**UNITED STATES****SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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** **

**FORM 10-K**

** **

**(Mark One)**

| **ý**                           | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF  1934**                             |
|--------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|
| ** **                           | **for the fiscal year ended September 30, 2004**                                                                       |
| ** **                           | **OR**                                                                                                                      |
| **o**                                | **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 814-00237** |

 

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**GLADSTONE CAPITAL CORPORATION**

(Exact name of registrant asspecified in its charter)

 

| **Maryland**                                                    | ** ** | **54-2040781**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **1616 Anderson Road, Suite 208  McLean, Virginia**             | ** ** | **22102**                             |
| (Address of principal executive offices)                        |       | (Zip Code)                            |
|                                                            |       |                                  |
| **(703) 286-7000**                                         |
| (Registrant’s telephone number, including  area code)      |

 

Securities registered pursuant to Section 12(b) of the Act: **None**

 

Securities registered pursuant to Section 12(g) of the Act: **Common Stock, $0.001 par value per share**

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days.   YES  ý  NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this 10-Kor any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

YES  ý  NO  o

 

The aggregate market value of the voting stock held by non-affiliatesof the Registrant on March 31, 2004, based on the closing price on that date of$22.41 on the Nasdaq National Market, was $209,638,939. For the purposes ofcalculating this amount only, all directors and executive officers of theRegistrant have been treated as affiliates.

 

There were 11,278,510 shares of the Registrant’s Common Stock, $0.001par value, outstanding as of December 2, 2004.

 

**Documents Incorporated by Reference.**  Portions of the Registrant’s Proxy Statementrelating to the Registrant’s 2005 Annual Meeting of Stockholders areincorporated by reference into Part III of this Report.

 

 

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**GLADSTONECAPITAL CORPORATION**

**FORM 10-KFOR THE FISCAL YEAR ENDED**

**SEPTEMBER 30,2004**

 

**TABLE OFCONTENTS**

 
| PART I     | Item 1  | Business                                                                                                            |   |
|------------|---------|---------------------------------------------------------------------------------------------------------------------|--------|
|       | Item 2  | Properties                                                                                                          |   |
|       | Item 3  | Legal  Proceedings                                                                                                  |   |
|       | Item 4  | Submission  of Matters to a Vote of Security Holders                                                                |   |
| PART II    | Item 5  | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |   |
|       | Item 6  | Selected  Financial Data                                                                                            |   |
|       | Item 7  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |
|       | Item 7A | Quantitative and Qualitative Disclosures  about Market Risk                                                         |   |
|       | Item 8  | Financial Statements and Supplementary Data                                                                         |   |
|       | Item 9  | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                               |   |
|       | Item 9A | Controls and Procedures                                                                                             |   |
|       | Item 9B | Other Information                                                                                                   |   |
| PART III   | Item 10 | Directors and Executive Officers of the  Registrant                                                                 |   |
|       | Item 11 | Executive Compensation                                                                                              |   |
|       | Item 12 | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                     |   |
|       | Item 13 | Certain Relationships and Related  Transactions                                                                     |   |
|       | Item 14 | Principal Accountant Fees and Services                                                                              |   |
| PART IV    | Item 15 | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                                              |   |
| SIGNATURES |    |                                                                                                                |

 

 

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**PART I**

 

**Item 1****. Business**

 

Gladstone Capital Corporation is a specialtyfinance company that was incorporated under the General Corporation Laws of theState of Maryland on May 30, 2001 and that commenced its initial publicoffering on August 24, 2001. We seek to achieve a high level of currentincome by investing in debt securities, consisting primarily of senior notes,senior subordinated notes and junior subordinated notes, of established privatebusinesses that are backed by leveraged buyout funds, venture capital funds orothers. We also seek to provide our stockholders with long-term capital growththrough the appreciation in the value of warrants or other equity instrumentsthat we may receive when we make loans. Our headquarters are in McLean,Virginia, a suburb of Washington, DC and we have offices in New York, New York,Chicago, Illinois, Pittsburgh, Pennsylvania, and Morristown, New Jersey. Wehave elected to be treated as a business development company under theInvestment Company Act of 1940, as amended (the “1940 Act”).

 

David Gladstone, our chairman and chiefexecutive officer, has over 25 years of experience in making loans to, andinvesting in, small and medium-sized companies at Gladstone CapitalCorporation, Allied Capital Corporation and American Capital Strategies Ltd.Allied Capital Corporation is a publicly traded subordinated debt lender andAmerican Capital Strategies is a publicly traded buyout and subordinated debtlender.       Mr. Gladstone is no longeraffiliated with Allied Capital Corporation or American Capital Strategies Ltd.

 

Terry Lee Brubaker, our vice chairman andchief operating officer, has over 25 years of experience in acquisitionsand managing companies subsequent to an acquisition. Prior to joining GladstoneCapital Corporation, he was a member of the management team that designed andimplemented the acquisition strategy of James River Corporation.

 

George Stelljes III, our president and chiefinvestment officer has an extensive background in subordinated debt and buyoutsand currently oversees the structuring and arranging of financing for potentialinvestments in small and medium-sized businesses.

 

Our chief financial officer, Harry Brill,brings significant experience from his role as the chief accounting officer ofAllied Capital where he was responsible for the public filings of a family offive public companies and oversaw the preparation of the operating reports andfinancial statements of these companies and of three private funds.

 

We typically make loans to companies that aresubstantially owned by leveraged buyout funds, venture capital funds, or familyowned businesses. Messrs. Gladstone, Brubaker and Stelljes have anextensive referral network of venture capitalists, leveraged buyout funds,investment bankers, attorneys, commercial bankers and business and financialbrokers. We believe that these entities have been, and will continue to be, animportant source of loan opportunities. We intend to enter into additionalinformal relationships with other leveraged buyout funds and venture capitalfunds, but we can not assure you that we will be able to do so or that any suchrelationships will lead to the origination of loans.

 

Effective October 1, 2004, weare externally managed by our affiliate Gladstone Management Corporation (“GladstoneManagement”), a registered investment adviser, pursuant to an investmentadvisory and administrative agreement.

 

We have two wholly owned subsidiaries,Gladstone Capital Advisers, Inc., through which we provide managerialassistance to our portfolio companies and Gladstone Business Loan LLC, through whichwe hold our loan investment portfolio.

 

**STRATEGY**

 

Our strategy is to make loans at favorableinterest rates to small and medium-sized businesses that we believe havetraditionally been underserved by conventional lenders. We use the loanreferral networks of Messrs. Gladstone, Stelljes and Brubaker and of our managingdirectors to identify and make senior and subordinated loans to selectedbusinesses that we believe do not have sufficient access to traditional sourcesof lending. We make loans to borrowers that need funds to finance growth,restructure their balance sheets or effect a change of control, all of which webelieve are typically underserved by banks and other traditional institutionallenders. We believe that our business strategy will enable us to achieve a highlevel of current income by investing in debt securities, consisting primarilyof senior notes, senior subordinated notes and junior subordinated notes, ofestablished private businesses that are backed by leveraged buyout funds,venture capital funds or others. In addition, from time to time we mightacquire existing loans that meet this profile from leveraged buyout funds,venture capital funds and others. We also seek to provide our stockholders withlong-term capital growth through the appreciation in the value of warrants orother equity instruments that we might

 

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receive when we make loans. Our financial plan presumes that(1) the net capital gains from the sale of the warrants (as well as otherprofit enhancements) we receive in connection with our lending activities willexceed any losses we may experience from loans that are not repaid, and(2) the managerial assistance fee income we derive from assisting ourportfolio companies will provide us with a source of revenue that approximatesour operating expenses (excluding interest expense). Effective October 1, 2004,our adviser, Gladstone Management will provide our managerial assistance, receivethe managerial assistance fee which will then be credited against theinvestment advisory fees. We cannot assure you that we will be able to achieveour investment objectives or that our business strategy will be successful.

 

We believe that we are well-positioned toprovide financing to small and medium-sized businesses that are undergoing achange of ownership, including management-led and third party leveragedbuyouts, and to those businesses that have good growth characteristics. We arenot limited by the capital and other regulatory requirements of the banking andsavings and loan industries and we have relatively low overhead andadministrative expenses. Moreover, our strategy of accepting warrants topurchase stock of our borrowers and other yield enhancements, such as successfees, is intended to closely align our interests with those of our portfoliocompanies, thereby reducing transaction costs, conveying our commitment to theborrowers and enhancing our attractiveness as a financing source. Perhaps mostimportantly, we believe that we have the experience and expertise to satisfythe financing needs of such businesses. In particular, we believe that we mayrealize a competitive advantage from Mr. Gladstone’s 25 years ofexperience in financing small to medium-sized private businesses, Mr. Stelljes’many years of financing medium and small businesses, and Mr. Brubaker’sextensive experience in acquisitions and operations. We believe that ourestablished network of loan referral sources, consisting of relationshipsestablished over many years by Messrs. Gladstone, Stelljes, and Brubakerand our managing directors will generate opportunities to identify and makesenior and subordinated loans to selected businesses that satisfy ourinvestment criteria. We intend to enter into additional informal relationshipswith leveraged buyout funds and venture capital funds, but we can not give anyassurance that we will be able to do so.

 

We target small and medium-sized privatebusinesses that meet certain criteria, including the potential for growth,adequate assets for loan collateral, experienced management teams withsignificant ownership interest in the business, adequate capitalization,profitable operations based on cash flow and potential opportunities for us torealize appreciation and gain liquidity in our various equity positions. We mayachieve liquidity in an equity position through a merger or acquisition of theborrower, a public offering of the borrower’s stock or by exercising our rightto require the borrower to buy back our warrants, although we cannot assure youthat we will always have these rights. We can also achieve a similar effect by requiring the borrower to pay usdeferred interest, which we refer to as a success fee, upon the occurence ofcertain events.  If the borrower doeswell we are paid a success fee in place of having warrants to own commonstock.  We cannot provide assurance thatwe will always have a success fee or warrant in place with every investment.

 

As a business development company, we makeavailable significant managerial assistance to our portfolio companies. Suchassistance typically involves reviewing existing credit facilities, arrangingbank financing, arranging equity financing, structuring financing from multiplelenders, structuring financing from equity investors, restructuring existingloans, raising equity and debt capital, closely monitoring the operations ofthe borrower, participating in its board and management meetings, beingavailable for consultation with its officers and providing generalorganizational and financial guidance.

 

We typically invest in senior, seniorsubordinated and junior subordinated notes. Our loans typically range from$5 million to $15 million, mature in no more than seven years andaccrue interest at a fixed or variable rate that exceeds the prime rate. Anumber of our loans have a provision that calls for some portion of theinterest payments to be deferred and added to the principal balance so that theinterest is paid, together with the principal, at maturity. This form ofdeferred interest is often called “paid in kind” (or “PIK”) interest, and, whenearned, we record PIK income as interest income and add the PIK interest to theprincipal balance of the loans.

 

Because our loans generally consist ofsubordinated debt of private companies who typically cannot or will not expendthe resources to have their debt securities rated by a credit rating agency, weexpect that most, if not all, of the debt securities we acquire will be unrated.We cannot accurately predict what ratings these loans might receive if theywere in fact rated, and therefore we cannot determine whether or not they couldbe considered to be “investment grade” quality.

 

To the extent possible, our loans generallyare collateralized by a security interest in the borrower’s assets.  We do not usually have the first claim onthese assets. Interest payments on loans we make will generally be made monthlyor quarterly (except to the extent of any PIK interest) with amortization ofprincipal generally being deferred for several years. The principal amount ofthe loans and any accrued but unpaid interest will generally become due atmaturity at five to seven years. We will focus on making loans accompanied bywarrants to purchase stock in the borrowers or other yield enhancements, suchas success fees. These warrants will typically have an exercise price equal tothe fair value of the portfolio company’s common stock at the time of the loanand entitle us to purchase a modest percentage of the borrower’s stock.  Success fees are conditional interest that ispaid if the borrower is successful. The success fee is calculated as additionalinterest on the loan and if certain events occur, such as the sale of theborrower, then the success fee is paid. If the event or events do not occur, then the success fee is not paid.

 

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From time to time, a portfolio company mayrequest additional financing, providing us with additional lending opportunities.We will consider such requests for additional financing under the criteria wehave established for initial investments and we anticipate that any debtsecurities we acquire in a follow-on financing will have characteristicscomparable to those issued in the original financing. In some situations, ourfailure, inability or decision not to make a follow-on investment may bedetrimental to the operations or survival of a portfolio company and thusjeopardize our investment in that borrower.

 

As noted above, we expect to receive warrants, to purchasestock, or other yield enhancements in many of our borrowers. If a financing issuccessful, not only will our debt securities have been repaid with interest,but we will be in a position to realize a gain on the accompanying equityinterests or other yield enhancements. The opportunity to realize such gain mayoccur if the borrower is sold to new owners or if it makes a public offering ofits stock. In most cases, we will not have the right to require that a borrowerundergo an initial public offering by registering securities under theSecurities Act of 1933, (“Securities Act”), but we generally will have theright to sell our equity interests in any subsequent public offering by theborrower. Even when we have the right to participate in a borrower’s publicoffering, the underwriters might insist, particularly if we own a large amountof equity securities, that we retain all or a substantial portion of our sharesfor a specified period of time. Moreover, we may decide not to sell an equityposition even when we have the right and the opportunity to do so. Thus,although we expect to dispose of an equity interest after a certain time,situations may arise in which we hold equity securities for a longer period.

 

In certain cases, we may receive the right,to which we refer as a put right, to require the borrower to repurchase thewarrants or other yield enhancements from us. When no public offering isavailable, we may exercise our put rights to dispose of our equity interest inthe borrower, although our ability to exercise put rights may be limited ornonexistent if a business does not have the money to repurchase our warrants orother yield enhancements. Similarly, we anticipate that we may obtain the right,to which we refer as an unlocking right, to require that the borrower purchaseour warrants or stock if it rejects a bona fide third party acquisition offer.The unlocking rights may allow us to sell our equity interests back to theborrower at the price offered by the potential acquirer.

 

In addition to the put rights and unlockingrights described above, when one of our portfolio companies does go public, wemay undertake hedging strategies with regard to our equity interests in it. Wemay mitigate risks associated with the volatility of publicly traded securitiesby, for instance, selling securities short or writing or buying call or putoptions. Hedging against a decline in the value of such investments in publiccompanies would not eliminate fluctuations in the values of such investments orprevent losses if the values of such investments decline, but would establishother investments designed to gain from those same developments. Therefore, byengaging in hedging transactions we can moderate the decline in the value ofour hedged investments in public companies. However, such hedging transactionswould also limit our opportunity to gain from an increase in the value of ourinvestment in the public company. Pursuant to our line of credit, we have agreedto enter into hedging transactions, such as interest rate cap agreement inconnection with the borrowings that we make under the line of credit, and todate we hold one interest rate cap agreement. Furthermore, in the event that we securitize a portion of our loanportfolio in the future, we believe that we will likely be required to enterinto similar arrangements with respect to the securitized loans.  Hedging strategies do pose risks to us andour stockholders, however we believe that such activities, because they will belimited to only a portion of our portfolio, are manageable.

 

Section 12(a)(3) of the 1940 Actprohibits us “in contravention of such rules and regulations or orders as [theSEC] may prescribe as necessary or appropriate in the public interest or forthe protection of investors . . . to effect a short sale of any security . . ...” However, to date, the SEC has not promulgated regulations under thisstatute. It is possible that such regulations could be promulgated in thefuture in a way that would require us to change any hedging strategies that wemay adopt. We will only engage in hedging activities in compliance withapplicable law and regulations.

 

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**SELECTION OF LOAN OPPORTUNITIES**

 

We have identified certain characteristicsthat we believe are important to profitably lend to small and medium-sizedbusinesses. The criteria listed below provide a general guidepost for ourlending and investment decisions, although not all of these criteria may befollowed in each instance.

 

•                                          **Growth.** In addition to generating sufficient cash flow toservice its debt, a potential borrower generally will be required to establishits ability to grow its cash flow. Anticipated growth will be a key factor in determiningthe value ascribed to any warrants we acquire in connection with our loans.

 

•                                          **Significant sponsor.** We seek businesses in which leveragedbuyout funds or venture capital funds have invested. We believe that a businessin which a substantial equity sponsor has made a meaningful investment is morelikely to be a good borrowing candidate.

 

•                                          **Liquidation value of assets.** Although we do not generallyintend to operate as an asset-based lender, liquidation value of the assetscollateralizing our loans is an important factor in each credit decision.Emphasis is placed both on tangible assets (e.g., inventory, plant, propertyand equipment) and intangible assets (e.g., accounts receivable, customerlists, networks, databases and recurring revenue streams).

 

•                                          **Experienced management team.** We will generally require thateach borrower have a management team that is experienced and properlyincentivized through a significant ownership interest in the borrower. Wegenerally will require that a borrower have, at a minimum, a strong chiefexecutive officer and chief financial officer who have demonstrated the abilityto accomplish the borrower’s objectives and implement its business plan.

 

•                                          **Profitable or near-profitable operations.** We focus onborrowers that are profitable or near-profitable at the operating level. We donot intend typically to lend to, or invest in, start-up or other early stagecompanies, nor do we intend typically to lend to, or invest in, businesses thatare experiencing significant operating problems.

 

•                                          **Exit strategy.** Prior to making a loan for which we receive awarrant to purchase stock of the borrower or other yield enhancement, we willanalyze the potential for the borrower to experience a liquidity event thatwill allow us to realize value for our equity position. Liquidity eventsinclude, among other things, an initial public offering, a private sale of ourfinancial interest, a merger or acquisition of the borrower or a purchase ofour equity position by the borrower or one of its stockholders.

 

**Loan Origination Process**

 

To originate loans, our lending officers usean extensive referral network comprised of venture capitalists, leveragedbuyout funds, investment bankers, attorneys, accountants, commercial bankersand business brokers. We intend to enter into additional informal relationshipswith leveraged buyout funds and venture capital funds, but we can give noassurance that we will be able to do so.

 

**Approval Process**

 

Our lending professionals reviewinformational packages in search of potential financing opportunities andconduct a due diligence investigation of each applicant that passes an initialscreening process. This due diligence investigation generally includes one ormore on-site visits, a review of the potential borrower’s historical andprojected financial information, interviews with management, employees,customers and vendors of the applicant and background checks and research onthe applicant’s product, service or particular industry. Upon completion of thedue diligence investigation, our financial professional creates a borrowerprofile summarizing the prospective borrower’s historical financial statements,industry and management team and analyzing its conformity to our generalinvestment criteria. Our lending professional then presents this profile to ourcredit committee, which is comprised of Messrs. Gladstone, Brubaker, andStelljes. Our credit committee must unanimously approve each loan, and eachmember of our Board of Directors must review each financing.

 

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**TEMPORARY INVESTMENTS**

 

Pending investment in other types of “qualifyingassets,” we invest our otherwise uninvested cash primarily in cash, cash items,government securities or high-quality debt securities maturing in one year orless from the time of investment, to which we refer collectively as temporaryinvestments, so that 70% of our assets are qualifying assets. For informationregarding regulations to which we are subject and the definition of “qualifyingassets,” see “Regulation.” Typically, we invest in US Treasury bills or inrepurchase obligations of a “primary dealer” in government securities, asdesignated by the Federal Reserve Bank of New York, or of any other dealerwhose credit has been established to the satisfaction of our Board of Directors.There is no percentage restriction on the proportion of our assets that may beinvested in such repurchase agreements. A repurchase agreement involves thepurchase by an investor, such as us, of a specified security and thesimultaneous agreement by the seller to repurchase it at an agreed-upon futuredate and at a price which is greater than the purchase price by an amount thatreflects an agreed-upon interest rate. Such interest rate is effective for the periodof time during which the investor’s money is invested in the arrangement and isrelated to current market interest rates rather than the coupon rate on thepurchased security. Our custodian, or the correspondent in its account with theFederal Reserve/Treasury Book Entry System, will be required to constantlymaintain underlying securities in an amount at least equal to the repurchaseprice. If the seller were to default on its repurchase obligation, we mightsuffer a loss to the extent that the proceeds from the sale of the underlyingsecurity were less than the repurchase price. A seller’s bankruptcy could delayor prevent a sale of the underlying securities. Our Board of Directors hasestablished procedures, which it will review periodically, requiring us tomonitor the creditworthiness of the dealers with which we enter into repurchaseagreement transactions.

 

**COMPETITION**

 

A large number of entities compete with usand make the types of investments that we seek to make in small andmedium-sized privately-owned businesses. Such competitors include privateequity funds, leveraged buyout funds, venture capital funds, investment banksand other equity and non-equity based investment funds, and other financingsources, including traditional financial services companies such as commercialbanks. Many of our competitors are substantially larger than we are and haveconsiderably greater financial, technical and marketing resources than we do.For example, some competitors may have a lower cost of funds and access tofunding sources that are not available to us. In addition, certain of ourcompetitors may have higher risk tolerances or different risk assessments,which could allow them to consider a wider variety of investments, establishmore relationships and build their market shares. Furthermore, many of thesecompetitors are not subject to the regulatory restrictions that the 1940 Actimposes on us as a business development company. We cannot assure you that thecompetitive pressures we face will not have a material adverse effect on ourbusiness, financial condition and results of operations.

 

**LEVERAGE**

 

For the purpose of making investments otherthan temporary investments and to take advantage of favorable interest rates,we intend to issue senior debt securities (including borrowings under ourcurrent lines of credit) up to the maximum amount permitted by the 1940 Act.The 1940 Act currently permits us to issue senior debt securities and preferredstock, to which we refer collectively as senior securities, in amounts suchthat our asset coverage, as defined in the 1940 Act, is at least 200% aftereach issuance of senior securities. We may also incur such indebtedness torepurchase our common stock. As a result of issuing senior securities, we are exposedto the risks of leverage. Although borrowing money for investments increasesthe potential for gain, it also increases the risk of a loss. A decrease in thevalue of our investments will have a greater impact on the value of our commonstock to the extent that we have borrowed money to make investments. There is apossibility that the costs of borrowing could exceed the income we receive onthe investments we make with such borrowed funds. In addition, our ability topay dividends or incur additional indebtedness would be restricted if assetcoverage is less than twice our indebtedness. If the value of our assetsdeclines, we might be unable to satisfy that test. If this happens, we may berequired to liquidate a portion of our loan portfolio and repay a portion ofour indebtedness at a time when a sale may be disadvantageous. Furthermore, anyamounts that we use to service our indebtedness will not be available fordistributions to our stockholders. Our Board of Directors is authorized toprovide for the issuance of preferred stock with such preferences, powers,rights and privileges as it deems appropriate, except that such an issuancemust adhere to the requirements of the 1940 Act. See “Regulation—BusinessDevelopment Company—Asset Coverage” for a discussion of leveraging constraints.

 

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**SECURITIZATION**

On February 3, 2003, we established awholly-owned subsidiary, Gladstone Business Loan LLC, “Business Loan”, for thepurpose of acquiring and holding certain of our loans. Business Loan has enteredinto a credit agreement with a group of institutional lenders that provides a$100 million revolving credit facility, the proceeds of which Business Loan usesto purchase loans from us. We, in turn, use these proceeds to make additionalloans and increase the size of our loan portfolio.  We currently intend to securitize all of theloans held by Business Loan and will use the proceeds from the securitizationto pay down any amounts outstanding under the revolving credit facility.

 

**INVESTMENT OBJECTIVES AND POLICIES**

We seek to achieve a high level of currentincome by investing in debt securities, consisting primarily of senior notes,senior subordinated notes and junior subordinated notes, of established privatebusinesses that are backed by leveraged buyout funds, venture capital funds orothers, with a particular emphasis on senior subordinated notes. We also seekto provide our stockholders with long-term capital growth through theappreciation in the value of warrants or other equity instruments that we mayreceive when we make loans. The following restrictions, along with theseinvestment objectives, are our only fundamental policies, which are policiesthat may not be changed without the approval of the holders of the majority ofour outstanding voting securities, as defined in the 1940 Act. For a fullerexplanation of the regulatory framework in which we operate, see “Business-Regulation.”The percentage restrictions set forth below, other than the restrictionpertaining to the issuance of senior securities, as well as those containedelsewhere in this Form 10-K, apply at the time we effect a transaction,and a subsequent change in a percentage resulting from market fluctuations orany cause other than an action by us will not require us to dispose ofportfolio securities or to take other action to satisfy the percentagerestriction. We will at all times conduct our business so as to retain ourstatus as a business development company. In order to retain that status, we maynot acquire any assets (other than non-investment assets necessary andappropriate to our operations as a business development company) if, aftergiving effect to such acquisition, the value of our “qualifying assets” is lessthan 70% of the value of our total assets. We anticipate that the securities weseek to acquire (provided that we control or, through our officers or otherparticipants in the financing transaction, make significant managerialassistance available to the issuers of these securities), as well as temporaryinvestments, will generally be qualifying assets.

 

We may invest up to 100% of our assets insecurities acquired directly from issuers in privately negotiated transactions.With respect to such securities, we may, for the purpose of public resale, bedeemed an “underwriter” as that term is defined in the Securities Act. We mayinvest up to 20% of our assets in securities of a particular issuer. We mayexceed this limitation in connection with bridge financings, although thesebridge investments will never exceed 25% of our total assets at any time. We donot intend to concentrate our investments in any particular industry or groupof industries. However, it is possible that, as the values of our portfoliocompanies change, one industry or a group of industries may comprise in excessof 25% of the value of our total assets.

 

We will at all times endeavor to conduct ourbusiness so as to retain our status as a regulated investment company underSubchapter M of the Internal Revenue Code of 1986 (the “Code”). In order to doso, we must meet income source, asset diversification and annual distributionrequirements. We may issue senior securities, such as debt or preferred stock,to the extent permitted by the 1940 Act for the purpose of making investments,to fund share repurchases, or for temporary emergency or other purposes. For adiscussion of the risks associated with the resulting leverage, see “Business—Leverage”and “Risk Factors—Our business is dependent upon external financing which mayexpose us to the risks associated with leverage.”

 

We will not (1) act as an underwriter ofsecurities of other issuers (except to the extent that we may be deemed an “underwriter”of securities we purchase that must be registered under the Securities Actbefore they may be offered or sold to the public); (2) purchase or sellreal estate or interests in real estate or real estate investment trusts(except that we may (a) purchase and sell real estate or interests in realestate in connection with the orderly liquidation of investments, (b) ownthe securities of companies or participate in a partnership or partnershipsthat are in the business of buying, selling or developing real estate, or(c) finance the purchase of real estate by our portfolio companies);(3) sell securities short (except with regard to managing the risksassociated with publicly-traded securities issued by our portfolio companies);(4) purchase securities on margin (except to the extent that we maypurchase securities with borrowed money); (5) write or buy put or calloptions (except (i) to the extent of warrants or conversion privileges inconnection with our acquisition financing or other investments and rights torequire the issuers of such investments or their affiliates to repurchase themunder certain circumstances, (ii) with regard to managing risks associatedwith publicly-traded securities issued by our portfolio companies, or(iii) with regard to managing the risks associated with interest ratefluctuations);

 

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(6) engage in the purchase or sale of commodities or commoditycontracts, including futures contracts (except where necessary in working outdistressed loan or investment situations or in managing the risks associated withinterest rate fluctuations); or (7) acquire more than 3% of the votingstock of, or invest more than 5% of our total assets in, any securities issuedby any other investment company (except as they may be acquired as part of amerger, consolidation or acquisition of assets). That portion of ourinvestments that is in securities issued by other investment companies maysubject our stockholders to additional expenses.

 

**EXTERNAL INVESTMENT ADVISER**

 

                                                Priorto October 1, 2004, we did not have an external investment adviser.  We were managed internally by our executiveofficers under the supervision of our Board of Directors, and had an expensesharing arrangement with our affiliate, Gladstone Management Corporation (“GladstoneManagement”), a registered investment adviser. Under the expense sharing arrangement, Gladstone Management reimbursed ourwholly-owned subsidiary Gladstone Capital Advisers for a portion of our totalpayroll and benefits expenses based on the percentage of total hours worked byeach of our employees on Gladstone Commercial Corporation (“GladstoneCommercial”) matters.  GladstoneManagement further passed its share of these expenses along to GladstoneCommercial under a separate advisory agreement. Gladstone Commercial is apublicly traded real estate investment trust affiliated with us and managed byGladstone Management.  Prior to October1, 2004, Gladstone Management also reimbursed Gladstone Capital Advisers forits pro rata portion of all other general expenses based on the percentage oftotal hours worked by all of our employees on Gladstone Commercial matters.

 

EffectiveOctober 1, 2004, we entered into an investment advisory and administrativeagreement with Gladstone Management pursuant to which Gladstone Managementbecame our external investment adviser. Our expense sharing arrangement with Gladstone Management terminatedimmediately upon our engagement of Gladstone Management as our externaladvisor.  Under the management agreement,Gladstone Management now directly employs all of our personnel and pays itspayroll, benefits, and general expenses directly.  Pursuant to the management agreement, we payGladstone Management an annual advisory fee of 1.25% of our total assets (asreduced by cash and cash equivalents pledged to creditors), payable inquarterly increments of 0.3125%, and an annual administrative fee of 0.75% ofour total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.1875%.  Managerial assistance fees received by ourinvestment adviser will be credited against the investment advisory fee. Wecontinue to pay direct expenses including, but not limited to, directors fees,legal and accounting fees, and stockholder related expenses.

 

 

**EMPLOYEES**

 

Effective October 1, 2004, all of ourexecutives, managing directors, principals, administrative staff and otherpersonnel became direct employees of our external investment adviser, GladstoneManagement.  However, our executives,managing directors, principals, administrative staff and other personnel willcontinue to be eligible to receive awards under our Amended and Restated 2001Equity Incentive Plan.  The employees ofGladstone Management perform services on our behalf and on behalf of GladstoneCommercial.  Most of the employees ofGladstone Management devote some or most of their time to work on our matters.We believe that our relations with these employees are excellent.

 

**REGULATION**

 

We are a closed-end, non-diversified,management investment company that has elected to be regulated as a businessdevelopment company under Section 54 of the 1940 Act. As such, we aresubject to regulation under the 1940 Act. The 1940 Act contains prohibitionsand restrictions relating to transactions between business development companiesand their affiliates, principal underwriters and affiliates of those affiliatesor underwriters and requires that a majority of the directors be persons otherthan “interested persons,” as defined in the 1940 Act. In addition, the 1940Act provides that we may not change the nature of our business so as to ceaseto be, or to withdraw our election as, a business development company unlessapproved by a majority of our outstanding voting securities.

 

**Regulated Investment Company**

 

In order to maintain the qualification fortreatment as a regulated investment company, or RIC, under Subchapter M of theCode, we must distribute to our stockholders, for each taxable year, at least90% of our investment company taxable income, which is generally our ordinaryincome plus short-term capital gains. We refer to this as the annualdistribution requirement. We must also meet several additional requirements,including:

 

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•                                          **Income source requirements.** At least 90% of our gross incomefor each taxable year must be from dividends, interest, payments with respectto securities loans, gains from sales or other dispositions of securities orother income derived with respect to our business of investing in securities,and

 

•                                          **Asset diversification requirements.** As of the close of eachquarter of our taxable year: (1) at least 50% of the value of our assetsmust consist of cash, cash items, US government securities, the securities ofother regulated investment companies and other securities to the extent that(a) we do not hold more than 10% of the outstanding voting securities ofan issuer of such other securities and (b) such other securities of anyone issuer do not represent more than 5% of our total assets, and (2) nomore than 25% of the value of our total assets may be invested in thesecurities of one issuer (other than US government securities or the securitiesof other regulated investment companies), or of two or more issuers that arecontrolled by us and are engaged in the same or similar or related trades orbusinesses.

 

If we are unable to qualify for treatment asa RIC, we will be subject to tax on all of our taxable income at regularcorporate rates. We would not be able to deduct distributions to stockholders,nor would we be required to make such distributions. Distributions would betaxable to our stockholders as ordinary dividend income to the extent of ourcurrent and accumulated earnings and profits. Subject to certain limitationsunder the Code, corporate distributees would be eligible for the dividendsreceived deduction.

 

Distributions in excess of our current andaccumulated earnings and profits would be treated first as a return of capitalto the extent of the stockholder’s tax basis, and then as a gain realized fromthe sale or exchange of property. If we fail to meet the RIC requirements formore than two consecutive years and then seek to requalify as a RIC, we wouldbe required to recognize gain to the extent of any unrealized appreciation onour assets unless we make a special election to pay corporate-level tax on anysuch unrealized appreciation recognized during the succeeding 10-year period.Absent such special election, any gain we recognized would be deemeddistributed to our stockholders as a taxable distribution. If we qualify as aRIC and distribute to stockholders each year in a timely manner at least 90% ofour investment company taxable income, we will not be subject to federal incometax on the portion of our taxable income and gains we distribute tostockholders. We would, however, be subject to a 4% nondeductible federalexcise tax if we do not distribute, actually or on a deemed basis, 98% of ourincome, including both ordinary income and capital gains. The excise tax wouldapply only to the amount by which 98% of our income exceeds the amount ofincome we distribute, actually or on a deemed basis, to stockholders.

 

We will be subject to regular corporateincome tax, currently at rates up to 35%, on any undistributed income,including both ordinary income and capital gains. We intend to retain some orall of our capital gains, but to designate the retained amount as a deemeddistribution. In that case, among other consequences, we will pay tax on theretained amount, each stockholder will be required to include its share of thedeemed distribution in income as if it had been actually distributed to thestockholder and the stockholder will be entitled to claim a credit or refundequal to its allocable share of the tax we pay on the retained capital gain.The amount of the deemed distribution net of such tax will be added to thestockholder’s cost basis for its common stock. Since we expect to pay tax onany retained capital gains at our regular corporate capital gain tax rate, andsince that rate is in excess of the maximum rate currently payable byindividuals on long-term capital gains, the amount of tax that individualstockholders will be treated as having paid will exceed the tax they owe on thecapital gain dividend and such excess may be claimed as a credit or refundagainst the stockholder’s other tax obligations. A stockholder that is notsubject to US federal income tax or tax on long-term capital gains would berequired to file a US federal income tax return on the appropriate form inorder to claim a refund for the taxes we paid. In order to utilize the deemeddistribution approach, we must provide written notice to the stockholders priorto the expiration of 60 days after the close of the relevant tax year. Wewill also be subject to alternative minimum tax, but any tax preference itemswould be apportioned between us and our stockholders in the same proportionthat dividends, other than capital gain dividends, paid to each stockholderbear to our taxable income determined without regard to the dividends paiddeduction.

 

If we acquire debt obligations that wereoriginally issued at a discount, which would generally include loans we makethat are accompanied by warrants, that bear interest at rates that are noteither fixed rates or certain qualified variable rates or that are notunconditionally payable at least annually over the life of the obligation, wewill be required to include in taxable income each year a portion of the “originalissue discount” that accrues over the life of the obligation. Such originalissue discount will be included in our investment company taxable income eventhough we receive no cash corresponding to such discount amount. As a result,we may be required to make additional distributions corresponding to such originalissue discount amounts in order to satisfy the annual distribution requirementand to continue to qualify as a RIC or to avoid the 4% excise tax. In thisevent, we may be required to sell temporary investments or other assets to meetthe RIC distribution requirements.

 

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For any period during which we qualify fortreatment as a RIC for federal income tax purposes, distributions to ourstockholders attributable to our investment company taxable income generallywill be taxable as ordinary income to stockholders to the extent of our currentor accumulated earnings and profits. Any distributions in excess of ourearnings and profits will first be treated as a return of capital to the extentof the stockholder’s adjusted basis in his or her shares of common stock andthereafter as gain from the sale of shares of our common stock. Distributionsof our long-term capital gains, designated by us as such, will be taxable tostockholders as long-term capital gains regardless of the stockholder’s holdingperiod for its common stock and whether the distributions are paid in cash orinvested in additional common stock. Corporate stockholders are generallyeligible for the 70% dividends received deduction with respect to ordinaryincome, but not to capital gains dividends to the extent such amount designatedby us does not exceed the dividends received by us from domestic corporations.Any dividend declared by us in October, November or December of anycalendar year, payable to stockholders of record on a specified date in such amonth and actually paid during January of the following year, will betreated as if it were paid by us and received by the stockholders onDecember 31 of the previous year. In addition, we may elect to relate adividend back to the prior taxable year if we (1) declare such dividendprior to the due date for filing our return for that taxable year,(2) make the election in that return, and (3) distribute the amountin the 12-month period following the close of the taxable year but not laterthan the first regular dividend payment following the declaration. Any suchelection will not alter the general rule that a stockholder will be treated asreceiving a dividend in the taxable year in which the distribution is made,subject to the October, November, December rule described above.

 

The “Jobs and Growth Tax ReliefReconciliation Act of 2003” did not alter the nature of our dividends that wepay to stockholders as taxable ordinary income. Accordingly, our dividends paid are not eligible for the lower tax rate.

 

**Business Development Company**

 

We intend to conduct our business so as toretain our status as a business development company. In general, a businessdevelopment company must have been organized and have its principal place ofbusiness in the United States and must be operated for the purpose of makinginvestments in the types of securities described in (1) or (2) below.

 

**Qualifying Assets**. Under the 1940 Act, a business development company may not acquire anyasset other than assets of the type listed in Section 55(a) of the 1940Act, which are referred to as qualifying assets, unless, at the time theacquisition is made, qualifying assets represent at least 70% of the company’stotal assets. The principal categories of qualifying assets relevant to ourbusiness are the following:

 

(1)           Securitiespurchased in transactions not involving any public offering from the issuer ofsuch securities, which issuer is an eligible portfolio company. An eligible portfoliocompany is generally defined in the 1940 Act as any issuer which, first, isorganized under the laws of, and has its principal place of business in, theUnited States. Second, the issuer must not be an investment company, other thana small business investment company wholly-owned by the business developmentcompany. Finally, the issuer may not have any class of securities with respectto which a broker or dealer may extend margin credit.

 

(2)           Securitiesof any eligible portfolio company over which we exercise a controllinginfluence and for which an affiliate of ours serves as a director.

 

(3)           Securitiesreceived in exchange for or distributed on or with respect to securitiesdescribed in (1) or (2) above, or pursuant to the exercise ofoptions, warrants or rights relating to such securities.

 

(4)           Cash,cash items, government securities or high quality debt securities maturing inone year or less from the time of investment.

 

Securities of public companies are generallynot qualifying assets unless they were acquired in a distribution or inexchange for, or upon the exercise of, a right relating to securities that werequalifying assets.

 

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**Asset Coverage**. We are permitted, under specified conditions, to issue multiple classesof indebtedness and one class of stock senior to our common stock if our assetcoverage, as defined in the 1940 Act, is at least 200% immediately after eachsuch issuance. In addition, while senior securities are outstanding, we mustmake provisions to prohibit any distribution to our stockholders or therepurchase of such securities or shares unless we meet the applicable assetcoverage ratios at the time of the distribution or repurchase. We may alsoborrow amounts up to 5% of the value of our total assets for temporarypurposes. The 1940 Act requires, among other things, that (1) immediatelyafter issuance and before any dividend or distribution is made with respect toour common stock or before any purchase of common stock is made, the preferredstock, together with all other senior securities, must not exceed an amountequal to 50% of our total assets after deducting the amount of such dividend,distribution or purchase price, as the case may be, and (2) the holders ofshares of preferred stock, if any are issued, must be entitled as a class toelect two directors at all times and to elect a majority of the directors ifdividends on the preferred stock are in arrears by two years or more.

 

**Significant Managerial Assistance**. For portfolio securities to be qualifying assets for the 70% testdescribed above, the business development company must either exercise acontrolling influence over the issuer of the securities or must make availableto the issuer of the securities significant managerial assistance. However,with respect to certain but not all such securities, where the businessdevelopment company purchases such securities in conjunction with one or moreother persons acting together, one of the other persons in the group may makeavailable such managerial assistance, or the business development company mayexercise such control jointly. Making available significant managerialassistance means, among other things, any arrangement whereby the businessdevelopment company, through its directors, officers or employees, offers toprovide, and, if accepted, does so provide, significant guidance and counselconcerning the management, operations or business objectives and policies of aportfolio company.

 

**Determination of Net Asset Value**

 

The net asset value per share of ouroutstanding shares is determined quarterly, as soon as practicable after and asof the end of each calendar quarter, by dividing the value of total assetsminus liabilities by the total number of shares outstanding at the date as ofwhich the determination is made.

 

We carry our investments at fair value.Securities that are publicly traded, if any, are valued at the closing price ofthe exchange or securities market on which they are listed on the valuationdate (to date there are no publicly traded securities in our portfolio).Securities which are not publicly traded on an exchange or securities market,but for which a limited market exists, such as participations in syndicatedloans, are valued at the indicative bid price offered by the syndication agenton the valuation date.  For securitiesthat are not publicly traded and do not have a limited market, the carryingvalue is based on valuations determined in good faith by our Board of Directors.  A majority of our loan portfolio, whichconsists of securities for which a limited market does not exist and are notpublicly traded, is reviewed by Standard & Poor’s Loan Evaluation Service(S&P).  S&P provides anindependent assessment of the loan portfolio data provided by us and assessesits own data to develop recommendations as to market values for thesesecurities.  Our Board of Directors voteson whether to accept the valuation recommendations presented by S&P.  To date the Board of Directors has alwaysaccepted the values recommended by S&P. Due to the uncertainty inherent inthe valuation process, such estimates of fair value may differ significantlyfrom the values that would have been obtained had a ready market for thesecurities existed, and the differences could be material. Additionally,changes in the market environment and other events that may occur over the lifeof the investments may cause the gains or losses ultimately realized on theseinvestments to be different than the valuations currently assigned.

 

A substantial portion of our assets willconsist of securities carried at fair market value, as determined by our Boardof Directors. Determination of fair market values, for those securities andinvestments not valued by S&P, involves subjective judgment not susceptibleto substantiation by auditing procedures. Accordingly, under generally acceptedaccounting principles, the notes to our consolidated financial statements willrefer to the uncertainty with respect to the possible effect of such valuationson our financial statements.

 

**Code of Ethics**

 

We and Gladstone Management have adopted acode of ethics and business conduct applicable to our officers, directors andall employees that complies with the guidelines set forth in Item 406 ofRegulation S-K of the Securities Act.  Asrequired by the 1940 Act, this code establishes procedures for personalinvestments and restricts certain transactions by our personnel. A copy of thiscode is available for review, free of charge, at our website at www.GladstoneCapital.com.

 

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**RISK FACTORS**

 

*An investment in our securities involves anumber of significant risks and other factors relating to our structure andinvestment objectives. As a result, we cannot assure you that we will achieveour investment objectives. You should consider carefully the followinginformation before making an investment in our securities.*

 

**We are dependent upon our key managementpersonnel for our future success, particularly David Gladstone, GeorgeStelljes III and Terry Lee Brubaker.**

 

We are dependent on the diligence, skill andnetwork of business contacts of our senior management and other managementmembers for the final selection, structuring, closing and monitoring of ourinvestments. Our future success depends to a significant extent on thecontinued service and coordination of our senior management team, particularlyDavid Gladstone, our chairman and chief executive officer, George Stelljes III,our president and chief investment officer, and Terry Lee Brubaker, our vice-chairmanand chief operating officer. The departure of any of our executive officers orkey employees from us or from our adviser, Gladstone Management, could have amaterial adverse effect on our ability to implement our business strategy andto achieve our investment objectives.

 

**Our financial condition and results ofoperations will depend on our ability to effectively manage our future growth.**

 

Our ability to achieve our investmentobjectives will depend on our ability to sustain continued growth, which willdepend on our ability to identify, evaluate, finance and invest in suitablecompanies that meet our investment criteria. Accomplishing this result on acost-effective basis is largely a function of our marketing capabilities, ourmanagement of the investment process, our ability to provide competent,attentive and efficient services and our access to financing sources onacceptable terms. As we grow, Gladstone Management will also be required tohire, train, supervise and manage new employees. Failure to effectively manageour future growth could have a material adverse effect on our business,financial condition and results of operations.

 

**We operate in a highly competitive market forinvestment opportunities.**

 

A large number of entities compete with usand make the types of investments that we seek to make in small and mediumsized privately owned businesses. We compete with a large number of privateequity funds, leveraged buyout funds and venture capital funds, investmentbanks and other equity and non-equity based investment funds, and other sourcesof financing, including traditional financial services companies such ascommercial banks. Many of our competitors are substantially larger and haveconsiderably greater financial, technical and marketing resources than we do.For example, some competitors may have a lower cost of funds and access tofunding sources that are not available to us. In addition, certain of ourcompetitors may have higher risk tolerances or different risk assessments,which could allow them to consider a wider variety of investments and establishmore relationships and build their market shares. Furthermore, many of ourpotential competitors are not subject to the regulatory restrictions that the1940 Act imposes on us as a business development company. We cannot assure youthat the competitive pressures we face will not have a material adverse effecton our business, financial condition and results of operations. Also, as aresult of this competition, we may not be able to take advantage of attractiveinvestment opportunities from time to time and there can be no assurance thatwe will be able to identify and make investments that satisfy our investmentobjectives or that we will be able to fully invest our available capital.

 

**Our business model is dependent upon developingand sustaining strong referral relationships with leveraged buyout funds andventure capital funds.**

 

We are dependent upon informal relationships with leveraged buyout funds,venture capital funds, and traditional lending institutions to provide us withdeal flow.  If we fail to maintain ourrelationship with such funds or institutions, or if we fail to establish strongreferral relationships with other funds, we will not be able to grow ourportfolio of loans and fully execute our business plan.

 

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**Our loans to small and medium sized borrowersare extremely risky and you could lose your entire investment.**

 

Loans to small and medium sized borrowers aresubject to a number of significant risks including the following:

 

•                                          **Small and medium sized businesses may have limited financial resourcesand may not be able to repay the loans we make to them.** Our strategyincludes providing financing to borrowers that typically is not readilyavailable to them. While we believe that this provides an attractiveopportunity for us to generate profits, this may make it difficult for theborrowers to repay their loans to us upon maturity. A borrower’s ability torepay its loan may be adversely affected by numerous factors, including thefailure to meet its business plan, a downturn in its industry or negativeeconomic conditions. A deterioration in a borrower’s financial condition andprospects usually will be accompanied by a deterioration in the value of anycollateral and a reduction in the likelihood of us realizing on any guaranteeswe may have obtained from the borrower’s management. Although we will sometimesseek to be the senior, secured lender to a borrower, in most of our loans weexpect to be subordinated to a senior lender, and our interest in anycollateral would, accordingly, likely be subordinate to another lender’ssecurity interest.

 

•                                          **Small and medium sized businesses typically have narrower product linesand smaller market shares than large businesses.** Because our targetborrowers are smaller businesses, they will tend to be more vulnerable tocompetitors’ actions and market conditions, as well as general economicdownturns. In addition, our portfolio companies may face intense competition,including competition from companies with greater financial resources, moreextensive development, manufacturing, marketing and other capabilities and alarger number of qualified managerial and technical personnel.

 

•                                          **There is generally little or no publicly available information aboutthese businesses.** Because we seek to make loans to privately ownedbusinesses, there is generally little or no publicly available operating andfinancial information about our potential borrowers. As a result, we rely onour officers, other employees and consultants to perform due diligenceinvestigations of these borrowers, their operations and their prospects. We maynot learn all of the material information we need to know regarding thesebusinesses through our investigations.

 

•                                          **Small and medium sized businesses generally have less predictableoperating results.** We expect that our borrowers may have significantvariations in their operating results, may from time to time be parties tolitigation, may be engaged in rapidly changing businesses with products subjectto a substantial risk of obsolescence, may require substantial additionalcapital to support their operations, to finance expansion or to maintain theircompetitive position, may otherwise have a weak financial position or may beadversely affected by changes in the business cycle. Our portfolio companiesmay not meet net income, cash flow and other coverage tests typically imposedby their senior lenders. A borrower’s failure to satisfy financial or operatingcovenants imposed by senior lenders could lead to defaults and, potentially,foreclosure on its senior credit facility, which could additionally triggercross-defaults in other agreements. If this were to occur, it is possible thatthe borrower’s ability to repay our loan would be jeopardized.

 

•                                          **Small and medium sized businesses are more likely to be dependent onone or two persons.** Typically, the success of a small or mediumsized business also depends on the management talents and efforts of one or twopersons or a small group of persons. The death, disability or resignation ofone or more of these persons could have a material adverse impact on ourborrower and, in turn, on us.

 

•                                          **Small and medium sized businesses are likely to have greater exposureto economic downturns than larger businesses.** We expect that ourborrowers will have fewer resources than larger businesses and an economicdownturn is more likely to have a material adverse effect on them. If one ofour borrowers is adversely impacted by an economic downturn, its ability torepay our loan would be diminished.

 

•                                          **Small and medium sized businesses may have limited operating histories.**While we intend to target stable companies with proven track records, we maymake loans to new companies that meet our other investment criteria. Borrowerswith limited operating histories will be exposed to all of the operating risksthat new businesses face and may be particularly susceptible to, among otherrisks, market downturns, competitive pressures and the departure of keyexecutive officers.

 

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**We may not realize gains from our equityinvestments and other yield enhancements.**

 

When we make a subordinated loan, wegenerally expect to receive warrants to purchase stock issued by the borroweror other yield enhancements, such as success fees (conditional interest). Ourgoal is to ultimately dispose of these equity interests and realize gains uponour disposition of such interests. We expect that, over time, the gains werealize on these warrants and other yield enhancements will offset any losseswe experience on loan defaults. However, any warrants we receive may notappreciate in value and, in fact, may decline in value and any other yieldenhancements, such as success fees, may not be realized. Accordingly, we maynot be able to realize gains from our equity interests or other yieldenhancements and any gains we do recognize may not be sufficient to offsetlosses we experience on our loan portfolio.

 

**Because the loans we make and equitysecurities we receive when we make loans are not publicly traded, there will beuncertainty regarding the value of our privately held securities that couldadversely affect our determination of our net asset value.**

 

We expect that very few, if any, of ourportfolio loans or equity securities, at least initially, will be publiclytraded or have a readily determinable market value. We value these securitiesbased on a determination of their fair value, based on recommendations providedby S&P and management and approved by our Board of Directors. Due to theuncertainty inherent in valuing these securities, our determinations of fairvalue may differ materially from the values that would exist if a ready marketfor these securities existed. Our net asset value could be materially affectedif our determinations regarding the fair value of our investments arematerially different from the values that we ultimately realize on our disposalof such securities.

 

**The lack of liquidity of our privately held investmentsmay adversely affect our business.**

 

Most of our investments presently consist of,and will continue to consist of, loans and warrants acquired in privatetransactions directly from borrowers or from the originators of loans to suchborrowers. Substantially all of the investments we presently hold are, and the investmentswe expect to acquire in the future will be, subject to restrictions on resale,including, in some instances, legal restrictions, or will otherwise be lessliquid than publicly traded securities. The illiquidity of our investments maymake it difficult for us to quickly obtain cash equal to the value at which werecord our investments if the need arises. This could cause us to missimportant business opportunities. In addition, if we are required to quicklyliquidate all or a portion of our portfolio, we may realize significantly lessthan the value at which we have previously recorded our investments.

 

**Our portfolio will be concentrated in alimited number of companies and industries, which subjects us to an increasedrisk of significant loss if any one of these companies does not repay us or ifthe industries experience downturns.**

 

We intend to have outstanding loans toapproximately 20 to 40 portfolio companies at any given time. A consequence ofa limited number of investments is that the aggregate returns we realize may besubstantially adversely affected by the unfavorable performance of a smallnumber of such loans or a substantial writedown of any one investment. Beyondour regulatory and income tax diversification requirements, we do not havefixed guidelines for industry concentration and our investments couldpotentially be concentrated in relatively few industries. In addition, while wedo not intend to invest 25% or more of our total assets in a particularindustry or group of industries at the time of investment, it is possible thatas the values of our portfolio companies change, one industry or a group ofindustries may comprise in excess of 25% of the value of our total assets. As aresult, a downturn in an industry in which we have made multiple loans couldhave a materially adverse effect on us.

 

**Our business plan is dependent upon externalfinancing which may expose us to risks associated with leverage.**

 

Our business will require a substantialamount of cash to operate and grow. We may acquire such additional capital fromthe following sources:

 

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•                                          **Senior Securities**.We intend to issue debt securities, other evidences of indebtedness (includingborrowings under our lines of credit) and possibly preferred stock, up to themaximum amount permitted by the 1940 Act. The 1940 Act currently permits us, asa business development company, to issue debt securities and preferred stock,to which we refer collectively as senior securities, in amounts such that ourasset coverage, as defined in the 1940 Act, is at least 200% after eachissuance of senior securities. As a result of issuing senior securities, wewill be exposed to the risks associated with leverage. Although borrowing moneyfor investments increases the potential for gain, it also increases the risk ofa loss. A decrease in the value of our investments will have a greater impacton the value of our common stock to the extent that we have borrowed money tomake investments. There is a possibility that the costs of borrowing couldexceed the income we receive on the investments we make with such borrowedfunds. In addition, our ability to pay dividends or incur additionalindebtedness would be restricted if asset coverage is not at least twice ourindebtedness. If the value of our assets declines, we might be unable tosatisfy that test. If this happens, we may be required to liquidate a portionof our loan portfolio and repay a portion of our indebtedness at a time when asale may be disadvantageous. Furthermore, any amounts that we use to serviceour indebtedness will not be available for distributions to our stockholders.

 

•                                          **Common Stock.** Because we are constrained in our ability toissue debt for the reasons given above, we are dependent on the issuance ofequity as a financing source. If we raise additional funds by issuing morecommon stock or debt securities convertible into or exchangeable for our commonstock, the percentage ownership of our stockholders at the time of the issuancewould decrease and they may experience dilution. In addition, any convertibleor exchangeable securities that we issue in the future may have rights,preferences and privileges more favorable than those of our common stock.

 

•                                          **Securitization.** In addition to issuing securities to raisecapital as described above, we anticipate that in the future we will securitizeour loans to generate cash for funding new investments. An inability tosuccessfully securitize our loan portfolio could limit our ability to grow ourbusiness, fully execute our business strategy and impact our profitability.Moreover, successful securitization of our loan portfolio might expose us tolosses as the loans in which we do not plan to sell interests will be thosethat are riskier and more apt to generate losses.

 

**A change in interest rates may adverselyaffect our profitability and our hedging strategy may expose us to additionalrisks.**

 

We anticipate using a combination of equityand long-term and short-term borrowings to finance our lending activities. As aresult, a portion of our income will depend upon the difference between therate at which we borrow funds and the rate at which we loan these funds.Certain of our borrowings may be at fixed rates and others at variable rates. Ultimately,we expect approximately 50% of the loans in our portfolio to be at fixed ratesand approximately 50% to be at variable rates determined on the basis of abenchmark prime rate. As of September 30, 2004, our portfolio had approximately35% of the total of the loan portfolio cost at fixed rates, approximately 42%of the total of the loan cost value at variable rates with a floor, and theremaining 23% at variable rates. We will typically seek to hedge against therisk of adverse movement in interest rates on our borrowings relative to ourportfolio of assets. As required by our warehouse line of credit, we hedgeagainst interest rate fluctuations by using standard hedging instruments suchas futures, options and forward contracts. While hedging activities mayinsulate us against adverse fluctuations in interest rates, they may also limitour ability to participate in the benefits of lower interest rates with respectto the hedged portfolio. Adverse developments resulting from changes ininterest rates or hedging transactions could have a material adverse effect onour business, financial condition and results of operations.

 

**Our credit facilities impose certainlimitations on us.**

 

We will have a continuing need for capital tofinance our loans. In order to maintain RIC status, we will be required todistribute to our stockholders at least 90% of our ordinary income and short-termcapital gains on an annual basis. Accordingly, such earnings will not beavailable to fund additional loans. Therefore, we are party to a credit agreement arranged by Deutsche BankAG as the structuring agent.  Theagreement provides us with a revolving credit line facility of $100million.  We also recently entered into a$15 million short-term revolving line of credit with BB&T.  In the future, borrowings outstanding onthese credit lines may be repaid with the proceeds we may receive from securitizingsome or all of the loans in our portfolio for long-term funding.  These credit line facilities will permit usto fund additional loans and investments as long as we are within theconditions set out in the credit agreement.

 

As a result of the credit line facilities, weare subject to certain limitations on the type of loan investments we make,including restrictions on geographic concentrations, sector concentrations,loan size, payment frequency and status, and average life.

 

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Our failure to satisfy these limitationscould result in foreclosure by our lenders which would have a material adverseeffect on our business, financial condition and results of operations.

 

**Our investments will typically be long termand will require several years to realize liquidation events.**

 

Since we generally intend to make five toseven year term loans and to hold our loans and related warrants or other yieldenhancements until the loans mature, you should not expect realization events,if any, to occur over the near term. In addition, we expect that any warrantsor other yield enhancements that we receive when we make loans may requireseveral years to appreciate in value and we cannot give any assurance that suchappreciation will occur.

 

**We will be subject to corporate level tax ifwe are unable to satisfy Internal Revenue Code requirements for RICqualification.**

 

To maintain our qualification as a RIC, wemust meet income source, asset diversification and annual distributionrequirements. The annual distribution requirement is satisfied if we distributeat least 90% of our ordinary income and short-term capital gains to ourstockholders on an annual basis. Because we use leverage, we are subject tocertain asset coverage ratio requirements under the 1940 Act and could, undercertain circumstances, be restricted from making distributions necessary toqualify as a RIC. Warrants we receive with respect to debt investments willcreate “original issue discount,” which we must recognize as ordinary income,increasing the amounts we are required to distribute to maintain RIC status.Because such warrants will not produce distributable cash for us at the sametime as we are required to make distributions in respect of the relatedoriginal issue discount, we will need to use cash from other sources to satisfysuch distribution requirements. The asset diversification requirements must bemet at the end of each calendar quarter. If we fail to meet these tests, we mayneed to quickly dispose of certain investments to prevent the loss of RICstatus. Since most of our investments will be illiquid, such dispositions, ifeven possible, may not be made at prices advantageous to us and, in fact, mayresult in substantial losses. If we fail to qualify as a RIC for any reason andbecome fully subject to corporate income tax, the resulting corporate taxescould substantially reduce our net assets, the amount of income available fordistribution, and the actual amount distributed. Such a failure would have amaterial adverse effect on us and our shares. For additional informationregarding asset coverage ratio and RIC requirements, see “Business—Leverage”and “Business—Regulation.”

 

**There are significant potential conflicts ofinterest which could impact our investment returns.**

 

Our executive officers and directors mayserve as officers and directors of entities that operate in the same or similarlines of business as we do. Accordingly, they may have obligations to investorsin those entities, the fulfillment of which might not be in the best interestsof us or our stockholders. It is possible that new investment opportunitiesthat meet our investment objectives may come to the attention of one of ourexecutive officers or directors, such as Mr. Gladstone, in his role as anofficer or director of another entity, and, if so, such opportunity might notbe offered, or otherwise made available, to us.

 

**Ifour primary investments are deemed not to be qualifying assets, we could loseour status as a business development company or be precluded from investingaccording to our current business plan.**

 

If we are tomaintain our status as a business development company, we must not acquire anyassets other than “qualifying assets” unless, at the time of and after givingeffect to such acquisition, at least 70% of our total assets are qualifyingassets. If we acquire senior loans, mezzanine debt or equity securities from anissuer which has outstanding marginable securities at the time we make aninvestment, these acquired assets cannot be treated as qualifying assets. (See “Business—Regulation—BusinessDevelopment Company—Qualifying Assets.”) This results from the definition of “eligibleportfolio company” under the 1940 Act, which in part looks to whether a companyhas outstanding marginable securities.

 

Amendmentspromulgated in 1998 by the Board of Governors of the Federal Reserve System toRegulation T under the Securities Exchange Act of 1934, as amended, or theExchange Act, expanded the definition of marginable security to include anynon-equity security. These amendments have raised questions as to whether aprivate company that has outstanding debt

would qualify as an eligibleportfolio company.

 

15

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We believethat substantially all of the senior loans, subordinated loans and equitysecurities that we hold and propose to acquire in the future should constitutequalifying assets because our current borrowers did not, and our expectedfuture borrowers will not, at the time of our investment, have outstandingmarginable securities. First, we have historically made, and expect to continueto make, a large portion of our senior loan and subordinated loan investmentson terms and in circumstances such that those investments should not underexisting legal precedent be “securities” under the Exchange Act and thereforeshould not be marginable securities under Regulation T. Second, we believe thatshould a different position be taken such that those investments may besecurities, they should still not be marginable securities. In particular, debtinstruments that do not trade in a public secondary market or are not ratedinvestment grade are not margin eligible securities under the rules establishedby the self- regulatory organizations, including the New York Stock Exchangeand National Association of Securities Dealers, that govern the terms on whichbroker-dealers may extend margin credit. Until the questions raised by theamendments to Regulation T have been addressed by legislative, administrativeor judicial action, we intend to treat as qualifying assets only those seniorloans and subordinated loans that are not investment grade, do not have apublic secondary market, and are issued by a private issuer that does not haveoutstanding a class of margin eligible securities at the time of ourinvestment. Likewise, we will treat equity securities issued by a portfoliocompany as qualifying assets only if such securities are issued by a privatecompany that has no marginable securities outstanding at the time we purchasesuch securities.

 

To date, we donot believe that either the Securities and Exchange Commission or its staff hastaken any position with respect to our analysis of the issues discussed above.We intend to adjust our investment focus as needed to comply with and/or takeadvantage of any future administrative position, judicial decision orlegislative action.

 

The Securitiesand Exchange Commission has recently proposed amendments to the rulesconcerning business development companies that would clarify that, among otherthings, companies that do not have a class of securities listed on an exchangeor Nasdaq would be considered eligible portfolio companies.  If these rules are adopted as proposed, itwould remove the uncertainty concerning the status of certain of ourinvestments as qualifying assets by clarifying that all of our portfoliocompanies would be considered eligible portfolio companies.  There can be no guarantee that the SEC willadopt these rules substantially as proposed, if at all.

 

Unless anduntil the proposed rules described above are adopted, if there were a courtruling or regulatory decision that conflicts with our interpretations, we couldlose our status as a business development company or be precluded frominvesting in the manner described in this prospectus. This in turn could causeus to lose our status as a RIC. Any of these results would have a materialadverse effect on our ability to invest in the manner described in this prospectus,on our operating results, financial condition and ability to pay dividends, andon the value of our common stock, For information regarding the consequences offailure to qualify as a RIC, see “Business—We will be subject to corporatelevel income tax if we are unable to satisfy Internal Revenue Code requirementsfor RIC qualification.”

 

Such a rulingor decision also may require that we dispose of investments that we made basedon our interpretation of Regulation T. Such dispositions could have a materialadverse effect on us and our stockholders. We may need to dispose of suchinvestments quickly, which would make it difficult to dispose of suchinvestments on favorable terms. In addition, because these types of investmentswill generally be illiquid, we may have difficulty in finding a buyer and, evenif we do find a buyer, we may have to sell the investments at a substantialloss. See “Business—The lack of liquidity of our privately held investments mayadversely affect our business.”

 

**Changes in laws or regulations governing ouroperations may adversely affect our business.**

 

We and our portfolio companies will besubject to regulation by laws at the local, state and federal level. These lawsand regulations, as well as their interpretation, may be changed from time totime. Accordingly, any change in these laws or regulations could have amaterial adverse impact on our business. For additional information regardingthe regulations to which we are subject, see “Business—Regulation”

 

**We may experience fluctuation in ourquarterly results.**

 

We could experience fluctuations in ourquarterly operating results due to a number of factors including, among others,variations in and the timing of the recognition of realized and unrealizedgains or losses, the degree to which we encounter competition in our marketsand general economic conditions. As a result of these factors, results for anyperiod should not be relied upon as being indicative of performance in futureperiods.

 

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**There is a risk that you may not receivedividends or that our dividends may not grow over time.**

 

Our current intention is to distribute atleast 90% of our ordinary income and short-term capital gains to ourstockholders on a quarterly basis. We expect to retain net realized long-termcapital gains to supplement our equity capital and support the growth of ourportfolio, although our Board of Directors may determine in certain cases todistribute these gains. We cannot assure you that we will achieve investmentresults or maintain a tax status that will allow or require any specified levelof cash distributions or year-to-year increases in cash distributions.

 

**Failure to deploy capital may reduce ourreturn on equity.**

 

In the past, we experienced delays ininvesting the proceeds of our initial public offering, which closed onAugust 29, 2001, as compared to the original timetable that we expected atthe time of our initial public offering. Because of this slower pace of investing, we did not fully invest thenet proceeds of our initial public offering until the fourth quarter of fiscal2003.  On September 30, 2004, we closed asecond public offering of common stock providing net proceeds of approximately$24.4 million. Currently all of these proceeds have been invested, however, inthe future, if we fail to invest our capital effectively, our return on equitymay be negatively impacted, which could result in a decline in the market priceof our common stock.

 

**Prepayments by our portfolio companies couldadversely impact our results of operations and reduce our return on equity.**

 

In addition to risks associated with delaysin investing our capital, we are also subject to the risk that investments thatwe make in our portfolio companies may be repaid prior to maturity. When thisoccurs, we will generally reinvest these proceeds in government securities,pending their future investment in new debt securities. These governmentsecurities will typically have substantially lower yields than the debtsecurities being prepaid and we could experience significant delays inreinvesting these amounts. As a result, our results of operations could bematerially adversely affected if one or more of our portfolio companies electsto prepay amounts owed to us. Additionally, prepayments could negatively impactour return on equity, which could result in a decline in the market price ofour common stock.

 

**Provisions of our articles of incorporationand bylaws could deter takeover attempts and adversely impact the price of ourshares.**

 

Our articles of incorporation and bylaws andthe Maryland General Corporation Law contain provisions that may have theeffect of discouraging, delaying or making more difficult a change in controland preventing the removal of incumbent directors. The existence of theseprovisions may negatively impact the price of our shares and may discouragethird-party bids. These provisions may reduce any premiums paid to you for ourshares. Furthermore, we are subject to Section 3-602 of the MarylandGeneral Corporation Law which governs business combinations with interestedstockholders and could delay or prevent a change in control. In addition, our Boardof Directors is elected in staggered terms which makes it more difficult for ahostile bidder to acquire control of us.

 

**The market price of our shares may fluctuatesignificantly.**

 

The market price and marketability of ourshares may from time to time be significantly affected by numerous factors,including many over which we have no control and that may not be directlyrelated to us. These factors include the following:

 

•                                          priceand volume fluctuations in the stock market from time to time, which are oftenunrelated to the operating performance of particular companies;

•                                          significantvolatility in the market price and trading volume of shares of RICs, businessdevelopment companies or other companies in our sector, which is notnecessarily related to the operating performance of these companies;

•                                          changesin regulatory policies or tax guidelines, particularly with respect to RICs orbusiness development companies;

•                                          lossof BDC status;

•                                          lossof RIC status;

•                                          changesin our earnings or variations in our operating results;

•                                          changesin the value of our portfolio of investments;

 

17

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•                                          anyshortfall in our revenue or net income or any increase in losses from levelsexpected by securities analysts;

•                                          departureof key personnel;

•                                          operatingperformance of companies comparable to us;

•                                          short-sellingpressure with respect to our shares or business development companiesgenerally;

•                                          generaleconomic trends and other external factors; and

•                                          lossof a major funding source.

 

Fluctuations in the trading prices of ourshares may adversely affect the liquidity of the trading market for our sharesand, if we seek to raise capital through future equity financings, our abilityto raise such equity capital.

 

**Shares of closed-end investment companiesfrequently trade at a discount from net asset value.**

 

Shares of closed-end investment companiesfrequently trade at a discount from net asset value. This characteristic ofshares of closed-end investment companies is separate and distinct from therisk that our net asset value per share will decline. Although shares of our commonstock have historically traded at a premium to net asset value, there can be noguarantee that they will continue to do so.

 

**Sales of substantial amounts of our commonstock in the public market may have an adverse effect on the market price ofour common stock.**

 

As of September 30, 2004 we had 11,278,510shares of common stock outstanding, of which 10,369,224 were freely tradablewithout restriction. The remaining 909,286 shares were held by employees,officers and directors, most of which were purchased upon exercise of stockoptions and all of which may currently be resold publicly in compliance withthe volume limitations and other restrictions of Rule 144 of theSecurities Act. On April 10, 2003 we filed a registration statement toregister for public resale 1,351,668 shares under our Amended and Restated 2001Equity Incentive Plan (including the shares that have already been issued uponoption exercises). Subsequent to the filing of this registration statement, allof these shares are now freely tradable without restriction, although certainof the options have not yet been granted and a portion of the options that havebeen granted are not yet vested and the shares underlying such options will,accordingly, not be eligible for resale until vested. Sales of substantialamounts of our common stock in the public market, pursuant to suchregistration, under Rule 144 or otherwise, or the availability of suchshares for sale, could adversely affect the prevailing market prices for ourcommon stock. If this occurs, it could impair our ability to raise additionalcapital through the sale of equity securities should we desire to do so.

 

**Ourengagement of Gladstone Management Corporation could have a material adverseeffect on our results of operations.**

 

EffectiveOctober 1, 2004, we engaged our affiliate, Gladstone Management Corporation, asour external investment adviser and we transitioned from being an internallymanaged company to an externally managed one. Under the terms of our advisoryagreement with Gladstone Management, we are required to pay GladstoneManagement an annual advisory fee of 1.25% of our total assets and an annualadministrative fee of 0.75% of our total assets. Under the terms of theadvisory agreement, we will continue to pay direct expenses including, but notlimited to, directors fees, legal and accounting fees, and stockholder relatedexpenses. It is possible that the transition to external management mayincrease our operating expenses, which could have a material adverse effect on ourresults of operations. For additional information, see “Business—ExternalInvestment Adviser.”

 

18

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**Available Information:**

 

Copies of our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments, ifany, to those reports filed pursuant to Section 13(a) or 15(d) of theExchange Act are available free of charge through our website atwww.GladstoneCapital.com.  A request forany of these reports may also be submitted to us by writing:  Corporate Secretary, Gladstone CapitalCorporation, 1616 Anderson Road, Suite 208, McLean, VA 22102.  The public may read and copy materials thatwe file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street,NW, Washington, DC 20549.  Information onthe operation of the Public Reference Room may be obtained by calling the SECat 1-800-SEC-0330.  The SEC alsomaintains a website that contains reports, proxy and information statements,and other information regarding issuers that file electronically with the SECat http://www.sec.gov.

 

**Item 2****. Properties**

 

We do not own any real estate or otherphysical properties materially important to our operation. Our headquarters arelocated in McLean, Virginia where we occupy our office space pursuant to alicense agreement that expired on October 31, 2004.  Subsequent to October 31, 2004, we occupy ourMcLean, Virginia office space pursuant to a month to month basis licenseagreement.  We also lease office space inNew York City pursuant to a service agreement that expires on August 31,2005 and in Chicago, Illinois pursuant to a service agreement that expires onJune 30, 2005.   Effective October 1, 2004, GladstoneManagement Corporation was assigned all of the outstanding leases for each ofthese facilities and we continue to occupy these premises pursuant to ourinvestment advisory and administrative agreement with Gladstone ManagementCorporation.

 

**Item 3****. Legal Proceedings**

 

We are not currently subject to any materiallegal proceedings, nor, to our knowledge, is any material legal proceedingthreatened against us.

 

**Item 4****. Submission of Matters to a Vote of Security Holders**

 

No matters were submitted to a vote ofsecurity holders during the fourth quarter of the fiscal year endedSeptember 30, 2004.

 

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**PART II**

 

**Item 5****. Market for Registrant’s Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities**

 

Our common stock is traded on the NasdaqNational Market under the symbol “GLAD.” The following table reflects, byquarter, the high and low closing prices per share of our common stock on theNasdaq National Market for each fiscal quarter during the last two fiscalyears.

 

| ** ** | ** ** | **Quarter  Ended** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------|------------|--------------------|------------|----------|------------|---------|------------|
|       |       |               |       |     |       |    |       |
| FY 2004    |       | 09/30/04           |       | $        | 23.71      |    | $          | 20.05 |   |
|       |       | 06/30/04           |       | 22.55    |       | 19.16   |       |
|       |       | 03/31/04           |       | 23.50    |       | 21.34   |       |
|       |       | 12/31/03           |       | 22.84    |       | 19.55   |       |
| FY 2003    |       | 09/30/03           |       | 20.52    |       | 18.76   |       |
|       |       | 06/30/03           |       | 20.50    |       | 16.25   |       |
|       |       | 03/31/03           |       | 16.78    |       | 15.55   |       |
|       |       | 12/31/02           |       | 17.00    |       | 14.90   |       |
|            |            |                    |            |          |            |         |            |  |  |

 

As of November 18, 2004, there wereapproximately 12,000 beneficial owners of our Common Stock.

 

**Dividends**

 

We currently intend to distribute in the formof cash dividends a minimum of 90% of our ordinary income and short-termcapital gains, if any, on a quarterly basis to our stockholders. For fiscalyear 2003, dividends were declared and paid quarterly. At the beginning offiscal year 2004, dividends were declared quarterly but paid monthly.  Amounts presented for each fiscal quarter of2004 represent the cumulative amount of the dividends declared for the monthscomposing such quarter. The following table reflects, by quarter, the dividendsper share that we have declared on our common stock for each quarter of thelast two fiscal years:

 

| ** ** | ** ** | **Quarter  Ended** | ** ** | **Cash Dividend  Per Share** | ** ** |
|------------|------------|--------------------|------------|------------------------------|------------|
|       |       |               |       |                         |       |
| FY 2004    |       | 09/30/04           |       | $                            | 0.360      |   |
|       |       | 06/30/04           |       | 0.345                        |       |
|       |       | 03/31/04           |       | 0.330                        |       |
|       |       | 12/31/03           |       | 0.330                        |       |
| FY 2003    |       | 09/30/03           |       | 0.330                        |       |
|       |       | 06/30/03           |       | 0.290                        |       |
|       |       | 03/31/03           |       | 0.250                        |       |
|       |       | 12/31/02           |       | 0.230                        |       |
|            |            |                    |            |                              |            |  |

 

**Recent Sales of Unregistered Securities**

 

There were no unregistered salesof securities during the fiscal year ended September 30, 2004.

 

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**Item 6****. Selected Financial Data**

 

The following selected financial data for thefiscal years ended September 30, 2004 and 2003 are derived from ourconsolidated financial statements which have been audited byPricewaterhouseCoopers LLP, independent accountants.  The following selected financial data for thefiscal year ended September 30, 2002 and the period endedSeptember 30, 2001 are derived from our consolidated financial statementswhich have been audited by Ernst & Young LLP, independent accountants.The data should be read in conjunction with our consolidated financialstatements and notes thereto and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” included elsewhere in thisreport.

 

**GLADSTONECAPITAL CORPORATION**

**SELECTEDFINANCIAL DATA**

** **
| ** **                                                                       | ** ** | **Year Ended  September 30,  2004** | ** **  | **Year Ended  September 30,  2003** | ** ** | **Year Ended  September 30,  2002** | ** ** | **Period May 30,2001  (Inception) Through  September 30, 2001** | ** **  |
|----------------------------------------------------------------------------------|------------|-------------------------------------|-------------|-------------------------------------|------------|-------------------------------------|------------|-----------------------------------------------------------------|-------------|
|                                                                             |       |                                |        |                                |       |                                |       |                                                            |        |
| Total Investment Income                                                          |       | $                                   | 20,395,968  |                                | $          | 15,154,874                          |       | $                                                               | 10,455,703  |   | $ | 394,855 |   |
| Total Expenses                                                                   |       | $                                   | 7,103,193   |                                | $          | 3,858,953                           |       | $                                                               | 2,839,102   |   | $ | 487,499 |   |
| Net Investment Income (Loss)                                                     |       | $                                   | 13,292,775  |                                | $          | 11,295,921                          |       | $                                                               | 7,616,601   |   | $ | (92,644 | ) |
| Net Increase (Decrease) in Stockholders’  Equity Resulting from Operations  |       | $                                   | 10,570,290  |                                | $          | 11,073,581                          |       | $                                                               | 7,616,601   |   | $ | (92,644 | ) |
|                                                                             |       |                                |        |                                |       |                                |       |                                                            |        |
| Per Share Data:                                                                  |       |                                |        |                                |       |                                |       |                                                            |        |
| Net Increase (Decrease) in Stockholders’  Equity Resulting from Operations: |       |                                |        |                                |       |                                |       |                                                            |        |
| Basic                                                                            |       | $                                   | 1.05        |                                | $          | 1.10                                |       | $                                                               | 0.76        |   | $ | (0.03 | ) |
| Diluted                                                                          |       | $                                   | 1.02        |                                | $          | 1.09                                |       | $                                                               | 0.75        |   | $ | (0.03 | ) |
| Cash Distributions Declared per Share                                            |       | $                                   | 1.365       |                                | $          | 1.10                                |       | $                                                               | 0.81        |   | $ | 0.00 |   |
|                                                                             |       |                                |        |                                |       |                                |       |                                                            |        |
| Balance Sheet Data:                                                              |       |                                |        |                                |       |                                |       |                                                            |        |
| Total Assets                                                                     |       | $                                   | 215,333,727 |                                | $          | 214,566,663                         |       | $                                                               | 172,922,039 |   | $ | 132,205,486 |   |
| Total Shareholders’ Equity                                                  |       | $                                   | 152,226,655 |                                | $          | 130,802,382                         |       | $                                                               | 130,663,273 |   | $ | 131,249,144 |   |
|                                                                             |       |                                |        |                                |       |                                |       |                                                            |        |
| Other Data:                                                                      |       |                                |        |                                |       |                                |       |                                                            |        |
| Number of Portfolio Companies at Period End                                      |       | 16                                  |        | 11                                  |       | 7                                   |       | NONE                                                            |        |
| Principal Amount of Loan Originations (1)                                        |       | $                                   | 86,267,500  |                                | $          | 47,011,278                          |       | $                                                               | 97,705,054  |   | NONE |   |
| Principal Amount of Loan Repayments (1)                                          |       | $                                   | 47,158,995  |                                | $          | 18,005,827                          |       | $                                                               | 18,387,191  |   | NONE |   |
| Total Return (2)                                                                 |       | 24.40                               | %           | 21.74                               | %          | 9.60                                | %          | 7.60                                                            | %           |
|                                                                             |       |                                |        |                                |       |                                |       |                                                            |        |
| Weighted Average Yield on Investments (3):                                       |       |                                |        |                                |       |                                |       |                                                            |        |
| With PIK Interest (4)                                                            |       | 13.78                               | %           | 13.86                               | %          | 14.79                               | %          | N/A                                                             |        |
| Without PIK Interest (4)                                                         |       | 13.44                               | %           | 13.14                               | %          | 13.82                               | %          | N/A                                                             |        |

 

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(1)           Includesall originations/prepayments related to a line of credit to one of ourportfolio companies during the fiscal year ended September 30, 2002.

 

(2)           Forthe fiscal year ended September 30, 2004, the total return equals the increaseof the ending market value over the beginning market value plus monthlydividends divided by the monthly beginning market value.  For the fiscal year ended September 30, 2003and prior periods, total return equals the increase of the ending market valueover the beginning market value, plus distributions, divided by the beginningmarket value. The return for 2001 has not been annualized.

 

(3)           Weightedaverage yield on investments equals interest income on investments divided bythe average investment balance throughout the year.

 

(4)           Referto Note 2 of the “Notes to Financial Statements” for an explanation of PIK, or “Paid-in-Kind,”interest.

 

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**Item 7****. Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

*The following analysis of our financialcondition and results of operations should be read in conjunction with ourfinancial statements and the notes thereto contained elsewhere in thisForm 10-K.*

 

**FORWARD-LOOKING STATEMENTS**

 

*All statements contained herein, other thanhistorical facts, may constitute “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Thesestatements may relate to, among other things, future events or our futureperformance or financial condition. In some cases, you can identifyforward-looking statements by terminology such as “may,” “might,” “believe,” “will,”“provided,” “anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,”“should,” “would,” “if,” “seek,” “possible,” “potential”, “likely” or thenegative of such terms or comparable terminology. These forward-lookingstatements involve known and unknown risks, uncertainties and other factors thatmay cause our actual results, levels of activity, performance or achievementsto be materially different from any future results, levels of activity,performance or achievements expressed or implied by such forward-lookingstatements. Such factors include, among others: (1) adverse changes ininterest rates; (2) our failure or inability to establish or maintainreferral arrangements with leveraged buyout funds and venture capital funds togenerate loan opportunities; (3) the loss of one or more of our executiveofficers, in particular David Gladstone, Terry Lee Brubaker, or George StelljesIII; (4) our inability to maintain a credit facility on terms reasonablyacceptable to us, if at all; (5) our inability to successfully securitizeour loan portfolio on terms reasonably acceptable to us, if at all;(6) the decision of our competitors to aggressively seek to make seniorand subordinated loans to small and medium-sized businesses on terms morefavorable than we intend to provide; and (7) those factors described inthe “Risk Factors” section of this Form 10-K. We caution readers notto place undue reliance on any such forward-looking statements, which are madepursuant to the Private Securities Litigation Reform Act on 1995 and, as such,speak only as of the date made. We undertake no obligation to publicly updateor revise any forward-looking statements, whether as a result of newinformation, future events or otherwise, after the date of this Form 10-K.*

 

**OVERVIEW**

 

We were incorporated under the General CorporationLaws of the State of Maryland on May 30, 2001. Our investment objectivesare to achieve a high level of current income by investing in debt securities,consisting primarily of senior notes, senior subordinated notes and juniorsubordinated notes, of established private businesses that are backed byleveraged buyout funds, venture capital funds or others, with a particularemphasis on senior subordinated notes. In addition, we may acquire existingloans that meet this profile from leveraged buyout funds, venture capital fundsand others. We also seek to provide our stockholders with long-term capitalgrowth through the appreciation in the value of warrants or other equityinstruments that we may receive when we make loans. We operate as a closed-end,non-diversified management investment company, and have elected to be treatedas a business development company under the 1940 Act.

 

We seek out small and medium-sized businessesthat meet certain criteria, including (1) the potential for growth in cashflow, (2) adequate assets for loan collateral, (3) experiencedmanagement teams with a significant ownership interest in the borrower,(4) profitable operations based on the borrower’s cash flow,(5) reasonable capitalization of the borrower (usually by leveraged buyoutfunds or venture capital funds) and (6) the potential to realizeappreciation and gain liquidity in our equity position, if any. We anticipatethat liquidity in our equity position will be achieved through a merger oracquisition of the borrower, a public offering by the borrower or by exerciseof our right to require the borrower to buy back its warrants. We lend toborrowers that need funds to finance growth, restructure their balance sheetsor effect a change of control.

 

Our loans typically range from$5 million to $15 million, mature in no more than seven years andaccrue interest at a fixed or variable rate that exceeds the prime rate. Anumber of our loans have a provision that calls for some portion of theinterest payments to be deferred and added to the principal balance so that theinterest is paid, together with the principal, at maturity. This form ofdeferred interest is often called “paid-in-kind” (or “PIK”) interest, and, whenearned, we record PIK interest as interest income and add the PIK interest tothe principal balance of the loans.

 

Because our loans will generally besubordinated debt of private companies who typically cannot or will not expendthe resources to have their debt securities rated by a credit rating agency, weexpect that most, if not all, of the debt securities we acquire will beunrated. We cannot accurately predict what ratings these loans might receive ifthey were in fact rated, and therefore we cannot determine whether or not theycould be considered to be “investment grade” quality.

 

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To the extent possible, our loans generallyare collateralized by a security interest in the borrower’s assets. Interestpayments are generally made monthly or quarterly (except to the extent of anyPIK interest) with amortization of principal generally being deferred forseveral years. The principal amount of the loans and any accrued but unpaidinterest generally become due at maturity at five to seven years. When wereceive a warrant to purchase stock in a borrower in connection with a loan,the warrant will typically have an exercise price equal to the fair value ofthe portfolio company’s common stock at the time of the loan and entitle us topurchase a modest percentage of the borrower’s stock.

 

In addition, as a business developmentcompany under the 1940 Act, we are required to make available significantmanagerial assistance to our portfolio companies. Prior to the externalizationof our management on October 1, 2004, we provided these services, for which wereceive fees, through our wholly-owned subsidiary, Gladstone CapitalAdvisers, Inc.  Upon theexternalization of our management on October 1, 2004, our investment adviser,Gladstone Management, began to provide these services on our behalf and as suchwill receive the fees for these services which will then be credited againstthe management advisory fee.  The feesfor these services are typically paid in part at the time a prospectiveportfolio company signs a non-binding term sheet with us, with the remainderpaid at the closing of the investment. These fees are generally non-recurring,however in some instances they may have a recurring component. The specificservices we provide vary by portfolio company, but generally consist ofreviewing existing credit facilities, arranging bank financing, arrangingequity financing, structuring financing from multiple lenders, structuringfinancing from equity investors, restructuring existing loans, raising equityand debt capital, closely monitoring the operations of the borrower,participating in its board and management meetings, being available forconsultation with its officers and providing general organizational andfinancial guidance.****Historically, we have record fees forthese services as managerial assistance fee revenue for the periods in which thesefees are earned by us.

 

Prior to making an investment, we ordinarilyenter into a non-binding term sheet with the potential borrower. Thesenon-binding term sheets are generally subject to a number of conditions,including but not limited to the satisfactory completion of our due diligenceinvestigations of the potential borrower’s business and reaching agreement onthe legal documentation for the loan. Typically, upon execution of thenon-binding term sheet, the potential borrower pays us a non-refundable fee forour services rendered through the date of the non-binding term sheet. We havehistorically recognized this as management fee revenue upon execution of thenon-binding term sheet.

 

In the event that we expend significanteffort in considering and negotiating a potential investment that ultimately isnot consummated, we generally will seek reimbursement from the proposedborrower for our reasonable expenses incurred in connection with the proposedtransaction.  Any amounts collected forexpenses incurred by Gladstone Management in connection with unconsummatedinvestments will be reimbursed to Gladstone Management. Amounts collected forthese expenses incurred by us will be reimbursed to us and will be recognizedas “other income” in the period in which such reimbursement is received.  Also, in the event that we have incurredsignificant legal fees in connection with the transaction, we will typicallyseek reimbursement for these expenses from the proposed borrower.  However, there can be no guarantee that wewill be successful in collecting any such reimbursements.

 

The only significant continuing revenueassociated with the investments we have already closed is interest income and,potentially, capital gains realized in connection with the liquidation of anyassociated equity interest (e.g., warrants).

 

The fiscal year ended September 30, 2004 sawsigns of improvement in the economy as well as an influx of low interest ratecapital into the debt markets as compare to the fiscal year ended September 30,2003.  As evidence of this improvement,several of our portfolio companies saw an increase in their earnings and assuch have repaid their entire outstanding loan balances earlier than thescheduled contractual maturity dates. During the fiscal year ended September 30, 2004, we saw four loaninvestments and one syndicated loan investment repay ahead of maturity date foran aggregate return of capital of approximately $36.5 million.  On September 30, 2004 we closed a secondpublic offering of common stock which provided us net proceeds of approximately$24.4 million.  Subsequent to September30, 2004, two loan investments repaid ahead of contractual maturity and one syndicatedloan investment was sold for an aggregate return of capital of approximately $25.3million.  Since our initial publicoffering in August 2001, we have made 39 different loans to or purchasedsyndicated participations in, or investments in, 23 companies for a total ofapproximately $219.1 million.

 

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We are steadily working toward theconsummation of more investments, both loan origination and syndicatedinvestments. These prospective loans are subject to, among other things, thesatisfactory completion of our due diligence investigation of each borrower,acceptance of terms and structure and attainment of necessary consents. Withrespect to each prospective loan, we will only agree to provide the loan if,among other things, the results of our due diligence investigations are satisfactory,the terms and conditions of the loan are acceptable and all necessary consentsare received. Our management has initiated its due diligence investigations ofthe potential borrowers, however we cannot assure you that we will not discoverfacts in the course of completing our due diligence that would render aparticular investment imprudent or that any of these loans will actually bemade.

 

**External Adviser**

 

In July 2003, we entered into an expense sharing arrangement withGladstone Management Corporation (“Gladstone Management”), a registeredinvestment adviser that serves as the external adviser to Gladstone CommercialCorporation, a real estate investment trust affiliated with us. Under thisexpense sharing arrangement, Gladstone Management reimbursed Gladstone CapitalAdvisers for a portion of our total payroll and benefits expenses (based on thepercentage of total hours worked by each of our employees on GladstoneCommercial matters). Gladstone Management also reimbursed Gladstone CapitalAdvisers for its pro rata portion of all other general expenses (based on thepercentage of total hours worked by all of our employees on GladstoneCommercial matters). Gladstone Management further passed its share of theseexpenses along to Gladstone Commercial under a separate advisory agreement. Asa result of this expense sharing arrangement, certain of our expenses, such asrent and insurance, declined during the fiscal year ended September 30, 2004.** **Followingour engagement of Gladstone Management on October 1, 2004, the first day of our2005 fiscal year, Gladstone Management now directly employs all of ourpersonnel and pays its payroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement betweenGladstone Capital Advisers and Gladstone Management terminated upon theexternalization of our management on October 1, 2004.

 

Effective October 1, 2004, pursuant to our advisory agreement withGladstone Management, we pay Gladstone Management an annual advisory fee of1.25% of our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.3125%, and an annualadministrative fee of 0.75% of our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly increments of 0.1875%.We continue to pay direct expenses including, but not limited to, directorsfees, legal and accounting fees, and stockholder related expenses.

 

**Critical Accounting Policies**

 

The preparation of financial statements andrelated disclosures in conformity with generally accepted accounting principlesin the United States requires management to make estimates and assumptions thataffect the reported consolidated amounts of assets and liabilities, disclosureof contingent assets and liabilities at the date of the financial statements,and revenues and expenses during the periods reported. Actual results couldmaterially differ from those estimates. Our accounting policies are more fullydescribed in the “Notes to Consolidated Financial Statements” containedelsewhere in this report. We have identified our investment valuation process,tax status and revenue recognition as our most critical accounting policies.

 

**Investment Valuation**

 

The most significant estimate inherent in thepreparation of our consolidated financial statements is the valuation ofinvestments and the related amounts of unrealized appreciation and depreciationof investments recorded.

 

 

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*GeneralValuation Policy:*Wevalue our investment portfolio each quarter. We carry our investments atfair value, as determined in good faith by our board of directors.  Securities that are publicly traded, if any,are valued at the closing price of the exchange or securities market on whichthey are listed on the valuation date. Securities which are not traded on apublic exchange or securities market, but for which a limited market exists,such as participations in syndicated loans, are valued at the indicative bidprice offered by the syndication agent on the valuation date.

 

Debt andequity securities that are not publicly traded and for which a limited marketdoes not exist (or for which we have various degrees of trading restrictions)are valued at fair value as determined in good faith by our board ofdirectors.  In making the good faithdetermination of the value of these securities, we start with the cost basis ofthe security, which includes the amortized original issue discount, and PIK interest,if any.  We then apply the methods setout below in “Valuation Methods.”  Members of our portfolio management team preparethe valuations of our investments in portfolio companies using the most recentportfolio company financial statements and forecasts.  These individuals also consult with portfoliocompany senior management to obtain further updates on the portfolio company’sperformance, including information such as industry trends, new productdevelopment, and other operational issues. Due to the uncertainty inherent in the valuation process, suchestimates of fair value may differ significantly from the values that wouldhave been obtained had a ready market for the securities existed, and thedifferences could be material. Additionally, changes in the market environment and other events thatmay occur over the life of the investments may cause the gains or lossesultimately realized on these investments to be different than the valuationscurrently assigned.  No single standardfor determining fair value in good faith exists since fair value depends uponcircumstances of each individual case. In general, fair value is the amount that we might reasonably expect toreceive upon the current sale of the security.

 

As of March 31, 2003, we engaged Standard & Poor’s Loan EvaluationService (S&P) to help evaluate the value of the majority of our loansecurities (other than those which are publicly traded or for which a limitedmarket exists, as described above). Since June 30, 2003, our S&P engagement includes evaluations onsuccess fees (conditional interest included in some loan securities).  We and S&P only evaluate the value of asuccess fee if the probability of receiving the success fee on a given loan isabove 6-8%, a threshold of significance, in which case a value isassigned.  Upon completing our collectionof data with respect to the investments (including the information describedunder “Credit Information,” the risk ratings of the loans described under “LoanGrading and Risk Rating” and the factors described under “Valuation Methods”),this valuation data is presented to S&P. S&P makes its independent assessment of the data that we haveassembled and assesses its own data to determine market values for thesecurities.  With regard to its work,S&P has issued the following paragraph:

 

S&Pprovides evaluated price opinions which are reflective of what S&P believesthe bid side of the market would be for each loan after careful review andanalysis of descriptive, market and credit information.  Each price reflects S&P’s best judgmentbased upon careful examination of a variety of market factors.  Because of fluctuation in the market and inother factors beyond its control, S&P cannot guarantee these evaluations.  The evaluations reflect the market prices, orestimates thereof, on the date specified. The prices are based on comparable market prices for similarsecurities.  Market information has beenobtained from reputable secondary market sources.  Although these sources are consideredreliable, S&P cannot guarantee their accuracy.

 

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With ourassessment and S&P value estimates as a backdrop, our board of directorsvotes to accept or not accept the analyses and values recommended by managementand S&P.  At September 30, 2004 andSeptember 30, 2003, the board of directors elected to accept the valuationsrecommended by S&P on those loans as denoted on the Schedule of Investmentsas of September 30, 2004 and September 30, 2003 in our consolidated financialstatements.

 

Because thereis a delay between when we close a loan and when the loan can be evaluated byS&P, new loans are not valued immediately by S&P; rather, the board ofdirectors makes its own determination about the value of these loans inaccordance with our valuation policy. Because S&P does not provide values for mortgage loans or equitysecurities, our board of directors also determines the fair value of theseinvestments using our valuation policy without the input of S&P.

 

*CreditInformation:*****Wemonitor a wide variety of key credit statistics that provide informationregarding our portfolio companies to help us assess credit quality andportfolio performance.  We require ourportfolio companies to provide annual audited and either monthly or quarterlyunaudited financial statements.  Usingthese statements, we calculate and evaluate the credit statistics.  For purposes of analyzing the financialperformance of our portfolio companies, we may make certain adjustments totheir cash flow statements to reflect the pro forma results of a companyconsistent with a change of control transaction, to reflect anticipated costsavings resulting from a merger or restructuring, costs related to new productdevelopment, compensation to previous owners, and other acquisition or restructuringrelated items.  For those investments forwhich S&P prepares valuation recommendations, we provide this creditinformation to S&P for its use in preparing its recommendations.  For those investments for which S&P doesnot prepare valuation recommendations, management uses this credit informationin connection with its preparation of valuation recommendations.

 

*LoanGrading and Risk Rating:*****As part of ourvaluation procedures we risk rate all of our loans.  Our risk rating system uses a scale of0 to 10.  This system is used to estimatethe probability of default on our debt securities and the probability of lossif there is a default.  These types ofsystems are referred to as risk rating systems and are used by banks and ratingagencies.  The risk rating system coversboth qualitative and quantitative aspects of the business and the securities wehold.  For those investments for which S&P prepares valuationrecommendations, we compile this information and provide it to S&P for itsconsideration in determining its valuation recommendations.  For those investments for which S&P doesnot prepare valuation recommendations, management uses this information todevelop valuation recommendations.

 

We seek tohave our risk rating system mirror the risk rating systems of major risk ratingorganizations such as those provided by nationally recognized statisticalrating organizations (“NRSRO”) as defined in Rule 2a-7 under the 1940 Act.While we seek to mirror the NRSRO systems, we cannot provide any assurance thatour risk rating system provides the same risk rating as a NRSRO. The followingchart is an estimate of the relationship of our risk rating system to thedesignations used by two NRSROs as they risk rate debt securities of majorcompanies.  Because we have establishedour system to rate debt securities of companies that are unrated by any NRSROthere can be no assurance that the correlation to the NRSRO set out below isaccurate. It is our understanding that most debt securities of middle marketcompanies do not exceed the grade of BBB on a NRSRO scale; so there would be nodebt securities in the middle market that would meet the definition of AAA, AAor A.  Therefore, our scale begins withthe designation BBB as the best risk rating.

 
| **Company’s  System** | ** ** | **First  NRSRO** | ** ** | **Second  NRSRO** | ** ** | **Gladstone  Capital’s Description(a)**                                                           | ** ** |
|----------------------------|------------|------------------|------------|-------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| **>10**                 |       | Baa2             |       | BBB               |       | Probability  of Default (PD) during the next ten years is 4% and the Expected Loss (EL) is  1% or less |       |
| **10**                     |       | Baa3             |       | BBB-              |       | PD  is 5% and the EL is 1% to 2%                                                                       |       |
| **9**                      |       | Ba1              |       | BB+               |       | PD  is 10% and the EL is 2% to 3%                                                                      |       |
| **8**                      |       | Ba2              |       | BB                |       | PD  is 16% and the EL is 3% to 4%                                                                      |       |
| **7**                      |       | Ba3              |       | BB-               |       | PD  is 17.8% and the EL is 4% to 5%                                                                    |       |
| **6**                      |       | B1               |       | B+                |       | PD  is 22.0% and the EL is 5% to 6.5%                                                                  |       |
| **5**                      |       | B2               |       | B                 |       | PD  is 25% and the EL is 6.5% to 8%                                                                    |       |
| **4**                      |       | B3               |       | B-                |       | PD  is 27% and the EL is 8% to 10%                                                                     |       |
| **3**                      |       | Caa1             |       | CCC+              |       | PD  is 30% and the EL is 10.0% to 13.3%                                                                |       |
| **2**                      |       | Caa2             |       | CCC               |       | PD  is 35% and the EL is 13.3% to 16.7%                                                                |       |
| **1**                      |       | Caa3             |       | CC                |       | PD  is 65% and the EL is 16.7% to 20%                                                                  |       |
| **0**                      |       | N/a              |       | D                 |       | PD  is 85% or there is a Payment Default: and the EL is greater than 20%                               |       |

 

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*(a) the default rates set here are for a ten year term debt, if thecompany’s debt security is less than ten years then the probability of defaultis adjusted to a lower percentage for the shorter period which may move thesecurity higher on the company’s risk rating scale.*

 

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The above scale gives an indication of the probability of default andthe magnitude of the loss if there is a default. At September 30, 2003,the average debt security was risk rated 7.8 for all debt securities and theweighted average risk rating was 7.6 for all debt securities.  The following table lists the risk ratingsfor all of the debt securities by quarter during the fiscal year endedSeptember 30, 2004:

 
| **Rating**       | ** ** | **December 31,  2003** | ** ** | **March 31,  2004** | ** ** | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** |
|------------------|------------|-----------------------------|------------|--------------------------|------------|-------------------------|------------|------------------------------|------------|
| Average          |       | 7.8                         |       | 7.7                      |       | 7.4                     |       | 7.6                          |       |
| Weighted Average |       | 7.6                         |       | 7.7                      |       | 7.3                     |       | 7.6                          |       |
| Highest          |       | 9.0                         |       | 9.0                      |       | 9.0                     |       | 9.0                          |       |
| Lowest           |       | 7.0                         |       | 6.0                      |       | 5.0                     |       | 5.0                          |       |

 

The above scale gives an indication of the probability of default andthe magnitude of the loss if there is a default.  Our policy is to stop accruinginterest on an investment if we determine that interest is no longercollectible. To date we have not placed any investments on non-accrual.  At September 30, 2004 andSeptember 30, 2003, no payments were past due on any of our debtsecurities.  We do not risk rate ourequity securities.

 

*ValuationMethods:*  Fordebt securities, we first determine if the debt security is publicly traded(i.e., if it is listed on an exchange or securities market).  If it is publicly traded, then we determinethe value based on the closing price for the security on the exchange orsecurities market on which it is listed on the valuation date.  If the security is not publicly traded, but alimited market for the security exists, such as for a participation in asyndicated loan, then we value it at the indicative bid price offered by thesyndication agent on the valuation date. At September 30, 2004, we determined that none of the debt securities inour portfolio were publicly traded and that there was a limited market for fivedebt securities in our portfolio.  AtSeptember 20, 2003, there was no market for any of the debt securities in ourportfolio.

 

For debt securitiesthat are not publicly traded and for which there is no market, we begin withthe risk rating designation of the security described above.  Using the risk rating designation above, weseek to determine the value of the security as if we intended to sell thesecurity in a current sale.  To determinethe current sale price of the security, we consider some or all of thefollowing factors:

•      financialstanding of the issuer of the security;

•      comparison ofthe business and financial plan of the issuer with actual results;

•      the cost ofthe security;

•      the size ofthe security held as it relates to the liquidity of the market for suchsecurities;

•      contractualrestrictions on the disposition of the security;

•      pendingpublic offering of the issuer of the security;

•      pendingreorganization activity affecting the issuer such as mergers or debtrestructuring;

•      reportedprices of similar securities of the issuer or comparable issuers;

•      ability ofthe issuer to obtain needed financing;

•      changes inthe economy affecting the issuer;

•      recentpurchases or sale of a security of the issuer;

•      pricing byother buyers or sellers of similar securities;

•      financialstatements of the borrower;

•      reports fromportfolio company senior management and ownership;

•      the type ofsecurity;

•      cost at dateof purchase;

•      size ofholding;

•      discount frommarket value of unrestricted securities of the same class at the time ofpurchase;

•      specialreports prepared by analysts;

•      informationas to any transactions or offers with respect to the security;

•      existence ofmerger proposals or tender offers affecting the securities;

•      thecollateral;

•      the issuer’sability to make payments;

 

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•      the currentand forecasted earnings of the issuer;

•      sales tothird parties of similar securities;

•      statisticalratios compared to lending standards;

•      statisticalratios compared to other similar securities; and

•      otherpertinent factors.

 

For those debtsecurities for which S&P prepares valuation recommendations, we provide theforegoing information to S&P for its use in preparing its recommendations.

 

Forconvertible debt, equity, success fees or other equity-like securities, wefirst determine if there is any market for the security.  If there is a market, then we determine thevalue based on the market prices for the security, even if that market is notrobust.  At September 30, 2004 andSeptember 30, 2003 there was no market for any of the equity securities weowned.  If there is no market for theequity securities, then we use the same information we would use for a debtsecurity valuation described above, except risk-rating, as well as standardvaluation techniques used by major valuation firms to value the equitysecurities of private companies.  Thesevaluation techniques consist of: discounted cash flow of the expected saleprice in the future, valuation of the securities based on recent sales incomparable transactions, and a review of similar companies that are publiclytraded and the market multiple of their equity securities.  At September 30, 2004 we had $37,000invested, at cost, in equity securities compared to our debt portfolio with acost basis of $149,152,306.

 

At September30, 2004, America’s Water Heater Rentals senior loan had an appreciation of $840,000in its value as a result of the value applied to the success fee.  Also, the value of our warrants of FinnCorporation had an appreciation of $437,984 at September 30, 2004.  This aforementioned appreciation plusappreciation of $314,970 on certain other investments, for overall appreciationof $1,592,953, partially offsets total depreciation of $4,336,019, which wasmainly composed of depreciation in our senior subordinated term debt investmentin Finn Corporation (excluding the warrants) of $2,887,500, our seniorsubordinated term debt investment in Marcal Paper Mills, Inc. of $612,000, oursenior term debt investment in Coyne International Enterprises of $392,516, andour senior term debt investment in Inca Metal Products Corporation of $250,693.

 

**Tax Status**

 

*Federal Income Taxes*

 

We intend to continue to qualify for treatment as a RIC under SubtitleA, Chapter 1 of Subchapter M of the Code. As a RIC, we are not subject tofederal income tax on the portion of our taxable income and gains distributedto stockholders. To qualify as a RIC, we are required to distribute tostockholders at least 90% of investment company taxable income, as defined bythe Code.  We have a policy to pay out asa dividend up to 100% of that amount.

 

**Revenue Recognition**

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis to the extent thatsuch amounts are expected to be collected. We will stop accruing interest oninvestments when it is determined that interest is no longer collectible.Conditional interest or a success fee is recorded when earned upon fullrepayment of a loan investment.

 

*Payment in Kind Interest*

 

We also have some loans in our portfolio which contain a payment inkind (“PIK”) provision. The PIK interest, computed at the contractual ratespecified in each loan agreement, is added to the principal balance of the loanand recorded as interest income. To maintain our status as a RIC, this non-cashsource of income must be paid out to stockholders in the form of dividends,even though we have not yet collected the cash.

 

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*Managerial Assistance Fees*

 

The 1940 Act requires that a businessdevelopment company make available managerial assistance to its portfoliocompanies. Prior to October 1, 2004, we provided managerial assistance to ourportfolio companies in connection with our investments through our wholly-ownedsubsidiary, Gladstone Capital Advisers, Inc.  Effective October 1, 2004, we began providingthese services through our external adviser, Gladstone Management.  We generally receive fees for our managerialassistance services. These fees are normally paid at the closing of ourinvestments in our portfolio companies, are generally non-recurring and arerecognized as revenue when earned. The managerial assistance services weprovide vary by investment, but generally consist of reviewing existing creditfacilities, arranging bank financing, arranging equity financing, structuringfinancing from multiple lenders, structuring financing from equity investors,restructuring existing loans, raising equity and debt capital, closelymonitoring the operations of the borrower, participating in its board andmanagement meetings, being available for consultation with its officers andproviding general organizational and financial guidance, which concludes uponclosing of the loan.  Any services ofthis nature subsequent to the closing would generally generate a separate feeat the time of completion. From time to time, we are invited to participate asa co-lender in a transaction. In the event that we do not provide significantmanagerial assistance services in connection with our investment, loan feespaid to us in such situations are deferred and amortized over the life of the loan.  After October 1, 2004 our adviser, GladstoneManagement, provides managerial assistance and receives the managerialassistance fees which are credited to the investment advisory fees due to theinvestment adviser.

 

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**RESULTS OF OPERATIONS**

*COMPARISON OF THE FISCAL YEARSENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003*

 

**Operating Income**

 

Operating income for the fiscalyear ended September 30, 2004 was $20.4 million as compared to $15.2million for the fiscal year ended September 30, 2003.  This increase is primarily a result of a risein interest income from an increase of approximately $86.3 million of new investmentsfrom the prior year and the collection of approximately $1.8 million of exitfees upon the full repayment of three portfolio company investments.

 

Interest income from our investments in debtsecurities of private companies was approximately $18.2 million, including $553,000of PIK interest, for the fiscal year ended September 30, 2004 as comparedto $13.2 million for the fiscal year ended September 30, 2003,including $781,000 of PIK interest.  Thisincrease was primarily the result of approximately $86.3 million of newinvestments for the fiscal year ended September 30, 2004 and the collectionof $1.8 million of exit fees upon the full repayment of three portfolio companyinvestments.  The decrease in PIK incomefor the fiscal year ended September 30, 2004 was the result of scheduledprincipal repayments for one loan containing the PIK provision.

 

The weighted average yield on our portfoliofor the fiscal year ended September 30, 2004 was 13.44% (without givingeffect to PIK interest) and 13.78% (after giving effect to PIK interest). Theweighted average yield on our portfolio for the fiscal year endedSeptember 30, 2003 was 13.14% (without giving effect to PIK interest) and13.86% (after giving effect to PIK interest). The yields were computed based on the cost value of the investmentportfolios.

 

Interest income from invested cash and cash equivalentsfor the fiscal year ended September 30, 2004 was approximately $84,000, ascompared to approximately $466,000 for the fiscal year ended September 30,2003. This decrease was primarily caused by a decrease in cash balances as aresult of $86.3 million of new investments.

 

For the fiscal year ended September 30,2004, we recorded approximately $444,000 in interest income from loans to ouremployees in connection with the exercise of employee stock options, ascompared to approximately $438,000 in interest income from such loans for thefiscal year ended September 30, 2003. During the year endedSeptember 30, 2004, one loan was repaid in full and two new loans wereentered into as a result of employee stock option exercises.

 

Managerial assistance fees were approximately$1.1 million for the fiscal year ended September 30, 2004 and $886,000 forthe fiscal year ended September 30, 2003. Fee income for each of the fiscal years ended September 30, 2004and 2003 consists primarily of managerial assistance fees received inconnection with investments we closed during the respective fiscal year. Duringthe fiscal year ended September 30, 2004, the increase was mainlyattributable to the closing of the Gamill, Inc., Woven Electronics Corp.,Benetech, Inc. Mistras Holdings Corp. ($1.0 million investment), A and G, Inc.and Allied Extruders, Inc. investments, in the approximate aggregate amount of$52.8 million, as compared to the fiscal year ended September 30, 2003 closingsof Wingstop Restaurants, America’s Water Heater Rentals, Fugate and Associates,Mistras Holdings Corp. ($15.0 million investment), and ARI Holdings Inc.investments in the approximate aggregate amount of $47.0 million.

 

Other income was approximately $573,000 forthe fiscal year ended September 30, 2004 and $117,000 for the fiscal yearended September 30, 2003.  For thefiscal year ended September 30, 2004, this amount was comprised of$545,000 of early principal payment penalty fees, $17,000 in waiver fees forcertain loan covenants,  and $11,000 inup-front fees for a proposed investment. For the fiscal year ended September 30, 2003, this amount wascomprised of $60,000 in waiver fees for certain loan covenants, $30,000 inearly principal payment penalty fees, $25,000 in up-front fees for a proposedinvestment and $2,000 in other income.

 

**Operating Expenses**

 

Operating expenses for the fiscal year endedSeptember 30, 2004 were approximately $7.1 million, compared toapproximately $3.9 million for the fiscal year ended September 30, 2003.This increase was primarily a result of the increase in salaries and benefits,professional fees, directors’ fees, financing fees incurred in connection withthe credit line facility we established in fiscal year 2003 and the line ofcredit entered into in June 2004, as well as interest and loan servicingexpenses.

 

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Salaries and benefits for the fiscal yearended September 30, 2004 were approximately $2.6 million, as comparedto approximately $2.0 million for the fiscal year ended September 30, 2003.The primary reason for the increase was the Board of Directors declaration ofan $800,000 performance based bonus during the fiscal year ended September 30,2004.  Although during the fiscal yearended September 30, 2004, salaries and benefits were allocated in accordancewith an expense sharing arrangement with Gladstone Management Corporation thatallocated expenses to Gladstone Management Corporation based on each employee’stime spent on Gladstone Commercial Corporation’s matters, no portion of thisbonus was allocated to Gladstone Management Corporation as it was solelyattributable to the performance of Gladstone Capital Corporation.  Without giving effect to the bonus, salariesand benefits slightly decreased as compared to the fiscal year ended September30, 2003.  Although employee head countincreased from the prior fiscal year, the cost of the increase was offset bythe savings attributable to the expense sharing arrangement with GladstoneManagement Corporation. As a result of the externalization of our management,effective October 1, 2004, we ceased incurring salaries and benefits expensesas our personnel are all now directly employed by Gladstone Management, whichpays these expenses directly.  In connectionwith this transition, effective October 1, 2004, we are obligated to makepayments to Gladstone Management pursuant to the terms of an investmentadvisory and administrative agreement with Gladstone Management.

 

Rent expense for the fiscal year endedSeptember 30, 2004 was approximately $139,000 as compared to $210,000 forthe fiscal year ended September 30, 2003. This decrease in rent was due to the expense sharing arrangement withGladstone Management, which allocated general expenses to Gladstone Managementbased on the ratio of all employees’ time spent of Gladstone CommercialCorporation’s matters to total time spent. As a result of the externalizationof our management, effective October 1, 2004, we ceased incurring rent expenseas we assigned our obligations under our lease to Gladstone Management, whichpays these expenses directly.  Inconnection with this transition, effective October 1, 2004, we are obligated tomake payments to Gladstone Management pursuant to the terms of the investment advisoryagreement with Gladstone Management.

 

Professional fees, consisting primarily oflegal and audit fees, for the fiscal year ended September 30, 2004 wereapproximately $580,000 as compared to approximately $410,000 for the fiscalyear ended September 30, 2003. This increase is primarily due to anincrease in legal fees associated with various SEC filings, certainnon-reimbursable due diligence fees incurred in connection with syndicatedinvestment participations, and other general corporate matters.

 

Directors’ fees for the fiscal year ended September 30, 2004 wereapproximately $112,000, as compared to approximately $74,000 for the fiscalyear ended September 30, 2003.  Theincrease is due to the addition of two new directors during the fiscal year endedSeptember 30, 2004, as well as an increase in the number of meetings during theyear.

 

General insurance expense for the fiscal year ended September 30,2004 was approximately $259,000 as compared to $276,000 for the fiscal yearended September 30, 2003.  Althoughoverall premiums have increased, the general insurance expense decreased forthe fiscal year ended September 30, 2004 as compared to the fiscal year endedSeptember 30, 2003 as a result of the expense sharing arrangement with GladstoneManagement which allocated general expenses to Gladstone Management based on aratio of all employees’ time spent of Gladstone Commercial Corporation’s matterto total time spent. As a result of the externalization of our management,effective October 1, 2004, we ceased incurring general insurance expenses andGladstone Management now pays these expenses directly.  However, we will continue to incur insuranceexpense in connection with our directors and officers insurance policy. Inconnection with this transition, effective October 1, 2004, we are obligated tomake payments to Gladstone Management pursuant to the terms of the investmentadvisory agreement with Gladstone Management.

 

Stockholder related costs for the fiscal year ended September 30,2004 were approximately $140,000 as compared to $143,000 for the fiscal yearended September 30, 2003.  Thesecosts include printing charges related to annual reports and proxysolicitations as well as other stockholder required communications such as theelectronic filings of SEC reports.

 

Financing fees for the fiscal year ended September 30, 2004 wereapproximately $1.4 million compared to financing fees for the fiscal year endedSeptember 30, 2003 of approximately $222,000.  These fees represent the amortization of certaincapitalized costs in connection with establishing the lines of credit.  In May 2003, we entered into a warehouse lineof credit with CIBC World Markets Inc. The interest of CIBC World Markets Inc.was subsequently assigned to Deutsche Bank AG in September 2004.  As a result of this transaction,approximately $1.2 million of capitalized fees were expensed.  Some of the increase in financing fees is aresult of the incurrence of financing fees related to this line of credit forthe full fiscal year ended September 30, 2004, as compared to a shorter periodof time during the fiscal year ended September 30, 2003.  Monthly fees associated with the line ofcredit are included in these financing fees. We also entered into an operating line of credit with Branch Banking andTrust Company (“BB&T”) in June 2004, and likewise incurred certaintransaction costs which are amortized into financing fees.  The fiscal year ended September 30, 2003 wasthe first year in which these charges were incurred.

 

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Interest expense for the fiscal year ended September 30, 2004 wasapproximately $742,000 and was incurred mainly on our borrowings from ourwarehouse line of credit as well as our new operating line of credit. There wasno interest expense incurred for the fiscal year ended September 30, 2003 asthere were no borrowings outstanding under our warehouse line of credit.

 

Loan servicing fees of approximately $502,000 were incurred for thefiscal year ended September 30, 2004. These fees were incurred from July 12, 2004 through September 30, 2004in connection with a loan servicing agreement between Gladstone Business LoanLLC and Gladstone Management Corporation, which became effective July 12,2004.   The loans in the portfolio werepreviously serviced under a similar agreement with Gladstone Capital AdvisersInc. and the fees were eliminated upon consolidation of the financial results.

 

General and administrative expenses, consisting primarily of officeoperations, travel and data communications, for the fiscal year endedSeptember 30, 2004 were approximately $702,000, as compared toapproximately $507,000 for the fiscal year ended September 30, 2003. Theseincreases were largely related to the recruiting and addition of several newemployees, the expansion of our operations, as well as the disposal of inactivefixed assets, and an increase in depreciation due to the addition of newcomputers for new employees.  Despitethese increases, depreciation expense decreased overall due to the sale of allfixed assets to Gladstone Management on July 1, 2004 at net book value, and assuch no depreciation was recorded for the last fiscal quarter of the fiscalyear ended September 30, 2004.  Certaingeneral and administrative expenses were allocated in accordance with theexpense sharing arrangement with Gladstone Management, which allocated generalexpense to Gladstone Management based on the ratio of all employees’ time spenton Gladstone Commercial Corporation matters which partially offset the increasein these general and administrative expenses. As a result of theexternalization of our management, effective October 1, 2004, we ceasedincurring certain general and administrative expenses and Gladstone Managementnow pays certain of these expenses directly. Certain general and administrative expenses, such as the backup serviceprovider will continue to be incurred directly by us.  In connection with this transition, effectiveOctober 1, 2004, we are obligated to make payments to Gladstone Managementpursuant to the terms of the investment advisory agreement with GladstoneManagement.

 

**Realized and Unrealized Gain (Loss) onInvestments**

 

During the fiscal year endedSeptember 30, 2004, we bought and sold shortly thereafter a $1.0 millioninvestment in Metokote Corporation for a gain of $12,500.

 

As a result of the decline in fair marketvalue of our interest rate cap agreement, we recorded net unrealizeddepreciation of approximately $214,000 for the fiscal year ended September 30,2004.  There were no derivatives in placeduring the previous fiscal year.

 

For the fiscalyear ended September 30, 2004 we recorded net unrealized depreciation oninvestments of approximately $2.5 million as compared to net unrealizeddepreciation of approximately $222,000 for the fiscal year ended September 30,2003. The increase in net unrealized depreciation was mainly attributable tothe valuation of our senior subordinated term debt investment in FinnCorporation (exclusive of the warrants). The increase is also due to the addition of nine new companies to theportfolio and the related valuations performed by S&P or the respective bidprice as of the balance sheet valuation date by the syndication agent.

 

**Net Increase in Stockholders’ Equity fromOperations**

 

We had a net increase in stockholders’ equity resulting from operationsof approximately $10.6 million for the fiscal year endedSeptember 30, 2004. Based on a weighted-average of 10,101,341 (basic) and10,344,388 (diluted) shares outstanding, our net increase in stockholders’equity resulting from operations per common share for the fiscal year endedSeptember 30, 2003 was $1.05 (basic) and $1.02 (diluted).

 

We had a net increase in stockholders’ equity resulting from operationsof approximately $11.1 million for the fiscal year endedSeptember 30, 2003. Based on a weighted-average of 10,072,677 (basic) and10,188,488 (diluted) shares outstanding, our net increase in stockholders’equity resulting from operations per common share for the fiscal year endedSeptember 30, 2003 was $1.10 (basic) and $1.09 (diluted).

 

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*COMPARISON OF THE FISCAL YEARSENDED SEPTEMBER 30, 2003 AND SEPTEMBER 30, 2002*

 

**Operating Income**

Operating income for the fiscal year ended September 30,2003 was $15.2 million as compared to $10.5 million for the fiscal year endedSeptember 30, 2002.  This increaseis primarily a result of increased interest income from an increase in theamount of investments. These debt securities provide a higher yield than theshort-term investment grade securities.

 

Interest income from ourinvestments in debt securities of private companies was approximately $13.2million, including $781,000 of PIK interest, for the fiscal year endedSeptember 30, 2003 as compared to $6.6 million for the fiscal yearended September 30, 2002, including $462,000 of PIK interest.  This increase was primarily the result ofapproximately $47.0 million of new investments for the fiscal year endedSeptember 30, 2003.

 

The weighted average yield on our portfoliofor the fiscal year ended September 30, 2003 was 13.14% (without givingeffect to PIK interest) and 13.86% (after giving effect to PIK interest). Theweighted average yield on our portfolio for the fiscal year ended September 30,2002 was 13.82% (without giving effect to PIK interest) and 14.79% (aftergiving effect to PIK interest).  Theyields were computed based on the cost value of the investment portfolios.

 

Interest income from invested cash and cashequivalents for the fiscal year ended September 30, 2003 was approximately$466,000, as compared to approximately $1.6 million for the fiscal year endedSeptember 30, 2002. This decrease was primarily a result of $47.0 millionof new investments for the fiscal year ended September 30, 2003.

 

For the fiscal year ended September 30,2003, we recorded approximately $438,000 in interest income from loans to ouremployees in connection with the exercise of employee stock options, ascompared to approximately $433,000 in interest income from such loans for thefiscal year ended September 30, 2002. During the year endedSeptember 30, 2003, one loan was repaid in full and a new loan was enteredinto as a result of an employee stock option exercise.

 

Managerial assistance fees were approximately$886,000 for the fiscal year ended September 30, 2003 and$1.7 million for the fiscal year ended September 30, 2002.  Fee income for each of the fiscal years endedSeptember 30 consists primarily of managerial assistance fees received inconnection with investments we closed during the respective fiscal year. Duringthe fiscal year ended September 30, 2003, we closed five new loanscompared to eight during the fiscal year ended September 30, 2002.

 

Other income was approximately $117,000 forthe fiscal year ended September 30, 2003 and $131,000 for the fiscal yearended September 30, 2002.  For thefiscal year ended September 30, 2003, this amount was comprised of $60,000in waiver fees for certain loan covenants, $30,000 in early principal paymentpenalty fees, $25,000 in up-front fees for a proposed investment and $2,000 inother income.  For the fiscal year endedSeptember 30, 2002, this amount was comprised of approximately $81,000 inup-front fees received in connection with five proposed investments thatultimately were not consummated and approximately $50,000 in other fees.

 

**Operating Expenses**

 

Operating expenses for the fiscal year endedSeptember 30, 2003 were approximately $3.9 million, compared toapproximately $2.8 million for the fiscal year ended September 30, 2002.This increase was primarily a result of the increase in personnel, new officespace acquired in September 2002, increased operations and financing feesincurred in connection with the credit line facility we established in fiscalyear 2003.

 

Salaries and benefits for the fiscal yearended September 30, 2003 were approximately $2.0 million, as comparedto approximately $1.4 million for the fiscal year ended September 30,2002. The primary reason for the increase was the hiring of additionalemployees during the year.

 

Rent expense for the fiscal year endedSeptember 30, 2003 was approximately $210,000 as compared to $125,000 forthe fiscal year ended September 30, 2002. This increase is due to the new office space acquired inSeptember 2002.

 

Professional fees, consisting primarily oflegal and audit fees, for the fiscal year ended September 30, 2003 wereapproximately $410,000 as compared to approximately $550,000 for the fiscalyear ended September 30, 2002. This decrease is the result of a decline inlegal fees during fiscal year 2003.

 

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Directors fees for the fiscal year ended September 30, 2003 wereapproximately $74,000, as compared to approximately $22,000 for the fiscal yearended September 30, 2002.  Theincrease is due to the increase in the annual directors fees as well as theincrease in the number of meetings during the year and the addition of newboard members.

 

General insurance expense for the fiscal year ended September 30,2003 was approximately $276,000 as compared to $206,000 for the fiscal yearended September 30, 2002.  Themajority of this increase is due to an increase in directors’ and officers’insurance premiums as insurance carriers have increased their premiums in thewake of the increase in high profile corporate fraud and mismanagement as wellas the Sarbanes Oxley Act.

 

Stockholder related costs for the fiscal year ended September 30,2003 were approximately $143,000 as compared to $104,000 for the fiscal yearended September 30, 2002.  Thesecosts include printing charges related to annual reports and proxysolicitations as well as other stockholder required communications such as theelectronic filings of SEC reports.

 

Financing fees for the fiscal year ended September 30, 2003 wereapproximately $222,000.  This is thefirst year in which these charges were incurred.  These fees represent the related service feesassociated with our line of credit, backup service and the amortization ofdeferred financing costs.

 

General and administrative expenses, consisting primarily of officeoperations, travel and data communications, for the fiscal year endedSeptember 30, 2003 were approximately $507,000, as compared toapproximately $464,000 for the fiscal year ended September 30, 2002. Theseincreases were largely related to new employees and the expansion ofoperations.

 

**Net Increase in Stockholders’ Equity fromOperations**

 

We had a net increase in stockholders’ equity resulting from operationsof approximately $11.1 million for the fiscal year endedSeptember 30, 2003. Based on a weighted-average of 10,072,677 (basic) and10,188,488 (diluted) shares outstanding, our net increase in stockholders’equity resulting from operations per common share for the fiscal year endedSeptember 30, 2003 was $1.10 (basic) and $1.09 (diluted).

 

For the fiscal year ended September 30, 2002, we realized a netincrease in stockholders’ equity resulting from operations of approximately$7.6 million. Based on a weighted-average of 10,064,900 (basic) and 10,166,752(diluted) shares outstanding, our net increase in stockholders’ equityresulting from operations per common share for the fiscal year endedSeptember 30, 2002 was $0.76 (basic) and $0.75 (diluted).

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

At September 30, 2004, we had investments in debt securities, orloans to or syndicated participations in, sixteen private companies totalingapproximately $149.2 million, including approximately $553,000 in accrued PIK interest.  At September 30, 2003, we hadinvestments in debt securities of, or loans to, eleven private companies,totaling approximately $109.5 million of total investment assets,including approximately $807,000 in accrued PIK interest.  PIK interest is described in “Overview,” andis added to our carrying value of our investments.

 

In November 2003, we purchased a $1.0 millionparticipation in a $55.0 million senior term loan to Burt’s Bees, Inc., amanufacturer of personal and household products.

 

In December 2003 we closed two loans with GQMAcquisition Corp. totaling $14.5 million and also containing a success feeprovision.  GQM Acquisition Corp conductsbusiness as Gammill, Inc. and is the designer and assembler of quiltingmachines and accessories.

 

In November 2003, Kozy Shack Enterprisesrepaid $900,000 to fully settle its principal obligation.

 

In December 2003, we sold a $3.2 millionprincipal portion of our Inca Metal Products Corp/Kingway AcquisitionInc./Clymer Acquisition Inc. investment. The remaining portion of this investment currently has a cost basis of$2.5 million.

 

During March 2004, we entered into a $14.5million loan investment, which also contains a success fee provision, withWoven Electronics Corporation, which specializes in custom electrical cableassemblies and also purchased a $6.0 million participation investment withMedassets, Inc., a pharmaceutical and healthcare group purchasing organization(GPO).

 

In April 2004, we sold $4.6 million of our principalportions of our investments in Gammill, Inc. Our remaining investments in Gammill, subsequent to the sale, are $4.963million and $4.75 million.  Anotherportfolio company, Wingstop Restaurants International, Inc. repaid its$5,375,000 outstanding loan obligations in April 2004.  Wingstop Restaurants International, Inc. alsoremitted related prepayment fees and an exit fee of $360,000 with its finalpayment.

 

During May 2004, we entered into a $6.5million loan investment with Benetech Inc., which specializes in dustmanagement systems for the coal and electric utility industries, purchased anadditional $2.0 million participation investment with Medassets, Inc., andpurchased a $10.0 million participation in Maidenform, Inc., a manufacturer of intimateapparel.

 

During June 2004, we extended an additional$1.0 million loan, which also contains a success fee provision, to MistrasHoldings Corp. and also invested in a $12.25 million loan to A and G, Inc. amanufacturer of activewear products.  Wealso purchased an $8.0 million participation in MD Beauty, Inc., a maker ofnatural cosmetic and skincare products and a $6.0 million participation in BearCreek Corporation, a purveyor of premium catalog food products.  In September 2004 we sold our entire participationin MD Beauty, Inc.

 

In June 2004, Home Care Supply Inc. repaidits entire $18.0 million outstanding loan obligation and remitted prepaymentfees and a success fee of approximately $1.1 million with its final payment.

 

In July 2004, we entered into a $4.0 millionloan investment, which also contains a success fee provision, with AlliedExtruders, Inc., a manufacturer of polyethylene film.

 

In September 2004, Fugate and Associates, Inc. repaid its entire $5.2million loan investment along with a success fee of $334,000 and relatedprepayment fees.

 

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Subsequent to the fiscal year ended September 30, 2004, in October2004, we sold our entire participation in Burt’s Bees Inc. for a premium of$9,750 and in November 2004, America’s Water Heater Rentals repaid its entire$12.0 million outstanding loan obligation and remitted prepayment fees and asuccess fee of approximately $1.4 million with its final payment and A and G,Inc. repaid its entire $12.25 million outstanding loan obligation.  Also, in November 2004, we entered into a$5.5 million loan investment, which also contains a success fee provision, withGlobal Material Technologies, Inc., a manufacturer and distributor of steelwool and metal fiber products, and a $7.95 million loan investment with SantanaProducts, Inc., a fabricator of solid plastic high density polyethylenebathroom partitions.  We also purchasedparticipations in Tech Lighting Corp. of $9.0 million and ValorTelecommunications, Inc. of $8.0 million.

 

The following table summarizes the contractual principal amortizationand maturity of our investment portfolio by fiscal year:

 

| **Year**   | ** ** | **Amount** | ** **  |
|------------|------------|------------|-------------|
|       |       |       |        |
| 2005       |       | $          | 4,760,536   |   |
| 2006       |       | $          | 20,713,431  |   |
| 2007       |       | $          | 37,574,606  |   |
| 2008       |       | $          | 31,109,625  |   |
| 2009       |       | $          | 38,923,370  |   |
| Thereafter |       | $          | 16,107,738  |   |
| Total      |       | $          | 149,189,306 |   |

 

Cash provided by operating activities for thefiscal year ended September 30, 2004, consisting primarily of the itemsdescribed in “Results of Operations,” was approximately $13.5 million ascompared to approximately $9.9 million for the fiscal year endedSeptember 30, 2003. Net cash used in investing activities for the fiscalyear ended September 30, 2004 was approximately $96.0 million as compared to netcash provided by investing activities of approximately $10.3 million forthe fiscal year ended September 30, 2003. At September 30, 2004, the netcash used was due largely in part to $57.1 million used in connection with the purchaseof the repurchase agreements and the repayments of the repurchase agreements,and new investments of approximately $86.3 million, partially offset by principalrepayments of $47.2 million. At September 30, 2003, the net cash providedwas due largely in part to $39.2 million provided in connection with therepurchase agreements and the repayments of the repurchase agreements, andprincipal repayments of $18.0 million, partially offset by $47.0 millionof invested cash. Net cash provided by financing activities was approximately $47.3million for the fiscal year ended September 30, 2004 and consisted of proceedsfrom a public shelf offering of common stock which yielded net proceeds ofapproximately $24.4 million, the borrowings, net of repayments, on the lines ofcredit for net proceeds of approximately $40.7 million, and the payment ofdividends of approximately $17.1 million. Net cash used in financing activitieswas approximately $10.9 million for the fiscal year ended September 30,2003 and consisted of the payment of dividends of $9.8 million and the paymentof deferred financing fees associated with the establishment of our warehouseline of credit of approximately $1.1 million.

 

During the fiscal year ended September 30, 2004, cash and cashequivalents decreased from approximately $101.1 million at the beginning of theyear to approximately $66.0 million at the end of the year.  This decrease was largely the result of thepurchase of new investments and the repurchase agreement described below.

 

During the fiscal year ended September 30, 2003, cash and cashequivalents increased from approximately $91.9 million at the beginning of theyear to approximately $101.1 million at the end of the year. This increase waslargely the result of the repurchase agreement described below.

 

On September 29, 2004, we entered into a repurchase agreement (the “FBWRepurchase Agreement”) with Ferris Baker Watts for $44,984,950. On September30, 2004, this amount was reduced to $21,345,997 with the application of thenet proceeds from a public offering of our common stock. This remaining balancewas settled on October 1, 2004. The FBW Repurchase Agreement was recorded atcost and was fully collateralized by a United States Treasury Bill with a fairvalue of $50,000,000, a carrying value of $49,984,950 that matured on October7, 2004 and earned interest of $2,133. The interest rate on the FBW RepurchaseAgreement was 4.25% for a cost of $7,831. In the future, we plan to use asimilar form of repurchase agreement as an investment option or in order tosatisfy certain asset diversification requirements and maintain our status as aRIC under Subchapter M of the Internal Revenue Code.

 

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On September 30, 2003, we entered into a repurchase agreement (the“UBS Repurchase Agreement”) with UBS for $78,449,000, which agreement wassettled on October 1, 2003.  The UBSRepurchase Agreement was recorded at cost and was fully collateralized by aUnited States Treasury Bill with a fair value of $80,050,000 and a carryingvalue of $80,022,249 that matured on October 16, 2003. The interest rateon the UBS Repurchase Agreement was 0.80% for a cost of $2,397. The UBSRepurchase Agreement was reflected on the consolidated balance sheet atSeptember 30, 2003 as cash and cash equivalents pledged to creditors of$80.0 million and a liability of $78.4 million.

 

In order to qualify as a regulated investment company and to avoidcorporate level tax on the income we distribute to our stockholders, we arerequired, under Subchapter M of the Internal Revenue Code, to distribute atleast 90% of our ordinary income and short-term capital gains to ourstockholders on an annual basis. In accordance with these requirements, wedeclared and paid monthly cash dividends of $0.11 per common share for October,November and December 2003 and January, February, and March 2004, $0.115 percommon share for April, May and June 2004, and $0.12 per common share for July,August and September 2004.  For thefiscal year ended September 30, 2003 we declared and paid quarterly dividendsof $0.23, $0.25, $0.29, and $0.33 per common share for the first, second, thirdand fourth quarters, respectively.

 

Aggregate dividends declared and paid for the 2004 fiscal year wereapproximately $17.1 million and exceeded our current and accumulated earningsand profits and, as a result, a portion of these dividends were treated as areturn of capital to our stockholders.

Aggregate dividends declared and paid for the 2003 fiscal year wereapproximately $11.1 million.  Thisresulted in our net investment income exceeding the dividends related to our2003 fiscal year by $0.3 million. Dividends related to our 2002 fiscal yearexceeded our current and accumulated earnings and profits and, as a result, aportion of these dividends were treated as a return of capital to ourstockholders.

 

We anticipate borrowing funds and issuing additional equity securitiesto obtain additional capital. To this end, we have filed with the SEC aregistration statement that would permit us to issue, through one or more transactions,up to an aggregate of $75 million in securities, consisting of commonstock, preferred stock and/or debt securities.  On September 30, 2004, we closed on our publicoffering pursuant to this registration statement of 1,150,000 shares at price of$22.75, less underwriters’ discount of five percent for net proceeds of approximately$24.9 million, excluding offering costs. We used the proceeds from this offering to repay borrowings under ourlines of credit.  Following this offeringwe may sell up to approximately $48.8 million of securities from the shelfregistration statement.

 

**Revolving Credit Facility**

 

Through our wholly-owned subsidiary Gladstone Business Loan LLC (“BusinessLoan”), the Company has obtained a $100 million revolving credit facility.  On May 19, 2003, the Company executed aPurchase and Sale Agreement pursuant to which it agreed to sell certain loansto Business Loan in consideration of a membership interest therein.  Simultaneously, Business Loan executed aCredit Agreement with CIBC World Markets Inc. (“CIBC”), as administrativeagent, and others, pursuant to which Business Loan pledged the loans purchasedfrom the Company to secure future advances by certain institutionallenders.  On September 28, 2004, CIBCassigned its interest in the credit facility to Deutsche Bank AG. Interestrates charged on the advances under the facility are based on London InterbankOffered Rate (“LIBOR”), the Prime Rate or the Federal Funds Rate, depending onmarket conditions, and adjusts periodically. As of September 30, 2004, the outstanding principal balance under thiscredit facility was approximately $25.7 million at an interest rate of 3.29%.

 

The facility contains covenants that require Business Loan to maintainits status as a separate entity; prohibit certain significant corporatetransactions (such as mergers, consolidations, liquidations or dissolutions);and restrict material changes to the Company’s credit and collectionpolicies.  The facility also restrictssome of the terms and provisions (including interest rates, terms to maturityand payments schedules) and limits the borrower and industry concentrations ofloans that are eligible to secure advances. As of September 30, 2004, Business Loan was in compliance with allof the facility covenants.  The Companycurrently intends to securitize all of the loans held by Business Loan and willuse the proceeds from the securitization to pay down any amounts thenoutstanding under the revolving credit facility.

 

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Gladstone Management, our affiliated servicingentity, services the loans pledged under the facility.  As a condition to this servicing arrangement,we executed a Performance Guaranty pursuant to which we guaranteed that GladstoneManagement would comply fully with all of its obligations under the facility.The Performance Guaranty requires us to maintain a minimum net worth of $100million and to maintain “asset coverage” with respect to “senior securitiesrepresenting indebtedness” of at least 200%, in accordance with Section 18of the 1940 Act.  As of September 30,2004, we were in compliance with our covenants under the Performance Guaranty.

 

InJune 2004, the Company entered into a $15.0 million line of credit agreementwith Branch Banking and Trust Company (“BB&T Agreement”) which matures onJune 1, 2005.  Interest on outstandingborrowings is based upon the one month LIBOR plus 2.5% per annum.  The unused portion of the line of credit issubject to a fee of 0.2% per annum.  TheBB&T Agreement requires the Company to meet and maintain certain covenantsand ratios with respect to leverage and liquidity. As of September 30, 2004,there was $15.0 million outstanding under the BB&T line of credit at aninterest rate of 4.34%.  At September 30,2004, the Company was in compliance with all covenants under the BB&TAgreement.

 

The following table shows our significantcontractual obligations for the repayment of debt and payment of othercontractual obligations as of September 30, 2004.

 
| ** **                                                                               | ** ** | **Payments due by period** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations (1)**                                                         | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Long-Term Debt Obligations                                                               |       | —                     |       | — |   | — |   | — |   | — |   |
| Capital Lease Obligations                                                                |       | —                     |       | — |   | — |   | — |   | — |   |
| Operating Lease Obligations (2)                                                          |       | 57,696                     |       | 57,696 |   | — |   | — |   | — |   |
| Purchase Obligations (3)                                                                 |       | 13,450,000                 |       | 13,450,000 |   | — |   | — |   | — |   |
| Other Long-Term Liabilities Reflected on  the Registrant’s Balance Sheet under GAAP |       | —                     |       | — |   | — |   | — |   | — |   |
| Total                                                                                    |       | $                          | 13,507,696 |   | $ | 13,507,696 |   | — |   | — |   | — |   |
|                                                                                          |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 

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(1)           The information included in the tableabove is based upon the internal management structure that was in place as ofSeptember 30, 2004.  We have entered intoan investment advisory and administrative agreement with Gladstone Managementthat became effective on October 1, 2004. Pursuant to the advisory agreement, we are obligate to make certainpayments to Gladstone Management that may increase the amount of ourcontractual obligations in future fiscal years. Payments under the advisory agreement consist of an annual advisory feeof 1.25% of our total assets (as reduced by cash and cash equivalents pledgedto creditors), payable in quarterly increments of 0.3125%, and an annualadministrative fee of 0.75% of our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly increments of0.1875%.  As the payments under theadvisory agreement will vary based on changes in our total assets during anygive payment period, we cannot accurately predict the amount of payments underthe advisory agreement.  If the advisoryagreement had been effective as of September 30, 2004, we estimate that ourtotal contractual obligations would have been approximately $2.5 million.  This estimate is based on the amount of ourtotal assets (net of cash and cash equivalents pledged to creditors) as ofSeptember 30, 2004.  As we expect tocontinue to make more investments in future fiscal years, we expense that theamount of our total assets may increase, and thus, the contractual obligationsattributable to advisory fee payments under the advisory agreement are likelyto be higher than this estimated amount.

 

(2)           Operating lease obligations representthe office leases for McLean, Virginia, New York City and Chicago, Illinoisfacilities which are scheduled to expire during the fiscal year 2005.  Effective October 1, 2004, all of theseoffice leases were assigned to Gladstone Management pursuant to the advisoryagreement and Gladstone Management will now pay these expenses directly.  Any future office lease renewals shall bedone so by Gladstone Management.

 

(3)           The purchase obligations reflected inthe above table represent commitments outstanding as of September 30, 2004 tofund two loan investments which were subsequently closed in November 2004.

 

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**Item 7A****. Quantitative and Qualitative Disclosures About Market Risk**

 

We are subjectto financial market risks, including changes in interest rates.  We expectthat, ultimately, approximately 50% of the loans in our portfolio will be madeat fixed rates, with approximately 50% made at variable rates.  Currentlyour portfolio has approximately 35% of the total of the loan portfolio costbasis at fixed rates, approximately 42% of the total loan portfolio cost basisat variable rates with a floor and the remaining 23% of the total loanportfolio cost basis at variable rates.

 

In addition,we have two variable rate borrowing facilities. We have a $100 million revolving credit facility with Deutsche Bank AGwhich matures in May 2005.  We also havea $15 million line of credit agreement which matures in June 2005.

 

To illustratethe potential impact of changes in interest rates on our net increase instockholders’ equity resulting from operations, we have performed the followinganalysis, which assumes that our balance sheet remains constant and no furtheractions beyond the interest rate cap agreement are taken to alter our existinginterest rate sensitivity.  Under thisanalysis, a hypothetical increase in the one month LIBOR by 1% would increaseour net increase in stockholders’ equity resulting from operations byapproximately $313,000 or 3.02%, over the next twelve months, compared to thenet increase in stockholders’ equity resulting from operations for the fiscalyear ended September 30, 2004.  Ahypothetical decrease in the one month LIBOR by 1% would decrease net increasein stockholders’ equity resulting from operations by approximately $313,000, or3.02%, over the next twelve months, compared to the net increase instockholders’ equity resulting from operations for the fiscal year ended September30, 2004.  Although management believesthat this analysis is indicative of our existing interest rate sensitivity, itdoes not adjust for potential changes in credit quality, size and compositionof our loan portfolio on the balance sheet and other business developments thatcould affect net increase in stockholders’ equity resulting fromoperations.  Accordingly, no assurancescan be given that actual results would not differ materially from the resultsunder this hypothetical analysis.

 

In February2004, we entered into an interest rate cap agreement as required under our lineof credit to enter into certain hedging transactions in connection with ourborrowings under the line of credit.  We purchased this interest rate capagreement with a notional amount of $35 million for a one-time, up-frontpayment of $304,000.  The interest rate cap agreement entitles us toreceive payments, if any, equal to the amount by which interest payments on $35million at the point which one monthLIBOR exceed the interest payments on $35 million at 5%.  The capexpires in February 2009.  This interest rate cap agreement effectivelycaps our interest payments on our line of credit borrowing, up to the notionalamount of the interest rate cap, at five percent.  This mitigates ourexposure to increases in interest rates on our borrowings on our lines ofcredit, which are at variable rates.  At September 30,2004, the cap agreement had a fair market value of approximately $89,741.  At September 30, 2004, the one month LIBORrate was approximately 1.84%.

 

In the eventthat we securitize a portion of our loan portfolio, we believe that we willlikely be required to enter into further hedging arrangements in the futurewith respect to securitized loans.  Whilehedging activities may mitigate our exposure to adverse fluctuations ininterest rates, certain hedging transactions that we may enter into in the future,such as interest rate swap agreements, may also limit our ability toparticipate in the benefits of lower interest rates with respect to ourportfolio of investments.

 

39

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**Item 8****. Financial Statements and Supplementary Data**

 

**Index to Consolidated Financial Statements**

 
| Report of Independent Registered Public  Accounting Firm                                                                                  |   |
|-------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Report of Independent Registered Public  Accounting Firm                                                                                  |   |
| Consolidated Balance Sheets as of September 30, 2004 and  September 30, 2003                                                    |   |
| Consolidated Schedules of Investments as of  September 30, 2004 and September 30, 2003                                          |   |
| Consolidated Statements of Operations for  the years ended September 30, 2004, September 30, 2003, and  September 30, 2002      |   |
| Consolidated Statements of Stockholders  Equity for the years ended September 30, 2004, September 30, 2003,  September 30, 2002 |   |
| Consolidated Statements of Cash Flows for the years ended September  30, 2004, September 30, 2003, September 30, 2002           |   |
| Notes to Financial Statements                                                                                                             |   |

 

40

----

 

**Reportof Independent Registered Public Accounting Firm**

 

Tothe Board of Directors and Stockholders

ofGladstone Capital Corporation:

 

We have audited theaccompanying consolidated balance sheets, including the schedules ofinvestments, of Gladstone Capital Corporation as of September 30, 2004 andSeptember 30, 2003, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended September 30, 2004.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether 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 theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Gladstone CapitalCorporation at September 30, 2004 and September 30, 2003 and the results of itsoperations and its cash flows for each of the three years in the period ended September30, 2004 in conformity with accounting principles generally accepted in theUnited States of America. The financial statements for the Company as ofSeptember 30, 2002 and for the year then ended were audited by other auditorswhose report dated November 1, 2002 expressed an unqualified opinion on thosestatements.

 
| /s/ PricewaterhouseCoopers LLP |   |
|--------------------------------|--------|
| McLean, Virginia               |
| December 13, 2004              |

 

41

----

 

**Reportof Independent Registered Public Accounting Firm**

 

We have audited theaccompanying consolidated statements of operations, stockholders’ equity, andcash flows of Gladstone Captial Corporation (the Company) for the year endedSeptember 30, 2002.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated results of operations andcash flows of Gladtone Captial Corporation for the year endedSeptember 30, 2002 in conformity with U.S. generally accepted accountingprinciples.

 
| /s/ Ernst & Young LLP |   |
|---------------------------|--------|
| McLean, Virginia          |
| November 1, 2002     |

 

42

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                               | ** ** | **September 30,  2004** | ** **  | **September 30,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-------------------------|------------|
| ASSETS                                                                                                                                   |       |                    |        |                    |       |
| Investments at fair value (Cost 9/30/2004:  $149,189,306; 9/30/2003: $109,529,893)                                                       |       | $                       | 146,446,240 |                    | $          | 109,307,553 |   |
| Cash and cash equivalents                                                                                                                |       | 15,969,890              |        | 21,143,972              |       |
| Cash and cash equivalents pledged to  creditors                                                                                          |       | 49,984,950              |        | 80,022,249              |       |
| Interest receivable – investments in debt  securities                                                                               |       | 837,336                 |        | 1,041,943               |       |
| Interest receivable – cash and cash  equivalents                                                                                    |       | —                  |        | 955                     |       |
| Interest receivable – officers                                                                                                      |       | 112,960                 |        | 108,657                 |       |
| Due from custodian                                                                                                                       |       | 1,203,079               |        | 1,207,000               |       |
| Due from affiliate                                                                                                                       |       | 109,639                 |        | 42,131                  |       |
| Deferred financing fees                                                                                                                  |       | 350,737                 |        | 1,086,864               |       |
| Prepaid assets                                                                                                                           |       | 191,676                 |        | 392,951                 |       |
| Other assets                                                                                                                             |       | 127,220                 |        | 212,388                 |       |
|                                                                                                                                     |       |                    |        |                    |       |
| TOTAL ASSETS                                                                                                                             |       | $                       | 215,333,727 |                    | $          | 214,566,663 |   |
|                                                                                                                                     |       |                    |        |                    |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                |       |                    |        |                    |       |
|                                                                                                                                     |       |                    |        |                    |       |
| LIABILITIES                                                                                                                              |       |                    |        |                    |       |
| Accounts payable                                                                                                                         |       | $                       | 105,921     |                    | $          | 23,247 |   |
| Dividends payable                                                                                                                        |       | —                  |        | 3,327,009               |       |
| Borrowings under lines of credit                                                                                                         |       | 40,743,547              |        | —                  |       |
| Accrued expenses and deferred liabilities                                                                                                |       | 911,607                 |        | 1,965,025               |       |
| Repurchase agreement                                                                                                                     |       | 21,345,997              |        | 78,449,000              |       |
|                                                                                                                                     |       |                    |        |                    |       |
| Total Liabilities                                                                                                                        |       | $                       | 63,107,072  |                    | $          | 83,764,281 |   |
|                                                                                                                                     |       |                    |        |                    |       |
| STOCKHOLDERS’ EQUITY                                                                                                                |       |                    |        |                    |       |
| Common stock, $0.001 par value, 50,000,000  shares authorized and 11,278,510 and 10,081,844 shares issued and  outstanding, respectively |       | $                       | 11,279      |                    | $          | 10,082 |   |
| Capital in excess of par value                                                                                                           |       | 164,294,781             |        | 140,416,674             |       |
| Notes receivable – officers                                                                                                         |       | (9,432,678              | )           | (8,985,940              | )          |
| Net unrealized depreciation on investments                                                                                               |       | (2,743,066              | )           | (222,340                | )          |
| Unrealized depreciation on derivative                                                                                                    |       | (214,259                | )           | —                  |       |
| Distributions less than (in excess of) net  investment income                                                                            |       | 310,598                 |        | (416,094                | )          |
|                                                                                                                                     |       |                    |        |                    |       |
| Total Stockholders’ Equity                                                                                                          |       | $                       | 152,226,655 |                    | $          | 130,802,382 |   |
|                                                                                                                                     |       |                    |        |                    |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                          |       | $                       | 215,333,727 |                    | $          | 214,566,663 |   |

 

*See accompanying notes.*

 

43

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OF INVESTMENTS**

**SEPTEMBER 30, 2004**

 
| **Company  (1)**                     | ** ** | **Industry**                                                          | ** ** | **Investment (2)**                                                                                    | ** ** | **Cost**             | ** ** | **Fair Value**       | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                           | ** ** | ** **                                                            | ** ** | ** **                                                                                            | ** ** | ** **           | ** ** | ** **           | ** ** |
| A and G, Inc.  (d/b/a Alstyle)       |       | Activewear products                                                   |       | Senior Term Debt (3) (6)  (11.0%, Due 6/2008)                                                         |       | $                    | 12,250,000 |                 | $          | 12,250,000 |   |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Allied Extruders,  Inc.              |       | Polyethylene film  manufacturer                                       |       | Senior Term Debt (3)  (12.3%, Due 7/2009)                                                             |       | 4,000,000            |       | 4,000,000            |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| America’s Water  Heater Rentals |       | Household appliances  rental                                          |       | Senior Term Debt (4) (6)  (8)  (12.5%, Due 2/2009)                                                    |       | 12,000,000           |       | 12,840,000           |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| ARI Holdings,  Inc.                  |       | Manufacturing-auto parts                                              |       | Senior Term Debt (6)                                                                                  |       | 1,190,141            |       | 1,188,653            |       |
|                                 |       |                                                                  |       | (9.75%, Due 6/2008)                                                                                   |       |                 |       |                 |       |
|                                 |       |                                                                  |       | Senior Subordinated Term  Debt (5) (6)                                                                |       | 3,657,164            |       | 3,634,306            |       |
|                                 |       |                                                                  |       | (11%, PIK 4%, Due  12/2008)                                                                           |       |                 |       |                 |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Bear Creek   Corporation             |       | Premium horticultural  and food products                              |       | Senior Subordinated Term  Debt (7)  (9.1%, Due 6/2010)                                                |       | 6,000,000            |       | 6,090,000            |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Benetech, Inc.                       |       | Dust management systems  for the coal and electric utility industries |       | Senior Term Debt (6)   (8.5%, Due 5/2009)  Senior Term Debt (3) (6)  (11.5%, Due 5/2009)              |       | 3,168,750  3,250,000 |       | 3,160,828  3,241,875 |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Burt’s Bees, Inc.               |       | Personal & household  products                                    |       | Senior Term Debt (7)  (5.4%, Due 11/2009)                                                             |       | 975,000              |       | 987,188              |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Coyne  International Enterprises     |       | Industrial services                                                   |       | Senior Term Debt (3) (5)  (6)  (13.0%, PIK 2%, Due 7/2007)                                            |       | 15,700,625           |       | 15,308,110           |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Finn Corporation                     |       | Manufacturing-landscape  equipment                                    |       | Senior Subordinated Term  Debt (6)  (13.0%, Due 2/2006)                                               |       | 10,500,000           |       | 7,612,500            |       |
|                                 |       |                                                                  |       | Common Stock Warrants                                                                                 |       | 37,000               |       | 474,984              |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Gammill, Inc.                        |       | Designer and assembler  of quilting machines and accessories          |       | Senior Term Debt (6)  (9.5%, Due 12/2008)  Senior Term Debt (3) (6)  (12.0%, Due 12/2008)             |       | 4,708,013  4,750,000 |       | 4,731,553  4,767,813 |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Inca Metal  Products Corporation     |       | Material handling and  storage products                               |       | Senior Term Debt (3) (6)  (4.6%, Due 9/2006)                                                          |       | 2,387,548            |       | 2,136,855            |       |
| Kingway Acquisition,  Inc.           |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Clymer Acquisition,  Inc.            |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Maidenform, Inc.                     |       | Intimate apparel                                                      |       | Senior Subordinated Term  Debt (7)                                                                    |       | 10,003,571           |       | 10,175,000           |       |
|                                 |       |                                                                  |       | (9.4%, Due 5/2011)                                                                                    |       |                 |       |                 |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| Marcal Paper  Mills, Inc.            |       | Manufacturing-paper  products                                         |       | Senior Subordinated Term  Debt (6)  (13.0%, Due 12/2006)  First Mortgage Loan (5)  (16%, Due 12/2006) |       | 6,800,000  9,254,715 |       | 6,188,000  9,254,715 |       |
|                                 |       |                                                                  |       |                                                                                                  |       |                 |       |                 |       |
| MedAssets, Inc.                      |       | Pharmaceuticals and  healthcare GPO                                   |       | Senior Term Debt (7)  (5.9%, Due 3/2007)  Senior Subordinated Term Debt (7)  (11.2%, Due 3/2008)      |       | 1,815,497  6,503,282 |       | 1,806,887  6,500,000 |       |
|                                      |            |                                                                       |            |                                                                                                       |            |                      |            |                      |            |  |  |

 

44

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| **Company  (1)**               | ** ** | **Industry**                                              | ** ** | **Investment (2)**                                                                                                                          | ** ** | **Cost**                        | ** **      | **Fair Value**                  | ** ** |
|--------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|-----------------|---------------------------------|------------|
|                           |       |                                                      |       |                                                                                                                                        |       |                            |            |                            |       |
| Mistras Holdings  Corp.        |       | Nondestructive testing  instruments, systems and services |       | Senior Term Debt (3) (6)  (10.5%, Due 8/2008)  Senior Term Debt (3) (6)  (12.5%, Due 8/2008)  Senior Term Debt (3) (6)  (13.5%, Due 8/2008) |       | 9,833,333  4,916,667  1,000,000 |            | 9,759,583  4,867,500  1,000,000 |       |
|                           |       |                                                      |       |                                                                                                                                        |       |                            |            |                            |       |
| Woven Electronics  Corporation |       | Custom electrical cable  assemblies                       |       | Senior Term Debt (3) (6)  (6.5%, Due 3/2009)                                                                                                |       | 2,488,000                       |            | 2,484,890                       |       |
|                           |       |                                                      |       | Senior Term Debt (4) (6)                                                                                                                    |       | 12,000,000                      |            | 11,985,000                      |       |
|                           |       |                                                      |       | (11.5%, Due 3/2009)                                                                                                                         |       |                            |            |                            |       |
| **Total:**                     | ** ** | ** **                                                | ** ** | ** **                                                                                                                                  | ** ** | **$**                           | **149,189,306** | ** **                      | **$**      | **146,446,240** | ** ** |
|                                |            |                                                           |            |                                                                                                                                             |            |                                 |                 |                                 |            |  |  |

 

----

(1) We do not “Control,”and are not an “Affiliate” of, any of our portfolio companies, each as definedin the Investment Company Act of 1940, as amended (the “1940 Act”). In general,under the 1940 Act, we would “Control” a portfolio company if we owned 25% ormore of its voting securities and would be an “Affiliate” of a portfoliocompany if we owned 5% or more of its voting securities.

(2) Percentage representsinterest rates in effect at September 30, 2004 and due date represents thecontractual maturity date.

(3) Last Out Tranche ofsenior debt, meaning if the company is liquidated then the holder of the LastOut Tranche is paid after the senior debt.

(4) Last Out Tranche ofsenior debt, meaning if the company is liquidated then the holder of the LastOut Tranche is paid after the senior debt, however the debt is junior toanother Last Out Tranche.

(5) Has some paid in kind(PIK) interest.  Refer to Note 2 “Summaryof Significant Accounting Policies”.

(6) Fair value was basedon valuation prepared and provided by Standard & Poor’s Loan EvaluationServices.

(7) Marketable securitiesare valued based on the bid price, as of September 30, 2004, from therespective originating syndication agent’s trading desk.

(8) Includes a success feewith a fair value of $660,000 and no cost basis.

 

*See accompanying notes.*

 

45

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OFINVESTMENTS**

**SEPTEMBER 30,2003**

 
| **Company  (1)**                                 | ** ** | **Industry**                                          | ** ** | **Investment (2)**                                                                  | ** ** | **Cost**             | ** **      | **Fair Value**       | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|----------------------|-----------------|----------------------|------------|
| ** **                                       | ** ** | ** **                                            | ** ** | ** **                                                                          | ** ** | ** **           | ** **      | ** **           | ** ** |
| America’s Water  Heater Rentals             |       | Household appliances rental                           |       | Senior Term Debt (3) (5)  (12.5%, Due 2/2009)                                       |       | 12,000,000           |            | 12,000,000           |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| ARI Holdings,  Inc.                              |       | Manufacturing-auto parts                              |       | Second Lien Term Debt (3)                                                           |       | 1,500,000            |            | 1,500,000            |       |
|                                             |       |                                                  |       | (5.1%, Due 6/2008)                                                                  |       |                 |            |                 |       |
|                                             |       |                                                  |       | Senior Term Debt  (3) (4)                                                           |       | 3,511,667            |            | 3,511,667            |       |
|                                             |       |                                                  |       | (8.0%, PIK 4%,  Due 12/2008)                                                        |       |                 |            |                 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Coyne  International Enterprises                 |       | Industrial services                                   |       | Senior Term Debt (3) (4) (5)  (13.0%, PIK 2%, Due 7/2007)                           |       | 15,421,740           |            | 15,306,077           |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Finn Corporation                                 |       | Manufacturing-landscape equipment                     |       | Senior Subordinated Term Debt (6)  (13.0%, Due 2/2006)                              |       | 10,500,000           |            | 10,421,250           |       |
|                                             |       |                                                  |       | Common Stock  Warrants                                                              |       | 37,000               |            | 431,111              |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Fugate and  Associates, Inc. (d/b/a ERS Imaging) |       | Aggregator & Reseller -  Printer Cartridges, etc. |       | Senior Term Debt (5)  (12.0%, Due 4/2007)  Senior Term Debt (5)  (9.0%, Due 4/2007) |       | 3,412,500  1,833,333 |            | 3,412,500  1,833,333 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Home Care Supply,  Inc.                          |       | Medical equipment rental                              |       | Senior Term Debt (3) (5) (6)                                                        |       | 18,000,000           |            | 18,428,400           |       |
|                                             |       |                                                  |       | (12.0%, Due  10/2008)                                                               |       |                 |            |                 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Inca Metal  Products Corporation                 |       | Material handling and storage products                |       | Senior Term Debt (3) (5)  (12.5%,Due 9/2007)                                        |       | 5,775,000            |            | 4,995,375            |       |
| Kingway Acquisition,  Inc.                       |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Clymer Acquisition,  Inc.                        |       |                                                  |       |                                                                                |       |                 |            |                 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Kozy Schack  Enterprises, Inc.                   |       | Food production and sales                             |       | Senior Term Debt (3) (5)  (18.0%, Due 5/2006)                                       |       | 900,000              |            | 909,000              |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Marcal Paper  Mills, Inc.                        |       | Manufacturing-paper products                          |       | Senior Term Debt (3) (5)  (13.0%, Due 12/2006)                                      |       | 6,975,000            |            | 6,922,687            |       |
|                                             |       |                                                  |       | First Mortgage  Debt (4)                                                            |       | 9,163,653            |            | 9,163,653            |       |
|                                             |       |                                                  |       | (16.0%, PIK 1%,  Due 12/2006)                                                       |       |                 |            |                 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Mistras Holdings  Corp.                          |       | Nondestructive testing                                |       | Senior Term Debt (3)                                                                |       | 10,000,000           |            | 10,000,000           |       |
|                                             |       | instruments, systems                                  |       | (10.5%, Due 8/2008)                                                                 |       |                 |            |                 |       |
|                                             |       | and services                                          |       | Senior Term Debt (3)                                                                |       | 5,000,000            |            | 5,000,000            |       |
|                                             |       |                                                  |       | (12.5%, Due  8/2008)                                                                |       |                 |            |                 |       |
|                                             |       |                                                  |       |                                                                                |       |                 |            |                 |       |
| Wingstop  Restaurants International, Inc.        |       | Restaurant - fast food                                |       | Senior Term Debt (5)  (12.5%, Due 1/2008)                                           |       | 3,500,000            |            | 3,482,500            |       |
|                                             |       |                                                  |       | Senior Debt (5)                                                                     |       | 2,000,000            |            | 1,990,000            |       |
|                                             |       |                                                  |       | (8.5%, Due  1/2008)                                                                 |       |                 |            |                 |       |
| **Total:**                                       | ** ** | ** **                                            | ** ** | ** **                                                                          | ** ** | **$**                | **109,529,893** | ** **           | **$**      | **109,307,553** | ** ** |
|                                                  |            |                                                       |            |                                                                                     |            |                      |                 |                      |            |  |  |

 

----

(1) We do not “Control,”and are not an “Affiliate” of, any of our portfolio companies, each as definedin the Investment Company Act of 1940, as amended (the “1940 Act”). In general,under the 1940 Act, we would “Control” a portfolio company if we owned 25% ormore of its voting securities and would be an “Affiliate” of a portfoliocompany if we owned 5% or more of its voting securities.

 

46

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(2) Percentage representsinterest rates in effect at September 30, 2003 and due date represents thecontractual maturity date.

(3) Last Out Tranche ofsenior debt, meaning if the company is liquidated then the holder of the LastOut Tranche is paid after the senior debt.

(4) Has some paid in kind(PIK) interest. Refer to Note 2 “Summary of Significant Accounting Policies”.

(5) Fair value was basedon valuation prepared and provided by Standard & Poor’s Loan Evaluation Services.

(6) Includes a success feewith a fair value of $473,400 and no cost basis.

 

*See accompanying notes.*

 

47

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                             | ** **              | **Year Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------|-------------------------|------------------------------|------------|
| ** **                                                                             | ** **              | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| INVESTMENT INCOME                                                                      |                    |                         |       |   |   |   |   |
| Interest income – investments                                                     |                    | $                            | 18,176,617 |   | $ | 13,248,415 |   | $ | 6,641,144 |   |
| Interest income – cash and cash equivalents                                       |                    | 84,273                       |       | 466,316 |   | 1,576,304 |   |
| Interest income – notes receivable from  officers                                 |                    | 443,658                      |       | 437,737 |   | 433,391 |   |
| Managerial assistance fees                                                             |                    | 1,118,106                    |       | 885,500 |   | 1,673,614 |   |
| Other income                                                                           |                    | 573,314                      |       | 116,906 |   | 131,250 |   |
|                                                                                   | Total investment income |                         | 20,395,968 |   | 15,154,874 |   | 10,455,703 |   |
|                                                                                   |                    |                         |       |   |   |   |   |
| EXPENSES                                                                               |                    |                         |       |   |   |   |   |
| Salaries and benefits                                                                  |                    | 2,554,490                    |       | 2,018,004 |   | 1,367,180 |   |
| Rent                                                                                   |                    | 139,399                      |       | 209,864 |   | 125,128 |   |
| Professional fees                                                                      |                    | 579,599                      |       | 409,826 |   | 549,781 |   |
| Directors fees                                                                         |                    | 112,210                      |       | 73,647 |   | 22,000 |   |
| Insurance                                                                              |                    | 258,358                      |       | 275,511 |   | 206,385 |   |
| Stockholder related costs                                                              |                    | 140,090                      |       | 143,273 |   | 104,167 |   |
| Financing fees                                                                         |                    | 1,373,415                    |       | 222,038 |   | — |   |
| Interest                                                                               |                    | 741,621                      |       | — |   | — |   |
| Loan servicing                                                                         |                    | 501,670                      |       | — |   | — |   |
| General and administrative                                                             |                    | 702,341                      |       | 506,790 |   | 464,461 |   |
|                                                                                   | Total expenses          |                         | 7,103,193  |   | 3,858,953 |   | 2,839,102 |   |
|                                                                                   |                    |                         |       |   |   |   |   |
| NET INVESTMENT INCOME                                                                  |                    | 13,292,775                   |       | 11,295,921 |   | 7,616,601 |   |
|                                                                                   |                    |                         |       |   |   |   |   |
| REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:                                    |                    |                         |       |   |   |   |   |
| Realized gain on sale of investment                                                    |                    | 12,500                       |       | — |   | — |   |
| Unrealized depreciation on derivative                                                  |                    | (214,259                     | )          | — |   | — |   |
| Net unrealized depreciation on investments                                             |                    | (2,520,726                   | )          | (222,340 | ) | — |   |
|                                                                                   | Net loss on investments |                         | (2,722,485 | ) | (222,340 | ) | — |   |
|                                                                                   |                    |                         |       |   |   |   |   |
| NET INCREASE IN STOCKHOLDERS’ EQUITY  RESULTING FROM OPERATIONS                   |                    | $                            | 10,570,290 |   | $ | 11,073,581 |   | $ | 7,616,601 |   |
|                                                                                   |                    |                         |       |   |   |   |   |
| NET INCREASE IN STOCKHOLDERS’ EQUITY  RESULTING FROM OPERATIONS PER COMMON SHARE: |                    |                         |       |   |   |   |   |
| Basic                                                                                  |                    | $                            | 1.05       |   | $ | 1.10 |   | $ | 0.76 |   |
| Diluted                                                                                |                    | $                            | 1.02       |   | $ | 1.09 |   | $ | 0.75 |   |
|                                                                                   |                    |                         |       |   |   |   |   |
| WEIGHTED AVERAGE SHARES OF COMMON STOCK  OUTSTANDING:                                  |                    |                         |       |   |   |   |   |
| Basic                                                                                  |                    | 10,101,341                   |       | 10,072,677 |   | 10,064,900 |   |
| Diluted                                                                                |                    | 10,344,388                   |       | 10,188,488 |   | 10,166,752 |   |
|                                                                                        |                         |                              |            |  |  |  |  |  |  |  |  |  |

 

*See accompanying notes.*

 

48

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

 
| ** **                                                           | ** ** | ** **        | ** ** | ** **     | ** ** | ** **        | ** ** | **Notes**         | ** ** | **Distributions  in** | ** ** | **Realized**       | ** ** | **Unrealized**      | ** ** | **Unrealized**         | ** ** | ** **  | ** ** |
|----------------------------------------------------------------------|------------|-------------------|------------|----------------|------------|-------------------|------------|-------------------|------------|-----------------------|------------|--------------------|------------|---------------------|------------|------------------------|------------|-------------|------------|
| ** **                                                           | ** ** | ** **        | ** ** | ** **     | ** ** | **Capital  in**   | ** ** | **Receivable**    | ** ** | **Excess  of Net**    | ** ** | **Gain on**        | ** ** | **Appreciation/**   | ** ** | **Appreciation/**      | ** ** | **Total**   | ** ** |
| ** **                                                           | ** ** | **Common  Stock** | ** ** | **Excess  of** | ** ** | **From  Sale of** | ** ** | **Investment**    | ** ** | **Sale of**           | ** ** | **(Depreciation)** | ** ** | **(Depreciation)**  | ** ** | **Stockholders’** | ** ** |
| ** **                                                           | ** ** | **Shares**        | ** ** | **Amount**     | ** ** | **Par  Value**    | ** ** | **Common  Stock** | ** ** | **Income**            | ** ** | **Investment**     | ** ** | **of  Investments** | ** ** | **of  Derivatives**    | ** ** | **Equity**  | ** ** |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Balance at  September 30, 2001                                       |       | 10,060,178        |       | $              | 10,060     |              | $          | 140,131,778       |       | $                     | (8,800,050 | )                  | $          | (92,644             | )          | $                      | —     |        | $          | — |   | $ | — |   | $ | 131,249,144 |   |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Issuance of  Common Stock Under Stock Option Plan                    |       | 11,666            |       | 12             |       | 185,878           |       | (185,890          | )          | —                |       | —             |       | —              |       | —                 |       | —      |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Shelf Offering  Costs                                                |       | —            |       | —         |       | (50,972           | )          | —            |       | —                |       | —             |       | —              |       | —                 |       | (50,972     | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Repayment of  Principal on Notes Receivable                          |       | —            |       | —         |       |              |       | 2,144             |       | —                |       | —             |       | —              |       | —                 |       | 2,144       |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —            |       | —         |       | —            |       | —            |       | 7,616,601             |       | —             |       | —              |       | —                 |       | 7,616,601   |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Distributions  Declared ($0.81 per common share)                     |       | —            |       | —         |       | —            |       | —            |       | (8,153,644            | )          | —             |       | —              |       | —                 |       | (8,153,644  | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Balance at  September 30, 2002                                       |       | 10,071,844        |       | $              | 10,072     |              | $          | 140,266,684       |       | $                     | (8,983,796 | )                  | $          | (629,687            | )          | $                      | —     |        | $          | — |   | $ | — |   | $ | 130,663,273 |   |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Issuance of  Common Stock Under Stock Option Plan                    |       | 10,000            |       | 10             |       | 149,990           |       | (150,000          | )          | —                |       | —             |       | —              |       | —                 |       | —      |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Repayment of  Principal on Notes Receivable                          |       | —            |       | —         |       | —            |       | 147,856           |       | —                |       | —             |       | —              |       | —                 |       | 147,856     |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —            |       | —         |       | —            |       | —            |       | 11,295,921            |       | —             |       | (222,340            | )          | —                 |       | 11,073,581  |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Distributions  Declared ($1.10 per common share)                     |       | —            |       | —         |       | —            |       | —            |       | (11,082,328           | )          | —             |       | —              |       | —                 |       | (11,082,328 | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Balance at  September 30, 2003                                       |       | 10,081,844        |       | $              | 10,082     |              | $          | 140,416,674       |       | $                     | (8,985,940 | )                  | $          | (416,094            | )          | $                      | —     |        | $          | (222,340 | ) | $ | — |   | $ | 130,802,382 |   |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Issuance of  Common Stock Under Shelf Offering                       |       | 1,150,000         |       | 1,150          |       | 24,854,375        |       | —            |       | —                |       | —             |       | —              |       | —                 |       | 24,855,525  |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Shelf Offering  Costs                                                |       | —            |       | —         |       | (476,168          | )          | —            |       | —                |       | —             |       | —              |       | —                 |       | (476,168    | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Issuance of  Common Stock Under Stock Option Plan                    |       | 46,666            |       | 47             |       | 707,043           |       | (549,990          | )          | —                |       | —             |       | —              |       | —                 |       | 157,100     |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Repayment of  Principal on Notes Receivable                          |       | —            |       | —         |       | —            |       | 103,252           |       | —                |       | —             |       | —              |       | —                 |       | 103,252     |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Net Increase in  Stockholders’ Equity Resulting from Operations |       | —            |       | —         |       | —            |       | —            |       | 13,292,775            |       | 12,500             |       | (2,520,726          | )          | (214,259               | )          | 10,570,290  |       |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Distributions  Declared ($1.245 per common share)                    |       | —            |       | —         |       | —            |       | —            |       | (12,578,583           | )          | —             |       | —              |       | —                 |       | (12,578,583 | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Tax Return of  Capital ($0.12 per common share)                      |       | —            |       | —         |       | (1,207,143        | )          | —            |       | —                |       | —             |       | —              |       | —                 |       | (1,207,143  | )          |
|                                                                 |       |              |       |           |       |              |       |              |       |                  |       |               |       |                |       |                   |       |        |       |
| Balance at  September 30, 2004                                       |       | 11,278,510        |       | $              | 11,279     |              | $          | 164,294,781       |       | $                     | (9,432,678 | )                  | $          | (298,098            | )          | $                      | 12,500     |        | $          | (2,743,066 | ) | $ | (214,259 | ) | $ | 152,226,655 |   |

 

*See accompanying notes.*

 

49

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

** **
| ** **                                                                                                                                   | ** ** | **Year Ended  September 30,  2004** | ** ** | **Year Ended  September 30,  2003** | ** ** | **Year Ended  September 30,  2002** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                                                                                     |       |                                |       |                                |       |                                |       |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| Net increase in stockholders’ equity  resulting from operations                                                                         |       | $                                   | 10,570,290 |                                | $          | 11,073,581                          |       | $ | 7,616,601 |   |
| Adjustments to reconcile net increase in  stockholders’ equity resulting from operations to net cash provided by  operating activities: |       |                                |       |                                |       |                                |       |
| Depreciation                                                                                                                                 |       | 24,356                              |       | 29,310                              |       | 13,822                              |       |
| Amortization of premiums                                                                                                                     |       | 2,036                               |       | —                              |       | —                              |       |
| Amortization of deferred financing fees                                                                                                      |       | 1,303,776                           |       | —                              |       |                                |       |
| Unrealized depreciation on derivative                                                                                                        |       | 214,259                             |       | —                              |       |                                |       |
| Change in net unrealized depreciation                                                                                                        |       | 2,520,726                           |       | 222,340                             |       | —                              |       |
| Decrease (increase) in interest receivable                                                                                                   |       | 201,259                             |       | (352,018                            | )          | (719,638                            | )          |
| Decrease (increase) in funds due from  custodian                                                                                             |       | 3,921                               |       | (1,207,000                          | )          | —                              |       |
| Decrease (increase) in prepaid assets                                                                                                        |       | 201,275                             |       | (34,996                             | )          | (191,705                            | )          |
| Increase in due from affiliate                                                                                                               |       | (67,508                             | )          | (42,131                             | )          | —                              |       |
| Decrease (increase) in other assets                                                                                                          |       | 33,188                              |       | (42,485                             | )          | 75,546                              |       |
| Increase in accounts payable                                                                                                                 |       | 82,674                              |       | 23,247                              |       | —                              |       |
| Increase in accrued expenses and deferred  liabilities                                                                                       |       | (1,053,418                          | )          | 1,020,065                           |       | 579,000                             |       |
| Increase in investment balance due to  payment in kind interest                                                                              |       | (552,944                            | )          | (806,088                            | )          | (400,491                            | )          |
| Net cash provided by operating activities                                                                                                    |       | 13,483,890                          |       | 9,883,825                           |       | 6,973,135                           |       |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                                                    |       |                                |       |                                |       |                                |       |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| Sale (purchase) of furniture &  equipment - net                                                                                          |       | 117,365                             |       | (82,344                             | )          | (70,976                             | )          |
| Purchase of investments                                                                                                                      |       | (86,267,500                         | )          | (47,011,278                         | )          | (97,705,054                         | )          |
| Principal repayments on investments                                                                                                          |       | 47,158,995                          |       | 18,005,827                          |       | 18,387,191                          |       |
| Proceeds from repurchase agreements                                                                                                          |       | 285,099,546                         |       | 245,070,973                         |       | 44,098,719                          |       |
| Repayment of repurchase agreements                                                                                                           |       | (342,202,549                        | )          | (205,820,693                        | )          | (4,900,000                          | )          |
| Receipt of principal on notes receivable -  officers                                                                                         |       | 103,252                             |       | 147,856                             |       | 2,144                               |       |
| Net cash (used in) provided by investing  activities                                                                                         |       | (95,990,891                         | )          | 10,310,341                          |       | (40,187,976                         | )          |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                                                    |       |                                |       |                                |       |                                |       |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| Net proceeds from issuance of common shares                                                                                                  |       | 24,379,357                          |       | —                              |       | (50,972                             | )          |
| Borrowings from the lines of credit                                                                                                          |       | 114,743,547                         |       | —                              |       | —                              |       |
| Repayments on the lines of credit                                                                                                            |       | (74,000,000                         | )          |                                |       |                                |       |
| Deferred financing fees                                                                                                                      |       | (567,649                            | )          | (1,086,864                          | )          | —                              |       |
| Decrease in accrued offering costs                                                                                                           |       | —                              |       | —                              |       | (590,382                            | )          |
| Distributions paid                                                                                                                           |       | (17,112,735                         | )          | (9,870,409                          | )          | (6,038,557                          | )          |
| Purchase of derivative                                                                                                                       |       | (304,000                            | )          |                                |       |                                |       |
| Exercise of employee stock options                                                                                                           |       | 157,100                             |       | —                              |       | —                              |       |
| Net cash provided by (used in) financing  activities                                                                                         |       | 47,295,620                          |       | (10,957,273                         | )          | (6,679,911                          | )          |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **NET (DECREASE) INCREASE IN CASH AND CASH  EQUIVALENTS (1)**                                                                                |       | (35,211,381                         | )          | 9,236,893                           |       | (39,894,752                         | )          |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF  PERIOD**                                                                                          |       | 101,166,221                         |       | 91,929,328                          |       | 131,824,080                         |       |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                                                                                 |       | $                                   | 65,954,840 |                                | $          | 101,166,221                         |       | $ | 91,929,328 |   |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **CASH PAID DURING PERIOD FOR INTEREST**                                                                                                     |       | $                                   | 672,449    |                                | $          | —                              |       | $ | — |   |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| **NON-CASH FINANCING ACTIVITIES**                                                                                                            |       |                                |       |                                |       |                                |       |
|                                                                                                                                         |       |                                |       |                                |       |                                |       |
| Notes receivable issued in exchange for  common stock associated with the exercise of employee stock options                                 |       | $                                   | 549,990    |                                | $          | 150,000                             |       | $ | 185,890 |   |

 

----

(1)   Cashand cash equivalents consist of demand deposits and highly liquid investmentswith original maturities of three months or less when purchased.

*See accompanying notes.*

 

50

----

 

**GLADSTONE CAPITAL CORPORATION**

**NOTES TO FINANCIAL STATEMENTS**

**SEPTEMBER 30, 2004**

 

**Note 1. Organization**

 

Gladstone Capital Corporation (the Company) was incorporated under theGeneral Corporation Laws of the State of Maryland on May 30, 2001 as aclosed-end investment company. The Company has elected to be treated as abusiness development company under the Investment Company Act of 1940, asamended. In addition, the Company has elected to be treated for tax purposes asa regulated investment company, or RIC, under the Internal Revenue Code of1986, as amended (the Code). The Company’s investment objectives are to achievea high level of current income by investing in debt and equity securities ofestablished private businesses.

 

Gladstone Capital Advisers, Inc. (Advisers), a wholly-ownedsubsidiary, conducts the daily administrative operations of the Company andprovides managerial assistance to the Company’s portfolio companies.

 

Gladstone Business Loan LLC, a wholly-owned subsidiary of the Company,was established on February 3, 2003 for the purpose of owning the Company’sportfolio of loan investments.  Thefinancial statements of the subsidiary are consolidated with those of theCompany.

 

**Note 2. Summary of SignificantAccounting Policies**

 

*Basis of Presentation*

 

The accompanying consolidated financial statements include the accountsof the Company and its wholly-owned subsidiaries. All significant intercompanybalances and transactions have been eliminated.

 

*Use of Estimates*

 

The consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of Americathat require management to make estimates and assumptions that affect theamounts reported in the financial statements and accompanying notes. Actualresults may differ from those estimates.

 

*Reclassifications*

Certain amounts in the prior years’ financial statements have beenreclassified to conform to the current year presentation with no effect to netincrease in stockholders’ equity resulting from operations.

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents consist of demand deposits and highly liquidinvestments with original maturities of three months or less when purchased.Cash and cash equivalents are carried at cost which approximates fair value asof September 30, 2004. Cash and cash equivalents pledged to creditors asof September 30, 2004 consists of the United States Treasury Bill thatcollateralizes the Company’s Repurchase Agreement.

 

*Concentration of Credit Risk*

 

The Company places its cash and cash equivalents with financialinstitutions and, at times, cash held in checking accounts may exceed theFederal Deposit Insurance Corporation insured limit.

 

51

----

 

*Investment Valuation*

 

TheCompany carries its investments at fair value, as determined by its Board ofDirectors.  Securities that are publiclytraded are valued at the closing price on the valuation date.  Securities for which a limited market exists,such as participations in syndicated loans, are valued at the indicative bidprice on the valuation date.  Debt andequity securities that are not publicly traded are valued at fair value asdetermined in good faith by the Board of Directors. Beginning in March 2003,the Company engaged Standard & Poor’s Loan Evaluation Service (S&P) toperform independent valuations of its investments.  The Board of Directors uses the recommendedvaluations as prepared by S&P as a component of the foundation for thefinal fair value determination.  Inmaking such determination, the Board of Directors values non-convertible debtsecurities at cost plus amortized original issue discount plus payment in kind (“PIK”)interest, if any, unless adverse factors lead to a determination of a lesservaluation.  In valuing convertible debt,equity, success or exit fees or other equity like securities, the Board ofDirectors determines the fair value based on the collateral, the issuer’sability to make payments, the earnings of the issuer, sales to third parties ofsimilar securities, the comparison to publicly traded securities, discountedcash flow and other pertinent factors. Due to the uncertainty inherent in the valuation process, such estimatesof fair value may differ significantly from the values that would have resultedhad a ready market for the securities existed, and the differences could bematerial. Additionally, changes in the market environment and other events thatmay occur over the life of the investments may cause the gains ultimatelyrealized on these investments to be different than the valuation currentlyassigned.  Because there is a lag betweenwhen the Company closes a loan and when the loan can be evaluated by S&P,new loans are not valued immediately by S&P; rather, the Board of Directorsmakes its own determination about the value of the loan in accordance with theCompany’s valuation policy.  BecauseS&P does not perform independent valuations of mortgage loans or equitysecurities, the Board of Directors also determines the fair value of theseinvestments without the input of S&P. The Board of Directors considers a number of qualitative andquantitative factors in current market conditions when performing valuations.

 

*Property and Equipment*

 

Property and equipment were carried at cost and depreciated using thestraight-line method over the estimated useful lives of the related assetsranging from three to five years.  OnJuly 1, 2004, the Company sold its fixed assets at net book value to GladstoneManagement Corporation.

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis to the extent thatsuch amounts are expected to be collected. The Company stops accruing intereston its investments when it is determined that interest is no longercollectible.  Conditional interest or asuccess fee is recorded when earned upon full repayment of a loan investment.

 

*Payment in Kind Interest*

 

The Company has loans in its portfolio which contain a payment in kind(“PIK”) provision. The PIK interest, computed at the contractual rate specifiedin each loan agreement, is added to the principal balance of the loan andrecorded as income. To maintain the Company’s status as a RIC, this non-cashsource of income must be paid out to stockholders in the form of dividends,even though the Company has not yet collected the cash. For the years endedSeptember 30, 2004, September 30, 2003 and September 30, 2002, theCompany recorded PIK income of $553,409, $781,407 and $461,627, respectively.

 

*Managerial Assistance Fees*

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies. The Companyprovides managerial assistance to its portfolio companies in connection withits investments through its wholly-owned subsidiary, Gladstone CapitalAdvisers, Inc. and receives fees for managerial assistance services. Thesefees are normally paid at the closing of the investments, are generallynon-recurring and are recognized as revenue when earned upon closing theinvestment. The managerial assistance services the Company provides vary byinvestment, but generally consist of reviewing existing credit facilities,arranging bank financing, arranging equity financing, structuring financingfrom multiple lenders, structuring financing from equity investors,restructuring existing loans, raising equity and debt capital, and providinggeneral financial advice, which concludes upon closing of the loan.  Any services of this nature subsequent to theclosing would generally generate a separate fee at the time of completion. Ifthe Company is invited to participate as a co-lender in a transaction and inthe event that the Company does not provide significant managerial assistanceservices in connection with the investment, loan fees paid to the Company insuch situations are deferred and amortized over the life of the loan.  Effective October 1, 2004, GladstoneManagement Corporation began providing these services and will receive any suchrelated fees.

 

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*Stock Options*

 

The Company applies Accounting Principles Board Opinion (“APB”)No. 25, “Accounting for Stock Issued to Employees” (APB 25), and relatedinterpretations in accounting for its stock-based compensation plan. InDecember 2002, the Company adopted Statement of Financial AccountingStandards (SFAS) Statement No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosure” which amended SFAS 123, “Accounting forStock-Based Compensation” (SFAS 123). The Company adopted SFAS 148 onJanuary 1, 2003 and elects to continue to account for its stock-basedcompensation plan under the provisions of APB 25. The Company continues toprovide pro forma disclosure (see Note 4) of the Company’s net increase(decrease) to stockholders’ equity resulting from operations calculated as ifthe grants of stock options had been recorded as compensation costs inaccordance with SFAS 148 and 123.

 

*Management Fees*

 

The Company was self-managed and therefore did not incur managementfees payable to third parties during the fiscal year ended September 30, 2004.

 

In July 2003, the Company entered into an expense sharing arrangementwith Gladstone Management Corporation (“Gladstone Management”), a registeredinvestment adviser that serves as the external adviser to Gladstone CommercialCorporation, a real estate investment trust, an affiliate. Under this expensesharing arrangement, Gladstone Management reimbursed Gladstone Capital Advisersfor a portion of total payroll and benefits expenses (based on the percentageof total hours worked by each of the Company’s employees on GladstoneCommercial matters). Gladstone Management also reimbursed Gladstone CapitalAdvisers for its pro rata portion of all other general expenses (based on thepercentage of total hours worked by all employees on Gladstone Commercialmatters). Gladstone Management further passed its share of these expenses alongto Gladstone Commercial under a separate advisory agreement. As a result ofthis expense sharing arrangement, certain of expenses, such as rent andinsurance, declined during the fiscal year ended September 30, 2004.** **Followingthe engagement of Gladstone Management on October 1, 2004, the first day of the2005 fiscal year, Gladstone Management now directly employs all personneland pays the payroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement betweenGladstone Capital Advisers and Gladstone Management terminated upon theexternalization of management on October 1, 2004.

 

Effective October 1, 2004, pursuant to theadvisory agreement with Gladstone Management, the Company willpay Gladstone Management an annual advisory fee of 1.25% of the Company’s totalassets (as reduced by cash and cash equivalents pledged to creditors), payablein quarterly increments of 0.3125%, and an annual administrative fee of 0.75%of the Company’s total assets (as reduced by cash and cash equivalents pledgedto creditors), payable in quarterly increments of 0.1875%. The Company willreceive a credit against this advisory fee for any managerial assistance feesreceived by Gladstone Management. The Company will continue to pay directexpenses including, but not limited to, directors fees, legal and accountingfees, and stockholder related expenses.

 

*Federal Income Taxes*

 

The Company intends to continue to qualify for treatment as a RIC underSubchapter M of the Code. As a RIC, the Company is not subject to federalincome tax on the portion of its taxable income and gains distributed tostockholders. To qualify as a RIC, the Company is required to distribute to itsstockholders at least 90% of investment company taxable income, as defined bythe Code.

 

*Dividends*

 

Distributions to stockholders are recorded on the ex-dividend date. TheCompany is required to pay out at least 90% of its ordinary income andshort-term capital gains for each taxable year as a dividend to itsstockholders in order to maintain its status as a RIC under Subtitle A, Chapter1 of Subchapter M of the Code. It is the policy of the Company to pay out as adividend up to 100% of those amounts. The amount to be paid out as a dividendis determined by the Board of Directors each quarter and is based on the annualearnings estimated by the management of the Company. Based on that estimate, adividend is declared each quarter and is paid out monthly over the course ofthe respective quarter. At year-end the Company may pay a bonus dividend, inaddition to the monthly dividends, to ensure that it has paid out at least 90%of its ordinary income and short-term capital gains for the year. The Companyhas a policy of retaining long-term capital gains, if any, and not paying themout as dividends.

 

53

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**Note 3. Issuance of Common Stock**

 

On September 30, 2004, theCompany closed a public offering of common stock. The Company issued 1,150,000shares of common stock at $22.75 per share, less an underwriting discount of$1.14 per share or 5%, and offering expenses of $476,168 for total net proceedsof $24,378,207.

 

**Note 4. Stock Option Plan**

 

Effective February 24, 2003 the Company adopted the Amended andRestated 2001 Equity Incentive Plan (the 2001 Plan). The Company has authorized2,000,000 shares of capital stock for the issuance of options under the 2001Plan to employees and directors. Options granted under the 2001 Plan may beexercised during a term not to exceed ten years from the date of grant. Unlessterminated sooner by the Company’s Board of Directors, the 2001 Plan willterminate on June 1, 2011 and no additional awards may be made under the2001 Plan after that date. Only employees of the Company and its subsidiariesare eligible to receive incentive stock options and both employees andnon-employee directors are eligible to receive nonstatutory stock options underthe 2001 Plan.

 

Options granted under the 2001 Plan may be either incentive stockoptions or nonstatutory stock options. The option exercise price is equal to the market price on the date ofthe grant.  For the options grantedduring fiscal year 2004, 50% vest after one year after the grant date and theremaining 50% vest on the second year anniversary of the grant date. A portionof the options granted during the fiscal years ended September 30, 2003and September 30, 2002 and each option granted during the period frominception through September 30, 2001 vest as follows: one-half of thenumber of shares issuable upon exercise of the option vested immediately on thegrant date and the remaining shares vest on the date that is one year after thegrant date. The remaining options granted during the fiscal year ended September 30,2002 vest as follows: 60% of the shares issuable upon exercise of the optionsvested immediately on the grant date and the remaining shares vest on the datethat is one year after the grant date. Some of the options granted during the fiscal year endedSeptember 30, 2003 vested at 25% on the grant date, 25% two months afterthe grant date, 25% seven months after the grant date and the final 25% vestone year and two months after the grant date.

 

The company accounts for its stock-based compensation plans inaccordance with APB 25, “Accounting for Stock Issued to Employees”.  The pro forma information below illustratesthe effect on net increase (decrease) in stockholders’ equity resulting fromoperations per share based on provisions of SFAS No. 123, “Accounting forStock-Based Compensation”, as amended by SFAS 148, “Accounting for Stock-BasedCompensation — Transition and Disclosure”, issued in December 2002.

 
| ** **                                                                                                  | ** ** | **Year Ended  September 30,  2004** | ** ** | **Year Ended  September 30,  2003** | ** ** | **Year Ended  September 30,  2002** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
|                                                                                                        |       |                                |       |                                |       |                                |       |
| Net increase (decrease) in stockholders’  equity resulting from operations                             |       |                                |       |                                |       |                                |       |
| As reported:                                                                                                |       | $                                   | 10,570,290 |                                | $          | 11,073,581                          |       | $ | 7,616,601 |   |
|                                                                                                        |       |                                |       |                                |       |                                |       |
| Deduct: Total stock-based compensation  expense determined using the fair value based method for all awards |       | (1,687,199                          | )          | (1,576,555                          | )          | (1,555,099                          | )          |
|                                                                                                        |       |                                |       |                                |       |                                |       |
| Pro forma net increase in stockholders’  equity resulting from operations per share                    |       | $                                   | 8,883,091  |                                | $          | 9,497,026                           |       | $ | 6,061,502 |   |
|                                                                                                        |       |                                |       |                                |       |                                |       |
| As reported - basic                                                                                         |       | $                                   | 1.05       |                                | $          | 1.10                                |       | $ | 0.76 |   |
| As reported - diluted                                                                                       |       | $                                   | 1.02       |                                | $          | 1.09                                |       | $ | 0.75 |   |
|                                                                                                        |       |                                |       |                                |       |                                |       |
| Pro forma-basic                                                                                             |       | $                                   | 0.88       |                                | $          | 0.94                                |       | $ | 0.60 |   |
| Pro forma-diluted                                                                                           |       | $                                   | 0.86       |                                | $          | 0.93                                |       | $ | 0.60 |   |

 

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For options granted during the fiscal year ended September 30,2004, the Company estimated a weighted-average fair value of $1.24 using aBlack-Scholes option pricing model and the following weighted-averageassumptions:  dividend yield of 6.67%,risk-free interest rate of 2.41%, expected volatility of 16.91%, and expectedlives of the options of three years.  Foroptions granted during the fiscal year ended September 30, 2003, theCompany estimated a weighted-average fair value of $2.29 using a Black-Scholesoption pricing model and the following assumptions:  dividend yield of 6.79%, risk-free interestrate of 0.95%, expected volatility of 17.71%, and expected lives of the optionsof three years.  For options grantedduring the fiscal year ended September 30, 2002, the Company estimated afair value per option on the date of grant of $1.40 using a Black-Scholesoption-pricing model and the following assumptions: dividend yield of 8.17%,risk-free interest rate of 2.02%, expected volatility of 25.8%, and expectedlives of the options of three years.

 

A summary of the status of the Company’s 2001 Plan for September 30,2002 through September 30, 2004 is as follows:

 
| ** **                                                                           | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|
|                                                                                 |       |       |       |                                 |       |
| Options outstanding at September 30, 2002,  of which 741,664 shares were exercisable |       | 811,664    |       | $                                    | 15.40      |   |
| Granted                                                                              |       | 180,000    |       | $                                    | 17.10      |   |
| Exercised                                                                            |       | (10,000    | )          | $                                    | 15.00      |   |
|                                                                                 |       |       |       |                                 |       |
| Options outstanding at September 30, 2003,  of which 841,664 shares were exercisable |       | 981,664    |       | $                                    | 15.71      |   |
| Granted                                                                              |       | 325,500    |       | $                                    | 22.20      |   |
| Exercised                                                                            |       | (46,666    | )          | $                                    | 15.15      |   |
| Options outstanding at September 30, 2004,  of which 897,496 shares are exercisable  |       | 1,260,498  |       | $                                    | 17.44      |   |

 

A detailed summary of the stock options outstanding at fiscal yearsended September 30, 2004, September 30, 2003 and September 30, 2002is presented in the following table:

 
| **Fiscal  Year Ended** | ** ** | **Range of Exercise Prices** | ** ** | **Stock Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life (Years)** | ** ** |
|------------------------|------------|------------------------------|------------|--------------------------------|------------|-----------------------------------------------------------|------------|
|                   |       |                         |       |                           |       |                                                      |       |
| September 30, 2004     |       | $15.00 -$22.84               |       | 1,260,498                      |       | 7.88                                                      |       |
| September 30, 2003     |       | $15.00 -$19.56               |       | 981,664                        |       | 8.33                                                      |       |
| September 30, 2002     |       | $15.00 - $17.18              |       | 811,664                        |       | 9.08                                                      |       |

 

During the fiscal year ended September 30, 2004, the Companyissued 46,666 shares of common stock to three employees pursuant to a stock optionexercise, in exchange for cash of $157,100 and two full recourse notesreceivable of $549,990.  During thefiscal year ended September 30, 2003, the Company issued 10,000 shares ofcommon stock to an employee pursuant to a stock option exercise, in exchangefor a full recourse note receivable of $150,000.  During the fiscal year endedSeptember 30, 2002, the Company issued 11,666 shares of common stock toemployees of the Company pursuant to stock option exercises, in exchange forfull recourse notes receivable totaling $185,890.  These transactions were effected pursuant tothe 2001 Plan, which allows the Company to lend its employees funds to pay forthe exercise of stock options. All loans made under this arrangement are fullysecured by the value of the common stock purchased. Interest is charged andpaid on such loans at the market rate as determined based on individualfinancial positions.

 

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**Note 5. Commitments and Contingencies**

 

The Company occupies its McLean, Virginia office space pursuant to alicense agreement scheduled to expire on October 31, 2004. The Company’sNew York City office facility has a service agreement scheduled to expireAugust 31, 2005.  During May 2004,the Company also entered into a service agreement for the Chicago, Illinoisoffice which is scheduled to expire on June 30, 2005. The Company also enteredinto signed term sheets for the two potential investments for the Company’sportfolio. The future scheduled contractual payments at September 30, 2004 areas follows:

 
| ** **                   | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|------------------------------|------------|------------|------------|---------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**  | ** ** | **Less than 1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than 5  Years** | ** ** |
|                         |       |       |       |                      |       |   |   |   |   |   |   |
| Office Lease Obligations     |       | 57,696     |       | 57,696                    |       |   |   |   |   |   |   |
| Investments                  |       | 13,450,000 |       | 13,450,000                |       |   |   |   |   |   |   |
| Total                        |       | $          | 13,507,696 |                      | $          | 13,507,696 |   | $ | — |   | $ | — |   | $ | — |   |
|                              |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

Effective October 1, 2004, the Companyassigned all of the outstanding leases for each of these facilities toGladstone Management Corporation.

 

**Note 6. Net Increase (Decrease) inStockholders’ Equity Resulting from Operations per Share**

 

The following table sets forth the computation of basic and diluted netincrease (decrease) in stockholders’ equity resulting from operations per sharefor the fiscal year ended September 2004, September 30, 2003, and September 30,2002:

 
| ** **                                                                                                    | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2002** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|
|                                                                                                          |       |                    |       |                    |       |                    |       |
| Numerator for basic and diluted net  increase in stockholders’ equity resulting from operation per share |       | $                       | 10,570,290 |                    | $          | 11,073,581              |       | $ | 7,616,601 |   |
|                                                                                                          |       |                    |       |                    |       |                    |       |
| Denominator for basic weighted average  shares                                                                |       | 10,101,341              |       | 10,072,677              |       | 10,064,900              |       |
| Dilutive effect of stock options                                                                              |       | 243,047                 |       | 115,811                 |       | 101,852                 |       |
| Denominator for diluted weighted average  shares                                                              |       | 10,344,388              |       | 10,188,488              |       | 10,166,752              |       |
|                                                                                                          |       |                    |       |                    |       |                    |       |
| Basic net increase in stockholers’ equity  resulting from operations per share                           |       | $                       | 1.05       |                    | $          | 1.10                    |       | $ | 0.76 |   |
|                                                                                                          |       |                    |       |                    |       |                    |       |
| Diluted net increase in stockholers’ equity  resulting from operations per share                         |       | $                       | 1.02       |                    | $          | 1.09                    |       | $ | 0.75 |   |

 

**Note 7. Related Party Transactions**

 

The Company has provided loans to employees for the exercise of optionsunder the 2001 Plan. The loans require the quarterly payment of interest at themarket rate of interest in effect at the date of issue, have varying terms notexceeding nine years and have been recorded as a reduction of stockholders’equity. The loans are evidenced by full recourse notes that are due uponmaturity or 60 days following termination of employment, and the shares ofcommon stock purchased with the proceeds of the loan are posted as collateral. Duringthe fiscal year ended September 30, 2004, the Company issued $549,990 in loansto two employees for the exercise of options and received the full repayment ofa loan that was issued during fiscal year 2002. During the fiscal year endedSeptember 30, 2003, the Company issued a $150,000 loan to an employee forthe exercise of options and received the final payment for a loan issued duringfiscal year 2001. During the fiscal year ended September 30, 2002, theCompany issued $185,890 in loans to two employees for the exercise of options.The Company recognized interest income from all employee stock option loans of  $443,658, $437,737, and  $433,391 during the fiscal years endedSeptember 30, 2004, September 30, 2003 and September 30, 2002,respectively. The outstanding principal balances due on all employee stockoption loans at September 30, 2004, September 30, 2003, and September 30,2002 were $9,432,678, $8,985,940, and $8,983,796, respectively.

 

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During the fiscal year ended September 30, 2003, the Company paidpersonnel recruiting fees totaling $2,269 to Snelling & Associates and$4,625 to Medical Funding Corporation. Anthony W. Parker, a director of the Company is the President ofSnelling & Associates and is the founder, Chairman and President of MedicalFunding Corporation. During the fiscal year ended September 30, 2002, theCompany paid personnel recruiting fees totaling $31,750 to Medical FundingCorporation. There were no such transactions during the fiscal year endedSeptember 30, 2004.

 

On July 1, 2004, the Company sold its fixed assets at cost, net ofaccumulated depreciation to Gladstone Management.

 

**Note 8. Repurchase Agreement**

 

On September 29, 2004, the Company entered into a repurchase agreement(the “Repurchase Agreement”) with Ferris Baker Watts for $44,984,950. OnSeptember 30, 2004, this amount was reduced to $21,345,997 with the applicationof the net proceeds from the public offering of common stock.  This remaining balance was settled on October1, 2004.  The Repurchase Agreement wasrecorded at cost and was fully collateralized by a United States Treasury Billwith a fair value of $50,000,000, a carrying value of $49,984,950 that maturedon October 7, 2004 and earned interest of $2,133.  The interest rate on the Repurchase Agreementwas 4.25% for a cost of $7,831.

 

On September 30, 2003, the Company entered into a repurchaseagreement with UBS for $78,449,000, which agreement was settled onOctober 1, 2003.  The agreement wasrecorded at cost and was fully collateralized by a United States Treasury Billwith a fair value of $80,050,000 and a carrying value of $80,022,249 thatmatured on October 16, 2003.  Theinterest rate on the agreement was 0.80% for a cost of $2,397.

 

A repurchase agreement involves the purchase by an investor, such asthe Company, of a specified security and the simultaneous agreement by theseller to repurchase it at an agreed-upon future date and at a price which isgreater than the purchase price by an amount that reflects an agreed-uponinterest rate. Such interest rate is effective for the period of time duringwhich the investor’s money is invested in the arrangement and is related tocurrent market interest rates rather than the coupon rate on the purchasedsecurity. The Company requires the continual maintenance by its custodian orthe correspondent in its account with the Federal Reserve/Treasury Book EntrySystem of underlying securities. In the future the Company plans to use a similarform of repurchase agreement as an investment option or in order to satisfycertain asset diversification requirements and maintain the Company’s status asa RIC under Subchapter M of the Code.

 

**Note 9. Dividends**

 

The following tableillustrates the 2004 fiscal year monthly dividends per share and the 2003 and2002 fiscal year quarterly dividends per share:

 

57

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| **Fiscal Year** | ** ** | **Record Date**    | ** ** | **Payment Date**   | ** ** | **Dividend  per Share** | ** ** | **Monthly  or  Quarterly** | ** ** |
|-----------------|------------|--------------------|------------|--------------------|------------|-------------------------|------------|----------------------------|------------|
| 2004            |       | September 17, 2004 |       | September 30, 2004 |       | $                       | 0.12       |                       | Monthly    |   |
|            |       | August 18,  2004   |       | August 31, 2004    |       | $                       | 0.12       |                       | Monthly    |   |
|            |       | July 19,  2004     |       | July 30, 2004      |       | $                       | 0.12       |                       | Monthly    |   |
|            |       | June 17,  2004     |       | June 30, 2004      |       | $                       | 0.115      |                       | Monthly    |   |
|            |       | May 17, 2004       |       | May 28, 2004       |       | $                       | 0.115      |                       | Monthly    |   |
|            |       | April 19,  2004    |       | April 30, 2004     |       | $                       | 0.115      |                       | Monthly    |   |
|            |       | March 18,  2004    |       | March 31, 2004     |       | $                       | 0.11       |                       | Monthly    |   |
|            |       | February 16,  2004 |       | February 27, 2004  |       | $                       | 0.11       |                       | Monthly    |   |
|            |       | January 19,  2004  |       | January 30, 2004   |       | $                       | 0.11       |                       | Monthly    |   |
|            |       | December 18,  2003 |       | December 31, 2003  |       | $                       | 0.11       |                       | Monthly    |   |
|            |       | November 17,  2003 |       | November 28, 2003  |       | $                       | 0.11       |                       | Monthly    |   |
|            |       | October 20,  2003  |       | October 31, 2003   |       | $                       | 0.11       |                       | Monthly    |   |
|            |       |               |       |               |       |                    |       |                       |       |
| 2003            |       | September 30, 2003 |       | October 6, 2003    |       | $                       | 0.33       |                       | Quarterly  |   |
|            |       | June 30,  2003     |       | July 7, 2003       |       | $                       | 0.29       |                       | Quarterly  |   |
|            |       | March 31,  2003    |       | April 7, 2003      |       | $                       | 0.25       |                       | Quarterly  |   |
|            |       | December 31,  2002 |       | January 7, 2003    |       | $                       | 0.23       |                       | Quarterly  |   |
|            |       |               |       |               |       |                    |       |                       |       |
| 2002            |       | September 30, 2002 |       | October 7, 2002    |       | $                       | 0.21       |                       | Quarterly  |   |
|            |       | June 28,  2002     |       | July 8, 2002       |       | $                       | 0.21       |                       | Quarterly  |   |
|            |       | March 28,  2002    |       | April 8, 2002      |       | $                       | 0.21       |                       | Quarterly  |   |
|            |       | December 31,  2001 |       | January 15, 2002   |       | $                       | 0.18       |                       | Quarterly  |   |

 

Aggregate dividends declared and paid for the 2004 fiscal year wereapproximately $13.8 million which were declared based on an estimate of netinvestment income for the year.  Sincenet investment income was lower than projected, due to the expensing of certainprepaid assets associated with financing fees surrounding the line of credit,it lead to dividends exceeding net investment income for the year byapproximately $0.5 million.  Therefore, aportion of the 2004 dividends will be treated as a return of capital to theCompany’s stockholders.

 

Aggregate dividends declared and paid for the 2002 fiscal year wereapproximately $8.2 million. The Company declared these dividends basedupon an estimate of net investment income for the year. Because of thedifficult economic climate during the year, the Company’s investment pace wasslower than originally anticipated, and consequently, net investment income waslower than originally projected. This resulted in dividends related to the 2002fiscal year exceeding net investment income for the year by approximately$0.5 million. Additionally, dividends related to the 2002 fiscal yearexceeded current and accumulated earnings and profits and, as a result, aportion of the Company’s dividends were treated as a return of capital to theCompany’s stockholders.

 

**Note 10. Managerial Assistance Fees**

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies.  The Company provides managerial assistance toits portfolio companies through its wholly-owned subsidiary, Gladstone CapitalAdvisers, Inc.  The Company receives feeincome for managerial assistance it renders to portfolio companies inconnection with its investments.  Suchfees are normally paid at the closing of the Company’s investments and aregenerally non-recurring.  Thesemanagerial assistance services vary by investment, but generally consist ofreviewing existing credit facilities, arranging bank financing, arrangingequity financing, structuring financing from multiple lenders, structuringfinancing from equity investors, restructuring existing loans, raising equityand debt capital, and providing general financial advice. Subsequent to thefiscal year ended September 30, 2004, these services will be provided byGladstone Management. For the fiscal years ended September 30, 2004, September 30,2003 and September 30, 2002, these fees totaled $1,118,106, $885,500 and$1,673,614, respectively.

 

58

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From time to time, the Company is invited to participate as a co-lenderin a transaction. In the event that the Company does not provide significantmanagerial assistance services in connection with its investment, loan feespaid to the Company in such situations are deferred and amortized over the lifeof the loan. The Company did not receive any such loan fees during the fiscalyears ended September 30, 2004, September 30, 2003, and September 30,2002.

 

**Note 11. Lines of Credit**

 

InJune 2004, the Company entered into a $15.0 million line of credit agreementwith Branch Banking and Trust Company (“BB&T Agreement”) which matures onJune 1, 2005.  Interest on outstandingborrowings is based upon the one month London Interbank Offered Rate (“LIBOR”)plus 2.5% per annum.  The unused portionof the line of credit is subject to a fee of 0.2% per annum.  The BB&T Agreement requires the Companyto meet and maintain certain covenants and ratios with respect to leverage andliquidity. As of September 30, 2004, there was $15.0 million outstanding underthe BB&T line of credit at an interest rate of 4.34%.  At September 30, 2004 the Company was incompliance with all covenants under the BB&T Agreement.

 

Through its wholly-owned subsidiary Gladstone Business Loan LLC(“Business Loan”), the Company has obtained a $100 million revolving credit facility.  On May 19, 2003, the Company executed aPurchase and Sale Agreement pursuant to which it agreed to sell certain loansto Business Loan in consideration of a membership interest therein.  Simultaneously, Business Loan executed aCredit Agreement with CIBC World Markets Inc. (“CIBC”), as administrativeagent, and others, pursuant to which Business Loan pledged the loans purchasedfrom the Company to secure future advances by certain institutionallenders.  On September 28, 2004, CIBCassigned its interest in the credit facility to Deutsche Bank AG, which expireson May 31, 2005 and can be extended at the option of Deutsche Bank AG. Interestrates charged on the advances under the facility are based on LIBOR, the PrimeRate or the Federal Funds Rate, depending on market conditions, and adjustsperiodically.  As of September 30, 2004,the outstanding principal balance under this credit facility was approximately$25.7 million at an interest rate of 3.29%.

 

The facility contains covenants that require Business Loan to maintainits status as a separate entity; prohibit certain significant corporatetransactions (such as mergers, consolidations, liquidations or dissolutions);and restrict material changes to the Company’s credit and collection policies.  The facility also restricts some of the termsand provisions (including interest rates, terms to maturity and paymentsschedules) and limits the borrower and industry concentrations of loans thatare eligible to secure advances.  As ofSeptember 30, 2004, Business Loan was in compliance with all of thefacility covenants.  The Companycurrently intends to securitize all of the loans held by Business Loan and willuse the proceeds from the securitization to pay down any amounts thenoutstanding under the revolving credit facility.

 

Gladstone Management, the Company’s affiliated servicing entity,services the loans pledged under the facility. As a condition to this servicing arrangement, the Company executed aPerformance Guaranty pursuant to which it guaranteed that Management wouldcomply fully with all of its obligations under the facility.  The Performance Guaranty requires the Companyto maintain a minimum net worth of $100 million and to maintain “assetcoverage” with respect to “senior securities representing indebtedness” of atleast 200%, in accordance with Section 18 of the 1940 Act.  As of September 30, 2004, the Company was incompliance with all covenants under the Performance Guaranty.

 

**Note 12. Interest Rate Cap Agreement**

 

Pursuant tothe CIBC World Markets, Inc. line of credit, the Company agreed to enter intohedging transactions, and as such purchased an interest rate cap agreement inFebruary 2004 as a result of borrowings under the line of credit.  The transaction effectively limits theinterest rate on a portion of these borrowings.

 

The use of acap involves risks that are different from those associated with ordinaryportfolio securities transactions.  Capagreements may be considered to be illiquid. Although the Company will not enter into any such agreements unless itbelieves that the other party to the transaction is creditworthy, the Companydoes bear the risk of loss of the amount expected to be received under suchagreements in the event of default or bankruptcy of the agreement counterparty.

 

59

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In February2004, the Company entered into an interest rate cap agreement with a notionalamount of $35.0 million at a cost of $304,000 and a current fair value ofapproximately $89,741 which is recorded in other assets on the Company’sconsolidated balance sheet at September 30, 2004.  The Company records changes in the fair valueof the interest rate cap agreement monthly based on the current market valuationat month end as unrealized depreciation or appreciation on derivative on theCompany’s consolidated statement of operations. The interest rate cap agreementexpires in February 2009. The agreement provides that the Company’s floatinginterest rate or cost of funds on a portion of the portfolio’s borrowings willbe capped at 5% when the LIBOR rate is in excess of 5%.

 

**Note 13. Deferred Compensation Plan**

 

The Company has adopted a deferred compensation plan (the 401(k) Plan)effective January 1, 2002. The 401(k) Plan permits an employee to defer thelesser of 75% of his or her total annual compensation or the applicableInternal Revenue Service (IRS) annual limit. Employees of the Company areeligible to participate in the 401(k) Plan upon completion of 1,000 hoursof service within the first six months of employment or after one year ofservice. The service requirement has been waived for those employees who wereemployed by the Company as of January 1, 2002. As of September 30, 2004,the Company funded $50,630 and as of September 30, 2003, the Companyfunded $23,987 in contributions to the 401(k) Plan. The Company has received adetermination letter from the IRS concurring that the deferred compensationplan satisfies the qualification requirements of the Code. For the fiscal yearsended September 30, 2004, September 30, 2003 and September 30, 2002,the Company recorded $48,502, $48,877 and $23,569, respectively, in expensesrelated to the 401(k) Plan.

 

**Note 14.  Subsequent Events**

 

In October 2004, the Company sold its entire interest in Burt’s Bees,Inc. for a premium of $9,750.  InNovember 2004, the Company purchased a $9.0 million syndicated participation inTech Lighting Inc. and an $8.0 million syndicated participation in ValorTelecommunications, Inc. and funded new loans to Global Materials Technology,Inc. for $5.5 million and to Santana Products, Inc. for $7.95 million. TheCompany received full repayments of two investments: America’s Water HeaterRentals repaid its entire loan of $12.0 million and remitted exit costs of$1,440,000 and A and G, Inc. repaid its entire loan of $12.25 million.

 

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**Note 15. Financial Highlights**

 
| ** **                                            | ** ** | **Year Ended  September 30,  2004** | ** **  | **Year Ended  September 30,  2003** | ** ** | **Year Ended  September 30,  2002** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|-------------|-------------------------------------|------------|-------------------------------------|------------|
|                                                  |       |                                |        |                                |       |                                |       |
| Per Share Data (1)                                    |       |                                |        |                                |       |                                |       |
| Net asset value at beginning of period                |       | $                                   | 12.97       |                                | $          | 12.97                               |       | $ | 13.05 |   |
| *Income from investment operations:*                  |       |                                |        |                                |       |                                |       |
| Net investment income (4)                             |       | 1.32                                |        | 1.12                                |       | 0.76                                |       |
| Realized gain on sale of investment (4)               |       | —                              |        | —                              |       | —                              |       |
| Net unrealized gain/(loss) on investments  (4)        |       | (0.25                               | )           | (0.02                               | )          | —                              |       |
| Net unrealized (loss) on derivatives (4)              |       | (0.02                               | )           | —                              |       | —                              |       |
| Total from investment operations                      |       | 1.05                                |        | 1.10                                |       | 0.76                                |       |
| Less distributions:                                   |       |                                |        |                                |       |                                |       |
| Distributions from net investment income              |       | (1.25                               | )           | (1.10                               | )          | (0.76                               | )          |
| Tax return of capital distribution                    |       | (0.12                               | )           | —                              |       | (0.05                               | )          |
| Total distributions                                   |       | (1.37                               | )           | (1.10                               | )          | (0.81                               | )          |
| Issuance of common stock under shelf  offering        |       | 0.99                                |        | —                              |       | —                              |       |
| Issuance of common stock under stock option  plan     |       | 0.01                                |        | —                              |       | (0.02                               | )          |
| Offering costs and underwriting discount              |       | (0.16                               | )           | —                              |       | (0.01                               | )          |
| Repayment of principal on notes receivable            |       | 0.01                                |        | —                              |       | —                              |       |
| Net asset value at end of period                      |       | $                                   | 13.50       |                                | $          | 12.97                               |       | $ | 12.97 |   |
|                                                  |       |                                |        |                                |       |                                |       |
| Per share market value at beginning of  period        |       | $                                   | 19.45       |                                | $          | 16.88                               |       | $ | 16.14 |   |
| Per share market value at end of period               |       | 22.71                               |        | 19.45                               |       | 16.88                               |       |
| Total Return (2)(3)                                   |       | 24.40                               | %           | 21.74                               | %          | 9.60                                | %          |
| Shares outstanding at end of period                   |       | 11,278,510                          |        | 10,081,844                          |       | 10,071,844                          |       |
|                                                  |       |                                |        |                                |       |                                |       |
| Ratios/Supplemental Data                              |       |                                |        |                                |       |                                |       |
| Net assets at end of period                           |       | $                                   | 152,226,655 |                                | $          | 130,802,382                         |       | $ | 130,663,273 |   |
| Average net assets                                    |       | $                                   | 130,385,129 |                                | $          | 132,196,505                         |       | $ | 130,984,674 |   |
| Ratio of expenses to average net assets               |       | 5.45                                | %           | 2.92                                | %          | 2.17                                | %          |
| Ratio of net investment income to average  net assets |       | 10.20                               | %           | 8.38                                | %          | 5.81                                | %          |

 

----

(1)           Basicper share data.

(2)           For the fiscal year ended September 30, 2004,the total return equals the increase of the ending market value over thebeginning market value plus monthly dividends divided by the monthly beginningmarket value, assuming monthly dividend reinvestment. For fiscal yearsended September 30, 2003 and 2002, total return equals the increase of theending market value over the beginning market value, plus distributions,divided by the beginning market value, assuming quarterly dividendreinvestment.

(3)           Amountswere not annualized.

(4)           Weighted average basicper share data was used.

 

61

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**Note 16.Selected Quarterly Data (Unaudited)**

 
| ** **                                                           | ** ** | **Year Ended September 30, 2004**     | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                           | ** ** | **Quarter Ended  December 31,  2003** | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended  June 30, 2004** | ** ** | **Quarter Ended  September 30,  2004** | ** ** |
|                                                                 |       |                                  |       |   |   |   |   |   |   |
| Total Investment Income                                              |       | $                                     | 3,967,949  |   | $ | 4,367,920 |   | $ | 6,709,810 |   | $ | 5,350,289 |   |
| Net Investment Income                                                |       | 2,938,636                             |       | 3,121,558 |   | 4,730,631 |   | 2,501,950 |   |
| Net Increase in Stockholders’ Equity  Resulting From Operations |       | 1,381,074                             |       | 2,828,583 |   | 5,609,893 |   | 750,740 |   |
|                                                                 |       |                                  |       |   |   |   |   |   |   |
| Basic Earnings per Common Share                                      |       | $                                     | 0.14       |   | $ | 0.28 |   | $ | 0.56 |   | $ | 0.07 |   |
| Diluted Earning per Common Share                                     |       | $                                     | 0.13       |   | $ | 0.27 |   | $ | 0.54 |   | $ | 0.08 |   |

 
| ** **                                                           | ** ** | **Year Ended September 30, 2003**     | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                           | ** ** | **Quarter Ended  December 31,  2002** | ** ** | **Quarter Ended  March 31,  2003** | ** ** | **Quarter Ended  June 30, 2003** | ** ** | **Quarter Ended  September 30,  2003** | ** ** |
|                                                                 |       |                                  |       |   |   |   |   |   |   |
| Total Investment Income                                              |       | $                                     | 3,235,432  |   | $ | 3,859,293 |   | $ | 4,059,744 |   | $ | 4,000,405 |   |
| Net Investment Income                                                |       | 2,412,154                             |       | 2,919,591 |   | 3,115,736 |   | 2,848,440 |   |
| Net Increase in Stockholders’ Equity  Resulting From Operations |       | 2,412,154                             |       | 3,662,015 |   | 2,370,899 |   | 2,628,513 |   |
|                                                                 |       |                                  |       |   |   |   |   |   |   |
| Basic Earnings per Common Share                                      |       | $                                     | 0.24       |   | $ | 0.36 |   | $ | 0.24 |   | $ | 0.26 |   |
| Diluted Earning per Common Share                                     |       | $                                     | 0.24       |   | $ | 0.36 |   | $ | 0.23 |   | $ | 0.26 |   |

 

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**Item 9****. Changes in and Disagreements with Accountants onAccounting and Financial Disclosure**

 

On December 19, 2002, we dismissed Ernst & Young LLP(“Ernst & Young”) as our independent auditor and on December 19,2002 engaged PricewaterhouseCoopers LLP (“PwC”) as its new independent auditorfor the fiscal year ending September 30, 2003. Our decision to changeauditors was made by our Audit Committee.

 

Ernst & Young’s reports on our consolidated financialstatements for the fiscal year ended September 30, 2002 and the periodfrom May 30, 2001 (inception) through September 30, 2001 did notcontain an adverse opinion or disclaimer of opinion, nor were they qualified ormodified as to uncertainty, audit scope or accounting principles.

 

In connection with the audits of our financial statements for thefiscal year ended September 30, 2002 and the period from May 30, 2001(inception) through September 30, 2001, and in the subsequent interimperiod, there were no disagreements with Ernst & Young on any mattersof accounting principles or practices, financial statement disclosure, orauditing scope and procedures which, if not resolved to the satisfaction ofErnst & Young, would have caused Ernst & Young to makereference to the matter in its report. There were no “reportable events” asthat term is described in Item 304(a)(1)(v) of Regulation S-K.

 

We have requested Ernst & Young to furnish a letter addressedto the SEC stating whether it agrees with the above statements. A copy of thatletter, dated December 20, 2002, is filed as Exhibit 16.1 to ourCurrent Report on Form 8-K filed on December 20, 2002.

 

During the fiscal year ended September 30, 2002 and the periodfrom May 30, 2001 (inception) through September 30, 2001, and throughthe date of the engagement of PwC, we did not consult PwC with respect to theapplication of accounting principles to a specified transaction, eithercompleted or proposed, or the type of audit opinion that might be rendered onour consolidated financial statements, or regarding any other matters orreportable events described under Item 304(a)(2)(i) and (ii) ofRegulation S-K.

 

**Item 9A****. Controls and Procedures.**

 

As of September 30, 2004 (the end of the period covered by thisreport), we, including our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures.  Based on thatevaluation, our management, including the Chief Executive Officer and ChiefFinancial Officer, concluded that our disclosure controls and procedures wereeffective in timely alerting management, including the Chief Executive Officerand Chief Financial Officer, of material information about us required to beincluded in periodic SEC filings. However, in evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

There have been no changes in our internal control over financialreporting that occurred during the fiscal year ended September 30, 2004,that have materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Item 9B****. Other Information.**

 

Not applicable.

 

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**PART III**

 

We will file a definitive Proxy Statement for our 2005 AnnualMeeting of Stockholders (the “2005 Proxy Statement”) with the SEC, pursuant toRegulation 14A, not later than 120 days after the end of our fiscalyear. Accordingly, certain information required by Part III has beenomitted under General Instruction G(3) to Form 10-K. Only those sectionsof the 2005 Proxy Statement that specifically address the items set forthherein are incorporated by reference.

 

**Item 10****. Directors and Executive Officers of the Registrant**

 

The information required by Item 10 is hereby incorporated by referencefrom our 2005 Proxy Statement under the captions “Election of Directors” and“Section 16(a) Beneficial Ownership Reporting Compliance.”  All members of the Audit Committee have beendesignated by the Board of Directors as financial experts.

 

**Item 11****. Executive Compensation**

 

The information required by Item 11 is hereby incorporated by referencefrom our 2005 Proxy Statement under the caption “Compensation of Directors andExecutive Officers.”

 

**Item 12****. Security Ownership of Certain Beneficial Owners andManagement**

 

The information required by Item 12 is hereby incorporated by referencefrom our 2005 Proxy Statement under the caption “Security Ownership of CertainBeneficial Owners and Management.”

 

**Item 13****. Certain Relationships and Related Transactions**

 

The information required by Item 13 is hereby incorporated by referencefrom our 2005 Proxy Statement under the caption “Certain Transactions.”

 

**Item 14****. Principal Accountant Fees and Services.**

 

The information required by Item 14 is hereby incorporated by referencefrom our 2005 Proxy Statement under the caption “Audit Fees.”

 

64

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**PART IV**

 

**Item 15****. Exhibits, Financial Statement Schedules, and Reportson Form 8-K**

 

**a.****             DOCUMENTSFILED AS PART OF THIS REPORT**

 

1.             Thefollowing financial statements are filed herewith:

 
| Reports of Independent Registered Public  Accounting Firms                                                                                  |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets as of September 30, 2004 and  September 30, 2003                                                      |   |
| Consolidated Schedule of Investments as of September 30,  2004                                                                    |   |
| Consolidated Schedule of Investments  as of September 30, 2003                                                                    |   |
| Consolidated Statements of Operations for  the years ended September 30, 2004, September 30, 2003 and  September 30, 2002         |   |
| Consolidated Statement of Stockholders  Equity for the years ended September 30, 2004, September 30, 2003 and  September 30, 2002 |   |
| Consolidated Statements of Cash Flows for  the years ended September 30, 2004, September 30, 2003 and  September 30, 2002         |   |
| Notes to Financial Statements                                                                                                               |   |

 

2.             Financialstatement schedules

 

No financial statement schedules are filed herewith because(1) such schedules are not required or (2) the information has beenpresented in the aforementioned financial statements.

 

3.             Exhibits

The following exhibits are filed as part of this report or herebyincorporated by reference to exhibits previously filed with the SEC:

 
| 3.1   |   | Articles of Amendment and Restatement of the Articles of  Incorporation, incorporated by reference to Exhibit a.2 to Pre-Effective  Amendment No. 1 to the Registration Statement on Form N-2 (File  No. 333-63700), filed July 27, 2001.                                                                                                            |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | By-laws, incorporated by reference to Exhibit b to Pre-Effective  Amendment No. 1 to the Registration Statement on Form N-2 (File No. 333-63700),  filed July 27, 2001.                                                                                                                                                                              |
| 3.3   |   | Amendment to By-laws, incorporated by reference to Exhibit 3.3 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended December 31,  2003 (File No. 814-00237), filed February 117, 2004.                                                                                                                                                                  |
| 4.1   |   | Form of Direct Registration Transaction Advice for the Company’s  common stock, par value $0.001 per share, the rights of holders of which are  defined in exhibits 3.1 and 3.2, incorporated by reference to Exhibit d  to Pre-Effective Amendment No. 1 to the Registration Statement on  Form N-2 (File No. 333-63700), filed July 27, 2001. |
| 4.2   |   | Specimen Stock Certificate, incorporated by reference to  Exhibit d.2 to Pre-Effective Amendment No. 3 to the Registration  Statement on Form N-2 (File No. 333-63700), filed August 23,  2001.                                                                                                                                                      |
| 10.1* |   | Employment Agreement, dated June 25, 2001, between the Company  and David Gladstone, incorporated by reference to Exhibit k.2 to  Pre-Effective Amendment No. 1 to the Registration Statement on  Form N-2 (File No. 333-63700), filed July 27, 2001.                                                                                           |
| 10.2* |   | Employment Agreement, dated July 23, 2001, between the Company  and Terry Lee Brubaker, incorporated by reference to Exhibit k.3 to  Pre-Effective Amendment No. 1 to the Registration Statement on  Form N-2 (File No. 333-63700), filed July 27, 2001.                                                                                        |
| 10.3* |   | Amendment to Employment Agreement, dated August 8, 2001, between  the Company and David Gladstone, incorporated by reference to  Exhibit k.4 to Pre-Effective Amendment No. 2 to the Registration  Statement on Form N-2 (File No. 333-63700), filed August 10,  2001.                                                                          |
| 10.4* |   | Employment Agreement, dated September 12, 2002, between the  Company and George Stelljes III, incorporated by reference to  Exhibit k.5 to Registration Statement on Form N-2 (File  No. 333-100385), filed October 7, 2002.                                                                                                                         |

 

 
| 10.5   |   | Promissory Note of David Gladstone in favor of the Company, dated  August 23, 2001, incorporated by reference to Exhibit 10.4 to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2001, filed October 4, 2001.                                             |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6   |   | Promissory Note of Terry Brubaker in favor of the Company, dated  August 23, 2001, incorporated by reference to Exhibit 10.5 to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2001, filed October 4, 2001.                                              |
| 10.7   |   | Promissory Note of Harry Brill in favor of the Company, dated  August 23, 2001, incorporated by reference to Exhibit 10.6 to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2001, filed October 4, 2001.                                                 |
| 10.8   |   | Subscription Agreement dated May 30, 2001, incorporated by  reference to Exhibit p to the Registration Statement on Form N-2  (File No. 333-63700), filed June 22, 2001.                                                                                                                   |
| 10.9*  |   | Investment Advisory and Administrative Agreement dated as of October  1, 2004 between the Company and Gladstone Management Corporation.                                                                                                                                                                             |
| 10.10* |   | Amended and Restated 2001 Equity Incentive Plan, incorporated by  reference to Exhibit i.1 to Pre-Effective Amendment No. 1 to the  Registration Statement on Form N-2 (File No. 333-63700), filed  July 27, 2001.                                                                    |
| 10.11* |   | First Amendment to Amended and Restated 2001 Equity Incentive Plan,  incorporated by reference to Exhibit i.3 to Pre-Effective Amendment  No. 2 to the Registration Statement on Form N-2  (File No. 333-63700), filed August 10, 2001.                                               |
| 10.12* |   | Form of Stock Option Agreement, incorporated by reference to Exhibit i.2  to Pre-Effective Amendment No. 1 to the Registration Statement on  Form N-2 (File No. 333-63700), filed July 27, 2001.                                                                                      |
| 10.13* |   | Form of Early Exercise Stock Purchase Agreement, incorporated by  reference to Exhibit i.4 to Pre-Effective Amendment No. 3 to the  Registration Statement on Form N-2 (File No. 333-63700), filed  August 23, 2001.                                                                  |
| 10.14* |   | Second Amendment to Amended and Restated 2001 Equity Incentive Plan,  incorporated by reference to Exhibit i.5 to the Registration Statement  on Form N-2 (File No. 333-100385), filed October 7, 2002.                                                                                         |
| 10.15* |   | Third Amendment to Amended and Restated 2001 Equity Incentive Plan,  incorporated by reference to Exhibit i.6 to Pre-Effective Amendment No. 2 to  the Registration Statement on Form N-2 (File No. 333-100385), filed February  28, 2003.                                                                          |
| 10.16  |   | Credit Agreement dated as of May 19, 2003 between Gladstone  Business Loan LLC and CIBC World Markets Corporation, incorporated by  reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for  the quarter ended June 30, 2003 (File No. 814-00237), filed  August 14, 2003. |
| 10.17  |   | Amendment No. 1 to Credit Agreement dated as of September 17,  2003, incorporated by reference to the Company’s Annual Report on Form 10-K  for the fiscal year ended September 30, 2003 (File No. 814-00237), filed  December 11, 2003.                                                        |
| 10.18  |   | Facility License Agreement, dated November 1, 2003, between the  Company and Teqcorner LLC, incorporated by reference to the Company’s Annual  Report on Form 10-K for the fiscal year ended September 30, 2003 (File No.  814-00237), filed December 11, 2003.                                 |
| 10.19  |   | Amendment No. 2 to Credit Agreement dated as of February 6,  2004, incorporated by reference to Exhibit 10.19 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 2004 (File No.  814-00237), filed May 13, 2004.                                              |
| 10.20  |   | Amendment No. 3 to Credit Agreement dated as of May 28, 2004,  incorporated by reference to Exhibit 10.20 to the Company’s Quarterly Report  on Form 10-Q for the quarter ended June 30, 2004 (File No. 814-00237),  filed August 10, 2004.                                                     |
| 10.21  |   | Second Amendment to Employment Agreement dated July 15, 2003 between  the Company and David Gladstone, incorporated by reference to Exhibit k.14 to  Post-Effective Amendment No. 2 to the Registration Statement on Form N-2  (File No. 333-100385), filed July 15, 2004.                                          |
| 10.22  |   | Amendment to Employment Agreement dated July 15, 2003 between  the Company and Terry Lee Brubaker, incorporated by reference to Exhibit k.15  to Post-Effective Amendment No. 2 to the Registration Statement on Form N-2  (File No. 333-100385), filed July 15, 2004.                                              |
| 10.23  |   | Amendment to Employment  Agreement dated July 15, 2003 between the Company and George Stelljes III,  incorporated by reference to Exhibit k.16 to Post-Effective Amendment No. 2  to the Registration Statement on Form N-2 (File No. 333-100385), filed July  15, 2004.                                            |

 
| 10.24 |   | Third Amendment to  Employment Agreement dated April 22, 2004 between the Company and David  Gladstone, incorporated by reference to Exhibit k.17 to Post-Effective  Amendment No. 2 to the Registration Statement on Form N-2 (File No.  333-100385), filed July 15, 2004.  |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25 |   | Second Amendment to  Employment Agreement dated May 6, 2004 between the Company and Terry Lee  Brubaker, incorporated by reference to Exhibit k.18 to Post-Effective Amendment  No. 2 to the Registration Statement on Form N-2 (File No. 333-100385), filed  July 15, 2004. |
| 10.26 |   | Second Amendment to Employment Agreement dated May 6, 2004  between the Company and George Stelljes III, incorporated by reference to  Exhibit k.19 to Post-Effective Amendment No. 2 to the Registration Statement  on Form N-2 (File No. 333-100385), filed July 15, 2004. |
| 10.27 |   | Loan Agreement dated as  of June 22, 2004 between the Company and Branch Banking and Trust Company,  incorporated by reference to Exhibit k.20 to Post-Effective Amendment No. 2  to the Registration Statement on Form N-2 (File No. 333-100385), filed July  15, 2004.     |
| 10.28 |   | Amendment No. 4 to Credit Agreement dated as of September 28, 2004,  incorporated by reference to Exhibit 10.1 to the Company’s Current Report on  Form 8-K (File no. 814-00237), filed on October 1, 2004.                                                             |
| 11    |   | Computation of Per Share Earnings (included in the notes to the  audited financial statements contained in this report).                                                                                                                                                     |
| 21    |   | Subsidiaries of the Registrant.                                                                                                                                                                                                                                              |
| 23.1  |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                       |
| 23.2  |   | Consent of Ernst & Young LLP.                                                                                                                                                                                                                                            |
| 31.1  |   | Certification of Chief Executive Officer pursuant to section 302  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                    |
| 31.2  |   | Certification of Chief Financial Officer pursuant to section 302  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                    |
| 32.1  |   | Certification of Chief Executive Officer pursuant to section 906  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                    |
| 32.2  |   | Certification of Chief Financial Officer pursuant to section 906  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                    |

 

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*              Denotesmanagement contract or compensatory plan or arrangement.

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| ** **                   | **GLADSTONE CAPITAL CORPORATION** |
|------------------------------|-----------------------------------|
| ** **                   | ** **                        | ** ** |
| Date: December 14, 2004 | By:                               | /s/ HARRY BRILL |
|                         |                              | Harry Brill |
|                         |                              | Chief Financial Officer and Treasurer |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacity and on the datesindicated.

 
| Date: December 14, 2004 | By:    | /s/ DAVID GLADSTONE                                                                           |
|------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                         |   | David Gladstone                                                                               |
|                         |   | Chief Executive Officer and Chairman of the Board of Directors  (principal executive officer) |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ TERRY LEE BRUBAKER                                                                        |
|                         |   | Terry Lee Brubaker                                                                            |
|                         |   | Vice Chairman, Chief Operating Officer and Director                                      |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ HARRY BRILL                                                                               |
|                         |   | Harry Brill                                                                                   |
|                         |   | Chief Financial Officer  (principal financial and accounting officer)                         |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ GEORGE STELLJES, III                                                                      |
|                         |   | George Stelljes, III                                                                          |
|                         |   | President, Chief Investment Officer and Director                                              |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ DAVID A.R. DULLUM                                                                         |
|                         |   | David A.R. Dullum                                                                             |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ ANTHONY W. PARKER                                                                         |
|                         |   | Anthony W. Parker                                                                             |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ MICHELA A. ENGLISH                                                                        |
|                         |   | Michela A. English                                                                            |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ PAUL ADELGREN                                                                             |
|                         |   | Paul Adelgren                                                                                 |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ MAURICE COULON                                                                            |
|                         |   | Maurice Coulon                                                                                |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 14, 2004 | By:    | /s/ JOHN OUTLAND                                                                              |
|                         |   | John Outland                                                                                  |
|                         |   | Director                                                                                      |

 

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