ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Management's Analysis of Business
We will have significant relative flexibility in selecting and structuring our investments. We will not be subject to many of the regulatory limitations that govern traditional lending institutions such as banks. We will seek to structure our investments so as to take into account the uncertain and potentially variable financial performance of our portfolio companies. This should enable our portfolio companies to retain access to committed capital at different stages in their development and eliminate some of the uncertainty surrounding their capital allocation decisions. We will calculate rates of return on invested capital based on a combination of up-front commitment fees, current and deferred interest rates and residual values, which may take the form of common stock, warrants, equity appreciation rights or future contract payments. We believe that this flexible approach to structuring investments will facilitate positive, long-term relationships with our portfolio companies and enable us to become a preferred source of capital to them. We also believe our approach should enable debt financing to develop into a viable alternative capital source for funding the growth of target companies that wish to avoid the dilutive effects of equity financings for existing equity holders.
Longer Investment Horizon - We will not be subject to periodic capital return requirements. These requirements, which are standard for most private equity and venture capital funds, typically require that these funds return to investors the initial capital investment after a pre-agreed time, together with any capital gains on such capital investment. These provisions often force such funds to seek the return of their investments in portfolio companies through mergers, public equity offerings or other liquidity events more quickly than they otherwise might, which can result in a lower overall return to investors and adversely affect the ultimate viability of the affected portfolio companies. Because we may invest in the same portfolio companies as these funds, we are subject to these risks if these funds demand a return on their investments in the portfolio companies. We believe that our flexibility to take a longer-term view should help us to maximize returns on our invested capital while still meeting the needs of our portfolio companies.
Established Deal Sourcing Network - We believe that, through our management and directors, we have solid contacts and sources from which to generate investment opportunities. These contacts and sources include:
o public and private companies, o investment bankers, o attorneys, o accountants, o consultants, and o commercial bankers.
However, we cannot assure you that such relationships will lead to the origination of debt or other investments.
Page 45 of 94 Investment Criteria
As a matter of policy, we will not purchase or sell real estate or interests in real estate or real estate investment trusts except that we may:
o purchase and sell real estate or interests in real estate in connection with the orderly liquidation of investments, or in connection with foreclosure on collateral; o own the securities of companies that are in the business of buying, selling or developing real estate; or o finance the purchase of real estate by our portfolio companies.
We will limit our investments in more traditional securities (stock and debt instruments) and will not, as a matter of policy:
o sell securities short except with regard to managing the risks associated with publicly-traded securities issued by our portfolio companies;
o Purchase securities on margin (except to the extent that we may purchase securities with borrowed money); or
o engage in the purchase or sale of commodities or commodity contracts, including futures contracts except where necessary in working out distressed loan; or
o investment situations or in hedging the risks associated with interest rate fluctuations, and, in such cases, only after all necessary registrations or exemptions from registration with the Commodity Futures Trading Commission have been obtained.
Prospective Portfolio Company Characteristics - We have identified several criteria that we believe will prove important in seeking our investment objective with respect to target companies. These criteria will provide general guidelines for our investment decisions; however, we caution readers that not all of these criteria will be met by each prospective portfolio company in which we choose to invest.
Experienced Management - We will generally require that our portfolio companies have an experienced president or management team. We will also require the portfolio companies to have in place proper incentives to induce management to succeed and to act in concert with our interests as investors, including having significant equity interests. We intend to provide assistance in this area either supervising management or providing management for our portfolio companies.
Products or Services - We will seek companies that are involved in products or services that do not require significant additional capital or research expenditures. In general, we will seek target companies that make innovative use of proven technologies or methods.
Proprietary Advantage - We expect to favor companies that can demonstrate some kind of proprietary sustainable advantage with respect to their competition. Proprietary advantages include, but are not limited to:
o patents or trade secrets with respect to owning or manufacturing its products, and o a demonstrable and sustainable marketing advantage over its competition
Page 46 of 94 Marketing strategies impose unusual burdens on management to be continuously ahead of its competition, either through some kind of technological advantage or by being continuously more creative than its competition.
Profitable or Nearly Profitable Operations Based on Cash Flow from Operations - We will focus on target companies that are profitable or nearly profitable on an operating cash flow basis. Typically, we would not expect to invest in start-up companies unless there is a clear exit strategy in place.
Potential for Future Growth - We will generally require that a prospective target company, in addition to generating sufficient cash flow to cover its operating costs and service its debt, demonstrate an ability to increase its revenues and operating cash flow over time. The anticipated growth rate of a prospective target company will be a key factor in determining the value that we ascribe to any warrants or other equity securities that we may acquire in connection with an investment in debt securities.
Exit Strategy - Prior to making an investment in a portfolio company, we will analyze the potential for that company to increase the liquidity of its common equity through a future event that would enable us to realize appreciation, if any, in the value of our equity interest. Liquidity events may include:
o an initial public offering, o a private sale of our equity interest to a third party, o a merger or an acquisition of the portfolio company, or o a purchase of our equity position by the portfolio company or one of its stockholders.
We may acquire warrants to purchase equity securities and/or convertible preferred stock of the eligible portfolio companies in connection with providing financing. The terms of the warrants, including the expiration date, exercise price and terms of the equity security for which the warrant may be exercised, will be negotiated individually with each eligible portfolio company, and will likely be affected by the price and terms of securities issued by the eligible portfolio company to other venture capitalists and other holders. We anticipate that most warrants will be for a term of five to ten years, and will have an exercise price based upon the price at which the eligible portfolio company most recently issued equity securities or, if a new equity offering is imminent, equity securities. The equity securities for which the warrant will be exercised generally will be common stock of which there may be one or more classes or convertible preferred stock. Substantially all the warrants and underlying equity securities will be restricted securities under the 1933 Act at the time of the issuance. We will generally negotiate for registration rights with the issuer that may provide:
o "piggyback" registration rights, which will permit us under certain circumstances, to include some or all of the securities owned by us in a registration statement filed by the eligible portfolio company, or o in circumstances, "demand" registration rights permitting us under certain circumstances, to require the eligible portfolio company to register the securities under the 1933 Act, in some cases at our expense. We will generally negotiate net issuance provisions in the warrants, which will allow us to receive upon exercise of the warrant
Page 47 of 94 without payment of any cash a net amount of shares determined by the increase in the value of the issuer's stock above the exercise price stated in the warrant.
Liquidation Value of Assets - Although we do not intend to operate as an asset-based lender, the prospective liquidation value of the assets, if any, collateralizing any debt securities that we hold will be an important factor in our credit analysis. We will emphasize both tangible assets, such as:
o accounts receivable, o inventory, and o equipment,
and intangible assets, such as:
o intellectual property, o customer lists, o networks, and o databases.
Investment Process
Due Diligence - If a target company generally meets the characteristics described above, we will perform initial due diligence, including:
o company and technology assessments, o existing management team, o market analysis, o competitive analysis, o evaluation of management, risk analysis and transaction size, o pricing, and o structure analysis.
Much of this work will be done by management and professionals who are well known by management. The criteria delineated above provide general parameters for our investment decisions. We intend to pursue an investment strategy by further imposing such criteria and reviews that best insures the value of our investments. As unique circumstances may arise or be uncovered, not all of such criteria will be followed in each instance but the process provides a guideline by which investments can be prudently made and managed. Upon successful completion of the preliminary evaluation, we will decide whether to deliver a non-binding letter of intent and move forward towards the completion of a transaction.
In our review of the management team, we look at the following:
o Interviews with management and significant shareholders, including any financial or strategic sponsor; o Review of financing history; o Review of management's track record with respect to:
Page 48 of 94 o product development and marketing, o mergers and acquisitions, o alliances, o collaborations, o research and development outsourcing and other strategic activities; o Assessment of competition; and o Review of exit strategies.
In our review of the financial conditions, we look at the following:
o Evaluation of future financing needs and plans; o Detailed analysis of financial performance; o Development of pro forma financial projections; and o Review of assets and liabilities, including contingent liabilities, if any, and legal and regulatory risks.
In our review of the products and services of the portfolio company, we look at the following:
o Evaluation of intellectual property position; o Review of existing customer or similar agreements and arrangements; o Analysis of core technology; o Assessment of collaborations; o Review of sales and marketing procedures; and o Assessment of market and growth potential.
Upon completion of these analyses, we will conduct on-site visits with the target company's management team. Also, in cases in which a target company is at a mature stage of development and if other matters that warrant such an evaluation, we will obtain an independent appraisal of the target company.
Ongoing Relationships with Portfolio Companies
Monitoring - We will continuously monitor our portfolio companies in order to determine whether they are meeting our financing criteria and their respective business plans. We may decline to make additional investments in portfolio companies that do not continue to meet our financing criteria. However, we may choose to make additional investments in portfolio companies that do not do so, but we believe that we will nevertheless perform well in the future.
We will monitor the financial trends of each portfolio company to assess the appropriate course of action for each company and to evaluate overall portfolio quality. Our management team and consulting professionals, who are well known by our management team, will closely monitor the status and performance of each individual company on at least a quarterly and, in some cases, a monthly basis.
We will use several methods of evaluating and monitoring the performance and fair value of our debt and equity positions, including but not limited to the following:
Page 49 of 94 o Assessment of business development success, including product development, financings, profitability and the portfolio company's overall adherence to its business plan; o Periodic and regular contact with portfolio company management to discuss financial position, requirements and accomplishments; o Periodic and regular formal update interviews with portfolio company management and, if appropriate, the financial or strategic sponsor; o Attendance at and participation in board meetings; o Review of monthly and quarterly financial statements and financial projections for portfolio companies.
Managerial Assistance - As a business development company, we will offer, and in many cases may provide, significant managerial assistance to our portfolio companies. This assistance will typically involve:
o monitoring the operations of our portfolio companies, o participating in their board and management meetings, o consulting with and advising their officers, and o providing other organizational and financial guidance.
Investment Amounts
The amount of funds committed to a portfolio company and the ownership percentage received will vary depending on the maturity of the portfolio company, the quality and completeness of the portfolio company's management team, the perceived business opportunity, the capital required compared to existing capital, and the potential return. Although investment amounts will vary considerably, we expect that the average investment, including follow-on investments, will be between $25,000 and $1,000,000.
Competition
Our primary competitors to provide financing to target companies will include private equity and venture capital funds, other equity and non-equity based investment funds and investment banks and other sources of financing, including traditional financial services companies such as commercial banks and specialty finance companies. Many of these entities have substantially greater financial and managerial resources than we will have. We believe that our competitive advantage with regard to quality target companies relates to our ability to negotiate flexible terms and to complete our review process on a timely basis. We cannot assure you that we will be successful in implementing our strategies.
FORWARD LOOKING STATEMENTS
Certain statements contained in this report that are not historical fact are "forward-looking statements" as that term is defined in the Private Securities Litigation Reform Act of 1995. The words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "believes," "estimates," "projects" or similar expressions are intended to identify these forward-looking
Page 50 of 94 statements. These statements are subject to risks and uncertainties beyond our reasonable control that could cause our actual business and results of operations to differ materially from those reflected in our forward-looking statements. The safe harbor provisions provided in the Securities Litigation Reform Act do not apply to forward-looking statements we make in this report. Forward-looking statements are not guarantees of future performance. Our forward-looking statements are based on trends which we anticipate in our industry and our good faith estimate of the effect on these trends of such factors as industry capacity, product demand and product pricing. The inclusion of projections and other forward-looking statements should not be regarded a representation by us or any other person that we will realize our projections or that any of the forward-looking statements contained in this prospectus will prove to be accurate.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 AND TO YEAR ENDED DECEMBER 31, 2004
REVENUES
During the year ended December 31, 2006, we received a cash dividend from our wholly owned portfolio company, ACL in the amount of $562,146.
We did not produce any revenue in the period ending December 31, 2005 or 2004. The Company did not produce any revenue in the period ended December 31, 2005 inasmuch as it had ceased operations in contemplation of a significant change in its business model. With no operations under its old model and the fact that it had not commenced acting as a BDC, save the acquisition of a portfolio company, there were no opportunities for revenue during 2005 or 2004.
COSTS AND EXPENSES
We had total costs and expenses in the amount of $246,694, ($80,835) and $72,932 during the years ended December 31, 2006, 2005 and 2004, respectively. The 2005 period included a gain on extinguishment of debt of $174,133. Accordingly, our actual expenses were $93,298.
The 2006 period increased $153,396 (164%) from the 2005 period. The primary increases were $56,535 in legal, audit and professional fees, $57,950 in compensation and benefits and $30,000 in director fees. The increase in professional fees was the result of increased accounting and audit costs associated with the acquisition of ACL and the conversion to a BDC. These costs should decrease in 2007. The increase in compensation and benefits and director fees is the result of converting from an inactive holding company to a BDC. These costs should remain approximately the same in 2007, unless there are other acquisitions.
NET REALIZED AND UNREALIZED GAINS AND LOSSES
As an investment company under the Investment Company Act of 1940, all of our investments must be carried at market value or fair value as determined by
Page 51 of 94 management for investments which do not have readily determinable market values. Prior to this conversion, only marketable debt and equity securities and certain derivative securities were required to be carried at market value.
Beginning December 16, 2005, portfolio assets for which market prices are available are valued at those prices. Securities that are traded in the over-the-counter market or on a stock exchange generally will be valued at the prevailing bid price on the valuation date. However, our current investments were acquired in privately negotiated transactions and may have no readily determinable market values. These securities are carried at fair value as determined by management and outside professionals as necessary under our valuation policy. Currently, the valuation policy provides for management's review of the management team, financial conditions, and products and services of the portfolio company. In situations that warrant such an evaluation, an independent business valuation may be obtained.
Value, as defined in Section 2(a)(41) of 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by management. There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. We must determine the fair value of each individual investment on a quarterly basis. We will record unrealized depreciation on investments when we believe that an investment has become impaired, including where realization of an equity security is doubtful. Conversely, we will record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and, therefore, its investment has also appreciated in value, where appropriate.
As an investment company, we invest primarily in illiquid securities including equity securities of private companies. The structure of each equity security is specifically negotiated to enable us to protect our investment and maximize our returns. We generally include many terms governing ownership parameters, dilution parameters, liquidation preferences, voting rights, and put or call rights. Our investments are generally subject to some restrictions on resale and generally have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation process requires an analysis of various factors. Our fair value methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.
During the year ended December 31, 2006, we recognized a realized loss of $5,000 and an unrealized gain of $188,835. The realized loss arose from our investment in Elitegroup Ventures Nevada, Inc. We made this investment early in 2006; however, Elitegroup was unable to raise sufficient capital to implement its business plan. Accordingly, we wrote off our investment. The unrealized gain of $188,835 is from our investment in ACL. At December 31, 2006, ACL had cash of $20,571 and investments in marketable equity securities valued at $589,100, for total assets of $609,671. ACL had liabilities of $105,107 and equity in net assets of $504,564, which is the amount we used to value our investment. At December 31, 2005, our carrying value in our investment in ACL was our net cost of $315,729. The increase in value of $188,835 to $504,564 accounts for the unrealized appreciation. We applied the same methodology in valuing the ACL investments that would have been used had we owned the investments directly.
Page 52 of 94 CAPITAL EXPENDITURES
We plan to raise funds to be used in making investments in other as yet unidentified portfolio companies.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 2006, we had net assets of $415,515 as compared to net liabilities of $263,672 at December 31, 2005. This increase of $679,187 consisted of net earnings of $499,287 and the net increase in net assets from stock transactions of $179,900.
During the year ended December 31, 2006, total assets declined $418,084, which includes an increase in investments of $188,835 offset by a decline in cash of $606,919. During this same period, liabilities decreased $595,956; the major components of the decrease were note payable to affiliate of $100,000, note payable to officer of $458,000 and advances from stockholders of $35,199. Series A convertible preferred stock also declined $501,315. The combination of the decline in assets along with the decline in liabilities and the decline in preferred stock resulted in the increase in net assets.
We currently have sufficient value in marketable equity securities in ACL which can be sold and the proceeds paid to us via dividends to cover our planned 2007 expenses of operation. We would expect to raise additional funds in the event we purchase any additional investments.
NET ASSET VALUE
As a Business Development Company, certain of our activities and disclosures are made in reference to Net Asset Value which is the value of our portfolio assets less debt and preferred stock. This may be viewed, simply and generalized, as the value of our assets to our common shareholders. As of the date of the financial information in this report, the value of our portfolio of assets including investments in equity securities and cash is $504,890 and from this, are subtracted liabilities and debts of $89,375. There are no shares of preferred stock outstanding but the rights of preferred stockholders would be included if there were. The Net Asset Value is therefore $415,515. We have 7,740,110 common shares outstanding at December 31, 2006, therefore, the Net Asset Value per Share is $.0537.
RECENT ACCOUNTING PRONOUNCEMENTS
There are several new accounting pronouncements issued by the Financial Accounting Standards Board ("FASB") which are not yet effective. Each of these pronouncements, as applicable, has been or will be adopted by the Company. Management does not believe any of these accounting pronouncements has had or will have a material impact on the Company's financial position or operating results.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140", to
Page 53 of 94 simplify and make more consistent the accounting for certain financial instruments. SFAS No. 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", to permit fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. SFAS No. 155 amends SFAS No. 140, "Accounting for the Impairment or Disposal of Long-Lived Assets", to allow a qualifying special-purpose entity to hold a derivative financial instrument that pertains to beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006, with earlier application allowed. This standard is not expected to have a significant effect on the Company's future reported financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measures". This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, expands disclosures about fair value measurements, and applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 does not require any new . . .
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