 million in investments in Federal agency securities. As a RIC, the Company is required to distribute annually 90% or more of its net operating income and net realized short-term capital gains to shareholders. While the Company will provide shareholders with the option of reinvesting their distributions in the Company, the Company anticipates having to borrow to obtain liquidity after the proceeds of the IPO have been fully invested in the debt and equity of small and medium sized businesses. No assurance can be given that such liquidity will be obtainable, or obtainable at interest rates favorable to the Company. Impact of The Year 2000 The "Year 2000 Issue" is the result of computer programs being written using two digits rather than four to define the applicable year. The Company's computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruption of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. The Company principally utilizes for its internal accounting and administrative requirements software written by third parties for sale to the public and not specifically written for the Company. Many of these software developers are reviewing and updating their programs to address the Year 2000 issue. The Company does not anticipate that it has significant exposure to the Year 2000 issue for its internal accounting and administrative software. The Company utilizes a commercial bank for loan processing and loan accounting. The Company will receive an assessment from the commercial bank of the potential for exposure and develop a plan to minimize or eliminate potential exposure in the loan processing and accounting area during 1998. The Company invests and will continue to invest in small and medium sized businesses. The Company will review the Year 2000 issue with the investee companies and make a determination of the potential impact. The Company currently cannot assess its exposure or the potential impact of the Year 2000 issue on its investees. 7 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Balance Sheets
December 31, December 31, 1997 1996 ---- ---- Assets (Note 2) Investments at fair value (cost or initial value of $133,274,408 and $905,748, respectively) .................................................. $133,415,261 $3,980,421 Cash and cash equivalents .................................................. 8,862,416 322,664 Investment in unconsolidated operating subsidiary .......................... 6,868,880 -- Due from unconsolidated operating subsidiary ............................... 861,028 -- Interest receivable ........................................................ 643,687 -- Accounts receivable (net of allowance for doubtful accounts of $0 and $249,609, respectively) ........................................... -- 917,625 Income taxes receivable .................................................... -- 52,225 Property and equipment: Computer equipment ....................................................... -- 154,182 Office furniture and equipment ........................................... -- 96,827 Less: accumulated depreciation ........................................... -- (130,495) ------------ ---------- -- 120,514 Other ...................................................................... 54,082 38,816 ------------ ---------- Total assets ............................................................... $150,705,354 $5,432,265 ============ ========== Liabilities and Shareholders' Equity Accounts payable and accrued liabilities ................................... $ 53,454 $ 322,252 Due to related parties ..................................................... -- 78,142 Deferred taxes ............................................................. -- 1,230,536 Notes payable .............................................................. -- 429,684 ------------ ---------- Total liabilities .......................................................... 53,454 2,060,614 Shareholders' equity: Undesignated preferred stock, $0.01 par value, 90,000 and 5,000,000 shares authorized, respectively, 0 issued and outstanding ..................... -- -- Class A preferred stock, $50 par value, 0 and 10,000 shares authorized, respectively, and $0 and 6,857 issued and outstanding, respectively .... -- 1,419,399 Unearned ESOP shares ..................................................... -- (116,668) Common stock, $.01 par value, 20,000,000 and 2,985,900 shares authorized, and 11,068,767 and 481,058 issued and outstanding, respectively ........ 110,688 4,811 Capital in excess of par value ........................................... 144,939,913 10,407 Retained earnings ........................................................ -- 2,053,702 Undistributed net realized earnings ...................................... (54,624) -- Unrealized appreciation of investments ................................... 5,655,923 -- ------------ ---------- Total shareholders' equity ................................................. 150,651,900 3,371,651 ------------ ---------- Total liabilities and shareholders' equity ................................. $150,705,354 $5,432,265 ============ ==========
See accompanying notes. 8 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Schedule of Investments December 31, 1997
Effective Interest Rate(1) Industry Cost Fair Value ---------------- -------- ---- ---------- Senior Debt--4.07% Four S Baking Company ................................... 9.50% 11.00 Baking $ 1,825,477 $ 1,825,477 BIW Connector Systems, LLC .............................. Manufacturing 3,890,000 3,890,000 ------------ ------------ Subtotal 5,715,477 5,715,477 Subordinated Debt--7.88% Four S Baking Company ................................... 20.00 Baking 1,491,797 1,491,797 BIW Connector Systems, LLC .............................. 15.40 Manufacturing 6,350,260 6,350,260 Westwinds Group Holdings, Inc. .......................... 17.20 Restaurant 3,205,662 3,205,662 ------------ ------------ Subtotal ................................................ 11,047,719 11,047,719 Convertible Preferred Stock(3)--1.64% Four S Baking Company 15% dividend convertible into 51,390 shares of common stock or 10.89% of Co. ........ Baking 2,302,500 2,302,500 Common Stock Warrants(2)(3)--1.13% Four S Baking Company 15,390 shares 3.26% of Co. ........ Baking 461,700 577,125 BIW Connector Systems, LLC 8% of LLC .................... Manufacturing 652,000 652,000 Westwinds Group Holdings, Inc. 5% of Co. ................ Restaurant 350,000 350,000 ------------ ------------ Subtotal ................................................ 1,463,700 1,579,125 Subtotal--non-publicly traded securities--14.72% ........ 20,529,396 20,644,821 Government Securities--80.39% FHLB Discount Note due 2/4/98 ........................... 20,969,205 20,981,628 FHLB Discount Note due 3/6/98 ........................... 10,892,628 10,898,000 FHLB Discount Note due 4/1/98 ........................... 9,865,203 9,868,130 FNMA Discount Note due 4/24/98 .......................... 6,877,260 6,883,007 FFCB 5.90% due 6/2/98 ................................... 20,016,853 20,016,000 FHLB Discount Note due 6/8/98 ........................... 14,645,792 14,643,875 FHLB Discount Note due 8/20/98 .......................... 14,483,150 14,479,800 FNMA 5.71% due 9/9/98 ................................... 14,994,920 15,000,000 ------------ ------------ Total Investments ....................................... 12,745,011 112,770,440 Investment in Unconsolidated Operating Subsidiary--4.90% ACS Capital Investment Corporation(3)(2)--100% of Co. ... Banking 402,700 6,868,880 ------------ ------------ Totals .................................................. $133,677,107 $140,284,141 ============ ============ Schedule of Investments December 31, 1996 Industry Cost Fair Value -------- ---- ---------- Common Stock(2) Erie Forge and Steel, Inc. 120,773 Shares ............. Manufacturing $ 500,000 $ 2,736,418 Four S Baking Company 27,000 Shares ............. Baking 67,750 486,000 Indiana Steel & Wire Corporation 7,547 Shares ............. Manufacturing 42,914 58,869 Martino's Bakery, Inc. 50,000 Shares ............. Baking 120,750 259,000 Mobile Tool International, Inc. 6,130 Shares ............. Manufacturing 74,334 440,134 ------------ ------------ Totals .................................................. $ 905,748 $ 3,980,421 ============ ============
- ---------- (1) Effective interest rate includes amortization of original issue discount if any (2) Non-income producing (3) Affiliate See accompanying notes. 9 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Statements of Operations
Three Months Nine Months Year Ended Ended Ended -------------------------- December 31, September 30, December 31, December 31, 1997 1997 1996 1995 Operating Income (Note 2) Financial advisory fees ................................. -- $1,122,357 $1,738,295 $1,148,752 Financial performance fees .............................. -- 797,600 649,030 1,288,797 Interest income ......................................... $2,122,876 553,267 -- -- Loan processing fees .................................... 653,568 -- -- -- Other ................................................... 20,223 427,577 359,097 268,083 ---------- ---------- ---------- ---------- Total operating income .................................. 2,796,667 2,900,801 2,746,422 2,705,632 Operating Expenses Salaries and benefits ................................... 243,142 1,220,907 1,283,198 1,701,660 General, administrative and other ....................... 307,919 1,514,122 1,282,195 851,314 Provision for (reversal of) doubtful accounts ........... -- (177,198) 224,329 302,283 Interest ................................................ -- 60,034 32,959 37,037 Depreciation and amortization ........................... -- 33,164 39,016 35,415 ---------- ---------- ---------- ---------- Total operating expenses ................................ 551,061 2,651,029 2,861,697 2,927,709 ---------- ---------- ---------- ---------- Operating income (loss) before equity in earnings of unconsolidated operating subsidiary ................... 2,245,606 249,772 (115,275) (222,077) Equity in earnings of unconsolidated operating subsidiary ............................................ 24,213 -- -- -- ---------- ---------- ---------- ---------- Net operating income (loss) ............................. 2,269,819 249,772 (115,275) (222,077) Realized gain on investments ............................ -- -- -- 66,148 Change in unrealized appreciation of investments ........ 167,573 5,321,421 483,665 370,696 ---------- ---------- ---------- ---------- Income before income taxes .............................. 2,437,392 5,571,193 368,390 214,767 Provision for income taxes .............................. -- 2,128,610 159,251 57,381 ---------- ---------- ---------- ---------- Net increase in shareholders' equity resulting from operations ....................................... $2,437,392 $3,442,583 $ 209,139 $ 157,386 ========== ========== ========== ========== Net operating income per share Basic ......... $ 0.21 Diluted ....... $ 0.20 Net increase in shareholders' equity Basic ......... $ 0.22 resulting from operations per share Diluted ....... $ 0.21 Weighted average shares of Basic ......... 11,068,767 common stock outstanding Diluted ....... 11,405,385
See accompanying notes. 10 AMERICAN CAPITAL STRATEGIES, INC. - -------------------------------------------------------------------------------- Statements of Shareholders' Equity
Unearned Common Stock Capital Preferred ESOP ------------------ in Excess of Retained Stock Shares Shares Amount Par Value Earnings ----- ------ ------ ------ --------- -------- Balance at December 31, 1994 ........... $ 1,419,399 $(549,378) 480,312 $ 4,804 $ 9,444 $ 1,687,177 Net increase in share- holders' equity result- ing from operations ....... -- -- -- -- -- 157,386 ESOP shares earned .......... -- 216,827 -- -- -- -- ----------- --------- --------- ------- ------------ ----------- Balance at December 31, 1995 ........... $ 1,419,399 $(332,551) 480,312 $ 4,804 $ 9,444 $ 1,844,563 Net increase in share- holders' equity result- ing from operations ......... -- -- -- -- -- 209,139 Options exercised ............. -- -- 746 7 963 -- ESOP shares earned ............ -- 215,883 -- -- -- -- ----------- --------- --------- ------- ------------ ----------- Balance at December 31, 1996 ........... $ 1,419,399 $(116,668) 481,058 $ 4,811 $ 10,407 $ 2,053,702 ----------- --------- --------- ------- ------------ ----------- Net increase in share- holders' equity result- ing from operations ....... -- -- -- -- -- 3,442,583 Contribution of common stock to ESOP ............. -- -- 529 5 7,930 (7,935) Conversion of preferred stock to common stock ..................... (1,419,399) -- 204,743 2,047 1,417,352 -- Issuance of common stock ..................... -- -- 10,382,437 103,825 143,504,224 -- ESOP shares earned .......... -- 116,668 -- -- -- -- ----------- --------- --------- ------- ------------ ----------- Balance at September 30, 1997 .......... $ -- $ -- 11,068,767 $110,688 $144,939,913 $ 5,488,350 =========== ========= ========== ======== ============ =========== Effect of reorganization as a RIC (Note 2) ............ -- -- -- -- -- (5,488,350) Net increase in share- holders' equity result- ing from operations ....... -- -- -- -- -- 2,437,392 Distributions ............... -- -- -- -- -- (2,324,443) ----------- --------- --------- ------- ------------ ----------- Balance at December 31, 1997 ........... $ -- $ -- 11,068,767 $110,688 $144,939,913 $ 5,601,299 =========== ========= ========== ======== ============ ===========
Undistributed Unrealized Total Net Realized Appreciation Shareholders' Earnings of Investments Equity -------- -------------- ------ Balance at December 31, 1994 ........... $ 2,571,446 Net increase in share- holders' equity result- ing from operations ......... 157,386 ESOP shares earned .......... 216,827 ----------- ---------- ------------ Balance at December 31, 1995 ........... $ 2,945,659 ----------- ---------- ------------ Net increase in share- holders' equity result- ing from operations ......... 209,139 Options exercised ............. 970 ESOP shares earned ............ 215,883 ----------- ---------- ------------ Balance at December 31, 1996 ........... $ 3,371,651 ----------- ---------- ------------ Net increase in share- holders' equity result- ing from operations ....... 3,442,583 Contribution of common stock to ESOP ............. -- Conversion of preferred stock to common stock ..................... -- Issuance of common stock ..................... 143,608,049 ESOP shares earned .......... 116,668 ----------- ---------- ------------ Balance at September 30, 1997 .......... $150,538,951 =========== ========== ============ Effect of reorganization as a RIC (Note 2) ............ $ 5,488,350 Net increase in share- holders' equity result- ing from operations ....... $ 2,269,819 167,573 -- Distributions ............... (2,324,443) -- -- ----------- ---------- ------------ Balance at December 31, 1997 ........... $ (54,624) $5,655,923 $150,651,900 =========== ========== ============
See accompanying notes. 11 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Statements of Cash Flows
Three Months Nine Months Year Ended Ended Ended ----------------------------- December 31, September 30, December 31, December 31, 1997 1997 1996 1995 ---- ---- ---- ---- Operating activities (Note 2) Net increase in shareholders' equity resulting from operations .................................... $ 2,437,392 $ 3,442,583 $ 209,139 $ 157,386 Adjustments to reconcile net increase in shareholders' equity resulting from operations to net cash provided by (used in) operating activities: Depreciation and amortization .................. -- 32,332 39,016 35,415 Unrealized appreciation of investments ......... (167,537) (5,321,421) (483,665) (370,696) Realized gain on investments ................... -- -- -- (66,148) Net amortization of securities ................. (1,233,443) (337,159) -- -- Amortization of deferred finance costs ......... -- 3,357 11,088 7,332 Provision for deferred income taxes ............ -- 2,102,243 120,578 115,485 Loss on disposal of property and equipment ................................ -- -- 629 91 ESOP contribution .............................. -- 116,668 215,883 216,827 Increase in interest receivable ................ (206,946) (122,074) -- -- Provision for doubtful accounts ................ -- (177,198) 224,329 302,283 Increase in due from unconsolidated operating subsidiary ......................... (526,149) -- -- -- Increase in accounts receivable ................ -- 486,198 (865,311) (182,056) (Increase) decrease in income taxes receivable.. -- 24,554 100,922 (32,822) Decrease (increase) in other assets ............ 61,947 (112,483) 5,665 (3,554) Increase (decrease) in accounts payable and accrued liabilities .......................... (328,195) 128,419 227,930 29,538 Gain of unconsolidated operating subsidiary .... (24,213) -- -- -- ------------ ------------- --------- --------- Net cash provided by (used in) operating activities .... 12,856 266,019 (193,797) 209,081 Investing activities Proceeds from sale or maturity of investments ........ 35,000,000 60,000 -- 66,148 Purchase of investments .............................. (20,529,396) (482,889) (74,640) (6,674) Purchase of securities ............................... (16,592,667) (129,896,447) -- -- Purchases of property and equipment, net of disposals ................................... -- (28,415) (39,669) (20,304) ------------ ------------- --------- --------- Net cash provided by (used in) investing activities .... (2,122,063) (130,347,751) (114,309) 39,170 Financing activities Proceeds from notes payable .......................... -- 589,625 429,684 -- Principal payments of notes payable .................. -- (1,019,309) (160,833) (77,500) Increase in deferred finance costs ................... -- -- (4,000) (25,849) Increase (decrease) in due to related parties ........ -- (78,142) 5,920 10,893 Issuance of common stock ............................. -- 143,608,049 -- -- Options exercised .................................... -- -- 970 -- Distributions ........................................ (2,324,443) -- -- -- ------------ ------------- --------- --------- Net cash provided by (used in) financing activities .... (2,324,443) 143,100,223 271,741 (92,456) ------------ ------------- --------- --------- Net increase (decrease) in cash and cash equivalents ... (4,433,650) 13,018,491 (36,365) 155,795 Cash and cash equivalents at beginning of year ......... 13,296,066 322,664 359,029 203,234 ------------ ------------- --------- --------- Cash and cash equivalents at end of year ............... $ 8,862,416 $ 13,341,155 $ 322,664 $ 359,029 ============ ============= ========= =========
See accompanying notes. 12 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Financial Highlights
Three Months Ended December 31, 1997 ----------------- Per Share Data(1) Net asset value at beginning of the period $ 13.60 Net operating income 0.21 Net realized and unrealized gains on investments 0.01 ------------ Net increase in shareholders' equity from operations 0.22 Distribution of net investment income 0.21 ------------ Net asset value at end of period $ 13.61 Per share market value at end of period $ 18.125 Shares outstanding at end of period 11,068,767 Ratio/Supplemental Data Net assets at end of period $150,651,900 Ratio of operating expenses to average net assets(2) 1.46% Ratio of net operating income to net assets(2) 6.03%
- ---------- (1) Basic per share data (2) Amounts were annualized since the results are for a three-month period. See accompanying notes. 13 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Notes to Financial Statements Note 1. Organization American Capital Strategies, Ltd. (the Company) is a Delaware Corporation formed in 1986 to provide merchant banking services to and invest in small and medium sized businesses. On August 29, 1997, the Company completed an initial public offering (IPO) of 10,382,437 shares of common stock, and elected to be treated as a Business Development Company under the Investment Company Act of 1940, as amended. On October 1, 1997, the Company began operations so as to qualify to be taxed as a regulated investment company (RIC) as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code. As contemplated by these transactions, the Company materially changed its business plan and format from structuring and arranging financing for buyout transactions on a fee for services basis to primarily being a lender to and investor in small and medium sized companies. As a result of the changes, the Company is operating as a holding company whose predominant source of operating income has changed from financial performance and advisory fees to interest and dividends earned from investing the Company's assets in debt and equity of businesses. The Company's investment objectives are to achieve current income from the collection of interest and dividends, as well as long-term growth in its shareholders' equity through appreciation in value of the Company's equity interests. The Company also provides financial advisory services to businesses through ACS Capital Investment Corporation (CIC), a wholly-owned subsidiary. The Company is headquartered in Bethesda, Maryland, and has offices in New York, Boston, Pittsburgh, San Francisco, and Savannah. Note 2. Summary of Significant Accounting Policies Basis of Presentation The accompanying financial statements have been prepared in accordance with generally accepted accounting principles and for periods commencing with the Company's election to be treated as a RIC, in accordance with Article 6 of Regulation S-X of the Code of Federal Regulations. For the nine months ended September 30, 1997 and the years ended December 31, 1996 and 1995 the financial statements are prepared on a consolidated basis with the accounts of the CIC, the Company's wholly owned subsidiary. All intercompany transactions and balances were eliminated. Effective October 1, 1997, pursuant to RIC accounting requirements, CIC was deconsolidated, and, as a result, for the three months ended December 31, 1997 the Company accounted for its investment in CIC under the equity method. In connection with this change, the Company contributed the following assets and liabilities to CIC: Investment in Erie Forge and Steel ................................. $2,736,418 Other assets ....................................................... $ 791,228 Other liabilities .................................................. $ 68,996 Deferred tax liability ............................................. $3,332,771 As a result of these changes, the Company's financial statements for periods through September 30, 1997 (pre-RIC periods) are not comparable with the financial statements for periods commencing after October 1, 1997 (post-RIC periods). Valuation of Investments Investments are carried at fair value, as determined by the Board of Directors. Securities which are publicly traded are valued at the closing bid price on the valuation date. Debt and equity securities which are not publicly traded, are valued at fair value as determined in good faith by the Board of Directors. In making such determination, the Board of Directors will value non-convertible debt securities at cost plus amortized original issue discount, if any, unless adverse factors lead to a determination of a lesser valuation. In valuing convertible debt, equity or other securities, the Board of Directors determines the fair value based on the collateral, the issuer's ability to make payments, the earnings of the issuer, sales to third parties of similar securities and other pertinent factors. Due to the uncertainty inherent in the valuation process, such estimates of fair value 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. Cash and Cash Equivalents Cash and cash equivalents consist of demand, deposits and highly liquid investments with original maturities of three months or less. Cash and cash equivalents are carried at cost which approximates fair value. Interest and Dividend Income Recognition Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. Original issue discount is amortized into interest income using the effective interest method. Dividend income is recognized on the ex-dividend date. 14 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Financial Advisory and Performance Fee Recognition Financial advisory fees represent amounts received for providing advice and analysis to small and medium sized businesses and are recognized as earned based on hours incurred. Financial performance fees represent amounts received for structuring, financing, and executing transactions and are generally payable only if the transaction closes and are recognized as earned when the transaction is completed. Financial advisory and performance fees are for services provided by CIC. Loan Processing Fee Recognition Loan processing fees are recorded as income on the closing date of the related loan. Realized Gain or Loss and Unrealized Appreciation or Depreciation on Investments Realized gain or loss is recorded at the disposition of an investment and is the difference between the net proceeds from the sale and the cost basis of the investment. Unrealized appreciation or depreciation reflects the difference between the Board of Directors' valuation of the investments and the cost basis of the investments. Distributions to Shareholders Distributions to shareholders are recorded on the ex-dividend date. Federal Income Taxes The Company operates so as to qualify to be taxed as a RIC under the Internal Revenue Code. Generally, a RIC is entitled to deduct dividends it pays to its shareholders from its income to determine "taxable income." The Company has distributed and currently intends to distribute sufficient dividends to eliminate taxable income. Therefore, the statement of operations contains no provision for income taxes for the three months ended December 31, 1997. During the pre-RIC periods, the Company operated under Subchapter C of the Internal Revenue Code and calculated its tax provision pursuant to Statement of Financial Accounting Standards No. 109. Deferred income taxes were determined based on the differences between financial reporting and tax basis of assets and liabilities. Use of Estimates in Preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. Property and Equipment Property and equipment is carried at cost and is depreciated using the straight-line method over the estimated useful lives of the related assets ranging from five to seven years. Management Fees The Company is self-managed and therefore does not incur management fees payable to third parties. Reclassifications Certain previously reported amounts have been reclassified to conform with the current financial statement presentation. Recent Accounting Pronouncements In February, 1997, the Financial Accounting Standards Board issued Statement No. 128, "Earnings Per Share," (SFAS 128). The Company adopted SFAS 128 for the three months ended December 31, 1997. The Company has not restated the earnings per share for prior periods since it is not meaningful due to the significant change in the Company's capital structure as a result of the IPO, and its change in operating activities to a RIC on October 1, 1997. In June 1997, Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130) was issued and is effective for fiscal years beginning after December 15, 1997. SFAS 130 establishes standards for the reporting and display of comprehensive income and its components (revenues, expenses, gains, losses) in a full set of general purpose financial statements. SFAS 130 requires the disclosure of an amount that represents total comprehensive income and the components of comprehensive income in a financial statement. The adoption of SFAS 130 is not expected to have a material impact on the financial statements of the Company. In June 1997, Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" (SFAS 131) was issued and is effective for fiscal years beginning after December 15, 1997. SFAS 131 establishes standards for determining an entity's operating segments and the type and level of financial information to be disclosed in both annual and interim financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The adoption of SFAS 131 is not expected to have a material impact on the financial statements of the Company. 15 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Notes to Financial Statements (Continued) Note 3. Investments Investments consists of securities issued by various agencies of the Federal government valued at $112,770,440 with maturities of less than one year from the date of purchase and securities issued by privately-held companies valued at $20,644,821. The securities issued by privately-held companies consists of senior loans, subordinated loans with equity warrants, convertible preferred stock and common stock. The loans have effective interest rates ranging from 9.5% to 20% and are payable in installments with final maturities from 5 to 7 years and are collateralized by assets of the borrower. The Company's investments in equity warrants and common stock are non-income producing. The net unrealized appreciation in investments for Federal income tax purposes is the same as for book purposes and none of the Company's investments are on non-accrual status. Note 4. Investment in Unconsolidated Operating Subsidiary As discussed in Note 2, CIC is an operating subsidiary of the Company and is accounted for under the equity method effective October 1, 1997. The investment in CIC is carried at fair value as determined by the Board of Directors. Condensed financial information for CICat December 31, 1997 and for the three months then ended is as follows: Assets Investments in portfolio companies, at fair value.................................. $10,360,904 Other assets, net................................ 990,926 ----------- Total assets................................... $11,351,830 =========== Liabilities and Shareholder's Equity Deferred income taxes............................ $ 3,322,688 Due to parent.................................... 861,028 Other liabilities................................ 299,234 Shareholder's Equity............................. 6,868,880 ----------- Total liabilities and shareholder's equity......... $11,351,830 =========== Total revenue...................................... $ 532,496 Operating expense.................................. 1,084,570 ----------- Net operating loss............................... (552,074) Unrealized appreciation of investments............. 605,045 Other.............................................. (28,758) ----------- Net income......................................... $ 24,213 =========== Note 5. Stock Option Plan The Company applies APB 25 and related interpretations in accounting for its stock-based compensation plan. In accordance with SFAS 123, "Accounting for Stock-Based Compensation," the Company elected to continue to apply the provisions of APB 25 and provide pro forma disclosure of the Company's net operating income and net increase in shareholders' equity resulting from operations calculated as if compensation costs were computed in accordance with SFAS 123. The Company is providing this information for the post-RICperiod as discussed in Notes 1 and 2 and from the time the 1997 Stock Option plan was established by the Company. Three months ended December 31, 1997 ----------------- Net operating income as reported ...... $2,269,819 pro forma ........ $2,029,525 Net increase in shareholders' equity resulting from operations as reported ...... $2,437,392 pro forma ........ $2,197,098 The effects of applying SFAS 123 for providing pro forma disclosures are not likely to be representative of the effects on reported net operating income and net increase in shareholders' equity resulting from operations for future years. The Company estimated a fair value per option on the date of grant of $2.33 using a Black-Scholes option pricing model and the following assumptions; dividend yield 6.5%, risk free interest rate 6.5%, expected volatility factor .25, expected lives of the options of 7 years, and an annual forfeiture rate of 5%. The Company established the 1997 Stock Option Plan (the 1997 Plan) which provides for the granting of options to purchase common stock at a price of not less than the fair market value of the common stock on the date of issuance to employees of the Company. There are 1,328,252 shares available to be granted under the 1997 Plan. Upon closing the IPO, the Company granted 1,302,703 fixed options at $15.00 per share, the market value at the date of grant. At December 31, 1997, all of the granted options were outstanding. On November 6, 1997, the Board of Directors authorized the establishment of a stock option plan for the non- employee directors. The plan must receive shareholder approval at the annual meeting to be held on May 14, 1998 before it becomes effective. Upon shareholder approval, the Board of Directors has authorized the Company to issue 15,000 options to each of the six non-employee directors. 16 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Notes to Financial Statements (Continued) Note 6. Related Parties ACS Partners I, L.P. was formed with a wholly owned subsidiary of the Company as sole general partner and several principals of the Company as limited partners to allow the principals the opportunity to co-invest in transactions with the Company. Pursuant to the terms of the partnership agreement of ACS Partners I, L.P. , the Company through its wholly owned subsidiary as sole general partner has all discretion over the purchase, sale, restructuring and disposition of the assets of ACS Partners I, L.P. As of December 31, 1997, principals of the Company had invested $260,000 in ACS Partners I, L.P. As of December 31, 1996, the Company had a note payable to its president for approximately $74,000. The interest rate was based on prime plus 4%. The related interest expense for the nine months ended September 30, 1997 and the years ended December 31, 1996 and 1995 was approximately $6,000, $8,000 and $3,000, respectively. In August 1997, the Company repaid the note in full. The Company and CIC have entered into an expense sharing agreement whereby CIC reimburses the Company for expenses paid by the Company on CIC's behalf. Note 7. Notes Payable At December 31, 1996, the Company had a line of credit with a term conversion provision with a finance company. During the first two years of the agreement, the Company had the ability to borrow up to $500,000 with interest payable monthly. The balance outstanding after the initial two-year period was repayable as a term loan in equal monthly installments of principal plus accrued interest over three years. The interest rate was the finance company's base rate plus 1.5%. This arrangement was secured by accounts receivable, furniture, fixtures, equipment, and 56,270 shares of common stock in Erie Forge and Steel, one of the Company's investments. At December 31, 1996, the outstanding balance was approximately $283,000, and the interest rate was 9.75%. In July 1997, the Company repaid the outstanding balance and closed the line of credit. At December 31, 1996, the Company had a term loan commitment with a finance company in the amount $750,000 which was subject to a two-year draw down period ending in October 1997. The interest rate was the finance company's base rate plus 3%. This arrangement was secured by accounts receivable, furniture, fixtures, equipment, and the Company's investments in shares of common stock. At December 31, 1996, the outstanding balance was approximately $146,000, was due in 2001, and the interest rate was 11.25%. On May 30, 1997, certain terms of the above described loan were amended. The term loan commitment was increased from $750,000 to $1,000,000 and the draw down period was extended until May 1999. Interest only was assessed over a four year term from the date of the draw, and thereafter, monthly payments of principal and interest are payable until all outstanding amounts became fully due in May 2004. In August 1997, the Company repaid the outstanding balance of $636,000 and extinguished the note. During the nine months ended September 30, 1997 and the years ended December 31, 1996 and 1995, the cash paid for interest was approximately $88,000, $43,000 and $36,000, respectively. The weighted average interest rates, including amortization of deferred finance costs, for the years nine months ended September 30, 1997 and the years ended December 31, 1996 and 1995 were 16.9%, 17.3% and 13.7%, respectively. There was no outstanding debt at December 31, 1997. Note 8. Income Taxes Significant components of the Company's deferred tax liabilities and assets were as follows: December 31, 1996 ---- Deferred tax liabilities: Investments ............................................. $1,303,911 Depreciation ............................................ 21,393 ---------- 1,325,304 Deferred tax assets: Net operating loss carryforward ......................... 63,085 Alternative minimum tax ................................. 25,509 Other ................................................... 6,174 ---------- 94,768 ---------- Net deferred tax liabilities ............................ $1,230,536 ========== The components of the income tax provision were as follows: Year Ended December 31, 1996 1995 ---- ---- Current provision (benefit) ............................ $ 38,673 $(58,104) Deferred provision ..................................... 120,578 115,485 -------- -------- $159,251 $ 57,381 ======== ======== 17 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Notes to Financial Statements (Continued) The differences between taxes at the Federal statutory tax rate and the effective tax rate were as follows:
Nine Months Ended Year Ended Sept. 30 December 31, 1997 1996 1995 ---- ---- ---- Statutory rate ................ $1,803,681 $125,253 $ 73,021 State taxes ................... 342,218 14,747 8,589 Change in valuation allowance ................... -- (25,509) (19,130) Other ......................... (17,289) 44,760 (5,099) ---------- -------- -------- Effective rate ................ $2,128,610 $159,251 $ 57,381 ========== ======== ========
During the nine months ended September 30, 1997 and years ended December 31, 1996 and 1995, cash paid for income taxes was approximately $2,000, $1,000 and $45,000, respectively. The aggregate gross and net unrealized appreciation over the cost for Federal income tax purposes was $7,413,705, $3,399,423 and $2,915,758 as of December 31, 1997, 1996 and 1995, respectively. The aggregate cost of securities for Federal income tax purposes were $132,870,434, $580,998 and $506,664 as of December 31, 1997, 1996 and 1995, respectively. As discussed in Note 1, the Company has historically been taxed under subchapter C and is currently operating so as to qualify and intends to file as a subchapter M corporation for Federal income tax purposes. The tax consequences of converting a corporation from taxation under subchapter C to subchapter M are uncertain. The Company has requested a ruling from the IRS to clarify the consequences of the conversion. The Company expects to receive a favorable ruling but there are no assurances that it will receive a favorable ruling. If the Company does not receive a timely favorable ruling, it intends to treat the conversion as a deemed sale which will result in taxes of approximately $3.1 million and will result in the Company declaring an additional dividend of approximately $5.9 million. Note 9. Lease Commitments The Company has non-cancelable operating leases for office space and office equipment. The leases expire over the next seven years and contain provisions for certain annual rental escalations. Rent expense for operating leases for three months ended December 31, 1997, the nine months ended September 30, 1997 and the years ended December 31, 1996 and 1995, was approximately $73,000, $97,000, $101,000 and $95,000, respectively. Future minimum lease payments under non-cancelable operating leases at December 31, 1997 were as follows: 1998 ............................................................... $ 331,000 1999 ............................................................... 237,000 2000 ............................................................... 237,000 2001 ............................................................... 242,000 2002 and thereafter ................................................ 604,000 ---------- Total .............................................................. $1,653,000 ========== Note 10. Employee Stock Ownership Plan The Company maintains an ESOP, which includes all employees and is fully funded by the Company. Contributions are made at the Company's discretion up to $30,000 or 25% of annual compensation expense for each employee. Employees are not fully vested until completing five years of service. The Company sponsors an employee stock ownership trust to act as the depository of employer contributions to the ESOP as well as to administer and manage the actual trust assets which are deposited into the ESOP. Note 11. Capital Stock In July, 1997, all unearned ESOP shares became earned and were distributed to the employees. Pursuant to the Company's Class A preferred stock declaration, the Class A preferred stock held by the ESOP was converted into common stock on a one share to one share basis. The Company also contributed an additional 529 shares of common stock to the ESOP. In August 1997, the Company increased its authorized shares of unallocated preferred stock to 5,000,000 and increased its authorized shares of common stock to 20,000,000. On August 27, 1997, the Company declared a stock split effective August 29, 1997, effected in the form of a stock dividend pursuant to which each outstanding share of common stock was effectively converted into 29.859 shares. Outstanding shares and per share amounts for all periods presented have been restated to reflect this stock split. 18 AMERICAN CAPITAL STRATEGIES, LTD. - -------------------------------------------------------------------------------- Notes to Financial Statements (Continued) On August 29, the Company completed its IPO and sold 10,382,437 shares of its common stock at a price of $15.00 per share. Pursuant to the terms of the Company's agreement with the underwriter of the offering, the Company issued 442,751 common stock warrants (Warrants) to the underwriter. The Warrants have a term of five years from the date of issuance and may be exercised at a price of $15.00 per share. The Company distributed $2,324,443 or $0.21 per share to its shareholders for the three months ended December 31, 1997. For Federal income tax purposes, the distribution was 100% from ordinary income. Note 12. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share for the three months ended December 31, 1997. For all other periods, earnings per share is not presented since it is not considered meaningful due to the IPO and reorganization of the Company as a RIC. Three Months Ended December 31, 1997 ----------------- Numerator for basic and diluted net increase in shareholders' equity resulting from operations.............................. $ 2,437,392 Denominator for basic-weighted average shares......................................... 11,068,767 Employee stock options................................... 251,232 Warrants................................................. 85,386 ----------- Dilutive potential common shares......................... 333,618 ----------- Denominator for diluted.................................. 11,405,385 =========== Basic earnings per share................................. $ 0.22 Diluted earnings per share............................... $ 0.21 19 - -------------------------------------------------------------------------------- Report of Independent Auditors Board of Directors American Capital Strategies, Ltd. We have audited the accompanying balance sheets of American Capital Strategies, Ltd., including the schedules of investments, as of December 31, 1997 and 1996, the related statements of operations, shareholders' equity and cash flows for the three months ended December 31, 1997, the nine months ended September 30, 1997, the years ended December 31, 1996 and 1995, and the financial highlights for the three months ended December 31, 1997. These financial statements and the financial highlights are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material aspects, the financial position of American Capital Strategies, Ltd. at December 31, 1997 and 1996, and the results of its operations and its cash flows for the three months ended December 31, 1997, the nine months ended September 30, 1997, the years ended December 31, 1996 and 1995, and the financial highlights for the three months ended December 31, 1997 in conformity with generally accepted accounting principles. Ernst & Young LLP Washington, D.C. February 12, 1998 20 - -------------------------------------------------------------------------------- Corporate Information Corporate Headquarters - ---------------------- American Capital Strategies 3 Bethesda Metro Center Suite 860 Bethesda, MD 20814 http://www.finance-company.com Stock Exchange Listing - ---------------------- American Capital Strategies is listed on the National Association of Securities Dealers (NASDAQ Symbol: ACAS). Price information for the common stock appears daily in major newspapers. Transfer Agent and Registrar - ---------------------------- Boston EquiServe, LP 150 Royall Street Canton, MA 02021 (781) 575-2393 Financial Publications - ---------------------- Shareholders may receive a copy of the 1997 Form 10-K, annual report and quarterly reports filed with the Securities and Exchange Commission in Washington, D.C., by writing to: American Capital Strategies Investor Relations Office 3 Bethesda Metro Center Suite 860 Bethesda, MD 20814 Dividend Reinvestment and Stock Purchase Plan - ------------------- American Capital Strategies offers a dividend reinvestment plan to its shareholders. Shareholders are enrolled in the plan upon purchasing the Company's stock and must contact their broker to elect to receive dividends in cash. Investor Inquiries - ------------------ Securities analysts, portfolio managers and others seeking information about the Company's business operations and financial performance are invited to contact the Investor Relations Office at (301) 951-6122. Auditors - -------- Ernst & Young LLP Washington, D.C. Legal Counsel - ------------- Arnold & Porter Washington, D.C. Price Range of Common Stock & Dividends - --------------------------------------- The Common Stock is quoted on NASDAQ stock market since August 29, 1997. The following table sets forth the range of high and low bid prices on the NASDAQ Stock Market for the applicable periods. Dividends 1997 High Low Declared - ---- ---- --- -------- Third quarter (beginning August 29, 1997)................................. $20.25 $18.50 -- Fourth quarter .................................... $20.75 $16.50 $0.21 As of March 20, 1997, there were 49 shareholders of record of the common stock. Included in this number are shares held by nominees or in "street name. 21 -----END PRIVACY-ENHANCED MESSAGE-----