News Column


June 18, 2014


Substantially all of our business has historically consisted of the securities brokerage and corporate finance activities of our majority-owned subsidiary, Paulson Investment Company, Inc. ("PIC"), which has operations in four principal categories, all of them in the financial services industry. These categories are:

? corporate finance revenues consisting principally of underwriting discounts

and underwriter warrants;

? securities trading from which we record profit or loss, depending on trading


? investment income resulting from earnings on, and increases or decreases in

the value of, our investment portfolio; and ? securities brokerage activities for which we earn commission revenues. During the second quarter of fiscal 2012 ended June 30, 2012, the Company sold substantially all of PIC's retail brokerage business to JHS Capital Advisors, LLC. and PIC is focusing its operations on boutique investment banking.

In addition, Paulson Capital Properties, LLC, a 100% owned subsidiary, was established for the purpose of purchasing, improving and remarketing underappreciated real estate. Through December 31, 2013, we had not purchased any real estate.

14 -------------------------------------------------------------------------------- Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. Further, past performance is not necessarily indicative of results to be expected in future periods. In our securities brokerage business, the amount of our revenues depends on levels of market activity requiring the services we provide. Our corporate finance activity, which consists of acting as the managing underwriter of initial and follow-on public offerings, private investments in public equity ("PIPEs") and private placements for smaller companies, is similarly affected by the strength of the market for new equity offerings, which has historically experienced substantial cyclical fluctuation. Global IPO volume increased by almost 50% and proceeds increased by 37% in 2013 compared to 2012, as 300 offerings were completed for proceeds of approximately $137 billion. Much of the increase was due to the strength in the US IPO market, where the number of IPO's rose by nearly 75% to 222. US IPO proceeds rose approximately 30% in 2013 to $55 billion. The outlook for the IPO market in 2014 is very good, as the continued strength in the market indices and global economic recovery has resulted in an increasing number of companies looking to go public. The recent implementation of the JOBS Act has led to increased interest in new offerings, particularly among smaller and development stage companies. Although we attempt to match operating costs with activity levels, many of our expenses are either fixed or difficult to change on short notice. Accordingly, fluctuations in corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss. Our investment and trading income or loss is affected by changes in market valuation of securities generally and, in particular, by changes in valuation of the equity securities of microcap companies in which our investments and trading activities tend to be concentrated. Equity markets in general, and microcap equity markets in particular, have always experienced significant volatility and this volatility has, in recent years, been extreme. As a result, the value of our investment portfolio and securities held in connection with our trading and investment activities has experienced large quarterly fluctuations in income or loss, and our net worth has substantially increased or decreased as our securities holdings are marked to market. A substantial portion of our corporate finance business consists of acting as placement agent of PIPEs and private placements for microcap and smallcap companies. As a part of our compensation for these activities, we typically receive warrants exercisable to purchase securities of the issuer similar to those that we offer and sell as placement agent. The warrants have varying terms and conditions, and generally have a five-year expiration date and are subject to a restricted period of six months to one-year during which we cannot exercise. The exercise price is typically 120% of the price at which the securities were initially sold in the offering in which we participated. Accordingly, unless there is at least a 20% increase in the price of these securities at some time more than six months and less than five years after the offering, the warrants will remain "under water" and will ultimately expire unexercised.


The following discussion and analysis of our financial condition and results of operations is based, in part, upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. In preparing our consolidated financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results are likely to differ from these estimates under different assumptions and conditions. As a result of the factors described below, our revenues and earnings are subject to substantial fluctuation from period to period based on a variety of circumstances, many of which are beyond our control. An increase in financial market activity, and/or an increase in equity valuations, will generally result in increases in our revenues, earnings and net worth as our activity levels and the value of our investment portfolio increase. Conversely, a general market retrenchment will typically lead to decreased revenues, earnings and net worth as a result of both decreased activity and the need to adjust high investment portfolio values to lower levels. Accordingly, results for any historical period are not necessarily indicative of similar results for any future period. 15 --------------------------------------------------------------------------------

The critical accounting policies described below include those that reflect significant judgments and uncertainties, which potentially could produce materially different results under different assumptions and conditions. We believe our critical accounting policies are limited to those described below.

Revenue Recognition Securities transactions and related commissions revenue, including the sale of investment company shares, are recorded on a trade date basis. Underwriter's fees and other underwriting revenues are recognized at the time the underwriting is completed. Revenue from sales of other securities including tax deferred units and insurance products is recorded when the units are sold. Revenue from the receipt of underwriter warrants is recognized when the underwriting is completed and the warrants are received based on the estimated fair value of the securities received as estimated using the Black-Scholes option-pricing model taking into account the exercise price, remaining life of the warrant, the current price of the underlying stock and its expected volatility, expected dividends on the stock and the risk-free interest rate for the remaining term of the warrant.

Value of Underwriter Warrants and Underwriter Warrants Payable to Employees

We are required to estimate the value of all securities that we hold at the date of any financial statements and to include that value, and changes in such value, in our financial statements. Accordingly, the aggregate fair value of our underwriter warrants is recorded as an asset on the balance sheets. When a new warrant is received, its fair value is included in corporate finance revenue on the date on which it is earned. Subsequently, any change in fair value is recorded as investment income or loss. When a warrant is exercised, the fair value is adjusted to reflect the value of the securities purchased, net of the exercise price, and the adjustment amount is recorded as income or loss for the relevant period. If a warrant expires unexercised, the fair value is adjusted to zero and the decrease is recorded as a loss in the relevant period. We estimate the value of our underwriter warrants using the Black-Scholes Option Pricing Model. The Black-Scholes model requires us to use five inputs including: price, risk free rate, exercise price, time remaining on the warrant and price volatility. After stock price, the most influential factor in this model is price volatility, which we calculate for each company's warrants based on each company's own historical stock closing prices as well as an index of historical prices for comparable companies. When we initially receive a new underwriter warrant from an initial public offering, its calculated volatility factor is entirely based on the volatility of an index of comparable companies, since there is no price history for a new publicly traded company. For publicly traded companies, as each underwriter warrant approaches its expiration date, its volatility factor is derived primarily from the historical prices of its underlying common stock. Private company underwriter warrant valuations use the volatility index of comparable companies. There is no assurance that we will ultimately be able to exercise any of our warrants in a way that will realize the value that has been recorded in our financial statements based on this model. Underwriter warrants payable to employees represent warrants that are held by PIC, but are distributable to employees as compensation at December 31, 2013. At December 31, 2013, the value of underwriter warrants was $5.276 million and underwriter warrants payable to employees was $3.641 million, which were each included as a separate line item on the consolidated balance sheets.

Fair Value of Investments

In addition to our underwriter warrants, we hold other securities, some of which have very limited liquidity and some of which do not have a readily ascertainable fair value. We are required to carry these securities at fair value. The fair value of not readily marketable securities is estimated by management using available information including the following: quoted market prices of similar securities (i.e., unrestricted shares of the same company); price of recent known trades of the same or similar securities; the cost of the security, if recently purchased, adjusted for changes in the financial condition of the issuer; all other information available from review of available documents related to the issuer or discussions with management of the issuer. Changes in the value of these securities are reflected currently in our results of operations as a component of investment income. Our estimates regarding the fair value of securities that are not readily marketable are significant estimates and these estimates could change in the near term. At December 31, 2013, the fair value of investments which do not have a readily ascertainable fair value was $1.1 million and was included as a component of trading and investment securities owned on our consolidated balance sheet. 16 --------------------------------------------------------------------------------

Notes and Other Receivables Notes and other receivables generally are stated at their outstanding unpaid principal balance. Interest income on receivables is recognized on an accrual basis. Receivables are reviewed on a regular and continual basis by our management and, if events or changes in circumstances cause us to doubt the collectability of the contractual payments, a receivable will be assessed for impairment. The Company considers a receivable to be impaired when, based on upon current information and events, it believes it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the receivable agreement. When we determine collection to be doubtful, an allowance for amounts receivable is recorded and the receivable is placed on a non-performing (non-accrual) status. Payments received on non-accrual receivables are applied first to reduce the outstanding interest, and are then applied to the receivable unless we determine impairment is likely in which case payments are applied to the outstanding receivable balance (cost recovery method). Interest received on impaired receivables is recorded using the cash receipts method unless management determines further impairment is probable. No impairment loss is recorded if the carrying amount of the receivable (principal and accrued interest) is expected to be fully recovered through borrower payments and enforcement of action against the borrower's collateral, if any. The conclusion that a receivable may become uncollectible, in whole or in part, is a matter of judgment. We do not have a formal risk rating system. Receivables and the related accrued interest are analyzed on an individual and continuous basis for recoverability. Delinquencies are determined based upon contractual terms. A provision is made for doubtful accounts to adjust the allowance for doubtful accounts to an amount considered to be adequate, with due consideration to workout agreements, to provide for unrecoverable receivables and receivables, including impaired receivables, other receivables, and accrued interest. Uncollectible receivables and related interest receivable are charged directly to the allowance account once it is determined that the full amount is not collectible. Legal Reserves We record reserves related to legal proceedings resulting from lawsuits and arbitrations, which arise from our business activities. Some of these lawsuits and arbitrations claim substantial amounts, including punitive damage claims. Management has determined that it is likely that ultimate resolution in favor of the claimant will result in losses to us on certain of these claims. We have, after consultation with outside legal counsel and consideration of facts currently known by management, recorded estimated losses to the extent we believe certain claims are probable of loss and the amount of the loss can be reasonably estimated. Factors considered by management in estimating our liability are the loss and damages sought by the claimant/plaintiff, the merits of the claim, the amount of loss in the client's account, the possibility of wrongdoing on the part of our employee and/or independent contractor, the total cost of defending the litigation, the likelihood of a successful defense against the claim, and the potential for fines and penalties from regulatory agencies. Results of litigation and arbitration are inherently uncertain, and management's assessment of risk associated therewith is subject to change as the proceedings evolve. After discussion with legal counsel, management, based on its understanding of the facts, accrues what they consider appropriate to reserve against probable loss for certain claims, which is included in the consolidated balance sheets under the caption "accounts payable and accrued expenses." At December 31, 2013, we had $52,500 accrued for pending legal matters.

Income Taxes

Benefits for uncertain tax positions are recognized when they are considered "more-likely-than-not" to be sustained by the taxing authority. At December 31, 2013, we did not have any unrecognized tax benefits which would have an impact on the effective tax rate if recognized. If we generate income before income taxes in future periods, our conclusion about the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance could change in a future period and we could record a substantial gain in our consolidated statements of operations when that occurs.

Stock-Based Compensation

Stock-based compensation for equity awards is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee's requisite service period (generally the vesting period of the equity award). Our awards typically vest on the date of grant and, accordingly, the expense is recognized on the date of grant. We utilize the Black-Scholes option pricing model for determining the fair value of stock option awards. 17 --------------------------------------------------------------------------------

RESULTS OF OPERATIONS Our revenues and operating results are influenced by fluctuations in the equity markets as well as general economic and market conditions, particularly conditions in the NASDAQ and over-the-counter markets, where our investment and trading positions and the underlying stock for the underwriter warrants are heavily concentrated. Significant fluctuations can occur in our revenues and operating results from one period to another. Our results of operations depend upon many factors, such as the number of companies that are seeking financing, the quality and financial condition of those companies, market conditions in general, the performance of our previous underwritings and interest in certain industries by investors. As a result, revenues and income derived from these activities may vary significantly from period to period. Our revenues include the following:

? Corporate finance revenues, which are a function of total proceeds from

offerings done during the period, compensation per offering and the fair value

of underwriter warrants received;

? Investment income (loss), which includes (i) the unrealized appreciation and

depreciation of securities held based on quoted market prices, (ii) the

unrealized appreciation and depreciation of securities held that are not

readily marketable, based upon our estimate of their fair value,

(iii) realized gains and losses on the sale of securities with quoted market

prices and securities that are not readily marketable, (iv) income on the

exercise of underwriter warrants, and (v) the unrealized appreciation and

depreciation of underwriter warrants held;

? Trading income (loss), which is the gain or loss from trading positions before

commissions paid to the representatives in the trading department; and ? Commissions, which represent amounts earned from our retail securities brokerage activities.

The following table sets forth the changes in our operating results in 2013 compared to 2012 (dollars in thousands):

Year Ended Favorable December 31, (Unfavorable) Percentage 2013 2012 Change Change Revenues: Commissions $ 2,590$ 3,767$ (1,177 ) (31.2 )% Corporate finance 7,782 521 7,261 1,393.7 Investment loss (880 ) (554 ) (326 ) (58.8 ) Trading income 1,248 1,036 212 20.5 Interest and dividends 34 1,280 (1,246 ) (97.3 ) Gain on sale of assets - 1,489 (1,489 ) (100.0 ) Other 60 186 (126 ) (67.7 ) Total revenues 10,834 7,725 3,109 40.2 Expenses: Commissions and salaries 4,983 4,655 (328 ) (7.0 ) Underwriter warrant commissions 3,863 - (3,863 ) (100.0 ) Underwriting expenses 215 182 (33 ) (18.1 ) Clearing expenses 75 182 107 58.8 Rent 316 288 (28 ) (9.7 ) Communication and quotation services 113 305 192 63.0 Professional fees 1,134 694 (440 ) (63.4 ) Travel and entertainment 70 64 (6 ) (9.4 ) Settlement expense 209 199 (10 ) (5.0 ) Bad debt expense 359 570 211 37.0 Depreciation and amortization 19 5 (14 ) (280.0 ) Licenses, taxes and insurance 607 589 (18 ) (3.1 ) Other 333 388 55 14.2 Total expenses 12,296 8,121 (4,175 ) (51.4 ) Income attributable to non-controlling interests 63 - (63 ) (100.0 ) Loss before income taxes $ (1,525 )$ (396 )$ (1,129 ) (285.1 )% 18


Revenues The recovery in the global economies, particularly in Europe and the United States, had a positive effect on investor confidence which was reflected in the strong financial markets. For the period from December 31, 2012 to December 31, 2013, the Dow Jones Industrial Average increased by 26.5%, and the NASDAQ Composite Index increased by 38.3%. Commissions declined 31% in 2013 compared to 2012, primarily due to the sale of substantially all the Company's retail brokerage business to JHS effective April 16, 2012 and the Company's renewed focus on investment banking operations for smaller and emerging companies. As of December 31, 2013, the Company had 24 registered representatives involved in brokerage activities and compensated primarily on a commission basis, which were included in the Company's 38 employees, compared to 4 registered representatives as of December 31, 2012.

Corporate finance income increased by 1,394% as the Company added additional personnel and two new offices to focus on investment banking operations. Corporate finance revenue in 2013 included:

? Participation in 12 private offerings during the year, in which we raised

$29.8 million in gross proceeds for 11 different companies, and earned $1.259

million in underwriting fees as well as the Black-Scholes value of $6.523

million of the underwriter warrants received in connection with the offerings.

Corporate finance revenue in 2012 included:

? Underwriting fees earned from the initial public offering of Methes Energies

International in the fourth quarter of 2012, in which we raised $2.8 million

in gross proceeds, as well as the Black-Scholes value of the underwriter

warrants received in connection with the offering.

? Fees earned in relation to an additional private placement of shares in Patron

Company, Inc., as well as the value of the underwriter warrants received in

connection with the offering.

? Fees earned performing financial advisory services for corporate financial

clients. ? Revenue related to our participation in closed-end mutual funds. Investment loss increased in 2013 by 59% over 2012 and included the following (in thousands): Year Ended December 31, 2013 2012

Net unrealized depreciation related to underwriter warrants

$ (2,795 )

$ (148 ) Net unrealized depreciation of securities held based on quoted market prices or, for securities that are not readily marketable, our estimate of their fair value

(2,074 ) (406 ) Net realized gain on the sale of securities with quoted market prices and securities that are not readily marketable 3,989 - $ (880 )$ (554 ) We exercised one of our underwriter warrant positions, and exercised and sold approximately 10% of another of our underwriter warrant positions in 2013, and did not exercise any underwriter warrants in 2012. Generally, when we exercise a warrant to obtain the underlying common stock, the common stock is subsequently sold in the near term and the related gain is reflected as a component of investment income. During 2013, we incurred significant mark-to-market write-downs in the fair-value estimate of two of our private investments, which more than offset a large realized gain on the sale of another private investment position. 19

-------------------------------------------------------------------------------- Investment income (loss) is volatile from period to period due to the fact that it is driven by the fair value of the securities and underwriter warrants held. In addition, the performance of the securities in which we have a concentration can significantly affect our investment income from period to period. Trading income increased by $212,000 in 2013 compared to 2012. Trading income was positively affected by the market value of certain securities in which we made a market. Our focus is on very small capitalization issues, especially those tied to our corporate finance clients.


Total expenses increased $4.18 million in 2013 compared to 2012, as described in more detail below.

Commissions and salaries increased $328,000 in 2013 compared to 2012. The Company has added additional personnel and two new offices in 2013 to support its investment banking operations.

Underwriter warrant commissions increased to $3.86 million in 2013 from zero in 2012. During 2013, the Company received warrants as compensation for completing private offerings of securities. A portion of the warrants received are payable to employees as commissions.

Underwriting expenses increased $33,000 in 2013 compared to 2012 as a result of the timing and level of investment banking activity in the respective periods.

Clearing expenses decreased $107,000 in 2013 compared to 2012. The decrease was primarily due to the sale of the Company's retail brokerage operations in April 2012.

Rent expense rose by $28,000 in 2013 compared to 2012 due to the Company adding new offices in New York and California during the year.

Communication and quotation services decreased by $192,000 due to the decline in the number of registered representatives in 2013 compared to 2012.

Professional fees rose by $440,000 in 2013 from 2012 primarily due to costs related to the reorganization of the Company and its PIC subsidiary.

Settlement expense increased $10,000 in 2013 compared to 2012, due to the settlement accruals of additional legal claims in 2013.

Bad debt expense, which is recorded for specific amounts when a receivable becomes impaired, totaled $359,000 in 2013 primarily due to impairment of the final installment due from the sale of one private investment. Bad debt expense in 2012 was $570,000 primarily due to the impairment of one note issued to a former employee, and two notes issued to corporate finance clients.

Licenses, taxes and insurance increased by $18,000 to $607,000 in 2013 from $589,000 in 2012 primarily due to higher insurance costs.


Our primary sources of liquidity include our cash and receivables from our clearing organization, offset by payables to our clearing organization.

In addition, our sources of liquidity include, to a certain extent, our trading positions, borrowings on those positions and profits realized upon the sale of the securities underlying underwriter warrants exercised. The liquidity of the market for many of our securities holdings, however, varies with trends in the stock market. Since many of the securities we hold are thinly traded, and we are, in many cases, a primary market maker in the issues held, any significant sales of our positions could adversely affect the liquidity of the issues held. In general, falling prices in NASDAQ and over-the-counter securities (which make up most of our trading positions) lead to decreased liquidity in the market for these issues, while rising prices in NASDAQ and over-the-counter issues tend to increase the liquidity of the market for these securities. 20 -------------------------------------------------------------------------------- We believe our cash and receivables from our clearing organization at December 31, 2013 are sufficient to meet our cash and regulatory net capital needs for at least the next 12-month period from December 31, 2013. Our liquidity could be negatively affected by protracted unfavorable market conditions.

As a securities broker-dealer, we are required by SEC regulations to meet certain liquidity and capital standards. We believe we were in compliance with these standards at December 31, 2013.

Following the lapse of restrictions upon issuance, capital available from the sale of the underlying securities of underwriter warrants exercised can fluctuate significantly from period to period as the value of the underlying securities fluctuates with overall market and individual company financial condition or performance. There is no public market for the underwriter warrants. The securities receivable upon exercise of the underwriter warrants cannot be resold unless the issuer has registered these securities with the SEC and with the states in which the securities will be sold unless exemptions are available. Any delay or other problem in the registration of these securities would have an adverse impact upon our ability to obtain funds from the exercise of the underwriter warrants and the resale of the underlying securities. At December 31, 2013, we owned 13 underwriter warrants from 9 issuers, all but 2 of which were exercisable. One of the warrants had an exercise price below the December 31, 2013 market price of the securities receivable upon exercise. There is little or no direct relationship between the intrinsic value of our underwriter warrants at the end of any given period and the fair value calculated using the Black-Scholes option pricing model. The prices of the securities underlying the underwriter warrants are very volatile, and substantial fluctuations in their fair value can be expected in the future. Cash provided by operating activities totaled $2.778 million in 2013, primarily due to the increase in trading and investment securities owned and other changes in our operating assets and liabilities as discussed in more detail below. In 2012, operating activities used cash of $213,000. Our net receivable from our clearing organization totaled $445,000 at December 31, 2013, compared to $2.3 million at December 31, 2012. Our net receivable from our clearing organization is affected by the results of the activity in our trading and investment accounts, as well as the timing of general corporate expenditures and cash flow requirements. Notes and other receivables increased by $1.568 million to $1.779 million at December 31, 2013 from $211,000 at December 31, 2012. The increase was primarily due to $1,200,000 in loans issued to the Company's newest employees.

Other assets in 2013 were $78,000 compared to zero in 2012. These assets represent the capitalized incremental direct costs related to the Proposed Financing.

Cash used by investing activities totaled $130,000 in 2013 compared to cash provided by investing activities of $1.413 million in 2012. In 2013, the Company acquired furniture and equipment for its relocated Portland office and new offices in New York City and Novato, California. In 2012, the cash provided was primarily from the sale of the Company's retail brokerage operations. Financing activities provided cash of $3.74 million in 2013. The cash was primarily related to the restructuring of PIC, including $700,000 from a note payable, $1.5 million from an advance from a related party, and $1.5 million from the issuance of preferred stock in PIC. During 2012, financing activities used cash of $1.16 million, with almost the entire amount due to dividends paid to common shareholders as the Company paid two special dividends totaling $0.20 per share to common shareholders during 2012.

Changes in our trading and investment securities owned are dependent on the purchase and sale of securities during the period, as well as changes in their fair values during the period.

21 --------------------------------------------------------------------------------

A summary of activity related to the fair value of our underwriter warrants was as follows (in thousands):

Balance, December 31, 2012$ 1,548 Receipt of underwriter warrants 6,523 Net unrealized loss on value of warrants (2,746 ) Warrants exercised or expired (49 ) Balance, December 31, 2013$ 5,276 In September 2001, our Board of Directors approved a stock repurchase program pursuant to which we are authorized to repurchase up to 600,000 shares of our common stock. In June 2008, our Board of Directors approved the repurchase of up to a total of an additional 200,000 shares of our common stock. We repurchased a total of 1,000 shares of our common stock during 2012 at an average price of $1.25 per share for a total of $1,250. Through December 31, 2013, 731,989 shares had been repurchased and, as of December 31, 2013, 68,011 shares remained available for repurchase. These repurchase programs do not have an expiration date.


We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. NEW ACCOUNTING PRONOUNCEMENTS

See Note 20. of Notes to Consolidated Financial Statements included under Part II, Item 8 of this Annual Report on Form 10-K.


Tabular disclosure of contractual payment obligations is not required for Smaller Reporting Companies.

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Source: Edgar Glimpses

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