**UNITED STATES**SECURITIES AND EXCHANGE COMMISSION

**WASHINGTON, DC 20549**

** **

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**FORM 10-K**

**(MarkOne)**
| **x**                                 | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**                              |
|---------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|
| ** **                            | ** ** | ** **                                                                                                                  |
| ** **                            | ** ** | **for the fiscal year ended September 30, 2006**                                                                       |
| ** **                            | ** ** | ** **                                                                                                                  |
| ** **                            | ** ** | **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 as specified in its charter)

 

| **Maryland**                                                     |   | **54-2040781**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **1521  Westbranch Drive, Suite 200  McLean, Virginia**          |   | **22102**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

** **

**(703) 287-5800**

(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 valueper share**

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.YES o NO x.

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.YES o NO x.

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days.   YES  x  NO  o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer (asdefined in Rule 12b-2 of the Exchange Act). Large Accelerated filer  o Accelerated filer  x  Non-Accelerated filer  o.

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12 b-2of the Exchange Act).YES o NO x.

The aggregate market value of the voting stock heldby non-affiliates of the Registrant on March 31, 2006, based on the closingprice on that date of $21.55 on the Nasdaq National Market, was $227,072,091.For the purposes of calculating this amount only, all directors and executiveofficers of the Registrant have been treated as affiliates.

There were 12,310,008 shares of the Registrant’sCommon Stock, $0.001 par value, outstanding as of December 1, 2006.

**Documents Incorporated byReference.** Portions ofthe Registrant’s Proxy Statement relating to the Registrant’s 2007 AnnualMeeting of Stockholders are incorporated by reference into Part III ofthis Report.

 

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**GLADSTONE CAPITALCORPORATIONFORM 10-K FOR THE FISCAL YEAR ENDEDSEPTEMBER 30, 2006**

**TABLE OF CONTENTS**

 
| PART I     |   | Item 1   |   | Business                                                                                                           |   |   |
|------------|--------|----------|--------|--------------------------------------------------------------------------------------------------------------------|--------|--------|
|       |   | Item 1A  |   | Risk Factors                                                                                                       |   |   |
|       |   | Item 1B  |   | Unresolved Staff Comments                                                                                          |   |   |
|       |   | 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 and Financial Statement Schedules                                                                         |   |   |
| SIGNATURES |   |     |   |                                                                                                               |   |   |

 

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**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 factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others:(1) adverse changes in interest rates; (2) our failure or inabilityto establish or maintain referral arrangements with leveraged buyout funds andventure capital funds to generate loan opportunities; (3) the loss of oneor more of our executive officers, in particular David Gladstone, Terry LeeBrubaker, or George Stelljes III; (4) our inability to extend, refinance,or maintain our credit facilities on terms reasonably acceptable to us, if atall, in future equity capital resources; (5) our inability to successfullysecuritize our 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 of 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.*

**PART I**

**Item 1. Business**

**About Gladstone Capital Corporation**

Weare a specialty finance company that was incorporated under the GeneralCorporation Laws of the State of Maryland on May 30, 2001 and completedour initial public offering on August 24, 2001. We operate as aclosed-end, non-diversified management investment company, and have elected tobe treated as a business development company under the Investment Company Actof 1940, as amended, which we refer to in this annual report as the 1940 Act.In addition, for tax purposes we have elected to be treated as a regulatedinvestment company, or RIC, under the Internal Revenue Code of 1986, asamended.

Weseek 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 substantiallyowned by leveraged buyout funds, venture capital funds or are family-ownedbusinesses. 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.

Weseek to invest in small and medium-sized private U.S. businesses that meetcertain criteria, including the potential for growth, adequate assets for loancollateral, experienced management teams with significant ownership interest inthe business, adequate capitalization, profitable operations based on cashflow, substantial ownership by leveraged buyout funds or venture capital fundsand potential opportunities for us to realize appreciation and gain liquidityin our equity positions.  We may achieveliquidity through a merger or acquisition of the borrower, a public offering ofthe borrower’s stock or by exercising our right to require the borrower torepurchase our warrants, though there can be no assurance that we will alwayshave these rights.

Weseek to invest primarily in three categories of debt of private companies:

·      *Senior Subordinated Notes. *Weseek to invest a portion of our assets in senior subordinated notes.  Holders of senior subordinated notes aresubordinated to the rights of holders of senior debt in their right to receiveprincipal and interest payments or, in the case of last out tranches of seniordebt, liquidation proceeds from the borrower. As a result, senior subordinated notes are riskier than senior notes.  Although such loans are sometimes secured bysignificant collateral, the lender is largely dependent on the borrower’s cashflow for repayment.  Additionally,lenders may receive warrants to acquire shares of stock in borrowers or otheryield enhancements in connection with these loans.  Senior subordinated notes include second lienloans and syndicated second lien loans.

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·      *Senior Notes.*  We seekto invest a portion of our assets in senior notes of borrowers.  Using its assets and cash flow as collateral,the borrower typically uses senior notes to cover a substantial portion of thefunding needed to operate.  Seniorlenders are exposed to the least risk of all providers of debt because theycommand a senior position with respect to scheduled interest and principalpayments.  However, unlike seniorsubordinated and junior subordinated lenders, these senior lenders typically donot receive any stock, warrants to purchase stock of the borrowers or otheryield enhancements.  As such, theygenerally do not participate in the equity appreciation of the value of thebusiness. Senior notes may include revolving lines of credit, senior termloans, senior syndicated loans and senior last-out tranche loans.

·      *Junior Subordinated Notes.* We also seek to invest a small portion of our assets in juniorsubordinated notes.  Holders of juniorsubordinated notes are subordinated to the rights of the holders of senior debtand senior subordinated debt in their rights to receive principal and interestpayments from the borrower.  The riskprofile of junior subordinated notes is high, which permits the juniorsubordinated lender to obtain higher interest rates and more equity andequity-like compensation.

Approximately69% of the aggregate value of our investment portfolio as of September 30, 2006was senior debt, approximately 31% was senior subordinated debt and there wereno investments in junior subordinated debt. As of September 30, 2006, we had approximately $216 million invested in32 portfolio companies.

 
| ** **                                     | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | ** **                       | ** ** | **% of**                    | ** ** | ** ** | ** ** | **% of** | ** ** |
| **Industry Classification**               | ** ** | **Fair Value**              | ** ** | **Total Investments**       | ** ** | **Fair Value** | ** ** | **Total Investments** | ** ** |
|                                           |       |                             |       |                             |       |   |   |   |   |
| Aerospace &  Defense                       |       | $                                | 5,529,891  |                             | 2.6        | % | $ | 15,021,732 |   | 7.6 | % |
| Automobile                                     |       | 6,332,906                        |       | 2.9                              | %          | 9,212,906 |   | 4.6 | % |
| Cargo Transport                                |       | 8,650,000                        |       | 4.0                              | %          | 8,627,500 |   | 4.3 | % |
| Chemicals,  Plastics & Rubber              |       | 31,105,148                       |       | 14.3                             | %          | 11,924,751 |   | 5.9 | % |
| Diversified/Conglomerate  Manufacturing        |       | —                           |       | 0.0                              | %          | 5,050,000 |   | 2.5 | % |
| Ecological                                     |       | —                           |       | 0.0                              | %          | 6,367,083 |   | 3.2 | % |
| Electronics                                    |       | 33,360,123                       |       | 15.3                             | %          | 39,744,432 |   | 19.8 | % |
| Entertainment                                  |       | 3,491,250                        |       | 1.6                              | %          | — |   | 0.0 | % |
| Farming &  Agriculture                     |       | 709,431                          |       | 0.3                              | %          | 8,032,114 |   | 4.0 | % |
| Healthcare,  Education & Childcare         |       | 16,707,500                       |       | 7.7                              | %          | 7,500,000 |   | 3.7 | % |
| Home &  Office Furnishings                 |       | 20,636,991                       |       | 9.5                              | %          | 14,898,968 |   | 7.4 | % |
| Mining, Steel,  Iron & Non-precious Metals |       | 5,233,750                        |       | 2.4                              | %          | 5,486,250 |   | 2.7 | % |
| Oil & Gas                                  |       | 6,056,250                        |       | 2.8                              | %          | 5,037,500 |   | 2.5 | % |
| Personal &  Non-durable Consumer Products  |       | —                           |       | 0.0                              | %          | 15,427,377 |   | 7.7 | % |
| Personal, Food  and Miscellaneous Services     |       | 6,011,288                        |       | 2.8                              | %          | — |   | 0.0 | % |
| Printing,  Publishing & Broadcasting       |       | 16,203,000                       |       | 7.4                              | %          | 7,064,500 |   | 3.5 | % |
| Retail Stores                                  |       | 14,981,250                       |       | 6.9                              | %          | — |   | 0.0 | % |
| Telecommunications                             |       | 23,596,040                       |       | 10.8                             | %          | 20,153,920 |   | 10.0 | % |
| Textiles &  Leather                        |       | 13,785,932                       |       | 6.3                              | %          | 15,265,019 |   | 7.6 | % |
| Utilities                                      |       | 5,252,000                        |       | 2.4                              | %          | 6,032,711 |   | 3.0 | % |
| **Total**                                      |       | 217,642,750                      |       | 100.0                            | %          | 200,846,763 |   | 100.0 | % |
|                                                |            |                                  |            |                                  |            |  |  |  |  |  |  |

 

Ourloans typically range from $5 million to $15 million, generally mature in nomore than seven years, and accrue interest at a fixed or variable rate thatexceeds the prime rate.  Because themajority of the loans in our portfolio consist of term debt of private companieswho typically cannot or will not expend the resources to have their debtsecurities rated by a credit rating agency, we expect that most if not all ofthe debt securities we acquire will be unrated. Accordingly, we cannot accurately predict what ratings these loans mightreceive if they were in fact rated, and thus cannot determine whether or notthey could be considered “investment grade” quality.

Wehold our loan investment portfolio through our wholly-owned subsidiary,Gladstone Business Loan LLC.

**About Gladstone Management Corporation**

Ouraffiliate Gladstone Management Corporation (the “Adviser” or “GMC”) is ourexternal investment adviser and is led by a management team which has extensiveexperience in our lines of business.  GMCis controlled by David Gladstone, our chairman and chief executiveofficer.  Mr. Gladstone is also thechairman and chief executive officer of GMC. Terry Lee Brubaker, our vice 

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chairman,chief operating officer and director, is also a member of the Board ofDirectors of GMC and its vice chairman and chief operating officer.  George Stelljes III, our president, chiefinvestment officer and director, is a member of the Board of Directors of GMCand its president and chief investment officer. Harry Brill, our chief financial officer, is the chief financial officerof GMC.

GMCalso provides investment advisory and administrative services to our affiliatesGladstone Commercial Corporation (“Gladstone Commercial”), a publicly tradedreal estate investment trust; Gladstone Investment Corporation (“GladstoneInvestment”), a publicly traded business development company; and GladstoneLand Corporation, an agricultural real estate company owned by Mr. Gladstone.All of our directors and executive officers serve as either directors orexecutive officers, or both, of Gladstone Commercial and GladstoneInvestment.  In the future, GMC mayprovide investment advisory and administrative services to other funds, bothpublic and private, of which it is the sponsor.

Wehave been externally managed by GMC pursuant to an investment advisory andadministrative agreement since October 1, 2004. GMC was organized as a corporation under the laws of the State ofDelaware on July 2, 2002, and is a registered investment adviser under theInvestment Advisers Act of 1940, as amended. GMC is headquartered in McLean, Virginia, a suburb of Washington, DC,and has offices in New York, New York, Chicago, Illinois, Pittsburgh,Pennsylvania, Morristown, New Jersey, Lexington, Kentucky and Dallas, Texas.

GMCalso has a wholly-owned subsidiary, Gladstone Administration, LLC (“GladstoneAdministration”) which employs our chief financial officer, chief complianceofficer and controller and their respective staffs.

**Our Investment Strategy**

Ourstrategy is to make loans at favorable interest rates to small and medium-sizedbusinesses that we believe have traditionally been underserved by conventionallenders. GMC uses the loan referral networks of Messrs. Gladstone,Stelljes and Brubaker and of its managing directors to identify and make seniorand subordinated loans to borrowers that need funds to finance growth,restructure their balance sheets or effect a change of control. We believe thatour business strategy will enable us to achieve a high level of current incomeby investing in debt securities, consisting primarily of senior notes, seniorsubordinated notes and junior subordinated notes of established privatebusinesses that are backed by leveraged buyout funds, venture capital funds orothers. In addition, from time to time we might acquire existing loans thatmeet this profile from leveraged buyout funds, venture capital funds andothers. We also seek to provide our stockholders with long-term capital growththrough the appreciation in the value of warrants or other equity instrumentsthat we might receive when we make loans.

Wetarget small and medium-sized private businesses that meet certain criteria,including the potential for growth, adequate assets for loan collateral,experienced management teams with significant ownership interest in thebusiness, adequate capitalization, profitable operations based on cash flow andpotential opportunities for us to realize appreciation and gain liquidity inour various equity positions. We may achieve liquidity in an equity positionthrough a merger or acquisition of the borrower, a public offering of theborrower’s stock or by exercising our right to require the borrower torepurchase our warrants, although we cannot assure you that we will always havethese rights.  We can also achieve asimilar effect by requiring the borrower to pay us conditional interest, whichwe refer to as a success fee, upon the occurrence of certain events.  Success fees are dependent upon the successof the borrower and the occurrence of a triggering event, and are paid in lieuof warrants to own common stock of the borrower.

**Investment Process**

***Overview of Loan Origination and Approval Process***

Tooriginate loans, GMC’s lending professionals use an extensive referral networkcomprised of venture capitalists, leveraged buyout funds, investment bankers,attorneys, accountants, commercial bankers and business brokers.  GMC’s lending professionals reviewinformational packages from these and other sources in search of potentialfinancing opportunities.  If a potentialopportunity matches our investment objectives, the lending professionals willseek an initial screening of the opportunity from GMC’s investment committee,which is composed of Messrs. Gladstone, Brubaker and Stelljes.  If the applicant passes this initialscreening, the lending professionals will conduct a due diligence investigationof the applicant. Upon completion of the due diligence investigation, thelending professionals create a detailed borrower profile summarizing the prospectiveborrower’s historical financial statements, industry and management team andanalyzing its conformity to our general investment criteria. The lendingprofessionals then present this profile to the investment committee, which mustunanimously approve each loan.

***Prospective Portfolio Company Characteristics***

Wehave identified certain characteristics that we believe are important toprofitably lend to small and medium-sized businesses. The criteria listed belowprovide general guideposts for our lending and investment decisions, althoughnot all of these criteria may be followed in each instance.

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·              *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 indetermining the value ascribed to any equity position we acquire in connectionwith 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 generally require that eachborrower have a management team that is experienced and properly incentivizedthrough a significant ownership interest in the borrower. We generally willrequire that a borrower have, at a minimum, a strong chief executive officerand chief financial officer who have demonstrated the ability to accomplish theborrower’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 typically lend to, or invest in, start-up or other early stage companies,nor do we typically lend to, or invest in, businesses that are experiencingsignificant operating problems.

·              *Exit strategy.* Prior to making a loan for which we receive awarrant to purchase stock of the borrower or other yield enhancement, weanalyze the potential for the borrower to experience a liquidity event that willallow us to realize value for our equity position. Liquidity events include,among other things, an initial public offering, a private sale of our financialinterest, a merger or acquisition of the borrower or a purchase of our equityposition by the borrower or one of its stockholders.

***Extensive Due Diligence***

GMCconducts what we believe are extensive due diligence investigations of ourprospective portfolio companies and investment opportunities.  Our due diligence investigation may beginwith a review of publicly available information, and will generally includesome or all of the following:

·      areview of the potential borrower’s historical and projected financialinformation;

·      interviewswith management, employees, customers and vendors of the applicant;

·      backgroundchecks; and

·      researchon the applicant’s products, services or particular industry.

Wealso rely on the long-term relationships that GMC’s professionals have withventure capitalists, leveraged buyout funds, investment bankers, commercialbankers and business brokers, and on the extensive direct experiences of ourexecutive officers and managing directors in providing debt and equity capitalto small and medium-sized private businesses. Prior to closing on ourinvestments, additional due diligence may be conducted on our behalf byattorneys, accountants or other outside advisers as appropriate.

***Investment Structure***

Wetypically invest in senior, senior subordinated and junior subordinated loans.Our loans typically range from $5 million to $15 million, althoughthe size of our investments may vary as our capital base changes.  Our loans generally mature within seven yearsand accrue interest at a fixed or variable rate that exceeds the prime rate.  In the past, some of our loans have had aprovision that calls for some portion of the interest payments to be deferredand added to the principal balance so that the interest is paid, together withthe principal, at maturity. This form of deferred interest is often called “paidin kind” (or “PIK”) interest, and, when earned, we record PIK income asinterest income and add the PIK interest to the principal balance of theloans.  At present, none of our loanscontain a PIK provision.

Tothe extent possible, our loans generally are collateralized by a securityinterest in the borrower’s assets.  Insenior and subordinated loans, we do not usually have the first claim on theseassets. Interest payments on loans we make will generally be made monthly orquarterly (except to the extent of any PIK interest) with amortization ofprincipal generally being deferred for several years. The 

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principalamount of the loans and any accrued but unpaid interest will generally becomedue at maturity at five to seven years. We seek to make loans that areaccompanied by warrants to purchase stock in the borrowers or other yieldenhancement features, such as success fees. Any warrants that we receive willtypically have an exercise price equal to the fair value of the portfoliocompany’s common stock at the time of the loan and entitle us to purchase amodest percentage of the borrower’s stock. Success fees are conditional interest that is paid if the borrower issuccessful. The success fee is calculated as additional interest on the loanand is paid upon the occurrence of certain triggering events, such as the saleof the borrower.  If the event or eventsdo not occur, no success fee will be paid.

From time to time,a portfolio company may request additional financing, providing us withadditional lending opportunities. We will consider such requests for additionalfinancing under the criteria we have established for initial investments and weanticipate that any debt securities we acquire in a follow-on financing willhave characteristics comparable to those issued in the original financing. Insome situations, our failure, inability or decision not to make a follow-oninvestment may be detrimental to the operations or survival of a portfoliocompany, and thus may jeopardize our investment in that borrower.

Asnoted above, we expect to receive yield enhancements in connection with many ofour loans, which may include warrants to purchase stock. 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, as amended, (the “Securities Act”), but we generallywill have the right to sell our equity interests in any subsequent publicoffering by the borrower. Even when we have the right to participate in aborrower’s public offering, the underwriters might insist, particularly if weown a large amount of equity securities, that we retain all or a substantialportion of our shares for a specified period of time. Moreover, we may decidenot to sell an equity position even when we have the right and the opportunityto do so. Thus, although we expect to dispose of an equity interest after acertain time, situations may arise in which we hold equity securities for alonger period.

***Temporary Investments***

Pendinginvestment in the debt of private companies, we invest our otherwise uninvestedcash primarily in cash, cash items, government securities or high-quality debtsecurities maturing in one year or less from the time of investment, to whichwe refer collectively as temporary investments, so that 70% of our assets are “qualifyingassets” for purposes of the business development company provisions of the 1940Act. For information regarding regulations to which we are subject and thedefinition of “qualifying assets,” see “Regulation as a Business DevelopmentCompany.”

***Hedging Strategies***

Althoughit has not yet happened, nor do we expect this to happen in the near future,when one of our portfolio companies goes public, we may undertake hedgingstrategies with regard to any equity interests that we may have in thatcompany. We may mitigate risks associated with the volatility of publiclytraded securities by, for instance, selling securities short or writing orbuying call or put options. Hedging against a decline in the value of suchinvestments in public companies would not eliminate fluctuations in the valuesof such investments or prevent losses if the values of such investmentsdecline, but would establish other investments designed to gain from those samedevelopments. Therefore, by engaging in hedging transactions, we can moderatethe decline in the value of our hedged investments in public companies.However, such hedging transactions would also limit our opportunity to gainfrom an increase in the value of our investment in the public company. Pursuantto our initial line of credit, we have agreed to enter into hedgingtransactions, such as interest rate cap agreements, in connection with the borrowingsthat we make under our line of credit. To date, we hold only one interest rate cap agreement.  In the event that we securitize a portion ofour loan portfolio in the future, we believe that we will likely be required toenter into 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 Act prohibits us from effecting a short sale of any security “incontravention of such rules and regulations or orders as U.S. Securities andExchange Commission (the “SEC”) may prescribe as necessary or appropriate inthe public interest or for the protection of investors . . .” However, to date,the SEC has not promulgated regulations under this statute. It is possible thatsuch regulations could be promulgated in the future in a way that would requireus to change any hedging strategies that we may adopt. We will only engage inhedging activities in compliance with applicable law and regulations.

***Competition***

Alarge number of entities compete with us and make the types of investments thatwe seek to make in small and medium-sized privately-owned businesses. Suchcompetitors include private equity funds, leveraged buyout funds, venturecapital funds, investment 

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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 funding sources that are not available to us. In addition,certain of our competitors may have higher risk tolerances or different riskassessments, which could allow them to consider a wider variety of investments,establish more relationships and build their market shares. Furthermore, manyof these competitors are not subject to the regulatory restrictions that the1940 Act imposes on us as a business development company.  Recently we have seen an increase in ourcompetition such that terms and rates for proposed loans have been reduced.However, we believe that our extensive loan referral network and flexibletransaction structuring enable us to compete effectively for opportunities inthe current market environment.

***Extensive Loan Referral Network***

Ourexecutive officers and GMC’s managing directors have an extensive referralnetwork of venture capitalists, leveraged buyout funds, investment bankers,attorneys, commercial bankers and business and financial brokers. We believethat this established network, consisting of relationships established overmany years by Messrs. Gladstone, Stelljes, and Brubaker and GMC’s managingdirectors will generate opportunities to identify and make senior andsubordinated loans to selected businesses that satisfy our investment criteria.We intend to continue to pursue additional informal relationships with otherleveraged buyout funds and venture capital funds that we believe may lead tothe origination of loans.

***Flexible Transaction Structuring***

Webelieve that we are well-positioned to provide financing to small andmedium-sized businesses that are undergoing a change of ownership, includingmanagement-led and third party leveraged buyouts, and to those businesses thathave good growth characteristics. We are not limited by the capital and otherregulatory requirements of the banking and savings and loan industries and wehave relatively low overhead and administrative expenses. Moreover, ourstrategy of seeking yield enhancements, such as success fees, is intended toclosely align our interests with those of our portfolio companies, therebyreducing transaction costs, conveying our commitment to our borrowers and enhancingour attractiveness as a financing source. Perhaps most importantly, we believethat we have the experience and expertise to satisfy the financing needs ofsuch businesses. In particular, we believe that we may realize a competitiveadvantage in this area from Mr. Gladstone’s more than 25 years ofexperience in financing small to medium-sized private businesses, Mr. Stelljes’19 years of financing these types of businesses, and Mr. Brubaker’sextensive experience in acquisitions and operations.

As abusiness development company, we are subject to certain general restrictions oninvesting in any portfolio company in which our affiliates currently have aninvestment, or making co-investments with our affiliates.  However, in certain circumstances, we mayco-invest in a portfolio company in which one of our affiliates has or willhave an investment, subject to satisfaction of any regulatory restrictions andto the prior approval of our Board of Directors.

***Leverage***

Forthe purpose of making investments other than temporary investments and to takeadvantage of favorable interest rates, we intend to issue senior debtsecurities (including borrowings under our current lines of credit) up to themaximum amount permitted by the 1940 Act. The 1940 Act currently permits us toissue senior debt securities and preferred stock, to which we refercollectively as senior securities, in amounts such that our asset coverage, asdefined in the 1940 Act, is at least 200% after each issuance of seniorsecurities. We may also incur such indebtedness to repurchase our common stock.As a result of issuing senior securities, we are exposed to the risks ofleverage. Although borrowing money for investments increases the potential forgain, it also increases the risk of a loss. A decrease in the value of ourinvestments will have a greater impact on the value of our common stock to theextent that we have borrowed money to make investments. There is a possibilitythat the costs of borrowing could exceed the income we receive on theinvestments we make with such borrowed funds. In addition, our ability to paydividends 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, provided that such an issuanceadheres to the requirements of the 1940 Act.  We have also filed a shelf registration statement with the SECregistering up to $75 million of common stock, preferred stock and debtsecurities, of which $48.8 million remains available for issuance as ofDecember 1, 2006.  See “Regulation as aBusiness Development Company—Asset Coverage” for a discussion of our leveragingconstraints.

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***Securitization***

Wehave a wholly-owned subsidiary, Gladstone Business Loan LLC, “Business Loan,”which acquires and holds loans that we anticipate will be securitized in thefuture. Business Loan entered into a credit agreement with a group ofinstitutional lenders that provides for a $100 million revolving creditfacility.  We use these proceeds to makeadditional loans and increase the size of our loan portfolio.  We currently intend to securitize all of theloans held by Business Loan and, if we are able to securitize these loans, wewill use the proceeds from the securitization to pay down any amountsoutstanding under the revolving credit facility.  On September 22, 2006, we increased ourrevolving credit facility by $50 million to $150 million.

**Ongoing Relationships with and Monitoring ofPortfolio Companies**

***Monitoring***

GMC’sinvestment professionals monitor the financial trends of each portfolio companyon an ongoing basis to determine if each is meeting its respective businessplans and to assess the appropriate course of action for each company.  We monitor this information regarding the statusand performance of each portfolio company, and use it to evaluate the overallperformance of our portfolio, on at least a quarterly basis.

GMCemploys various methods of evaluating and monitoring the performance of ourinvestments, which generally include but are not limited to the following:

·      Assessmentof success in the portfolio company’s overall adherence to its business planand compliance with covenants;

·      Attendanceat and participation in meetings of the portfolio company’s board of directors;

·      Periodiccontact, including formal update interviews with portfolio company management,and, if appropriate, the financial or strategic sponsor;

·      Comparisonwith other companies in the portfolio company’s industry; and

·      Reviewof monthly and quarterly financial statements and financial projections forportfolio companies.

***Managerial Assistance***

Asa business development company, we are required to make available significantmanagerial assistance to our portfolio companies. Managerial assistance may beprovided by obtaining board seats of portfolio companies, attending boardmeetings as an observer as well as providing general business guidance in themanagement of the business.  We providethese services through GMC, who provides these services on our behalf throughits officers, who are also our officers. GMC may provide other services to our portfolio companies such asinvestment banking services, reviewing existing credit facilities, arrangingbank financing, arranging equity financing, structuring financing from multiplelenders and investors, structuring financing from equity investors,restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services, closely monitoring the operationsof the borrower, and recruiting new management personnel. To date, neither wenor GMC has received fees in connection with managerial assistance.  Any fees received for managerial assistancein the future would either be received by us directly, or received by GMC directlyand credited against investment advisory fees owed to GMC.  GMC does receive fees for certain otherservices it provides to our portfolio companies, which are credited against theinvestment advisory fees that we owe to GMC.

***Valuation Process***

The following is ageneral description of the steps we take each quarter to determine the value ofour investment portfolio. All of our portfolio investments are recorded at fairvalue as determined in good faith by GMC and our management using proceduresestablished by, and under the direction of our Board of Directors. As a result,there is uncertainty as to the value of our portfolio investments, and ourestimates of fair value may differ significantly from the values that couldobtained if a ready market for the securities existed. Investments for whichmarket quotations are readily available are recorded in our financialstatements at such market quotations. With respect to any investments for whichmarket quotations are not readily available, we follow the following valuationprocess each quarter:
|        | · | Our quarterly valuation process begins with each  portfolio company or investment being initially assessed by GMC’s investment  professionals responsible for the investment, using valuation policies and  procedures previously established by our Board of Directors. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                          |
|   | · | For all debt securities other than those that we  value using the latest bid and ask price, we will seek an independent opinion  of value of such debt securities from SPSE.                                                                                                  |

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|        |   |                                                                                                                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | · | Preliminary valuation conclusions are then discussed  with our management, and documented, along with any SPSE opinions of value,  for review by our Board of Directors.                                                      |
|   |   |                                                                                                                                                                                                                          |
|   | · | Our Board of Directors reviews this documentation  and discusses the input of GMC, management, and the opinions of value of SPSE  to arrive at a determination for the aggregate fair value of our portfolio of  investments. |

 

Our valuation policies,procedures and processes are more fully described under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations —Critical Accounting Policies — Investment Valuation.”

**Investment Advisory Agreements**

SinceOctober 1, 2004, we have been externally managed pursuant to a contractualinvestment advisory arrangement with GMC, under which GMC has directly employed all of our personnel and paid its payroll,benefits, and general expenses directly. Our initial investment advisory agreement with GMC was in place fromOctober 1, 2004 through September 30, 2006 (the “Initial Advisory Agreement”).  On October 1, 2006, we entered into anamended and restated investment advisory agreement with GMC (the “AmendedAdvisory Agreement”) and an administration agreement with GladstoneAdministration  (the “AdministrationAgreement”). Our Board of Directors proposed the Amended Advisory Agreement tostockholders in order to provide what it considers to be more appropriateincentives to reward fund management, and our stockholders approved each ofthese agreements on December 2, 2005. The management services and fees in effect under the Initial and AmendedAdvisory Agreements are described below. In addition to the fees described below, certain fees received by GMCfrom our portfolio companies were credited against the investment advisory feeunder the Initial Advisory Agreement, and will continue to be paid to GMC andcredited under the Amended Advisory Agreement. In addition, we will continue to pay our direct expenses including, butnot limited to, directors fees, legal and accounting fees, and stockholderrelated expenses under the Amended Advisory Agreement.

***Management services and fees in effect through September 30, 2006***

Pursuant to the Initial Advisory Agreement, wepaid GMC an annual advisory fee of 1.25% of our total assets (as reduced by cashand cash equivalents pledged to creditors), payable in quarterly increments of0.3125%, and an annual administrative fee of 0.75% of our total assets (asreduced by cash and cash equivalents pledged to creditors), payable inquarterly increments of 0.1875%.  GMC’sBoard of Directors agreed to waive, for the quarters ending June 30, 2006 andSeptember 30, 2006, the annual advisory fee of 1.25% to 0.5% for those seniorsyndicated loans in which we had existing syndicated second lienparticipations.

***Managementservices and fees under the amended and restated investment advisory agreement***

Effective October 1,2006, we now pay GMC an annual base management fee of 2% of our average grossassets, which is defined as total assets less cash and cash equivalents pledgedto creditors calculated as of the end of the two most recently completed fiscalquarters, in addition to a two-part incentive fee.  The first part of the incentive fee is anincome-based incentive fee which rewards GMC if our quarterly net investmentincome (before giving effect to any incentive fee) exceeds 1.75% of our netassets (the “hurdle rate”). We will pay GMC an income incentive fee withrespect to our pre-incentive fee net investment income in each calendar quarteras follows:

·    no incentive fee in any calendar quarter inwhich our pre-incentive fee net investment income does not exceed the hurdlerate (7% annualized);

·    100% of our pre-incentive fee net investmentincome with respect to that portion of such pre-incentive fee net investment income,if any, that exceeds the hurdle rate but is less than 2.1875% in any calendarquarter (8.75% annualized); and

·    20% of the amount of our pre-incentive feenet investment income, if any, that exceeds 2.1875% in any calendar quarter(8.75% annualized).

The second part of theincentive fee is a capital gains incentive fee that will be determined andpayable in arrears as of the end of each fiscal year (or upon termination ofthe Amended Advisory Agreement, as of the termination date), commencing on October1, 2006, and will equal 20% of our realized capital gains as of the end of thefiscal year. In determining the capital gains incentive fee payable to GMC, wewill calculate the cumulative aggregate realized capital gains and cumulativeaggregate realized capital losses since our inception, and the aggregateunrealized capital depreciation as of the date of the calculation, asapplicable, with respect to each of the investments in our portfolio.

GMC’s Board of Directorshas agreed to waive, for the fiscal quarter ending December 31, 2006, theannual 2.0% base management fee to 0.5% for senior syndicated loanparticipations.

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Under the AmendedAdvisory Agreement, we will pay separately for administrative services underthe Administration Agreement. The Administration Agreement provides forpayments equal to our allocable portion of Gladstone Administration’s overheadexpenses in performing its obligations under the Administration Agreement,including but not limited to rent, and our allocable portion of the salariesand benefits expenses of our chief financial officer, chief compliance officerand controller and their respective staffs.

The same individuals whomanaged our portfolio continue to manage our portfolio under the AmendedAdvisory Agreement and, although the administrative services are now providedseparately pursuant to the Administration Agreement, we do not expect that ourstockholders will notice any change or diminution in services because of thisorganizational separation.

Regulations promulgatedby the SEC prohibit business development companies from implementing anincentive advisory fee while having in place a stock option plan or anyoutstanding stock options.  In connectionwith the approval of the Amended Advisory Agreement, and pursuant to an offerapproved by our Board of Directors on April 11, 2006, we extended an offer tothe then-current stock option holders to amend the terms of all outstandingstock options under our Amended and Restated 2001 Equity Incentive Plan (the “2001Plan”) to accelerate the contractual expiration date of these options toSeptember 30, 2006.  The offer was filedwith the SEC on April 12, 2006, was conducted in accordance with the federaltender offer rules and regulations, and was conditioned upon the acceptance by100% of the current stock option holders. Our Board of Directors also accelerated in full the vesting of alloutstanding options other than options held by the non-employee Directorseffective April 11, 2006, resulting in accelerated vesting of 34,500outstanding options.  On May 31, 2006,100% of the current stock option holders accepted the tender offer, and onSeptember 30, 2006, all outstanding stock options and the 2001 Plan wereterminated.  Upon the effectiveness ofthe Amended Advisory Agreement and Administration Agreement on October 1, 2006,the Initial Advisory Agreement terminated.

***Boardapproval of the amended and restated investment advisory agreement***

Our Board of Directorsapproved the Amended Advisory Agreement at a meeting held on July 7, 2005. Inits consideration of the Amended Advisory Agreement, the Board of Directorsfocused on information it had received relating to, among other things: thereasonableness of the advisory fee (including the incentive fee), theexperience of GMC’s personnel, the potential for additional attractiveinvestments resulting from synergies with other funds to be managed by GMC,potential savings due to economies of scale and the advantage of terminatingour equity incentive plan in favor of the incentive fee arrangement. The Boardof Directors considered the investment advisory and incentive fees under theAmended Advisory Agreement and the administrative fees under the AdministrationAgreement (the “Proposed Fees”) and information on fees charged by otherinvestment advisers and administrators for comparable services, and determinedthat the Proposed Fees were reasonable in relation to the services to beprovided by GMC and Gladstone Administration.

In recommending that wecontinue to use GMC as our investment adviser, our Board of Directorsconsidered the fact that the advisory and administrative team of GMC andGladstone Administration were expected to be in all material respects, for atleast the next year, the same as the then-current team responsible for ourmanagement and administration and the fact that our investment objectives areconsistent with the investment selection process employed by GMC. In connectionwith its final deliberations, the Board of Directors reviewed and discussedadditional materials provided by GMC in response to the Board’s request,including information regarding the services to be performed; the priorexperience of GMC’s personnel in connection with the types of investments wepropose to make, including such personnel’s extensive network of contacts; thesize of GMC’s staff; anticipated changes in GMC’s current personnel; thecompensation of such personnel; GMC’s ability to provide managerial assistanceto portfolio companies; the written plan for allocating investmentopportunities among GMC’s current and future clients; GMC’s operations; and GMC’sorganizational capability and financial condition as evidenced by GMC’s levelof service to us and to our affiliates, Gladstone Investment Corporation andGladstone Commercial Corporation. The Board of Directors also relied uponcomparisons of the services to be rendered and the amounts to be paid under theAmended Advisory Agreement with those under other investment advisory contracts,such as Gladstone Investment Corporation, which has entered into an agreementwith GMC on substantially identical terms and conditions.

When evaluatingcomparisons, the Board of Directors considered, among other things:

·      GMC’s strong performance, as evidenced bythe fact that the total stockholder return on an investment in our common stockhas historically exceeded the Standards & Poor’s 500 Index and our peergroup (which is composed of Allied Capital Corporation and American CapitalStrategies, Ltd.);

·      the high quality and extensive level ofthe advisory and other services that we expect GMC to continue to provide tous;

·      the fact that our projected operatingexpenses and expense ratio are equal to or lower than those of other businessdevelopment companies with similar investment objectives; and

·      the difficulty of obtaining similarservices from other third party service providers.

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The Board of Directorsacknowledged that the fees to be received by GMC under the Amended AdvisoryAgreement are expected to exceed GMC’s costs of providing services to us.However, the board did not attempt to quantify GMC’s level of profits(including those based on fees received from our portfolio companies) becauseof its satisfaction with GMC’s performance advising us. The Amended AdvisoryAgreement does not provide for any reduction in fees in the event that GMCexperiences any economies of scale in its provision of management services tous. The Board of Directors also considered the fact that GladstoneAdministration allocates the costs of providing administrative services to GMC’sexternally managed funds on a pro-rata basis and, therefore, to the extent GMCrecognizes economies of scale in providing administrative services to itsexternally managed funds, those economies of scale will also be indirectlyrecognized by us under the Administration Agreement. Thus, to the extent thatGladstone Administration’s costs decrease, those reductions will be passedthrough indirectly to us in the form of a reduced administration fee.

In its consideration ofthe incentive fee included in the Amended Advisory Agreement, the Board ofDirectors focused on information it had received relating to, among otherthings:

·      the fact that the Amended AdvisoryAgreement provides for substantially the same fees as those paid by otherbusiness development companies with similar investment objectives and no equityincentive plans, including Gladstone Investment Corporation;

·      the fact that an incentive fee arrangementis more appropriate to an externally managed fund such as ours, than is a stockoption program;

·      the fact that stockholders increasinglydemand strong fund performance and are willing to reward managers for meetingthose goals;

·      the fact that the utility of a stockoption plan to reward fund management has been curtailed by recent regulationsthat prohibit executive officers from borrowing from an issuer to finance theexercise of their stock options;

·      the concern that stock options mayincentivize managers (and directors who receive stock options) to manage a fundfor short-run returns rather than long-term goals;

·      the fact that incentive fees are thepredominant method used by private equity firms with whom we and GMC competefor talented professionals;

·      the fact that the use of incentive fees isnow becoming standard among business development companies and is acompensation structure that is both understood and expected by analysts whoevaluate us and our stock; and

·      the expectation that we and ourstockholders would benefit from the removal of the dilutive effects associatedwith stock options, and the avoidance of the accounting charges related tostock options that are now required to be recognized as non-cash expense by usunder recently adopted accounting rules.

Based on the informationreviewed by, and the ensuing discussions of, our Board of Directors, the board,including a majority of the non-interested directors, concluded that theinvestment advisory fee rates, including the incentive fee rates, werereasonable in relation to the services to be provided by GMC and GladstoneAdministration. Based on its review and discussion, the board approved theAmended Advisory Agreement as being in the best interests of our stockholders.The board then directed that the Amended Advisory Agreement be submitted tostockholders for approval with the board’s recommendation that our stockholdersvote to approve the Amended Advisory Agreement.

**Material U.S. Federal Income Tax Considerations**

***Regulated Investment Company Status***

Inorder to maintain the qualification for treatment as a RIC under Subchapter Mof the Internal Revenue Code of 1986 (the “Code”), we must distribute to ourstockholders, for each taxable year, at least 90% of our investment companytaxable income, which is generally our ordinary income plus short-term capitalgains. We refer to this as the annual distribution requirement. We must alsomeet several additional requirements, including:

·              **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

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·              **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.

Ifwe are unable to qualify for treatment as a RIC, we will be subject to tax onall of our taxable income at regular corporate rates. We would not be able todeduct distributions to stockholders, nor would we be required to make suchdistributions. Distributions would be taxable to our stockholders as ordinarydividend income to the extent of our current and accumulated earnings andprofits. Subject to certain limitations under the Code, corporate distributeeswould be eligible for the dividends received deduction. Distributions in excessof our current and accumulated earnings and profits would be treated first as areturn of capital to the extent of the stockholder’s tax basis, and then as again realized from the sale or exchange of property. If we fail to meet the RICrequirements for more than two consecutive years and then seek to requalify asa RIC, we would be required to recognize a gain to the extent of any unrealizedappreciation on our assets unless we make a special election to paycorporate-level tax on any such unrealized appreciation recognized during thesucceeding 10-year period. Absent such special election, any gain we recognizedwould be deemed distributed to our stockholders as a taxable distribution.

Ifwe qualify as a RIC and distribute to stockholders each year in a timely mannerat least 90% of our investment company taxable income, we will not be subjectto federal income tax on the portion of our taxable income and gains wedistribute to stockholders. We would, however, be subject to a 4% nondeductiblefederal excise tax if we do not distribute, actually or on a deemed basis, 98%of our income, including both ordinary income and capital gains. The excise taxwould apply 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.

Ifwe acquire debt obligations that were originally issued at a discount, whichwould generally include loans we make that are accompanied by warrants, thatbear interest at rates that are not either fixed rates or certain qualifiedvariable rates or that are not unconditionally payable at least annually overthe life of the obligation, we will be required to include in taxable incomeeach year a portion of the “original issue discount” that accrues over the lifeof the obligation. Such original issue discount will be included in ourinvestment company taxable income even though we receive no cash correspondingto such discount amount. As a result, we may be required to make additionaldistributions corresponding to such original issue discount amounts in order tosatisfy the annual distribution requirement and to continue to qualify as a RICor to avoid the 4% excise tax. In this event, we may be required to selltemporary investments or other assets to meet the RIC distributionrequirements.  At September 30, 2006, noneof our loans had original issue discount.

Forany period during which we qualify for treatment as a RIC for federal incometax purposes, distributions to our stockholders attributable to our investmentcompany taxable income generally will be taxable as ordinary income tostockholders to the extent of our current or accumulated earnings and profits. Anydistributions in excess of our earnings and profits will first be treated as areturn of capital to the extent of the stockholder’s adjusted basis in his orher shares of common stock and thereafter as gain from the sale of shares ofour common stock. Distributions of our long-term capital gains, designated byus as such, will be taxable to stockholders as long-term capital gainsregardless of the stockholder’s holding period for its common stock and whetherthe distributions are paid in cash or invested in additional common stock.Corporate stockholders are generally eligible for the 70% dividends receiveddeduction 

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withrespect to ordinary income, but not to capital gains dividends to the extentsuch amount designated by us does not exceed the dividends received by us fromdomestic corporations. Any dividend declared by us in October, November orDecember of any calendar year, payable to stockholders of record on aspecified date in such a month and actually paid during January of the followingyear, will be treated as if it were paid by us and received by the stockholderson December 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.

Ingeneral, the tax rates applicable to our dividends other than dividendsdesignated as capital gain dividends will be the standard ordinary income taxrates, and not the lower federal income tax rate applicable to “qualifieddividend income.” If we distribute dividends that are attributable to actualdividend income received by us that is eligible to be, and is, designated by usas qualified dividend income, such dividends would be eligible for such lowerfederal income tax rate. For this purpose, “qualified dividend income” meansdividends received by us from United States corporations and qualifying foreigncorporations, provided that both we and the stockholder recipient of ourdividend satisfy certain holding period and other requirements in respect ofour shares (in the case of our stockholder) and the stock such corporations (inour case). However, we do not anticipate receiving or distributing asignificant amount of qualified dividend income.

**Regulation as a Business Development Company**

Weare a closed-end, non-diversified management investment company that haselected to be regulated as a business development company under Section 54of the 1940 Act. As such, we are subject to regulation under the 1940 Act. The1940 Act contains prohibitions and restrictions relating to transactions betweenbusiness development companies and their affiliates, principal underwriters andaffiliates of those affiliates or underwriters and requires that a majority ofthe directors be persons other than “interested persons,” as defined in the1940 Act. In addition, the 1940 Act provides that we may not change the natureof our business so as to cease to be, or to withdraw our election as, abusiness development company unless approved by a majority of our outstandingvoting securities.

Weintend to conduct our business so as to retain our status as a businessdevelopment company. In general, a business development company must have beenorganized and have its principal place of business in the United States andmust be operated for the purpose of making investments in the types ofsecurities described in (1) or (2) below.

***Qualifying Assets***

Underthe 1940 Act, a business development company may not acquire any asset otherthan assets of the type listed in Section 55(a) of the 1940 Act, which arereferred to as qualifying assets, unless, at the time the acquisition is made,qualifying assets represent at least 70% of the company’s total assets. Thetypes of qualifying assets in which we may invest under the 1940 Act include,but are not limited to the following:

(1)           Securities purchased in transactionsnot involving any public offering from the issuer of such securities, whichissuer is an eligible portfolio company. An eligible portfolio company isgenerally defined in the 1940 Act as any issuer which (A) is organized underthe laws of, and has its principal place of business in, the United States; (B)is neither an investment company as defined in Section 3 of the 1940 Act (otherthan a small business investment company which is licensed by the SmallBusiness Administration to operate under the Small Business Investment Act of1958 and which is a wholly-owned subsidiary of the business developmentcompany) not a company which would be an investment company except for theexclusion from the definition of investment company in Section 3(c) of the 1940Act; and (C) satisfies one of the following: (i) it does not have any class ofsecurities with respect to which a member of a national securities exchange,broker, or dealer may extend or maintain credit to or for a customer pursuantto rules or regulations adopted by the Board of Governors of the FederalReserve System under Section 7 of the Securities Exchange Act of 1934, asamended; (ii) it is controlled by a business development company, either aloneor as part of a group acting together, and such business development company infact exercises a controlling influence over the management or policies of sucheligible portfolio company and, as a result of such control, has an affiliatedperson who is a director of such eligible portfolio company; (iii) it has totalassets of not more than $4,000,000, and capital and surplus (shareholders’equity less retained earnings) of not less than $2,000,000, except that the SECmay adjust such amounts by rule, regulation, or order to reflect changes in oneor more generally accepted indices or other indicators for small businesses; or(iv) all private domestic operating companies and those public domesticoperating companies whose securities are not listed on a national securitiesexchange.

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(2)           Securities received in exchange foror distributed on or with respect to securities described in (1) above, orpursuant to the exercise of options, warrants or rights relating to suchsecurities.

(3)           Cash, cash items, governmentsecurities or high quality debt securities maturing in one year or less fromthe time of investment.

***Asset Coverage***

Weare permitted, under specified conditions, to issue multiple classes ofindebtedness 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***

Forportfolio securities to be qualifying assets for the 70% test described above,the business development company must either exercise a controlling influenceover the issuer of the securities or must make available to the issuer of thesecurities significant managerial assistance. However, with respect to certainbut not all such securities, where the business development company purchasessuch securities in conjunction with one or more other persons acting together,one of the other persons in the group may make available such managerialassistance, or the business development company may exercise such controljointly. Making available significant managerial assistance means, among otherthings, any arrangement whereby the business development company, through itsdirectors, officers or employees, offers to provide, and, if accepted, does soprovide, significant guidance and counsel concerning the management, operationsor business objectives and policies of a portfolio company.

***Fundamental Investment Policies***

Weseek 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 and subordinated notes. We also seek to provide ourstockholders with long-term capital growth through the appreciation in thevalue of warrants or other equity instruments that we may receive when we makeloans. The following restrictions, along with these investment objectives, areour only fundamental policies, which are policies that may not be changedwithout the approval of the holders of the majority of our outstanding votingsecurities, as defined in the 1940 Act. The percentage restrictions set forthbelow, other than the restriction pertaining to the issuance of seniorsecurities, as well as those contained elsewhere in this Form 10-K, applyat the time we effect a transaction, and a subsequent change in a percentageresulting from market fluctuations or any cause other than an action by us willnot require us to dispose of portfolio securities or to take other action tosatisfy the percentage restriction. We will at all times conduct our businessso as to retain our status as a business development company. In order toretain that status, we may not acquire any assets (other than non-investmentassets necessary and appropriate to our operations as a business developmentcompany) if, after giving effect to such acquisition, the value of our “qualifyingassets” is less than 70% of the value of our total assets. We anticipate thatthe securities we seek to acquire (provided that we control or, through ourofficers or other participants in the financing transaction, make significantmanagerial assistance available to the issuers of these securities), as well astemporary investments, will generally be qualifying assets.

Wemay invest up to 100% of our assets in securities acquired directly fromissuers in privately negotiated transactions. With respect to such securities,we may, for the purpose of public resale, be deemed an “underwriter” as thatterm is defined in the Securities Act. We may invest up to 20% of our assets insecurities of a particular issuer. We may exceed this limitation in connectionwith bridge financings, although these bridge investments will never exceed 25%of our total assets at any time. We do not intend to concentrate ourinvestments in any particular industry or group of industries. However, it ispossible that, as the values of our portfolio companies change, one industry ora group of industries may comprise in excess of 25% of the value of our totalassets.

Wewill at all times endeavor to conduct our business so as to retain our statusas a RIC under Subchapter M of the Code. In order to do so, we must meet incomesource, asset diversification and annual distribution requirements. We mayissue senior securities, such as debt or preferred stock, to the extentpermitted by the 1940 Act for the purpose of making investments, to fund sharerepurchases, or 

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fortemporary emergency or other purposes. For a discussion of the risks associatedwith the resulting leverage, see “—Leverage” and “Risk Factors—Our businessplan is dependent upon external financing which may expose us to risksassociated with leverage.”

Wewill not (1) act as an underwriter of securities of other issuers (exceptto the extent that we may be deemed an “underwriter” of securities we purchasethat must be registered under the Securities Act before they may be offered orsold to the public); (2) purchase or sell real estate or interests in realestate or real estate investment trusts (except that we may (a) purchaseand sell real estate or interests in real estate in connection with the orderlyliquidation of investments, (b) own the securities of companies orparticipate in a partnership or partnerships that are in the business ofbuying, selling or developing real estate, or (c) finance the purchase ofreal estate by our portfolio companies); (3) sell securities short (exceptwith regard to managing the risks associated with publicly-traded securitiesissued by our portfolio companies); (4) purchase securities on margin(except to the extent that we may purchase securities with borrowed money);(5) write or buy put or call options (except (i) to the extent ofwarrants or conversion privileges in connection with our acquisition financingor other investments and rights to require the issuers of such investments ortheir affiliates to repurchase them under certain circumstances, (ii) withregard to managing risks associated with publicly-traded securities issued byour portfolio companies, or (iii) with regard to managing the risksassociated with interest rate fluctuations); (6) engage in the purchase orsale of commodities or commodity contracts, including futures contracts (exceptwhere necessary in working out distressed loan or investment situations or inmanaging the risks associated with interest rate fluctuations); or(7) acquire more than 3% of the voting stock of, or invest more than 5% ofour total assets in, any securities issued by any other investment company(except as they may be acquired as part of a merger, consolidation oracquisition of assets). That portion of our investments that is in securitiesissued by other investment companies may subject our stockholders to additionalexpenses.

***Code of Ethics***

Weand GMC have each adopted a code of ethics and business conduct applicable toour officers, directors and all employees of GMC that complies with theguidelines set forth in Item 406 of Regulation S-K of the Securities Act.  As required by the 1940 Act, this codeestablishes procedures for personal investments, restricts certain transactionsby our personnel and requires the reporting of certain transactions andholdings by our personnel.  A copy ofthis code is available for review, free of charge, at our website at www.GladstoneCapital.com.  We intend to provide any required disclosureof any amendments to or waivers of the provisions of this code by postinginformation regarding any such amendment or waiver to our website within fourdays of its effectiveness.

***Compliance Policies and Procedures***

Weand GMC have adopted and implemented written policies and procedures reasonablydesigned to prevent violation of the federal securities laws, and our Board ofDirectors is required to review these compliance policies and proceduresannually to assess their adequacy and the effectiveness of theirimplementation.  We have designated achief compliance officer, Allyson Williams, who also serves as chief complianceofficer for GMC.

**Staffing**

Wedo not currently have any employees and do not expect to have any employees inthe foreseeable future.  Currently,services necessary for our business are provided by individuals who areemployees of GMC and Gladstone Administration pursuant to the terms of theAmended Advisory Agreement and the Administration Agreement, respectively.  Each of our executive officers is an employeeand executive officer of GMC and Gladstone Administration.  No employee of GMC or GladstoneAdministration will dedicate all of his or her time to us.  However, we expect that 20-25 full timeemployees of GMC or Gladstone Administration will spend substantial time on ourmatters during the remainder of calendar year 2006 and all of calendar year2007.  We anticipate that the number ofemployees of GMC who devote time to our matters will increase as we acquiremore investments.

EffectiveOctober 1, 2006, with our entrance into the Amended Advisory Agreement andAdministration Agreement, as approved by our stockholders on December 2, 2005,accounting and compliance services are provided by the same individuals whocurrently provide these services to us, however these individuals now providethese services to us through Gladstone Administration pursuant to theAdministration Agreement.   All otherservices will continue to be performed by the same individuals under theAmended Advisory Agreement.

Asof December 1, 2006, GMC and Gladstone Administration had 46 full-timeemployees, a breakdown of these full-time employees is summarized by functionalarea in the table below:

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| Number of Individuals | ** ** | **Functional Area**                                                    |
|-----------------------|------------|------------------------------------------------------------------------|
| 6                     |       | Executive Management                                                   |
|                  |       |                                                                   |
| 31                    |       | Investment Management, Portfolio Management, and Due  Diligence        |
|                  |       |                                                                   |
| 9                     |       | Administration, Accounting, Compliance, Human  Resources, and Treasury |

 

**Available Information**

Copiesof our annual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments, if any, to those reports filed pursuant toSection 13(a) or 15(d) of the Exchange Act are available free of chargethrough our website at www.GladstoneCapital.com.  A request for any of these reports may alsobe submitted to us by sending a written request addressed to CorporateSecretary, Gladstone Capital Corporation, 1521 Westbranch Drive, Suite 200,McLean, VA 22102, or by calling our toll-free investor relations line at1-866-366-5745.  The public may read andcopy materials that we file with the SEC at the SEC’s Public Reference Room at100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may beobtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website that contains reports, proxy andinformation statements, and other information regarding issuers that fileelectronically with the SEC at http://www.sec.gov.

**Item 1A. Risk Factors**

*An investment in our securities involves a number ofsignificant risks and other factors relating to our structure and investmentobjectives. As a result, we cannot assure you that we will achieve ourinvestment objectives. You should consider carefully the following informationbefore making an investment in our securities.*

**We are dependent upon our keymanagement personnel and the key management personnel of GMC, particularlyDavid Gladstone, George Stelljes III and Terry Lee Brubaker, and on thecontinued operations of GMC, for our future success.**

We have noemployees. Our chief executive officer, chief operating officer, chiefinvestment officer and chief financial officer, and the employees of GMC, donot spend all of their time managing our activities and our investmentportfolio. We are particularly dependent upon David Gladstone, George StelljesIII and Terry Lee Brubaker in this regard. Our executive officers and theemployees of GMC allocate some, and in some cases a material portion, of theirtime to businesses and activities that are not related to our business. We haveno separate facilities and are completely reliant on GMC, which has significantdiscretion as to the implementation and execution of our business strategiesand risk management practices. We are subject to the risk of discontinuation ofGMC’s operations or termination of the investment advisory agreement and therisk that, upon such event, no suitable replacement will be found. We believethat our success depends to a significant extent upon GMC and thatdiscontinuation of its operations could have a material adverse effect on ourability to achieve our investment objectives.

**Our incentive fee may induce GMC to make certaininvestments, including speculative investments.**

Themanagement compensation structure that has been implemented under the AmendedAdvisory Agreement with GMC may cause GMC to invest in high risk investments ortake other risks.  In addition to itsmanagement fee, GMC is entitled under the Amended Advisory Agreement to receiveincentive compensation based in part upon our achievement of specified levelsof income.  In evaluating investments andother management strategies, the opportunity to earn incentive compensationbased on net income may lead GMC to place undue emphasis on the maximization ofnet income at the expense of other criteria, such as preservation of capital,maintaining sufficient liquidity, or management of credit risk or market risk,in order to achieve higher incentive compensation.  Investments with higher yield potential aregenerally riskier or more speculative. This could result in increased risk to the value of our investmentportfolio.

**We maybe obligated to pay GMC incentive compensation even if we incur a loss.**

On October 1,2006, the Amended Advisory Agreement became effective and entitles GMC toincentive compensation for each fiscal quarter in an amount equal to apercentage of the excess of our investment income for that quarter (beforededucting incentive compensation, net operating losses and certain other items)above a threshold return for that quarter. Our pre-incentive fee net investmentincome for incentive compensation purposes excludes realized and unrealizedcapital losses that we may incur in the fiscal quarter, even if such capitallosses result in a net loss on our statement of operations for that quarter.Thus, we may be required to pay GMC incentive compensation for a fiscal quartereven if there is a decline in the value of our portfolio or we incur a net lossfor that 

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quarter. Foradditional information on incentive compensation under the Amended AdvisoryAgreement with GMC, see “Business — Investment Advisory Agreement — Managementservices and fees under the amended and restated investment advisory agreement.”

**GMC’s failure to identify and invest in securitiesthat meet our investment criteria or perform its responsibilities under theAmended  Advisory Agreement may adverselyaffect our ability for future growth.**

Ourability to achieve our investment objectives will depend on our ability togrow, which in turn will depend on GMC’s ability to identify and invest insecurities that meet our investment criteria. Accomplishing this result on a cost-effective basis will be largely afunction of GMC’s structuring of the investment process, its ability to providecompetent and efficient services to us, and our access to financing onacceptable terms.  The senior managementteam of GMC has substantial responsibilities under the Amended AdvisoryAgreement.  In order to grow, GMC willneed to hire, train supervise and manage new employees successfully.  Any failure to manage our future growtheffectively could have a material adverse effect on our business, financialcondition and results of operations.

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

Alarge number of entities compete with us and make the types of investments thatwe seek to make in small and medium-sized privately owned businesses. Wecompete with a large number of private equity funds, leveraged buyout funds andventure capital funds, investment banks and other equity and non-equity basedinvestment funds, and other sources of financing, including traditionalfinancial services companies such as commercial banks. Many of our competitorsare substantially larger and have considerably greater financial, technical andmarketing resources than we do. For example, some competitors may have a lowercost of funds and access to funding sources that are not available to us. Inaddition, certain of our competitors may have higher risk tolerances ordifferent risk assessments, which could allow them to consider a wider varietyof investments and establish more relationships and build their market shares.Furthermore, many of our potential competitors are not subject to theregulatory restrictions that the 1940 Act imposes on us as a businessdevelopment company. We cannot assure you that the competitive pressures weface will not have a material adverse effect on our business, financialcondition and results of operations. Also, as a result of this competition, wemay not be able to take advantage of attractive investment opportunities fromtime to time and there can be no assurance that we will be able to identify andmake investments that satisfy our investment objectives or that we will be ableto 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 dependentupon informal relationships with leveraged buyout funds, venture capital funds,and traditional lending institutions to provide us with deal flow.  If we fail to maintain our relationship withsuch funds or institutions, or if we fail to establish strong referralrelationships with other funds, we will not be able to grow our portfolio ofloans and fully execute our business plan.

**Our loans to small and medium-sized borrowers areextremely risky and you could lose all or a part of your investment.**

Loansto small and medium-sized borrowers are subject to a number of significantrisks 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 attractive opportunityfor us to generate profits, this may make it difficult for the borrowers torepay their loans to us upon maturity. A borrower’s ability to repay its loanmay be adversely affected by numerous factors, including the failure to meetits business plan, a downturn in its industry or negative economic conditions.A deterioration in a borrower’s financial condition and prospects usually willbe accompanied by a deterioration in the value of any collateral and areduction in the likelihood of us realizing on any guarantees we may haveobtained from the borrower’s management. Although we will sometimes seek to bethe senior, secured lender to a borrower, in most of our loans we expect to besubordinated to a senior lender, and our interest in any collateral would,accordingly, likely be subordinate to another lender’s security 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.

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·              **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, GMC and its 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 ormedium-sized business also depends on the management talents and efforts of oneor two persons or a small group of persons. The death, disability or resignationof one 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.

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

Whenwe make a subordinated loan, we may receive warrants to purchase stock issuedby the borrower or other yield enhancements, such as success fees (conditionalinterest). Our goal is to ultimately dispose of these equity interests andrealize gains upon our disposition of such interests. We expect that, overtime, the gains we realize on these warrants and other yield enhancements willoffset any losses we experience on loan defaults. However, any warrants wereceive may not appreciate in value and, in fact, may decline in value and anyother yield enhancements, such as success fees, may not be realized.Accordingly, we may not be able to realize gains from our equity interests orother yield enhancements and any gains we do recognize may not be sufficient tooffset losses we experience on our loan portfolio.

**Because the loans we make and equity securities wereceive when we make loans are not publicly traded, there will be uncertaintyregarding the value of our privately held securities that could adverselyaffect our determination of our net asset value.**

A large percentageof our portfolio investments are, and will continue to be, in the form ofsecurities that are not publicly traded. The fair value of securities and otherinvestments that are not publicly traded may not be readily determinable. OurBoard of Directors has established a valuation policy and consistently appliedvaluation procedures used to determine the fair value of these securities quarterly.These procedures for the determination of value of many of our debt securitiesrely on the opinions of value submitted to us by Standard & Poor’sSecurities Evaluations, Inc., which we refer to as SPSE. SPSE will onlyevaluate the debt portion of our investments for which we specifically requestevaluation, and SPSE may decline to make requested evaluations for any reasonin its sole discretion. However, to date, SPSE has accepted each of ourrequests for evaluation.

Our proceduresalso include provisions whereby GMC will establish the fair value of any equitysecurities we may hold where SPSE is unable to provide evaluations. The typesof factors that may be considered in determining the fair value of our debt andequity investments include some or all of the following: the nature andrealizable value of any collateral, the portfolio company’s earnings and cashflows and its ability to make payments on its obligations, the markets in whichthe portfolio company does business, comparison to publicly traded companies,discounted cash flow, and other relevant factors. Because such valuations,particularly valuations of 

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private securitiesand private companies, are inherently uncertain, may fluctuate over shortperiods of time, and may be based on estimates, our determinations of fairvalue may differ materially from the values that might have resulted from areadily available market for these securities.

 In the future, we anticipate that a smallportion of our assets may consist of equity securities that are valued based oninternal assessment, using our own, Board of Directors’ approved valuationmethods, without the input of SPSE or any other third-party evaluator. Webelieve that our equity valuation methods reflect those regularly used asstandards by other professionals in our industry who value equity securities.However, determination of fair value for securities that are not publiclytraded, whether or not we use the recommendations of an independent third partyevaluator, necessarily involves the exercise of subjective judgment. Our netasset value could be adversely affected if our determinations regarding thefair value of our investments were materially higher than the values that weultimately realize upon the disposal of such securities.

**The lack of liquidity of our privately heldinvestments may adversely affect our business.**

Mostof our investments presently consist of, and will continue to consist of, loansand warrants acquired in private transactions directly from borrowers or fromthe originators of loans to such borrowers. Substantially all of theinvestments we presently hold are, and the investments we expect to acquire inthe future will be, subject to restrictions on resale, including, in someinstances, legal restrictions, or will otherwise be less liquid than publiclytraded securities. The illiquidity of our investments may make it difficult forus to quickly obtain cash equal to the value at which we record our investmentsif the need arises. This could cause us to miss important businessopportunities. In addition, if we are required to quickly liquidate all or aportion of our portfolio, we may realize significantly less than the value atwhich we have previously recorded our investments.  In addition, we may face other restrictionson our ability to liquidate an investment in a portfolio company to the extentthat we, GMC, or our respective officers, employees or affiliates have materialnon-public information regarding such portfolio company.

Dueto the uncertainty inherent in valuing these securities, our determinations offair value may differ materially from the values that would exist if a readymarket for these securities existed. Our net asset value could be materiallyaffected if our determinations regarding the fair value of our investments arematerially different from the values that we ultimately realize on our disposalof such securities.

**Our portfolio is concentrated in a limited numberof companies and industries, which subjects us to an increased risk ofsignificant loss if any one of these companies does not repay us or if theindustries experience downturns.**

Asof September 30, 2006 we had loans outstanding to 32 portfolio companies. Aconsequence of a limited number of investments is that the aggregate returns werealize may be substantially adversely affected by the unfavorable performanceof a small number of such loans or a substantial writedown of any oneinvestment. Beyond our regulatory and income tax diversification requirements,we do not have fixed guidelines for industry concentration and our investmentscould potentially be concentrated in relatively few industries. In addition,while we do not intend to invest 25% or more of our total assets in aparticular industry or group of industries at the time of investment, it ispossible that as the values of our portfolio companies change, one industry ora group of industries may comprise in excess of 25% of the value of our totalassets. As a result, a downturn in an industry in which we have made multipleloans could have a materially adverse effect on us.

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

Ourbusiness requires a substantial amount of cash to operate and grow. We mayacquire such additional capital from the following sources:

·              **Senior Securities**.We intend to issue debt securities, other evidences of indebtedness (includingborrowings under our line 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.

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·              **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 adversely affect ourprofitability and our hedging strategy may expose us to additional risks.**

Weanticipate using a combination of equity and long-term and short-termborrowings to finance our lending activities. As a result, a portion of ourincome will depend upon the difference between the rate at which we borrowfunds and the rate at which we loan these funds. Certain of our borrowings maybe at fixed rates and others at variable rates. Ultimately, we expectapproximately 20% of the loans in our portfolio to be at fixed rates andapproximately 80% to be at variable rates determined on the basis of abenchmark prime rate. As of September 30, 2006, our portfolio had approximately65% of the total of the loan cost value at variable rates with a floor,approximately 3% of the total loan cost value at variable rates with a floorand ceiling, and the remaining 32% at variable rates. Pursuant to our initialline of credit, we have agreed to enter into hedging transactions such asinterest rate cap agreements, futures, options and forward contracts. To date,we hold only one interest rate cap agreement. In the event that we securitize a portion of our loan portfolio in thefuture, we believe that we will likely be required to enter into similararrangements with respect to the securitized loans.  While hedging activities may insulate usagainst adverse fluctuations in interest rates, they may also limit our abilityto participate in the benefits of lower interest rates with respect to the hedgedportfolio. Adverse developments resulting from changes in interest rates orhedging transactions could have a material adverse effect on our business,financial condition and results of operations.

**Our credit facility imposes certain limitations onus.**

Wewill have a continuing need for capital to finance our loans. In order tomaintain RIC status, we will be required to distribute to our stockholders atleast 90% of our ordinary income and short-term capital gains on an annualbasis. Accordingly, such earnings will not be available to fund additionalloans. Therefore, we are party to acredit agreement arranged by Deutsche Bank AG as the structuring agent.  The agreement provides us with a revolvingcredit line facility of $150 million.  Inthe future, borrowings outstanding on the credit line facility may be repaidwith the proceeds we may receive from securitizing some or all of the loans inour portfolio for long-term funding.  Theline of credit facility will permit us to fund additional loans and investmentsas long as we are within the conditions set out in the credit agreement.

Asa result of the line of credit facility, we are subject to certain limitationson the type of loan investments we make, including restrictions on geographicconcentrations, sector concentrations, loan size, payment frequency and status,and average life. Our failure to satisfy these limitations could result inforeclosure by our lenders which would have a material adverse effect on ourbusiness, financial condition and results of operations.

**Our investments are typically long term and willrequire several years to realize liquidation events.**

Sincewe generally intend to make five to seven year term loans and hold our loansand related warrants or other yield enhancements until the loans mature, youshould not expect realization events, if any, to occur over the near term. Inaddition, we expect that any warrants or other yield enhancements that wereceive when we make loans may require several years to appreciate in value andwe cannot give any assurance that such appreciation will occur.

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

Inaddition to risks associated with delays in investing our capital, we are alsosubject to the risk that investments that we make in our portfolio companiesmay be repaid prior to maturity. We will first use any proceeds fromprepayments to repay any borrowings outstanding on our line of credit.  In the event that funds remain afterrepayment of our outstanding borrowings, then we will generally reinvest theseproceeds in government securities, pending their future investment in new debtsecurities. These government securities will typically have substantially loweryields than the debt securities being prepaid and we could experiencesignificant delays in 

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reinvestingthese amounts. As a result, our results of operations could be materiallyadversely affected if one or more of our portfolio companies elects to prepayamounts owed to us. Additionally, prepayments could negatively impact ourreturn on equity, which could result in a decline in the market price of ourcommon stock.

**We will be subject to corporate level tax if weare unable to satisfy Internal Revenue Code requirements for RIC qualification.**

Tomaintain our qualification as a RIC, we must meet income source, assetdiversification and annual distribution requirements. The annual distributionrequirement is satisfied if we distribute at least 90% of our ordinary incomeand short-term capital gains to our stockholders on an annual basis. Because weuse leverage, we are subject to certain asset coverage ratio requirements underthe 1940 Act and could, under certain circumstances, be restricted from makingdistributions necessary to qualify as a RIC. Warrants we receive with respectto debt investments will create “original issue discount,” which we mustrecognize as ordinary income, increasing the amounts we are required todistribute to maintain RIC status. Because such warrants will not producedistributable cash for us at the same time as we are required to makedistributions in respect of the related original issue discount, we will needto use cash from other sources to satisfy such distribution requirements. Theasset diversification requirements must be met at the end of each calendarquarter. If we fail to meet these tests, we may need to quickly dispose ofcertain investments to prevent the loss of RIC status. Since most of ourinvestments will be illiquid, such dispositions, if even possible, may not bemade at prices advantageous to us and, in fact, may result in substantiallosses. If we fail to qualify as a RIC for any reason and become fully subjectto corporate income tax, the resulting corporate taxes could substantiallyreduce our net assets, the amount of income available for distribution, and theactual amount distributed. Such a failure would have a material adverse effecton us and our shares. For additional information regarding asset coverage ratioand RIC requirements, see “Business—Leverage” and “Business—Material U.S.Federal Income Tax Considerations—Regulated Investment Company Status.”

**There aresignificant potential conflicts of interest which could impact our investmentreturns.**

Our executiveofficers and directors, and the officers and directors of our investmentadviser, GMC, serve or may serve as officers, directors or principals ofentities that operate in the same or a related line of business as we do or ofinvestment funds managed by our affiliates. Accordingly, they may haveobligations to investors in those entities, the fulfillment of which might notbe in the best interests of us or our stockholders. For example,Mr. Gladstone, our chairman and chief executive officer, is the chairmanof the board and chief executive officer of GMC, Gladstone Investment andGladstone Commercial. In addition, Mr. Brubaker, our vice chairman, chiefoperating officer and secretary is either the vice chairman or president, andthe chief operating officer and secretary of GMC, Gladstone Investment andGladstone Commercial. Mr. Stelljes, our president and chief investmentofficer, is also either the president or executive vice president, and thechief investment officer, of GMC, Gladstone Investment and GladstoneCommercial. Moreover, GMC may establish or sponsor other investment vehicleswhich from time to time may have potentially overlapping investment objectiveswith those of ours and accordingly may invest in, whether principally orsecondarily, asset classes similar to those we targeted. While GMC generallyhas broad authority to make investments on behalf of the investment vehiclesthat it advises, GMC has adopted investment allocation procedures to addressthese potential conflicts and intends to direct investment opportunities to theGladstone affiliate with the investment strategy that most closely fits theinvestment opportunity. Nevertheless, the management of GMC may face conflictsin the allocation of investment opportunities to other entities managed by GMC.As a result, it is possible that we may not be given the opportunity toparticipate in certain investments made by other members of the GladstoneCompanies or investment funds managed by investment managers affiliated withGMC.

Incertain circumstances, we may make investments in a portfolio company in whichone of our affiliates has or will have an investment, subject to satisfactionof any regulatory restrictions and, where required, to the prior approval ofour Board of Directors. As of September 30, 2006, our Board of Directorshas approved the following types of co-investment transactions:

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·              Our affiliate, GladstoneCommercial, may purchase property from or lease property to portfolio companiesthat we do not control under certain circumstances. We may pursue suchtransactions only if (i) the portfolio company is not controlled by us orany of our affiliates, (ii) the portfolio company satisfies the tenantunderwriting criteria or owns real estate that meets the lease underwritingcriteria of Gladstone Commercial, and (iii) the transaction is approved bya majority of our independent directors and a majority of the independentdirectors of Gladstone Commercial. We expect that any such negotiations betweenGladstone Commercial and our portfolio companies would result in lease termsconsistent with the terms that the portfolio companies would be likely toreceive were they not portfolio companies of ours. However, if GladstoneCommercial provides a lease to a current or prospective portfolio company ofours, it is likely that there will be a conflict of interest in connection withsuch a transaction. There is a risk that, for Gladstone Commercial to provide alease to a portfolio company, there could be situations where we enter into atransaction that is riskier than we would customarily make in order to enableGladstone Commercial, or another affiliate, to provide the lease portion of thefinancing; this carries a greater risk of default. If any of these risks wereto materialize, it could have a material adverse effect on our ability togenerate cash flow to make distributions to stockholders.

·              We may investsimultaneously with our affiliate Gladstone Investment in senior syndicatedloans whereby neither we nor any affiliate has the ability to dictate the termsof the loans.

 In this regard, GMC has implemented allocationprocedures designed to ensure the fair and equitable treatment of all the fundsit manages.

Certain of ourofficers, who are also officers of GMC, may from time to time serve asdirectors of certain of our portfolio companies. If an officer serves in suchcapacity with one of our portfolio companies, such officer will owe fiduciaryduties to all shareholders of the portfolio company, which duties may from timeto time conflict with the interests of our stockholders.

In the course ofour investing activities, we will pay management and incentive fees to GMC andwill reimburse Gladstone Administration for certain expenses it incurs. As aresult, investors in our common stock will invest on a “gross” basis and receivedistributions on a “net” basis after expenses, resulting in, among otherthings, a lower rate of return than one might achieve through our investorsthemselves making direct investments. As a result of this arrangement, theremay be times when the management team of GMC has interests that differ fromthose of our stockholders, giving rise to a conflict.

**Changesin laws or regulations governing our operations, or changes in theinterpretation thereof, and any failure by us to comply with laws or regulationsgoverning our operations may adversely affect our business.**

We and our portfoliocompanies are subject to regulation by laws at the local, state and federallevels. These laws and regulations, as well as their interpretation, may bechanged from time to time.  Accordingly,any change in these laws or regulations, or their interpretation, or anyfailure by us or our portfolio companies to comply with these laws orregulations may adversely affect our business. For additional information regarding the regulations to which we aresubject, see “Business—Regulation as a Business Development Company” and “Business**—**Material U.S. Federal Income Tax Considerations**—**Regulated Investment Company Status.”

**We may experience fluctuation in our quarterlyresults.**

Wecould experience fluctuations in our quarterly operating results due to anumber of factors including, among others, the interest rates payable on ourdebt securities, variations in and the timing of the recognition of realizedand unrealized gains or losses, the level of our expenses, the degree to whichwe encounter competition in our markets and general economic conditions. As aresult of these factors, results for any period should not be relied upon asbeing indicative of performance in future periods.

**There is a risk that you may not receive dividendsor that our dividends may not grow over time.**

Ourcurrent intention is to distribute at least 90% of our ordinary income andshort-term capital gains to our stockholders on a quarterly basis. We expect toretain net realized long-term capital gains to supplement our equity capitaland support the growth of our portfolio, although our Board of Directors maydetermine in certain cases to distribute these gains. We cannot assure you thatwe will achieve investment results or maintain a tax status that will allow orrequire any specified level of cash distributions or year-to-year increases incash distributions.

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

Ourarticles of incorporation and bylaws and the Maryland General Corporation Lawcontain provisions that may have the effect of discouraging, delaying or makingmore difficult a change in control and preventing the removal of incumbentdirectors. The existence of these provisions may negatively impact the price ofour shares and may discourage third-party bids. These provisions may reduce anypremiums paid to you for our shares. Furthermore, we are subject toSection 3-602 of the Maryland General Corporation Law which governsbusiness combinations with interested stockholders and could delay or prevent achange in control. In addition, our Board of Directors is elected in staggeredterms which makes it more difficult for a hostile bidder to acquire control ofus.

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

Themarket price and marketability of our shares may from time to time be significantlyaffected by numerous factors, including many over which we have no control andthat may not be directly related 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 business development company status;

·              lossof RIC status;

·              changesin our earnings or variations in our operating results;

·              changesin the value of our portfolio of investments;

·              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.

Fluctuationsin the trading prices of our shares may adversely affect the liquidity of thetrading market for our shares and, if we seek to raise capital through futureequity financings, our ability to raise such equity capital.

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

Sharesof closed-end investment companies frequently trade at a discount from netasset value. This characteristic of shares of closed-end investment companiesis separate and distinct from the risk that our net asset value per share willdecline. Although shares of our common stock have historically traded at apremium to net asset value, there can be no guarantee that they will continueto do so.

**We could face losses and potential liability ifintrusion, viruses or similar disruptions to our technology jeopardize ourconfidential information or that of users of our technology.**

Althoughwe have implemented, and will continue to implement, security measures, ourtechnology platform is and will continue to be vulnerable to intrusion,computer viruses or similar disruptive problems caused by transmission fromunauthorized users.  The misappropriationof proprietary information could expose us to a risk of loss or litigation.

**Item 1B. Unresolved Staff Comments**

None.

**Item 2. Properties**

We do not own any real estate or other physicalproperties materially important to our operation.  Gladstone Management Corporation is thecurrent leaseholder of all properties in which we operate.  We occupy these premises pursuant to ourAmended Advisory and Administration Agreement with GMC and GladstoneAdministration, respectively.  Ourheadquarters are located in McLean, Virginia and we also have operations in NewYork, New York, Morristown, New Jersey, Chicago, Illinois, Pittsburgh,Pennsylvania, Lexington, Kentucky, and Dallas, Texas.

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**Item 3. Legal Proceedings**

We are not currently subject to any material legalproceedings, nor, to our knowledge, is any material legal proceeding threatenedagainst us.

**Item 4. Submission of Matters to a Vote of SecurityHolders**

No matters were submitted to a vote of securityholders during the fourth quarter of the fiscal year ended September 30,2006.

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**PART II**

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

Ourcommon stock is traded on the Nasdaq Global Select Market under the symbol “GLAD.”The following table reflects, by quarter, the high and low closing prices pershare of our common stock on the Nasdaq Global Select Market (for periods priorto July 1, 2006, the Nasdaq National Market) for each fiscal quarter during thelast two fiscal years.

 

|         | ** ** | **Quarter  Ended** | ** ** | **High** | ** ** | **Low** | ** ** |
|---------|------------|--------------------|------------|----------|------------|---------|------------|
|    |       |               |       |     |       |    |       |
| FY 2006 |       | 09/30/06           |       | $        | 23.08      |    | $          | 21.10 |   |
|    |       | 06/30/06           |       | 23.50    |       | 20.79   |       |
|    |       | 03/31/06           |       | 22.42    |       | 19.96   |       |
|    |       | 12/31/05           |       | 23.68    |       | 20.36   |       |
| FY 2005 |       | 09/30/05           |       | 26.00    |       | 22.55   |       |
|    |       | 06/30/05           |       | 23.96    |       | 21.18   |       |
|    |       | 03/31/05           |       | 24.80    |       | 20.94   |       |
|    |       | 12/31/04           |       | 25.35    |       | 22.61   |       |
|         |            |                    |            |          |            |         |            |  |  |

 

Asof November 17, 2006, there were approximately 19,000 beneficial owners of ourcommon stock.

**Dividends**

Wecurrently intend to distribute in the form of cash dividends a minimum of 90%of our ordinary income and short-term capital gains, if any, on a quarterlybasis to our stockholders in the form of monthly dividends. Amounts presentedfor each fiscal quarter of 2006 and 2005 represent the cumulative amount of thedividends declared for the months composing such quarter. The following tablereflects, by quarter, the dividends per share that we have declared on ourcommon stock in the last two fiscal years.

|         | ** ** | **Quarter  Ended** | ** ** | **Cash Dividend  Per Share** | ** ** |
|---------|------------|--------------------|------------|----------------------------------------|------------|
|    |       |               |       |                                   |       |
| FY 2006 |       | 09/30/06           |       | $                                      | 0.420      |   |
|    |       | 06/30/06           |       | 0.405                                  |       |
|    |       | 03/31/06           |       | 0.405                                  |       |
|    |       | 12/31/05           |       | 0.405                                  |       |
| FY 2005 |       | 09/30/05           |       | 0.405                                  |       |
|    |       | 06/30/05           |       | 0.390                                  |       |
|    |       | 03/31/05           |       | 0.360                                  |       |
|    |       | 12/31/04           |       | 0.360                                  |       |
|         |            |                    |            |                                        |            |  |

 

**Recent Sales of Unregistered Securities**

There were no unregistered sales of securitiesduring the fiscal year ended September 30, 2006.

**Securities Authorized for Issuance Under Equity CompensationPlans**

There were no securities authorized for issuanceunder equity compensation plans as of September 30, 2006.

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**Item 6. Selected Financial Data**

Thefollowing selected financial data for the fiscal years ended September 30,2006, 2005, 2004, 2003 and 2002 are derived from our audited consolidatedfinancial statements. The data should be read in conjunction with ourconsolidated financial statements and notes thereto and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this report.

**GLADSTONE CAPITALCORPORATIONSELECTED FINANCIAL DATA**
| ** **                                             | ** ** | **Year Ended  September 30,  2006** | ** **  | **Year Ended  September 30,  2005** | ** ** | **Year Ended  September 30,  2004** | ** ** | **Year Ended  September 30,  2003** | ** **  | **Year Ended  September 30,  2002** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|-------------|-----------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|-------------|-----------------------------------------------|------------|
|                                                   |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Total Investment Income                                |       | $                                             | 26,899,846  |                                          | $          | 23,949,759                                    |       | $                                             | 20,395,968  |                                          | $          | 15,154,874 |   | $ | 10,455,703 |   |
| Total Expenses                                         |       | $                                             | 9,498,349   |                                          | $          | 7,531,436                                     |       | $                                             | 7,103,193   |                                          | $          | 3,858,953 |   | $ | 2,839,102 |   |
| Net Investment Income                                  |       | $                                             | 19,350,580  |                                          | $          | 17,286,145                                    |       | $                                             | 13,292,775  |                                          | $          | 11,295,921 |   | $ | 7,616,601 |   |
|                                                   |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Net Increase in Net  Assets Resulting from Operations  |       | $                                             | 24,430,235  |                                          | $          | 15,490,682                                    |       | $                                             | 10,570,290  |                                          | $          | 11,073,581 |   | $ | 7,616,601 |   |
|                                                   |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Per Share Data:                                        |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Net Increase in  Net Assets Resulting from Operations: |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Basic                                                  |       | $                                             | 2.15        |                                          | $          | 1.37                                          |       | $                                             | 1.05        |                                          | $          | 1.10 |   | $ | 0.76 |   |
| Diluted                                                |       | $                                             | 2.10        |                                          | $          | 1.33                                          |       | $                                             | 1.02        |                                          | $          | 1.09 |   | $ | 0.75 |   |
| Cash  Distributions Declared per Share                 |       | $                                             | 1.635       |                                          | $          | 1.515                                         |       | $                                             | 1.365       |                                          | $          | 1.10 |   | $ | 0.81 |   |
|                                                   |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Statement of Assets and  Liabilities Data:             |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Total Assets                                           |       | $                                             | 225,783,215 |                                          | $          | 205,793,094                                   |       | $                                             | 215,333,727 |                                          | $          | 214,566,663 |   | $ | 172,922,039 |   |
| Net Assets                                             |       | $                                             | 172,570,487 |                                          | $          | 151,610,683                                   |       | $                                             | 152,226,655 |                                          | $          | 130,802,382 |   | $ | 130,663,273 |   |
|                                                   |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Other Data:                                            |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Number of  Portfolio Companies at Period End           |       | 32                                            |        | 28                                            |       | 16                                            |       | 11                                            |        | 7                                             |       |
| Principal Amount  of Loan Originations                 |       | $                                             | 135,954,879 |                                          | $          | 143,794,006                                   |       | $                                             | 86,267,500  |                                          | $          | 47,011,278 |   | $ | 97,705,054 |   |
| Principal Amount  of Loan Repayments                   |       | $                                             | 124,009,929 |                                          | $          | 88,019,136                                    |       | $                                             | 47,158,995  |                                          | $          | 18,005,827 |   | $ | 18,387,191 |   |
| Total Return (1)                                       |       | 5.21                                          | %           | 5.93                                          | %          | 24.40                                         | %          | 21.74                                         | %           | 9.60                                          | %          |
|                                                   |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| Weighted Average Yield  on Investments (2):            |       |                                          |        |                                          |       |                                          |       |                                          |        |                                          |       |
| With PIK  Interest (3)                                 |       | 12.74                                         | %           | 12.36                                         | %          | 13.78                                         | %          | 13.86                                         | %           | 14.79                                         | %          |
| Without PIK Interest  (3)                              |       | 12.74                                         | %           | 12.23                                         | %          | 13.44                                         | %          | 13.14                                         | %           | 13.82                                         | %          |

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(1)    For thefiscal years ended September 30, 2006, 2005 and 2004, the total return equalsthe increase of the ending market value over the beginning market value plusmonthly dividends 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.

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

(3)    Refer toNote 2 of the “Notes to Consolidated Financial Statements” for an explanationof PIK, or “Paid-in-Kind,” interest.

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

*The following analysis of our financial conditionand results of operations should be read in conjunction with our financialstatements and the notes thereto contained elsewhere in this Form 10-K.*

**OVERVIEW**

Wewere incorporated under the General Corporation Laws of the State of Marylandon May 30, 2001. Our investment objectives are to achieve a high level ofcurrent income by investing in debt securities, consisting primarily of seniornotes, senior subordinated notes and junior subordinated notes, of establishedprivate businesses that are substantially owned by leveraged buyout funds,venture capital funds or are family-owned businesses, with a particular focuson senior subordinated notes. In addition, we may acquire existing loans thatmeet this profile from leveraged buyout funds, venture capital funds andothers. 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. We operate as a closed-end,non-diversified management investment company, and have elected to be treatedas a business development company under the Investment Company Act of 1940 (the“1940 Act”).

Weseek out small and medium-sized businesses that meet certain criteria,including (1) the potential for growth in cash flow, (2) adequateassets for loan collateral, (3) experienced management teams with asignificant ownership interest in the borrower, (4) profitable operationsbased on the borrower’s cash flow, (5) reasonable capitalization of theborrower (usually by leveraged buyout funds or venture capital funds) and(6) the potential to realize appreciation and gain liquidity in our equityposition, if any. We anticipate that liquidity in our equity position will beachieved through a merger or acquisition of the borrower, a public offering ofthe borrower’s stock or by exercising our right to require the borrower torepurchase our warrants. We lend to borrowers that need funds to financegrowth, restructure their balance sheets or effect a change of control.

Ourloans typically range from $5 million to $15 million, generallymature in no more than seven years and accrue interest at a fixed or variablerate that exceeds the prime rate. Some of our loans contain a provision thatcalls for some portion of the interest payments to be deferred and added to theprincipal balance so that the interest is paid, together with the principal, atmaturity. This form of deferred interest is often called “paid in kind” (“PIK”)interest, and, when earned, we record PIK interest as interest income and addthe PIK interest to the principal balance of the loans.  We seek to avoid PIK interest with allpotential investments under review and presently do not hold any loans thatcontain a PIK provision.

Becausethe majority of our portfolio loans consist of term debt of private companieswho typically cannot or will not expend the resources to have their debtsecurities rated by a credit rating agency, we expect that most, if not all, ofthe debt securities we acquire will be unrated. We cannot accurately predictwhat ratings these loans might receive if they were in fact rated, and thuscannot determine whether or not they could be considered “investment grade”quality.

Tothe extent possible, our loans generally are collateralized by a securityinterest in the borrower’s assets. Interest payments are generally 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 generally become due at maturityat five to seven years. When we receive a warrant to purchase stock in aborrower in connection with a loan, the warrant will typically have an exerciseprice equal to the fair value of the portfolio company’s common stock at thetime of the loan and entitle us to purchase a modest percentage of the borrower’sstock.

Original issue discounts(“OID”) arise when we extend a loan and receive an equity interest in theborrower at the same time.  To the extentthat the price paid for the equity is not at market value, we must allocatepart of the price paid for the loan, to the value of the equity.  Then the amount allocated to the equity, theOID, must be amortized over the life of the loan.  As with PIK interest, the amortization of OIDalso produces income that must be recognized for purposes of satisfying thedistribution requirements for a regulated investment company (“RIC”) underSubchapter M of the Internal Revenue Code of 1986 (the “Code”), whereas thecash is received, if at all, when the equity instrument is sold.  We seek to avoid OID with all potentialinvestments under review and to date do not hold any investments with OID.

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Inaddition, as a business development company under the 1940 Act, we are requiredto make available significant managerial assistance to our portfolio companies.Prior to the externalization of our management on October 1, 2004, the start ofthe 2005 fiscal year, we provided these services through our wholly-ownedsubsidiary, Gladstone Capital Advisers, Inc.  Since the externalization of our managementon October 1, 2004, our investment adviser, Gladstone Management Corporation (“GMC”or “Adviser”), began to provide these services on our behalf through itsofficers who are also our officers.  Inaddition, GMC provides other services to our portfolio companies, for which itreceives fees, in connection with our investments.  The fees for these services are generallypaid to GMC in part at the time a prospective portfolio company signs anon-binding term sheet with us (as further described in the followingparagraph), with the remainder paid at the closing of the investment. Thesefees are generally non-recurring, however, in some instances they may have arecurring component which is also paid to GMC. Any such fees received, with the exception of the recurring fees, by GMCare credited against the management advisory fee payable to GMC pursuant to theterms of our advisory agreement, which has the effect of reducing our expensesto the extent of any such fees received by GMC. The specific non-managerial assistance services GMC provides vary byportfolio company, but generally include a wide variety of services to theportfolio companies such as investment banking services, arranging bankfinancing, arranging equity financing, structuring financing from multiplelenders and investors, reviewing existing credit facilities, restructuringexisting loans, raising equity and debt capital, turnaround management, mergerand acquisition services, closely monitoring the operations of the borrower,participating in its board and management meetings, and recruiting newmanagement personnel.  Prior to the startof fiscal year 2005, Gladstone Capital Advisers, Inc. provided these servicesand received these fees and we have recorded fees for these services as feeincome for the periods in which these fees were earned by us.

Prior to making aninvestment, we ordinarily enter into a non-binding term sheet with thepotential borrower. These term sheets are generally subject to a number ofconditions including, but not limited to, the satisfactory completion of ourdue diligence investigations of the potential borrower’s business and reachingagreement on the legal documentation for the loan. Upon execution of thenon-binding term sheet, the potential borrower generally pays GMC anon-refundable fee for its services rendered through the date of thenon-binding term sheet. Prior to the externalization of our management onOctober 1, 2004, we recognized this as fee revenue upon execution of thenon-binding term sheet. Since October 1, 2004, these fees have been received byGMC and offset against amounts due to GMC, which has the effect of reducing ourexpenses to the extent of any such fees received by GMC.

Inthe event that we expend significant effort in considering and negotiating apotential investment that ultimately is not consummated, we generally will seekreimbursement from the proposed borrower for our reasonable expenses incurredin connection with the proposed transaction and we reimburse GMC for anyamounts collected for expenses incurred by GMC. Also, in the event that we have incurred significant legal fees inconnection with the transaction, we will typically seek reimbursement for theseexpenses from the proposed borrower. However, there can be no guarantee that we will be successful in collectingany such reimbursements.

Theonly significant continuing revenue associated with the investments we havealready closed is interest income and, potentially, capital gains realized inconnection with the liquidation of any associated equity interest (e.g.,warrants).

During the fiscal yearended September 30, 2006, we extended, directly or through participations,approximately $136 million of new loans to a total of 22 companies.  Also, during the fiscal year ended September30, 2006, 7 borrowers repaid their loans ahead of contractual maturity and wesold or repaid in full on 9 syndicated loans, and sold 3 loan investments at aloss for an aggregate return of capital of approximately $20 million and wereceived scheduled contractual principal repayments of approximately $20million, for total principal repayments of approximately $124 million.  Since our initial public offering in August2001, we have made 124 different loans to, or investments in, 66****companies for a total of approximately$501.5****million, before givingeffect to principal repayments on investments and divestitures.

Weare continuously working toward the consummation of more loan origination andsyndicated investments in an effort to grow our loan portfolio. Theseprospective loans are subject to, among other things, the satisfactorycompletion of our due diligence investigation of each borrower, acceptance ofterms and structure and attainment of necessary consents. With respect to eachprospective loan, we will only agree to provide the loan if, among otherthings, the results of our due diligence investigations are satisfactory, theterms and conditions of the loan are acceptable and all necessary consents arereceived. Our management has initiated its due diligence investigations of thepotential 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.

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**External Adviser**

SinceOctober 1, 2004, we have been externally managed pursuant to a contractualinvestment advisory arrangement with GMC, under which GMC has directly employed all of our personnel and paid its payroll,benefits, and general expenses directly. Our Initial Advisory Agreement with GMC was in place through September30, 2006.  Pursuant to the InitialAdvisory Agreement, we paid GMC an annual advisory fee of 1.25% of ourtotal assets (as reduced by cash and cash equivalents pledged to creditors),payable in quarterly increments of 0.3125%, and an annual administrative fee of0.75% of our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.1875%.  GMC’s Board of Directors agreed to waive, forthe quarters ending June 30, 2006 and September 30, 2006, the annual advisoryfee of 1.25% to 0.5% for those senior syndicated loans in which we already havesyndicated second lien participations.

On October 1, 2006, we entered into the AmendedAdvisory Agreement with GMC and the Administration Agreement with GladstoneAdministration. Our Board of Directors proposed the Amended Advisory Agreementto stockholders in order to provide what it considers to be more appropriateincentives to reward fund management, and our stockholders approved each ofthese agreements on December 2, 2005.

Under the AmendedAdvisory Agreement, we pay GMC an annual base management fee of 2% of ouraverage gross assets, which is defined as total assets less cash and cashequivalents pledged to creditors calculated as of the end of the two mostrecently completed fiscal quarters, in addition to a two-part incentivefee.  The first part of the incentive feeis an income-based incentive fee which rewards GMC if our quarterly netinvestment income (before giving effect to any incentive fee) exceeds 1.75% ofour net assets (the “hurdle rate”). We will pay GMC an income incentive feewith respect to our pre-incentive fee net investment income in each calendarquarter as follows:

·    no incentive fee in any calendar quarter inwhich our pre-incentive fee net investment income does not exceed the hurdlerate (7% annualized);

·    100% of our pre-incentive fee net investmentincome with respect to that portion of such pre-incentive fee net investmentincome, if any, that exceeds the hurdle rate but is less than 2.1875% in anycalendar quarter (8.75% annualized); and

·    20% of the amount of our pre-incentive feenet investment income, if any, that exceeds 2.1875% in any calendar quarter(8.75% annualized).

The second part of theincentive fee is a capital gains incentive fee that will be determined andpayable in arrears as of the end of each fiscal year (or upon termination ofthe Amended Advisory Agreement, as of the termination date), commencing onOctober 1, 2006, and will equal 20% of our realized capital gains as of the endof the fiscal year. In determining the capital gains incentive fee payable toGMC, we will calculate the cumulative aggregate realized capital gains andcumulative aggregate realized capital losses since our inception, and theaggregate unrealized capital depreciation as of the date of the calculation, asapplicable, with respect to each of the investments in our portfolio.

GMC’s Board of Directorshas agreed to waive, for the fiscal quarter ending December 31, 2006, theannual 2.0% base management fee to 0.5% for those senior syndicated loans inwhich we already have syndicated second lien participations.

Inaddition to the base management and incentive fees under the Amended AdvisoryAgreement, certain fees received by GMC from our portfolio companies werecredited against the investment advisory fee under the Initial AdvisoryAgreement, and will continue to be paid to GMC and credited under the AmendedAdvisory Agreement.  In addition, we willcontinue to pay our direct expenses including, but not limited to, directorsfees, legal and accounting fees, and stockholder related expenses under theAmended Advisory Agreement.

Under the AmendedAdvisory Agreement, we will pay separately for administrative services underthe Administration Agreement. The Administration Agreement provides forpayments equal to our allocable portion of Gladstone Administration’s overheadexpenses in performing its obligations under the Administration Agreement,including but not limited to rent, and our allocable portion of the salariesand benefits expenses of our chief financial officer, chief compliance officerand controller and their respective staffs.

The same individuals whomanaged our portfolio continue to manage our portfolio under the AmendedAdvisory Agreement and, although the administrative services are now providedseparately pursuant to the Administration Agreement, we do not expect that ourstockholders will notice any change or diminution in services because of thisorganizational separation.

GMC has alsoserviced our loan portfolio pursuant to a loan servicing agreement withGladstone Business Loan LLC (“Business Loan”) since July 12, 2004. GMC servicesthese loans in return for a 1.5% annual fee, based on the monthly aggregateoutstanding 

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loan balance ofthe loans pledged under the facility. Prior to July 12, 2004, our loans were serviced under a similaragreement between Business Loan and Gladstone Capital Advisers, Inc., ourwholly-owned subsidiary, although the fees from these intercompany transactionswere eliminated through the consolidation of our financial results with thoseof Business Loan and Gladstone Capital Advisers, Inc.

Prior to theexternalization of our management, we were party to an expense sharingarrangement with GMC, which during such time served as the external adviser toGladstone Commercial Corporation (“Gladstone Commercial”), a real estateinvestment trust affiliated with us. Under this expense sharing arrangement,GMC reimbursed Gladstone Capital Advisers, Inc. for a portion of our totalpayroll and benefits expenses (based on the percentage of total hours worked byeach of our employees on Gladstone Commercial matters). GMC also reimbursedGladstone Capital Advisers, Inc. for its pro-rata portion of all other generalexpenses (based on the percentage of total hours worked by all of our employeeson Gladstone Commercial matters). GMC further passed its share of theseexpenses along to Gladstone Commercial under a separate advisoryagreement.  Following our engagement ofGMC on October 1, 2004, the first day of our 2005 fiscal year, GMCdirectly employs all of our personnel and pays its payroll, benefits, andgeneral expenses directly.  Thus, theexpense sharing arrangement between Gladstone Capital Advisers, Inc. and GMCterminated upon the externalization of our management on October 1, 2004.

**Off-Balance Sheet Arrangements**

Wedo not have any significant off-balance sheet arrangements as defined inItem 303(a)(4)(ii) of SEC Regulation S-K as ofSeptember 30, 2006.

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**Critical Accounting Policies**

Thepreparation of financial statements and related disclosures in conformity withgenerally accepted accounting principles in the United States requiresmanagement to make estimates and assumptions that affect the reported consolidatedamounts of assets and liabilities, disclosure of contingent assets andliabilities at the date of the financial statements, and revenues and expensesduring the periods reported. Actual results could materially differ from thoseestimates. Our accounting policies are more fully described in the “Notes toConsolidated Financial Statements” contained elsewhere in this report. We haveidentified our investment valuation process, tax status and revenue recognitionas our most critical accounting policies.

**Investment Valuation**

The most significantestimate inherent in the preparation of our consolidated financial statementsis the valuation of investments and the related amounts of unrealizedappreciation and depreciation of investments recorded.

*General Valuation Policy*:  Using procedures established by our Board ofDirectors, we value our investment portfolio each quarter. We carry ourinvestments at fair value, as determined in good faith by or under thedirection of our Board of Directors. Securities that are publicly traded, ifany, are valued at the closing price of the exchange or securities market onwhich they are listed on the valuation date. Securities that are not traded ona public exchange or securities market, but for which a limited market existsand that have been rated by a nationally recognized statistical ratingorganizations, which we refer to as a NRSRO, (such as certain participations insyndicated loans) are valued at the indicative bid price offered by thesyndication agent on the valuation date.

Debt and equitysecurities that are not publicly traded, for which a limited market does notexist, or for which a limited market exists but that have not been rated by aNRSRO (or for which we have various degrees of trading restrictions) are valuedat fair value as determined in good faith by or under the direction of ourBoard of Directors. In making the good faith determination of the value ofthese securities, we start with the cost basis of the security, which includesthe amortized OID and PIK interest, if any. We then apply the methods set outbelow in “Valuation Methods.” Members of GMC’s portfolio management teamprepare the valuations of our investments in portfolio companies using the mostrecent portfolio company financial statements and forecasts. These individualsalso consult with portfolio company senior management and ownership to obtainfurther updates on the portfolio company’s performance, including informationsuch as industry trends, new product development, and other operational issues.Due to the uncertainty inherent in the valuation process, such estimates offair value may differ significantly from the values that would have beenobtained had a ready market for the securities existed, and the differencescould be material. Additionally, changes in the market environment and otherevents that may occur over the life of the investments may cause the gains orlosses ultimately realized on these investments to be different than thevaluations currently assigned. There is no single standard for determining fairvalue in good faith, as fair value depends upon circumstances of eachindividual case. In general, fair value is the amount that we might reasonablyexpect to receive upon the current sale of the security.

At September 30, 2006, weengaged SPSE to submit opinions of value for 39 of our loan securities. Werequest that SPSE also evaluate and assign values to success fees (conditionalinterest included in some loan securities) when we determine that theprobability of receiving a success fee on a given loan is above 6-8%, athreshold of significance. Upon completing our collection of data with respectto the investments (including the information described under “CreditInformation,” the risk ratings of the loans described under “Loan Grading andRisk Rating” and the factors described under “Valuation Methods”), thisvaluation data is presented to SPSE. SPSE makes its independent assessment ofthe data that we have assembled and assesses its own data to form an opinion asto what they consider to be the market values for the securities. With regardto its work, SPSE has issued the following paragraph:

SPSE provides evaluatedprice opinions which are reflective of what SPSE believes the bid side of themarket would be for each loan after careful review and analysis of descriptive,market and credit information. Each price reflects SPSE’s best judgment basedupon careful examination of a variety of market factors. Because of fluctuationin the market and in other factors beyond its control, SPSE cannot guaranteethese evaluations. The evaluations reflect the market prices, or estimatesthereof, on the date specified. The prices are based on comparable marketprices for similar securities. Market information has been obtained fromreputable secondary market sources. Although these sources are consideredreliable, SPSE cannot guarantee their accuracy.

SPSE opinions of valueare submitted to our Board of Directors along with GMC’s supplementalassessment and recommendation regarding valuation of each of these investments.GMC generally accepts the opinion of value given by SPSE, however in certainlimited circumstances, such as when GMC may learn new information regarding aninvestment between the time of submission to SPSE and the date of the boardassessment, GMC’s conclusions as to value may differ from the opinion of valuegiven by SPSE. Our Board of Directors then reviews whether GMC has followed itsestablished procedures for determinations of fair value, and votes to accept ornot accept the recommended valuation of our investment portfolio. At theSeptember 30, 2006 meeting of the Board of Directors, GMC and our managementrecommended, and the Board of Directors elected to accept, the opinions ofvalue given by 

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SPSE on the 39 loans inour portfolio as denoted on the Schedule of Investments as of September 30,2006 in our consolidated financial statements.

Because there is a delaybetween when we close an investment and when the investment can be evaluated bySPSE, new loans are not valued immediately by SPSE; rather, management makesits own determination about the value of these investments in accordance withour valuation policy. Because SPSE does not provide values for equitysecurities, GMC determines the fair value of these investments using valuationpolicies approved by our Board of Directors.

*Credit Information: *GMC monitors a wide varietyof key credit statistics that provide information regarding our portfoliocompanies to help us assess credit quality and portfolio performance. We andGMC participate in periodic board meetings of our portfolio companies in whichwe hold control investments and also require them to provide annual audited andmonthly unaudited financial statements. Using these statements and board discussions,GMC calculates and evaluates the credit statistics.

*Loan Grading and Risk Rating:*  As part of our valuation procedures we riskrate all of our investments in debt securities. Our risk rating system uses ascale of 0 to 10, with 10 being the lowest probability of default. This systemis used to estimate the probability of default on our debt securities and theprobability of loss if there is a default. These types of systems are referredto as risk rating systems and are used by banks and rating agencies. The riskrating system covers both qualitative and quantitative aspects of the businessand the securities we hold.

We seek to have our riskrating system mirror the risk rating systems of major risk rating organizationssuch as those provided by a 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 established our system to rate debt securities ofcompanies that are unrated by any NRSRO, there can be no assurance that the correlationto the NRSRO set out below is accurate. We believe our risk rating would besignificantly higher than a typical NRSRO risk rating because the risk ratingof the typical NRSRO is designed for larger businesses. However, our riskrating has been designed to risk rate the securities of smaller businesses thatare not rated by a typical NRSRO. Therefore, when we use our risk rating onlarger business securities, the risk rating is higher than a typical NRSROrating. The primary difference between our risk rating and the rating of atypical NRSRO is that our risk rating uses more quantitative determinants andincludes qualitative determinants that we believe are not used in the NRSROrating. 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 with the designation 10 as the best riskrating which may be equivalent to a BBB from a NRSRO, however, no assurance canbe given that a 10 on our scale is equal to a BBB on a NRSRO scale.

 
| **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) thedefault rates set here are for a ten year term debt security.  If a debt security is less than ten years thenthe probability of default is adjusted to a lower percentage for the shorterperiod which may move the security higher on our risk rating scale.*

The above scalegives an indication of the probability of default and the magnitude of the lossif there is a default.  Our policy is tostop accruing interest on an investment if we determine that interest is nolonger collectible.  AtSeptember 30, 2006, no payments were past due on any of our debtsecurities.  At September 30, 2005, ARIHoldings, Inc. was past due on its payments and was placed on non-accrual.  We do not risk rate our equity securities.

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The followingtable lists the risk ratings for all of the debt securities by quarter duringthe fiscal year ended September 30, 2006:
| **Rating**       | ** ** | **December 31, 2005** | ** ** | **March 31, 2006** | ** ** | **June 30, 2006** | ** ** | **September 30, 2006** | ** ** |
|------------------|------------|----------------------------|------------|-------------------------|------------|------------------------|------------|-----------------------------|------------|
| Average          |       | 7.1                        |       | 7.1                     |       | 6.9                    |       | 6.7                         |       |
| Weighted Average |       | 7.2                        |       | 7.1                     |       | 6.8                    |       | 6.9                         |       |
| Highest          |       | 9.0                        |       | 9.0                     |       | 9.0                    |       | 9.0                         |       |
| Lowest           |       | 5.0                        |       | 4.0                     |       | 4.0                    |       | 4.0                         |       |

 

*Valuation Methods:*  We determine the value of publicly-tradeddebt securities based on the closing price for the security on the exchange orsecurities market on which it is listed on the valuation date. We value debtsecurities that are not publicly traded, but for which a limited market for thesecurity exists, such as participations in syndicated loans, at the indicativebid price offered by the syndication agent on the valuation date.  At September 30, 2006, none of the debtsecurities in our portfolio were publicly traded and there was a limited marketfor 9 debt securities in our portfolio. At September 30, 2005, none of the debt securities in our portfolio werepublicly traded and there was a limited market for 12 debt securities in ourportfolio.

We determine the value ofdebt securities that are not publicly traded, for which there is no market, orfor which there is a market but have not been rated by a NRSRO by first usingthe risk rating designation of the security as described above.  Using this risk rating designation, we seekto determine the value of the security as if we currently intended to sell thesecurity.  To determine the current saleprice of the security, we consider some or all of the following factors:

·      financialstanding of the issuer of the security;

·      comparisonof the business and financial plan of the issuer with actual results;

·      thecost of the security;

·      thesize of the 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;

·      abilityof the issuer to obtain needed financing;

·      changesin the economy affecting the issuer;

·      recentpurchases or sales of a security of the issuer;

·      pricingand sales by other buyers or sellers of similar securities;

·      financialstatements of the borrower;

·      reportsfrom portfolio company senior management and ownership;

·      minutesof portfolio company board meetings;

·      thetype of security;

·      costat date of purchase;

·      sizeof holding;

·      discountfrom market 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;

·      existenceof merger proposals or tender offers affecting the securities;

·      thecollateral;

·      theissuer’s ability to make payments;

·      thecurrent and forecasted earnings of the issuer;

·      statisticalratios compared to lending standards;

·      statisticalratios compared to similar securities; and

·      otherpertinent factors.

For those debt securitiesfor which SPSE prepares opinions of value, we provide some or all of theforegoing information to SPSE for its use in preparing its recommendations.

We value convertibledebt, equity, success fees or other equity-like securities for which there is amarket based on the market prices for such securities, even if that market isnot robust. At September 30, 2006 and September 30, 2005 there was nomarket for any of the equity securities we owned. To value equity securitiesfor which no market exists, 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. These valuation techniques consist ofdiscounted cash flow of the expected sale price in the future, valuation of thesecurities based on recent sales in comparable transactions, and a review ofsimilar companies that are 

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publicly tradedand the market multiple of their equity securities.  At September 30, 2006 and September 30, 2005,we had $37,000 invested, at cost, in equity securities compared to our debtportfolio with a cost basis of $216,165,988 and $205,338,554, respectively.

At September 30, 2006, wehad total unrealized appreciation of $2,015,198, which was mainly comprised ofunrealized appreciation of $672,431 on our warrants of Finn Corporation,unrealized appreciation of $607,625 on our senior term debt in Mistras HoldingCorporation and unrealized appreciation of $148,287 on our senior subordinatedterm debt investment in Xspedius Communications, LLC.  This unrealized appreciation was offset byunrealized depreciation of $575,434, most notably composed of unrealizeddepreciation of $131,367 on our senior subordinated term debt investment in ConsolidatedBedding, Inc. and unrealized depreciation of $115,750 on our senior term debtin LocalTel Inc. In the aggregate, we recorded net unrealized appreciation of$1,439,764 on our total investment portfolio.

At September 30, 2005, wehad total unrealized depreciation of $6,231,296, which was mainly composed ofunrealized depreciation in our senior subordinated term debt investment in FinnCorporation (excluding the warrants) of $3,150,000, our senior subordinatedterm debt investment in Xspedius Communications, LLC of $1,493,182, and oursenior term debt in ARI Holdings, Inc. of $1,053,939 (which was subsequentlysold at the September 30, 2005 reflected fair value), partially offset byunrealized appreciation, most notably, on the value of our warrants of FinnCorporation, which had unrealized appreciation of $645,114 and our senior termdebt investment in Woven Electronics Corporation, which had unrealizedappreciation of $431,436.  Thisaforementioned unrealized appreciation plus unrealized appreciation of $625,955on certain other investments, primarily in our originated loan investments andcertain syndicate participations, most notably Infor Global Solutions Ltd.which had unrealized appreciation of $248,750, which resulted in overall netunrealized depreciation of $4,528,791.

**Tax Status**

*Federal Income Taxes*

We intend tocontinue to qualify for treatment as a RIC under Subtitle A, Chapter 1 ofSubchapter M of the Code. As a RIC, we are not subject to federal income tax onthe portion of our taxable income and gains distributed to stockholders. Toqualify as a RIC, we are required to distribute to stockholders at least 90% ofinvestment company taxable income, as defined by the Code.  We have a policy to pay out as a dividend upto 100% of that amount.

**Revenue Recognition**

*Interest Income Recognition*

Interest income isrecorded on the accrual basis to the extent that such amounts are expected tobe collected. We will stop accruing interest on investments when it isdetermined that interest is no longer collectible. Conditional interest or asuccess fee is recorded when earned upon full repayment of a loan investment.

*Paid in Kind Interest*

In the past, wehave had some loans in our portfolio which contain a paid in kind (“PIK”)provision. The PIK interest, computed at the contractual rate specified in eachloan agreement, is added to the principal balance of the loan and recorded asinterest income. To maintain our status as a RIC, this non-cash source ofincome must be paid out to stockholders in the form of dividends, even thoughwe have not yet collected the cash.

*Fee Income*

The 1940 Actrequires that a business development company make available managerialassistance to its portfolio companies by providing significant guidance andcounsel concerning the management, operations, or business objective andpolicies of the respective portfolio company. Prior to October 1, 2004, weprovided managerial assistance to our portfolio companies in connection withour investments through our wholly-owned subsidiary, Gladstone CapitalAdvisers, Inc.  Since theexternalization of our management on October 1, 2004, we have provided these and other services through ourexternal adviser, GMC.  Currently,neither we nor GMC receive fees in connection with managerial assistance.However, effective October 1, 2004 GMC, GMC, receives the fees for the otherservices it provides, and those fees for other services are credited to theinvestment advisory fees due to GMC. These other fees are generally paid to GMC in part at the time aprospective portfolio company signs a non-binding term sheet with us, with theremainder paid at the closing of the investment.  These fees are generally non-recurring, arerecognized as revenue when earned and are paid directly to GMC by the borrower orpotential borrower, effective October 1, 2004 and for all future periods.  The services GMC provides vary by investment,but generally include a wide variety of services to the portfolio companiessuch as investment banking 

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services,arranging bank financing, arranging equity financing structuring financing frommultiple lenders and investors, reviewing existing credit facilities,restructuring existing loans, raising equity and debt capital, turnaroundmanagement, merger and acquisition services and recruiting new managementpersonnel.  Any services of this naturesubsequent to the closing would generally generate a separate fee at the timeof completion. From time to time, we are invited to participate as a co-lenderin a transaction. In the event that we do not provide significant services inconnection with our investment, loan fees paid directly to GMC in suchsituations are deferred and amortized over the life of the loan.

**RESULTS OF OPERATIONS**

*COMPARISONOF THE FISCAL YEARS ENDED SEPTEMBER 30, 2006 AND SEPTEMBER 30, 2005*

**Investment Income**

Investmentincome for the fiscal year ended September 30, 2006 was approximately$26.9 million as compared to approximately $23.9 million for the fiscal yearended September 30, 2005.  Thisincrease is primarily a result of a rise in interest income from an increase ofapproximately $136.0 million of new investments from the prior year and thecollection of approximately $1.3 million of exit fees upon the full repaymentof two portfolio company investments.

Interestincome from our investments in debt securities of private companies wasapproximately $25.6 million, including $63,000 of PIK interest, for the fiscalyear ended September 30, 2006 as compared to $22.4 million for thefiscal year ended September 30, 2005, including $394,000 of PIKinterest.  This increase was primarilythe result of approximately $136.0 million of new investments for the fiscalyear ended September 30, 2006 and the collection of approximately $1.3million of exit fees upon the full repayment of two portfolio companyinvestments.  The decrease in PIK incomefor the fiscal year ended September 30, 2006 was the result of the earlyrepayment in full of one loan containing a PIK provision.

Theweighted average yield on our portfolio for the fiscal year endedSeptember 30, 2006 was 12.74% (with and without giving effect to PIKinterest).  The weighted average yield onour portfolio for the fiscal year ended September 30, 2005 was 12.23%(without giving effect to PIK interest) and 12.36% (after giving effect to PIKinterest).  The yields were computedbased on the cost value of the investment portfolios.

Interestincome from invested cash and cash equivalents for the fiscal year endedSeptember 30, 2006 was approximately $38,000, as compared to approximately$33,000 for the fiscal year ended September 30, 2005. This increase wasprimarily caused by an increase  in cashbalances during the year resulting from sales and principal repayments ofportfolio investments of approximately $124 million for the fiscal year endedSeptember 30, 2006.

Prepaymentfees and other income was approximately $0.8 million for the fiscal year endedSeptember 30, 2006 and $1.1 million for the fiscal year endedSeptember 30, 2005.  For the fiscalyear ended September 30, 2006, this consisted of approximately $0.8 million ofprepayment penalty fees.  For the fiscalyear ended September 30, 2005, this consisted of approximately $1.0 million ofprepayment penalty fees and approximately $24,000 of waiver fees for certainloan covenants.

**Operating Expenses**

Operating expenses forthe fiscal year ended September 30, 2006 were approximately $9.5 million, ascompared to approximately $7.5 million for the fiscal year ended September 30,2005. This increase****was mainly aresult of an increase in loan servicing fees, interest expense, stockholderrelated costs and other expenses, offset by reductions in professional fees andamortization of deferred financing fees.

Loan servicingfees of approximately $2.9 million were incurred for the fiscal year endedSeptember 30, 2006 as compared to approximately $2.5 million for the fiscalyear ended September 30, 2006.  Thesefees were incurred in connection with a loan servicing agreement betweenBusiness Loan and GMC, which is based on the size of the aggregate outstandingloan portfolio.  These fees were directlycredited against the amount of the management fee due to GMC.

EffectiveOctober 1, 2004, we entered into an advisory agreement with GMC whereby GMCserves as our external adviser.  Ascompensation for the services of GMC, we pay GMC an annual advisory fee of1.25% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total fee of 2% of total assets (as reduced by cash and cashequivalents pledged to creditors). Effective in April 2006, GMC’s Board ofDirectors voluntarily waived the advisory fee on a temporary basis by reducingthe 1.25% annual fee to 0.5% per annum applicable only to the senior syndicatedloans in which we already have a second lien position. We continue to paydirect expenses including, but 

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notlimited to, directors’ fees, legal and accounting fees, stockholder relatedexpenses, and directors and officers insurance. Under the advisory agreement, GMC provides the managerial assistance andother services to our portfolio companies and likewise GMC directly receivesany fees for such services.  Any suchfees are credited directly against the 2% management fee payable to GMC.  The 2% management fee is also directlyreduced by the amount of the monthly loan servicing fees we pay to GMC.Overall, the management fee due to GMC cannot exceed 2% of total assets (asreduced by cash and cash equivalents pledged to creditors) during any givenfiscal year.  On October 1, 2006, weentered into the Amended Advisory Agreement with GMC and the AdministrationAgreement with Gladstone Administration (See “— Overview — External Adviser.”)

Thefollowing table sets forth the quarterly computations of the management fee forthe fiscal years ended September 30, 2006 and September 30, 2005, based on thequarterly increment of 0.50% (0.3125% quarterly advisory fee plus 0.1875%quarterly administrative fee) and the reduced fee for senior syndicated loansof 0.125% per quarter:
| ** **                                                          | ** ** | **September 30,** | ** **  | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** **  |
|---------------------------------------------------------------------|------------|------------------------|-------------|-------------------|------------|--------------------|------------|-----------------------|-------------|
| ** **                                                          | ** ** | **2006**               | ** **  | **2006**          | ** ** | **2006**           | ** ** | **2005**              | ** **  |
| **Fee:**                                                            |       |                   |        |              |       |               |       |                  |        |
| Total assets at                                                     |       | $                      | 223,979,932 | (f)               | $          | 207,265,095        |       | $                     | 217,404,695 |   | $ | 211,823,244 |   |
| Less: Senior  syndicated loans subject to reduced fee               |       | (11,011,616            | )(a)        | (3,018,897        | )(a)       | —             |       |                  |        |
| Less: Borrowings  under line of credit at                           |       | —                 |        | —            |       | —             |       | (15,000,000           | )(d)        |
| Total assets  subject to quarterly fee of 0.50% as of               |       | 212,968,316            |        | 204,246,198       |       | 217,404,695        |       | 196,823,244           |        |
| Quarterly fee  rate                                                 |       | 0.50%                  |        | 0.50%             |       | 0.50%              |       | 0.50%                 |        |
| Management fee  before senior syndicated loan advisory fee          |       | 1,064,841              |        | 1,021,231         |       | 1,087,023          |       | 984,116               |        |
| Total senior  syndicated loan advisory fee at quarterly rate 0.125% |       | 13,765                 | (b)         | 3,774             | (b)        | —             |       | —                |        |
| Gross management  fee before loan servicing fee credit              |       | 1,078,606              |        | 1,025,005         |       | 1,087,023          |       | 984,116               |        |
| Less: loan  servicing fee from Business Loan                        |       | 763,851                |        | 693,965           |       | 734,644            |       | 715,415               |        |
| Management fee before credit:                                       |       | 314,755                |        | 331,040           |       | 352,379            |       | 268,701               |        |
| **Direct  Credit to Management Fee:**                               | ** ** | ** **             | ** **  | ** **        | ** ** | ** **         | ** ** | ** **            | ** **  |
| Fee revenue  recorded by GMC:                                       |       | 289,000                |        | 539,000           |       | 673,000            |       | 550,000               |        |
| Net management fee for  the three months ended (c):                 |       | $                      | 25,755      |              | $          | (207,960           | )          | $                     | (320,621    | ) | $ | (281,299 | ) |

 
| ** **                                             | ** ** | **September 30,** | ** **  | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** **  |
|--------------------------------------------------------|------------|------------------------|-------------|-------------------|------------|--------------------|------------|-----------------------|-------------|
| ** **                                             | ** ** | **2005**               | ** **  | **2005**          | ** ** | **2005**           | ** ** | **2004**              | ** **  |
| **Fee:**                                               | ** ** | ** **             | ** **  | ** **        | ** ** | ** **         | ** ** | ** **            | ** **  |
| Total assets                                           |       | $                      | 205,793,094 |              | $          | 209,320,463        |       | $                     | 213,753,998 |   | $ | 194,085,591 |   |
| Less: Borrowings  under line of credit                 |       | —                 |        | —            |       | (18,644,179        | )(e)       | (22,435,000           | )(e)        |
| Total assets  subject to quarterly fee of 0.50% as of  |       | 205,793,094            |        | 209,320,463       |       | 195,109,819        |       | 171,650,591           |        |
| Quarterly fee  rate                                    |       | 0.50%                  |        | 0.50%             |       | 0.50%              |       | 0.50%                 |        |
| Gross management  fee before loan servicing fee credit |       | 1,028,965              |        | 1,046,602         |       | 975,549            |       | 858,254               |        |
| Less: loan  servicing fee from Business Loan           |       | 745,263                |        | 687,971           |       | 585,542            |       | 530,952               |        |
| Management fee before credit:                          |       | 283,702                |        | 358,631           |       | 390,007            |       | 327,302               |        |
| **Direct  Credit to Management Fee:**                  | ** ** | ** **             | ** **  | ** **        | ** ** | ** **         | ** ** | ** **            | ** **  |
| Fee revenue recorded  by GMC:                          |       | 100,000                |        | 240,600           |       | 450,000            |       | 286,500               |        |
| Net management  fee for the three months ended:        |       | $                      | 183,702     |              | $          | 118,031            |       | $                     | (59,993     | ) | $ | 40,802 |   |

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*(a)   In April 2006, GMC’s Board of Directors waived on a temporarybasis the annual advisory fee from 1.25% to 0.5% (0.125% quarterly) for thosesenior syndicated loans in which we also hold a syndicated second lienposition.*

*(b)   This amount represents the reduced quarterly advisory feeapplicable only to the senior syndicated loans.*

*(c)    If the amount presented is in parentheses it denotes the amountis due back to us from GMC; if the amount is positive, it indicates that we oweGMC the stated amount.*

*(d)   This amount represents borrowings under one of our lines of creditthat were held in cash and cash equivalents as of December 31, 2005.  The $15.0 million was to be used to fund anew loan investment, however, the investment did not**fund until**January 2006.  Solely for the purposes of calculating theamount of the management fee due to GMC, we treat any such amounts as “cash andcash equivalents pledged to creditors” under the terms of our advisoryagreement with GMC.  As a result, suchamounts are deducted from our total assets for purposes of computing the assetbase upon which the management fee is determined.*

*(e)    This amount represents borrowings under one of our lines ofcredit that were held in cash and cash equivalents as of March 31, 2005 andDecember 31, 2004, for the purpose of satisfying our asset diversificationrequirements under the Code.  Solely forthe purposes of calculating the amount of the management fee due to GMC, wetreat any such amounts as “cash and cash equivalents pledged to creditors”under the terms of our advisory agreement with GMC.  As a result, such amounts are deducted fromour total assets for purposes of computing the asset base upon which themanagement fee is determined.*

*(f)     Excludesamounts due from employees in connection with tax withholdings related to theexercise of non-qualified stock options during the third and fourth quarters offiscal 2006. (Refer to Note 5 of the “Notes to Consolidated FinancialStatements”)*

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Professional fees,consisting primarily of legal and audit fees, for the fiscal year endedSeptember 30, 2006 were approximately $548,000, as compared to approximately$725,000 for the fiscal year ended September 30, 2005.  The decrease is due primarily to a decreasein non-reimbursable legal fees and extra audit fees in the prior year inconnection with internal control procedures.

Amortization of deferredfinancing costs, in connection with our lines of credit, were approximately$140,000 for the fiscal year ended September 30, 2006 and approximately$386,000 for the fiscal year ended September 30, 2005.  The decrease is due to the completion of theamortization cycle related to certain deferred financing costs.

Interest expense for thefiscal year ended September 30, 2006 was approximately $3.2 million as comparedto approximately $1.8 million for the fiscal year ended September 30,2005.   This increase is primarily aresult of increased borrowings under our lines of credit during the fiscal yearended September 30, 2006, which borrowings were used, in part, to finance ourincreased investments, borrowings remaining outstanding for longer periods oftime and an increase in the interest rates on our borrowings.

Stockholder related costsfor the fiscal year ended September 30, 2006 were approximately $304,000, ascompared to approximately $220,000 for the fiscal year ended September 30,2005.  Stockholder related costs includesuch recurring items as transfer agent fees, securities listing fees, andelectronic filing fees.  The increase isdue mainly to the printing and mailing of the special proxy statement inconnection with the special meeting of stockholders, the printing and mailingof the annual report to stockholders and the annual proxy to stockholders, andthe fees associated with the Schedule TO filed in connection with the offer toamend the terms of the options outstanding under the 2001 Plan.

Directors’ fees for thefiscal year ended September 30, 2006 were approximately $116,000, as comparedto approximately $102,000 for the fiscal year ended September 30, 2005. This isthe result of the addition of a new director in December 2005.

Insurance expense for thefiscal year ended September 30, 2006 was approximately $207,000, as compared toapproximately $178,000 for the fiscal year ended September 30, 2005. Theincrease is primarily the result of an increase of our directors and officersinsurance premiums.

Stock option compensationexpense for the fiscal year ended September 30, 2006 was approximately$285,000.  This is the result of theadoption of SFAS No. 123(R) *Share-basedPayment*. SFAS No. 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*andsupersedes Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005.  We adopted SFAS No. 123(R) onOctober 1, 2005 using the modified prospective approach. Under themodified prospective approach, stock-based compensation expense will berecorded for the unvested portion of previously issued awards that remain outstandingat October 1, 2005 using the same estimate of the grant date fair valueand the same attribution method used to determine the pro forma disclosureunder SFAS No. 123. SFAS No. 123(R) also requires that allshare-based payments to employees after October 1, 2005, includingemployee stock options, be recognized in the financial statements asstock-based compensation expense based on the fair value on the date ofgrant.  There was no stock optioncompensation expense recorded for the fiscal year ended September 30,2005.  As a result of the amendment ofthe 2001 Plan, all unvested stock options became vested as of April 11, 2006and therefore, all residual stock compensation expense related to optionsvesting subsequent to September 30, 2006 was recorded in the current fiscalyear.  As of September 30, 2006, therewere no options outstanding.

Other expenses wereapproximately $485,000 for the fiscal year ended September 30, 2006, ascompared to approximately $236,000 for the fiscal year ended September 30, 2005.Of this $485,000, approximately $300,000 relates to employer taxes, interestand penalties arising from withholding taxes on stock option exercises thatwere not remitted to the respective taxing authorities during the third andfourth quarters of fiscal 2006.  Theremaining $185,000 of other expenses primarily represent direct expenses suchas travel related specifically to our portfolio companies, loan evaluationservices for our portfolio companies, press releases and backup servicerexpenses.

**Income Tax Expense**

During the fiscal yearended September 30, 2006, we recorded approximately $102,000 in tax expense inconnection with interest penalties incurred on misclassified revenue on itsfiscal year 2004 corporate tax return.

Gladstone Capital Advisers,Inc., our wholly-owned subsidiary, is subject to federal and state incometaxation on the income it has recorded such as managerial assistance and otherfees.  During the fiscal year endedSeptember 30, 2005, Gladstone Capital Advisers incurred aggregate federal andstate income taxes of $209,278 resulting from taxable income it received duringthe 2004 fiscal year.  Following theexternalization of our management effective October 1, 2004, substantially allrevenues previously received by Gladstone Capital Advisers are now received byGMC.  As a result, we do not anticipateincurring significant tax expense as a result of the activities of GladstoneCapital Advisers in the future.

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**Realized (Loss) Gain on Sale ofInvestments**

During the fiscal yearended September 30, 2006, we sold our investments in ARI Holdings, Inc. andMarcal Paper Mills, Inc. for an aggregate loss of approximately $1.18 millionand were repaid on several syndicated loans which contained unamortizedpremiums resulting in realized gains of approximately $149,000 for a total netrealized loss of approximately $904,000. During the fiscal year ended September 30, 2005, we sold our $975,000syndicated participation in Burt’s Bees, Inc. for a gain of $9,750 and we soldour $2.0 million syndicated participation in Marietta Corp. for a gain of$20,000.

**Realized Gain on Settlement ofDerivative**

During the fiscal yearended September 30, 2006, we received our first interest rate cap agreementpayments totaling approximately $15,000 as a result of the one month LIBORexceeding 5%.  There was no realizationduring the fiscal year ended September 30, 2005 as the one month LIBOR wasbelow 5%.

**Net Unrealized Depreciation onDerivative**

As a result of theincrease in fair market value of our interest rate cap agreement, we recorded anominal net unrealized appreciation derivative for the fiscal year endedSeptember 30, 2006, as compared to net unrealized depreciation of approximately$39,000 for the fiscal year ended September 30, 2005.

**Net Unrealized Appreciation(Depreciation) on Investments**

For the fiscal year endedSeptember 30, 2006, we recorded net unrealized appreciation on investments ofapproximately $6.0 million as compared to net unrealized depreciation ofapproximately $1.8 million for the fiscal year ended September 30, 2005.  The unrealized appreciation is mainlyattributable to the early repayment or sale of loans that were underperformingas of September 30, 2005, most notably Finn Corporation and ARI Holdings, Inc.,as well as the unrealized appreciation on the Finn Corporation warrantcurrently still in our portfolio.

**Net Increase in Net Assets from Operations**

Overall, we realized a net increase in net assets resulting fromoperations of approximately $24.4 million for the fiscal year ended September30, 2006.  Based on a weighted average of11,381,378 (basic) and 11,615,922 (diluted) shares outstanding, our netincrease in net assets from operations per weighted average common share forthe fiscal year ended September 30, 2006 was $2.15 (basic) and $2.10 (diluted).

For the fiscal year ended September 30,2005, we realizeda net increase in net assets resulting from operations of approximately $15.5million.  Based on a weighted average of11,292,466 (basic) and 11,609,146 (diluted) shares outstanding, our netincrease in net assets from operations per weighted average common share forthe fiscal year ended September 30, 2005 was $1.37 (basic) and $1.33 (diluted).

*COMPARISONOF THE FISCAL YEARS ENDED SEPTEMBER 30, 2005 AND SEPTEMBER 30, 2004*

**Investment Income**

Investmentincome for the fiscal year ended September 30, 2005 was approximately$23.9 million as compared to approximately $20.4 million for the fiscal yearended September 30, 2004.  Thisincrease was primarily a result of a rise in interest income from an increaseof approximately $143.8 million of new investments from the prior year and thecollection of approximately $1.2 million of exit fees upon the full repaymentof a portfolio company investment.

Interestincome from our investments in debt securities of private companies wasapproximately $22.4 million, including $394,000 of PIK interest, for the fiscalyear ended September 30, 2005 as compared to $18.2 million for thefiscal year ended September 30, 2004, including $553,000 of PIKinterest.  This increase was primarilythe result of approximately $143.8 million of new investments for the fiscalyear ended September 30, 2005 and the collection of $1.2 million of exitfees upon the full repayment of a portfolio company investment.  The decrease in PIK income for the fiscalyear ended September 30, 2005 was the result of scheduled principal repaymentsfor one loan containing a PIK provision and an early repayment for another loancontaining a PIK provision.

Theweighted average yield on our portfolio for the fiscal year endedSeptember 30, 2005 was 12.23% (without giving effect to PIK interest) and12.36% (after giving effect to PIK interest). The weighted average yield on ourportfolio for the fiscal year ended September 30, 2004 was 13.44% (withoutgiving effect to PIK interest) and 13.78% (after giving effect to PIKinterest).  The yields were computedbased on the cost value of the investment portfolios.

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Interestincome from invested cash and cash equivalents for the fiscal year endedSeptember 30, 2005 was approximately $33,000, as compared to approximately$84,000 for the fiscal year ended September 30, 2004. This decrease wasprimarily caused by a decrease in cash balances as a result of $143.8 millionof new investments and generally maintaining less cash on hand and usingborrowed funds to fund new investments.

Nofee income was recorded for the fiscal year ended September 30, 2005, ascompared to approximately $1.1 million for the fiscal year endedSeptember 30, 2004.  This decreasewas the result of the externalization of our management, effective October 1,2004, through the engagement of our affiliate, GMC, to serve as our externaladviser. GMC receives all fees in connection with our investments andprospective investments, which fees are offset against the advisory fee payableto GMC.  Fee income for the fiscal yearended September 30, 2004 consisted primarily of investment banking andannual review fees received in connection with investments we closed during the2004 fiscal year. During the fiscal year ended September 30, 2004, the feeincome was mainly attributable to the closing of the Gammill, Inc., WovenElectronics Corp., Benetech, Inc,. Mistras Holdings Corp. ($1.0 millioninvestment), A and G, Inc. and Allied Extruders, Inc. investments, in theapproximate aggregate amount of $52.8 million.

Prepaymentfees and other income was approximately $1.1 million for the fiscal year endedSeptember 30, 2005 and $573,000 for the fiscal year endedSeptember 30, 2004.  For the fiscalyear ended September 30, 2005, this consisted of approximately $1.0 million ofearly principal payment penalty fees and approximately $24,000 of waiver feesfor certain loan covenants.  For thefiscal year ended September 30, 2004, this amount was comprised of$545,000 of early principal payment penalty fees, $17,000 of waiver fees forcertain loan covenants, and $11,000 in up-front fees for a proposed investment.

**Operating Expenses**

Operating expenses forthe fiscal year ended September 30, 2005 were approximately $7.5 million, ascompared to approximately $7.1 million for the fiscal year ended September 30,2004. This increase****was mainly aresult of an increase in interest expense, stockholder related costs andprofessional fees.  Additionally,operating expenses for the fiscal year ended September 30, 2005 reflected asignificant reduction in direct operating expenses, as a result of theexternalization of our management effective October 1, 2004, offset by anincrease in loan servicing fees and management fees incurred as a result ofthis externalization.

Loan servicingfees of approximately $2.5 million were incurred for the fiscal year endedSeptember 30, 2005.  These fees wereincurred in connection with a loan servicing agreement between Business Loanand GMC, which became effective July 12, 2004. These fees were directly credited against the amount of the managementfee due to GMC.  During the fiscal yearended September 30, 2004, loan servicing fees of approximately $502,000 wereincurred from the period July 12, 2004, the date that GMC began to service ourloan portfolio, since prior to that the loan portfolio was serviced under asimilar agreement with Gladstone Capital Advisers, Inc., our wholly-ownedsubsidiary, and the fees Business Loan paid to Gladstone Capital Advisers, Inc.were eliminated upon consolidation of our financial results.

EffectiveOctober 1, 2004, we entered into an advisory agreement with GMC whereby GMCserved as our external adviser.  Ascompensation for the services of GMC, we paid GMC an annual advisory fee of1.25% of total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly computed increments of 0.3125%, and an annualadministrative fee of 0.75% of total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly computed increments of0.1875%, for a total fee of 2% of total assets (as reduced by cash and cashequivalents pledged to creditors). We continued to pay direct expensesincluding, but not limited to, directors’ fees, legal and accounting fees,stockholder related expenses, and directors and officers insurance.  Under the advisory agreement, GMC providedthe managerial assistance and other services to our portfolio companies that wepreviously provided through our wholly-owned subsidiary Gladstone CapitalAdvisers, and likewise GMC directly received any fees for such services.  Any such fees were credited directly againstthe 2% management fee payable to GMC. The 2% management fee was also directly reduced by the amount of themonthly loan servicing fees we paid to GMC. Overall, the management fee due toGMC cannot exceed 2% of total assets (as reduced by cash and cash equivalentspledged to creditors) during any given fiscal year.  Because we were internally managed at alltimes prior to October 1, 2004, no management fee was recorded for the threemonths ended September 30, 2004, June 30, 2004, March 31, 2004 or December 31,2003.

Thefollowing table sets forth the quarterly computations of the management fee forthe fiscal year ended September 30, 2005, based on the quarterly increment of0.50% (0.3125% quarterly advisory fee plus 0.1875% quarterly administrativefee):

38

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| ** **                                                 | ** ** | **September 30,** | ** **  | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** **  |
|------------------------------------------------------------|------------|------------------------|-------------|-------------------|------------|--------------------|------------|-----------------------|-------------|
| ** **                                                 | ** ** | **2005**               | ** **  | **2005**          | ** ** | **2005**           | ** ** | **2004**              | ** **  |
| **Fee:**                                                   | ** ** | ** **             | ** **  | ** **        | ** ** | ** **         | ** ** | ** **            | ** **  |
| Total assets                                               |       | $                      | 205,793,094 |              | $          | 209,320,463        |       | $                     | 213,753,998 |   | $ | 194,085,591 |   |
| Less: Borrowings  under line of credit *(a)*               |       | —                 |        | —            |       | (18,644,179        | )          | (22,435,000           | )           |
| Total assets  subject to quarterly fee                     |       | 205,793,094            |        | 209,320,463       |       | 195,109,819        |       | 171,650,591           |        |
| Quarterly fee  rate                                        |       | 0.50%                  |        | 0.50%             |       | 0.50%              |       | 0.50%                 |        |
| Gross management  fee before loan servicing fee credit     |       | 1,028,965              |        | 1,046,602         |       | 975,549            |       | 858,254               |        |
| Less: loan  servicing fee from Gladstone Business Loan LLC |       | 745,263                |        | 687,971           |       | 585,542            |       | 530,952               |        |
| Management fee before credit:                              |       | 283,702                |        | 358,631           |       | 390,007            |       | 327,302               |        |
| **Direct  Credit to Management Fee:**                      | ** ** | ** **             | ** **  | ** **        | ** ** | ** **         | ** ** | ** **            | ** **  |
| Fee revenue  recorded by GMC:                              |       | 100,000                |        | 240,600           |       | 450,000            |       | 286,500               |        |
| Net management  fee for the three months ended:            |       | $                      | 183,702     |              | $          | 118,031            |       | $                     | (59,993     | ) | $ | 40,802 |   |

----

*(a)   Thisamount represents borrowings under one of our lines of credit that were held incash and cash equivalents as of March 31, 2005 and December 31, 2004, for eachrespective quarter, for the purpose of satisfying our asset diversificationrequirements under the Internal Revenue Code. There were no borrowingsoutstanding for this purpose at September 30, 2005 or at June 30, 2005.  Solely for the purposes of calculating theamount of the management fee due to GMC, we treat any such amounts as “cash andcash equivalents pledged to creditors” under the terms of our advisoryagreement with GMC.  As a result, suchamounts are deducted from our total assets for purposes of computing the assetbase upon which the management fee is determined.*

Professional fees,consisting primarily of legal and audit fees, for the fiscal year endedSeptember 30, 2005 were approximately $725,000, as compared to approximately$580,000 for the fiscal year ended September 30, 2004.  The increase is due primarily to an increasein non-reimbursable legal fees and audit costs incurred in connection withinternal control procedures.

Amortization of deferredfinancing costs, in connection with our lines of credit, were approximately$386,000 for the fiscal year ended September 30, 2005 and approximately $1.4million for the fiscal year ended September 30, 2004.  The decrease is due to the expensing ofapproximately $1.2 million of capitalized fees during the fiscal year endedSeptember 30, 2004 which related to the assignment of the warehouse line ofcredit from a former lender, CIBC World Markets, Inc., to Deutsche Bank AG inSeptember 2004.

Interest expense for thefiscal year ended September 30, 2005 was approximately $1,775,000 as comparedto approximately $742,000 for the fiscal year ended September 30, 2004.   This increase is a result of increasedborrowings under our lines of credit during the fiscal year ended September 30,2005, which borrowings were used, in part, to finance our increasedinvestments, and to a lesser extent, an increase in the interest rate.

Stockholder related costsfor the fiscal year ended September 30, 2005 were approximately $220,000, ascompared to approximately $140,000 for the fiscal year ended September 30,2004.  Stockholder related costs includesuch recurring items as transfer agent fees, securities fees, electronic filingfees and printing and mailing of annual reports and proxy statements tostockholders.

Directors’ fees for thefiscal year ended September 30, 2005 were approximately $102,000, as comparedto approximately $112,000 for the fiscal year ended September 30, 2004. This isthe result of fewer board meetings held during the fiscal year ended September30, 2005 as compared to the fiscal year ended September 30, 2004.

Insurance expense for thefiscal year ended September 30, 2005 was approximately $178,000, as compared toapproximately $258,000 for the fiscal year ended September 30, 2004. Thedecrease is primarily the result of the externalization of our management.  Effective October 1, 2004, GMC pays generalinsurance expenses directly and such insurance coverage is included in theservices we receive in consideration for the 2% management fee we pay toGMC.  Insurance expense incurred duringthe fiscal year ended September 30, 2005 represents the amortization of ourdirectors and officers insurance premiums, which are expenses for which wecontinue to be responsible following the externalization of our management.

Effective October 1,2004, all of our employees became employees of GMC and therefore no salaries orbenefit expenses were incurred by us for the fiscal year ended September 30,2005, as compared to approximately $2.6 million for the fiscal year endedSeptember 30, 2004.  We reimburse GMC forits employee services as part of the annual advisory and administrative feespayable under the advisory agreement.

Effective October 1,2004, our external adviser, GMC, began to pay rent directly, and therefore forthe fiscal year ended September 30, 2005 no rent expense was incurred by us ascompared to approximately $139,000 of rent expense for the fiscal year endedSeptember 30, 2004.  General overheadexpenses, such as rent, are also included as part of the management fee to GMC.

39

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Other expenses wereapproximately $236,000 for the fiscal year ended September 30, 2005, ascompared to approximately $702,000 for the fiscal year ended September 30,2004. This decrease****is primarily aresult of GMC handling general overhead type expenses.  The expenses for the fiscal year endedSeptember 30, 2005 primarily represent direct expenses such as travel relatedspecifically to our portfolio companies, loan evaluation services for ourportfolio companies, press releases and backup servicer expenses.

**Income Tax Expense**

Gladstone CapitalAdvisers, Inc., our wholly-owned subsidiary, is subject to federal and stateincome taxation on the income it has recorded such as managerial assistance andother fees.  During the fiscal year endedSeptember 30, 2005, Gladstone Capital Advisers incurred aggregate federal andstate income taxes of approximately $209,000 resulting from taxable income itreceived during the 2004 fiscal year. Following the externalization of our management effective October 1,2004, substantially all revenues previously received by Gladstone CapitalAdvisers are now received by GMC.  As aresult, we do not anticipate incurring significant tax expense as a result ofthe activities of Gladstone Capital Advisers in the future.

**Realized Gain on Sale ofInvestments**

During the fiscal yearended September 30, 2005, we sold our $975,000 syndicated participation in Burt’sBees, Inc. for a gain of $9,750 and we sold our $2.0 million syndicatedparticipation in Marietta Corp. for a gain of $20,000, as compared to thefiscal year ended September 30, 2004 in which we bought and sold our $1.0million investment in Metokote Corporation for a gain of $12,500.

**Net Unrealized Depreciation onDerivative**

As a result of thedecline in fair market value of our interest rate cap agreement, we recordednet unrealized depreciation on derivative of approximately $39,000 for thefiscal year ended September 30, 2005, as compared to net unrealizeddepreciation of approximately $214,000 for the five months the investment washeld during the fiscal year ended September 30, 2004.

**Net Unrealized Appreciation(Depreciation) on Investments**

For the fiscal year endedSeptember 30, 2005, we recorded net unrealized depreciation on investments ofapproximately $1.8 million as compared to net unrealized depreciation ofapproximately $2.5 million for the fiscal year ended September 30, 2004.  The increase in unrealized depreciation wasmainly attributable to the decrease in the value of the Finn Corporation seniorsubordinated term debt of approximately $3.2 million, a decline of approximately$1.5 million in the fair value of Xspedius Communications, LLC and a decline inthe value of ARI Holdings, Inc. of approximately $1.1 million, partially offsetby appreciation of approximately $645,000 in the value of the Finn warrants,and the fair value of the success fee on Woven Electronics Corporation ofapproximately $348,000 as well as unrealized appreciation on certain of oursyndicated loan participations.

**Net Increase in Net Assets from Operations**

Overall, we realized a net increase in net assets resulting fromoperations of approximately $15.5 million for the fiscal year ended September30, 2005.  Based on a weighted average of11,292,466 (basic) and 11,609,146 (diluted) shares outstanding, our netincrease in net assets from operations per weighted average common share forthe fiscal year ended September 30, 2005 was $1.37 (basic) and $1.33 (diluted).

For the fiscal year ended September 30,2004, we realizeda net increase in net assets resulting from operations of approximately $10.6million.  Based on a weighted average of10,101,341 (basic) and 10,344,388 (diluted) shares outstanding, our netincrease in net assets resulting from operations per weighted average commonshare for the fiscal year ended September 30, 2004 was $1.05 (basic) and $1.02(diluted).

40

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**LIQUIDITYAND CAPITAL RESOURCES**

At September 30,2006, we had investments in debt securities, or loans to or syndicatedparticipations in, 32 private companies, totaling approximately $216.2 million(cost basis) of total assets.  AtSeptember 30, 2005, we had investments in debt securities, or loans to orsyndicated participations in, 28 private companies, totaling approximately$205.4 million (cost basis) of total assets, which included approximately$254,000 in accrued PIK interest.  AtSeptember 30, 2004, we had investments in debt securities, or loans to orsyndicated participations in, 16 private companies totaling approximately$149.2 million (cost basis), including approximately $553,000 in accrued PIKinterest.  PIK interest is described in “Overview,”and is added to the carrying value of our investments.

*During the fiscal years ended September 30, 2006,September 30, 2005 and September 30, 2004, the following investment activityoccurred during each quarter of the respective fiscal year:*

|                        | ** ** | ** **               | ** **  | ** **                    | ** ** | **Net Gain/(Loss)** | ** ** |
|------------------------|------------|--------------------------|-------------|-------------------------------|------------|--------------------------|------------|
| **Quarter Ended** | ** ** | **New Investments** | ** **  | **Principal Repayments** | ** ** | **on Disposal**     | ** ** |
|                   |       |                     |        |                          |       |                     |       |
| December 31, 2005      |       | $                        | 26,688,457  |                          | $          | 38,702,066               |       | $ | (1,180,595 | ) |
| March 31, 2006         |       | 38,471,109               |        | 24,815,067                    |       | 377,500                  |       |
| June 30, 2006          |       | 39,916,834               |        | 44,358,944                    |       | (100,850                 | )          |
| September 30, 2006     |       | 30,878,479               |        | 16,133,852                    |       | —                   |       |
| Total fiscal year 2006 |       | $                        | 135,954,879 |                          | $          | 124,009,929              |       | $ | (903,945 | ) |
|                   |       |                     |        |                          |       |                     |       |
| December 31, 2004      |       | $                        | 46,949,500  |                          | $          | 25,975,707               |       | $ | 9,750 |   |
| March 31, 2005         |       | 44,513,875               |        | 33,859,918                    |       | 20,000                   |       |
| June 30, 2005          |       | 34,732,083               |        | 18,154,719                    |       | —                   |       |
| September 30, 2005     |       | 17,598,548               |        | 10,028,792                    |       | —                   |       |
| Total fiscal year 2005 |       | $                        | 143,794,006 |                          | $          | 88,019,136               |       | $ | 29,750 |   |
|                   |       |                     |        |                          |       |                     |       |
| December 31, 2003      |       | $                        | 15,500,000  |                          | $          | 4,504,167                |       | $ | — |   |
| March 31, 2004         |       | 20,500,000               |        | 674,337                       |       | 12,500                   |       |
| June 30, 2004          |       | 46,267,500               |        | 28,712,212                    |       | —                   |       |
| September 30, 2004     |       | 4,000,000                |        | 13,268,279                    |       | —                   |       |
| Total fiscal year 2004 |       | $                        | 86,267,500  |                          | $          | 47,158,995               |       | $ | 12,500 |   |

 

The followingtable summarizes the contractual principal amortization and maturity of ourinvestment portfolio by fiscal year.

| Fiscal Year Ended September 30, | ** ** | **Amount** | ** **  |
|-----------------------------------------------------|------------|------------|-------------|
|                                                |       |       |        |
| 2007                                                |       | 9,150,322  |        |
| 2008                                                |       | 24,815,822 |        |
| 2009                                                |       | 21,712,102 |        |
| 2010                                                |       | 37,806,330 |        |
| 2011                                                |       | 65,939,375 |        |
| Thereafter                                          |       | 56,779,035 |        |
|                                                |       | $          | 216,202,986 |   |
|                                                     |            |            |             |  |

 

Netcash provided by operating activities for the fiscal year ended September 30,2006, consisting primarily of the items described in “Results of Operations”and the investment activity described above, was approximately $7.2 million ascompared to net cash used in operating activities of approximately $61.5million for the fiscal year ended September 30, 2005.  Net cash provided by investing activities wasapproximately $0.2 million for the fiscal year ended September 30, 2006 andconsisted of the repayment of employee loans. Net cash used in financing activities for the fiscal year endedSeptember 30, 2006 was approximately $7.2 million and consisted ofapproximately $149.8 million of repayments on the lines of credit, andapproximately $18.6 million for the payment of dividends.  These outflows were partially offset byapproximately $146.7 million of cash received from borrowings on the lines ofcredit and the exercise of stock options for approximately $14.7 million.

Duringthe fiscal year ended September 30, 2006, cash and cash equivalents increasedfrom approximately $504,000 at the beginning of the year to approximately$732,000 at the end of the year.  Thisincrease was largely the result of cash generated from operations offset byinvestment purchases and repayments of our revolving credit facility.

41

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Netcash used in operating activities for the fiscal year ended September 30, 2005,consisting primarily of the items described in “Results of Operations” and theinvestment activity described above, was approximately $61.5 million ascompared to net cash used operating activities of approximately $82.8 millionfor the fiscal year ended September 30, 2004. In addition, net cash used in operating activities for the year endedSeptember 30, 2005 included the repayment of the repurchase agreement (asdescribed below) of approximately $21.3 million.  Net cash provided by investing activities wasapproximately $0.8 million for the fiscal year ended September 30, 2005 and wascomprised of employee loan principal repayments.  Net cash used in financing activities for thefiscal year ended September 30, 2005 was approximately $4.8 million andconsisted mainly of approximately $142.7 million of repayments on the lines ofcredit, approximately $17.1 million for the payment of dividends, $105,000 paidto renew a line of credit and approximately $111,000 of costs incurredsubsequent to the shelf offering in September 2004.  These outflows were partially offset byapproximately $155.0 million of cash received from borrowings on the lines ofcredit and the exercise of stock options for approximately $270,000.

Duringthe fiscal year ended September 30, 2005, cash and cash equivalents decreasedfrom approximately $66.0 million at the beginning of the year to approximately$504,000 at the end of the year.  Thisdecrease was largely the result of the purchase of new investments, therepayment of the repurchase agreement in October 2004 (as described below) andalso the payment of dividends throughout the fiscal year ended September 30,2005.

Netcash used in operating activities for the fiscal year ended September 30,2004, consisting primarily of the items described in “Results of Operations”and the investment activity described above, was approximately $82.7 million . At September 30, 2004, the netcash used was due largely in part to $57.1 million used in connection with thepurchase of the repurchase agreement and the repayments of the repurchaseagreement, and new investments of approximately $86.3 million, partially offsetby principal repayments of $47.2 million Net cash provided by investing activities for the fiscal year endedSeptember 30, 2004 was approximately $0.2 million and consisted of principalrepayments on employee loans. Net cash provided by financing activities wasapproximately $47.3 million for the fiscal year ended September 30, 2004and consisted primarily of proceeds from a public shelf offering of commonstock which yielded net proceeds of approximately $24.4 million, theborrowings, net of repayments, on the lines of credit for net proceeds ofapproximately $40.7 million, partially offset by the payment of dividends ofapproximately $17.1 million

During the fiscalyear ended September 30, 2004, cash and cash equivalents decreased fromapproximately $101.1 million at the beginning of the year to approximately$66.0 million at the end of the year. This decrease was largely the result of the purchase of new investmentsand the repurchase agreement described below.

On September 29,2004, we entered into a repurchase agreement (the “FBW Repurchase Agreement”)with Ferris Baker Watts, Incorporated for $44,984,950. On September 30, 2004,this amount was reduced to $21,345,997 with the application of the net proceedsfrom a public offering of our common stock. This remaining balance was 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 Repurchase Agreement was 4.25% for a costof $7,831. In the future, we may use a similar form of repurchase agreement asan investment option or in order to satisfy certain asset diversificationrequirements and maintain our status as a RIC under Subchapter M of the Code.

In order toqualify as a RIC and to avoid corporate level tax on the income we distributeto our stockholders, we are required, under Subchapter M of the Code, todistribute at least 90% of our ordinary income and short-term capital gains toour stockholders on an annual basis. In accordance with these requirements, wedeclared and paid monthly cash dividends of $0.135 per common share for eachmonth of October 2005 through June 2006 and $0.14 per common share for July,August and September 2006. For the fiscal year ended September 30, 2005 wedeclared and paid monthly cash dividends of $0.12 per common share for October,November and December 2004 and January, February, and March 2005, $0.13 forApril, May, and June 2005, and $0.135 for July, August and September 2005.  For the fiscal year ended September 30, 2004,we declared and paid monthly cash dividends of $0.11 per common share forOctober, November and December 2003 and January, February, and March 2004,$0.115 per common share for April, May and June 2004, and $0.12 per commonshare for July, August and September 2004.

Aggregatedividends declared and paid for the 2004 fiscal year were approximately $17.1million and exceeded our current and accumulated earnings and profits and, as aresult, a portion of these dividends were treated as a return of capital to ourstockholders.

We anticipateborrowing funds and issuing additional equity securities to obtain additionalcapital. To this end, we have filed with the SEC a registration statement thatwould permit us to issue, through one or more transactions, up to an aggregateof $75 million in securities, consisting of common stock, preferred stockand/or debt securities.  On September 30,2004, we closed on our public offering pursuant to this registration statementof 1,150,000 shares at price of $22.75, less underwriters’ discount of fivepercent for net proceeds of approximately $24.9 million, excluding offeringcosts.  We used the proceeds from thisoffering to repay borrowings under our lines of credit.  In the future, we may sell up toapproximately $48.8 million of securities from the shelf registrationstatement.

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**RevolvingCredit Facility**

Through our wholly-ownedsubsidiary Business Loan, we initially obtained a $100 million revolving creditfacility.  On May 19, 2003, weexecuted a Purchase and Sale Agreement pursuant to which we agreed to sellcertain loans to Business Loan in consideration of a membership interesttherein.  Simultaneously, Business Loanexecuted a Credit Agreement with CIBC World Markets Inc. (“CIBC”), asadministrative agent, and others, pursuant to which Business Loan pledged theloans purchased from us to secure future advances by certain institutionallenders.  On September 28, 2004, CIBCassigned its interest in the credit facility to Deutsche Bank AG, which maturedon May 26, 2005 and was subsequently renewed for a fee of $105,000 (as renewed,the “DB Facility”) for one year intervals and is currently due to mature on May25, 2007.  Interest rates charged on theadvances under the facility are based on London Interbank Offered Rate (“LIBOR”),the Prime Rate or the Federal Funds Rate, depending on market conditions, andadjusts periodically.  As of September30, 2006, the outstanding principal balance under this credit facility wasapproximately $50.0 million at an interest rate of 5.37%.   As of September 30, 2005, the outstandingprincipal balance under this credit facility was approximately $53.0 million atan interest rate of 3.71%.  Availableborrowings are subject to various constraints imposed by Deutsche Bank AG,based on the aggregate loan balance pledged by Business Loan, which varies asloans are added and repaid, regardless of whether such repayments are earlyprepayment or are made as contractually required.  At September 30, 2006, the remainingborrowing capacity available under the DB Facility was approximately $100.0million.  At September 30, 2005, theremaining borrowing capacity available under the DB Facility was approximately$37.8 million.  In the event that we arenot able to renew or refinance the DB Facility once it matures, this could havea material adverse impact on our liquidity and ability to fund new investments.  On September 22, 2006 we increased ourborrowing capacity under the DB Facility from $100 million to $150 million.

The DB Facilitycontains covenants that require Business Loan to maintain its status as aseparate entity; prohibit certain significant corporate transactions (such asmergers, consolidations, liquidations or dissolutions); and restrict materialchanges to our credit and collection policies. The facility also restricts some of the terms and provisions (includinginterest rates, terms to maturity and payments schedules) and limits theborrower and industry concentrations of loans that are eligible to secureadvances.  As of September 30, 2006,Business Loan was in compliance with all of the facility covenants.  We currently intend to securitize all of theloans held by Business Loan and if we are able to do so, we will use theproceeds from the securitization to pay down any amounts then outstanding underthe revolving credit facility.

The administrativeagent also requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork as custodian.  Deutsche Bank AG isalso the trustee of the account and once a month remits the collected funds tous. For the fiscal year ended September 30, 2006, the amount due from custodianincreased by approximately $1.0 million as compared to September 30, 2005.

GMC, ouraffiliated external adviser, services the loans pledged under the DBFacility.  As a condition to this servicingarrangement, we executed a performance guaranty pursuant to which we guaranteedthat GMC would comply fully with all of its obligations under the facility. Theperformance 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 30,2006, we were in compliance with our covenants under the performance guaranty.

In June 2004, weentered into a $15.0 million line of credit agreement with Branch Banking andTrust Company (the “BB&T Agreement”) which matured on June 1, 2005, wasmodified to extend the maturity date to December 31, 2005, and again extendedto mature on December 31, 2006.  However,on June 22, 2006, we terminated the BB&T Agreement due to infrequentborrowings.  Interest on outstandingborrowings was based upon the one month LIBOR plus 2.5% per annum.  The unused portion of the line of credit wassubject to a fee of 0.2% per annum.  Asof September 30, 2005, there were no borrowings outstanding under the BB&Tline of credit.

43

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The followingtable shows our significant contractual obligations for the repayment of debtand payment of other contractual obligations as of September 30, 2006:
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Long-Term Debt  Obligations (1)  |       | $                                         | 49,993,000 |   | $ | 49,993,000 |   | — |   | — |   | — |   |
| Purchase Obligations  (2)        |       | 16,226,000                                |       | 16,226,000 |   | — |   | — |   | — |   |
| Total                            |       | $                                         | 66,219,000 |   | $ | 66,219,000 |   | — |   | — |   | — |   |

----

(1)    Thelong-term debt obligations represent borrowings under our DB Facility line ofcredit that were outstanding at September 30, 2006.  This line of credit is scheduled to mature onMay 25, 2007.  In the event that we arenot able to extend or renew the DB Facility, we would have to repay theborrowings outstanding under this line of credit which could have a materialadverse impact on our liquidity and financial statements.

(2)    Thepurchase obligations reflected in the above table represent commitmentsoutstanding as of September 30, 2006 to fund one loan investment and threesyndicated loan participations which were subsequently closed in October andNovember 2006.

At September 30,2006, we had unpaid federal and state withholding taxes of $1,803,283 relatedto the exercise of non-qualified stock options during the third and fourthquarters of fiscal 2006.  These withholding taxes were unfunded by theoptionees at September 30, 2006 and as a result a corresponding receivable isrecorded on our consolidated statements of assets and liabilities at September30, 2006.  During the first fiscal quarter of 2007 we remitted the entiretax withholding liability to the respective taxing authorities and we havereceived substantially all of the amounts due from the optionees.

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

We are subject tofinancial market risks, including changes in interest rates.  While weexpect that ultimately approximately 20% of the loans in our portfolio will bemade at fixed rates, with approximately 80% made at variable rates, currentlyour entire investment portfolio is at variable rates.  Our portfolio has approximately 65% of thetotal loan portfolio cost basis at variable rates with a floor, approximately3% of the total loan portfolio cost basis at a variable rate with a floor andceiling, and the remaining 32% of the total loan portfolio cost basis atvariable rates. General interest rate fluctuations may have a substantialnegative impact on our investments and investment opportunities and,accordingly have a material adverse effect on our investment objectives and ourrate of return on invested capital. In addition, an increase in interest rateswould make it more expensive to use debt for our financing needs, if any.

Under the DB Facility, wehave a $150 million revolving line of credit facility, based on variable rates,with Deutsche Bank AG which matured in May 2006 and was extended and amendedthrough May 2007.

In February 2004, weentered into an interest rate cap agreement in order to fulfill an obligationunder the DB Facility to enter into certain hedging transactions in connectionwith our borrowings under the line of credit.  We purchased this interestrate cap agreement with a notional amount of $35 million for a one-time,up-front payment of $304,000.  The interest rate cap agreement entitles usto receive payments, if any, equal to the amount by which interest payments on$35 million at the point which onemonth LIBOR exceed the 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 our exposureto increases in interest rates on our borrowings on our lines of credit, whichare at variable rates.  At September 30,2006, the cap agreement had a fair market value of $50,284 and a currentnotional amount of $16.4 million.  AtSeptember 30,2006, the one month LIBOR rate was approximately 5.32%.

To illustrate thepotential impact of changes in interest rates on our net increase in net assetsresulting from operations, we have performed the following analysis, whichassumes that our balance sheet remains constant and no further actions beyondthe interest rate cap agreement are taken to alter our existing interest ratesensitivity.  Under this analysis, ahypothetical increase in the one month LIBOR by 1% would increase our netincrease in net assets resulting from operations by approximately $1.9 millionor 7.9%, over the next twelve months, compared to the net increase in netassets resulting from operations for the twelve months ended September 30,2006.  A hypothetical decrease in the onemonth LIBOR by 1% would decrease net increase in net assets resulting fromoperations by approximately $1.9 million, or 7.9%, over the next twelve months,compared to the net increase in net assets resulting from operations for thetwelve months ended September 30, 2006. Although management believes that this analysis is indicative of ourexisting interest rate sensitivity, it does not adjust for potential changes incredit quality, size and composition of our loan portfolio on the balance sheetand other business developments that could affect net increase in net assetsresulting from operations.  Accordingly,no assurances can be given that actual results would not differ materially fromthe results under this hypothetical analysis.

In the event that wesecuritize a portion of our loan portfolio, we believe that we will likely berequired to enter into further hedging arrangements in the future with respectto securitized loans.  While hedgingactivities may mitigate our exposure to adverse fluctuations in interest rates,certain hedging transactions that we may enter into in the future, such asinterest rate swap agreements, may also limit our ability to participate in thebenefits of lower interest rates with respect to our portfolio of investments.

We may also experiencerisk associated with investing in securities of companies with foreignoperations. We currently do not anticipate investing in debt or equity offoreign companies, however, some potential portfolio companies may haveoperations located outside the United States. These risks include, but are notlimited to, fluctuations in foreign currency exchange rates, imposition offoreign taxes, changes in exportation regulations and political and socialinstability.

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

**Index to Consolidated Financial Statements**
| Report of Independent  Registered Public Accounting Firm                                                                                        |   |   |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Consolidated Statements of Assets and Liabilities as  of September 30, 2006 and September 30, 2005                                    |   |   |   |
| Consolidated Schedules of Investments as of  September 30, 2006 and September 30, 2005                                                |   |   |   |
| Consolidated Statements of Operations for the years  ended September 30, 2006, September 30, 2005, and September 30,  2004            |   |   |   |
| Consolidated Statements of Changes in Net Assets for  the years ended September 30, 2006, September 30, 2005, and  September 30, 2004 |   |   |   |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2006, September 30, 2005, and September 30,  2004            |   |   |   |
| Financial  Highlights for the years ended September 30, 2006, September 30, 2005 and  September 30, 2004                                        |   |   |   |
| Notes to Consolidated Financial Statements                                                                                                      |   |   |   |

 

46

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### **Report of Independent Registered PublicAccounting Firm**

To the Stockholders andBoard of Directors of Gladstone Capital Corporation:

We have completedintegrated audits of Gladstone Capital Corporation’s 2006 and 2005 consolidatedfinancial statements and of its internal control over financial reporting as ofSeptember 30, 2006, and audits of its 2004 consolidated financial statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States) (“PCAOB”).  Our opinions, based on our audits, arepresented below.

Consolidated financial statements and financial statementschedules

In our opinion, the consolidated financial statements listed inthe accompanying index presentfairly, in all material respects, the financial position of Gladstone CapitalCorporation and its subsidiaries (the “Company”) at September 30, 2006 andSeptember 30, 2005, and the results of their operations and their cash flowsfor each of the three years in the period ended September 30, 2006 inconformity with accounting principles generally accepted in the United Statesof America.  In addition, in our opinion, the financial statement schedules listed inthe accompanying indexpresentfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements.  These consolidated financialstatements and financial statement schedules are the responsibility of theCompany’s management.  Our responsibilityis to express an opinion on these consolidated financial statements andfinancial statement schedules based on our audits.  We conducted our audits of these statementsin accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

Internal controlover financial reporting

Also, in ouropinion, management’s assessment, included in Management’s Annual Report onInternal Control over Financial Reporting appearing under Item 9A, that theCompany maintained effective internal control over financial reporting as ofSeptember 30, 2006 based on criteria established in *InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of September 30, 2006, based on criteria established in *Internal Control - Integrated Framework* issued by theCOSO.  The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness ofthe Company’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the PCAOB.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects.  Anaudit of internal control over financial reporting includes obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Acompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accounting principles,and that receipts and expenditures of the company are being made only inaccordance with authorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopers LLPMcLean, VirginiaDecember 6, 2006

47

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES**
| ** **                                                                                                                               | ** ** | **September 30,** | ** **  | **September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|------------------------|------------|
| ** **                                                                                                                               | ** ** | **2006**               | ** **  | **2005**               | ** ** |
|                                                                                                                                     |       |                   |        |                   |       |
| ASSETS                                                                                                                                   |       |                   |        |                   |       |
| Investments at fair  value (Cost 9/30/2006: $216,202,986; 9/30/2005: $205,375,554)                                                       |       | $                      | 217,642,750 |                   | $          | 200,846,763 |   |
| Cash and cash  equivalents                                                                                                               |       | 731,744                |        | 503,776                |       |
| Interest receivable —  investments in debt securities                                                                               |       | 1,394,942              |        | 1,406,212              |       |
| Interest receivable —  employees                                                                                                    |       | 37,396                 |        | 27,067                 |       |
| Due from custodian                                                                                                                       |       | 3,587,152              |        | 2,624,074              |       |
| Deferred financing fees                                                                                                                  |       | 145,691                |        | 70,000                 |       |
| Prepaid assets                                                                                                                           |       | 226,747                |        | 177,848                |       |
| Due from employees                                                                                                                       |       | 1,803,283              |        | —                 |       |
| Other assets                                                                                                                             |       | 213,510                |        | 137,354                |       |
| TOTAL ASSETS                                                                                                                             |       | $                      | 225,783,215 |                   | $          | 205,793,094 |   |
|                                                                                                                                     |       |                   |        |                   |       |
| LIABILITIES                                                                                                                              |       |                   |        |                   |       |
| Accounts payable                                                                                                                         |       | $                      | 4,072       |                   | $          | 21,893 |   |
| Interest payable                                                                                                                         |       | 247,530                |        | 183,707                |       |
| Fees due to Adviser                                                                                                                      |       | 240,363                |        | 391,322                |       |
| Borrowings under lines  of credit                                                                                                        |       | 49,993,000             |        | 53,034,064             |       |
| Withholding taxes  payable                                                                                                               |       | 1,803,283              |        | —                 |       |
| Accrued expenses and  deferred liabilities                                                                                               |       | 721,287                |        | 350,665                |       |
| Funds held in escrow                                                                                                                     |       | 203,193                |        | 200,760                |       |
| TOTAL LIABILITIES                                                                                                                        |       | 53,212,728             |        | 54,182,411             |       |
| NET ASSETS                                                                                                                               |       | $                      | 172,570,487 |                   | $          | 151,610,683 |   |
|                                                                                                                                     |       |                   |        |                   |       |
| ANALYSIS OF NET ASSETS                                                                                                                   |       |                   |        |                   |       |
| Common stock, $0.001  par value, 50,000,000 shares authorized and 12,305,008 and 11,303,510 shares  issued and outstanding, respectively |       | $                      | 12,305      |                   | $          | 11,304 |   |
| Capital in excess of  par value                                                                                                          |       | 181,270,565            |        | 164,610,873            |       |
| Notes receivable —  employees                                                                                                       |       | (10,248,308            | )           | (8,745,781             | )          |
| Net unrealized  appreciation (depreciation) on investments                                                                               |       | 1,439,764              |        | (4,528,791             | )          |
| Unrealized depreciation  on derivative                                                                                                   |       | (253,716               | )           | (253,747               | )          |
| Realized (loss) gain on  sale of investments                                                                                             |       | (861,695               | )           | 42,250                 |       |
| Realized gain on  settlement of derivative                                                                                               |       | 15,014                 |        | —                 |       |
| Accumulated  undistributed net investment income                                                                                         |       | 1,196,558              |        | 474,575                |       |
| TOTAL NET ASSETS                                                                                                                         |       | $                      | 172,570,487 |                   | $          | 151,610,683 |   |
| NET ASSETS PER SHARE                                                                                                                     |       | $                      | 14.02       |                   | $          | 13.41 |   |

 

*The accompanying notes are anintegral part of these consolidated financial statements.*

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSSEPTEMBER 30, 2006**
| Company (1)                        | ** ** | **Industry**                     | ** ** | **Investment (2)**                    | ** ** | **Cost**  | ** ** | **Fair Value** |
|------------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|-----------|------------|----------------|
|                               |       |                             |       |                                  |       |      |       |           |
| ActivStyle Acquisition Co.         |       | Service-medical products         |       | Line of Credit (16)                   |       | $         | —     |           | $ | — |
| ActivStyle, Inc.                   |       | distribution                     |       | (9.6%, Due 7/2009)                    |       |      |       |           |
|                               |       |                             |       | Senior Term Debt (5)                  |       | 3,200,000 |       | 3,200,000      |
|                               |       |                             |       | (9.6%, Due 7/2011)                    |       |      |       |           |
|                               |       |                             |       | Senior Term Debt (3) (5)              |       | 2,500,000 |       | 2,500,000      |
|                               |       |                             |       | (11.8%, Due 7/2011)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Advanced Homecare Management, Inc. |       | Service-home health nursing      |       | Senior Subordinated Term Debt(5)(6)   |       | 5,000,000 |       | 5,000,000      |
|                               |       | services                         |       | (11.33%, Due 12/2013)                 |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Allied Extruders, LLC              |       | Manufacturing-polyethylene       |       | Senior Real Estate Term Debt          |       | 1,000,000 |       | 1,000,000      |
| P&O Packaging Acquisition LLC  |       | film                             |       | (9.8%, Due 3/2011)                    |       |      |       |           |
|                               |       |                             |       | Senior Term Debt (3) (5)              |       | 8,000,000 |       | 8,030,000      |
|                               |       |                             |       | (11.3%, Due 3/2011)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Badanco Acquisition Corp.          |       | Manufacturing-luggage            |       | Senior Term Debt (5)                  |       | 5,145,019 |       | 5,157,881      |
|                               |       |                             |       | (10.8%, Due 2/2010)                   |       |      |       |           |
|                               |       |                             |       | Senior Term Debt (3) (5)              |       | 8,585,125 |       | 8,628,051      |
|                               |       |                             |       | (13.8%, Due 2/2010)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Benetech, Inc.                     |       | Service & Manufacturing-dust |       | Senior Term Debt (5)                  |       | 2,112,500 |       | 2,144,187      |
|                               |       | management systems for the       |       | (10.3%, Due 5/2009)                   |       |      |       |           |
|                               |       | coal and electric utility        |       | Senior Term Debt (3) (5)              |       | 3,046,875 |       | 3,107,813      |
|                               |       | industries                       |       | (13.3%, Due 5/2009)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Bresnan Communications, LLC        |       | Service-telecommunications       |       | Senior Term Debt (6)                  |       | 1,002,115 |       | 997,500        |
|                               |       |                             |       | (7.2%, Due 9/2013)                    |       |      |       |           |
|                               |       |                             |       | Senior Subordinated Term Debt         |       | 1,511,554 |       | 1,533,750      |
|                               |       |                             |       | (9.9%, Due 3/2014)                    |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Consolidated Bedding, Inc.         |       | Manufacturing-mattresses         |       | Senior Subordinated Term Debt (5)     |       | 2,438,359 |       | 2,306,991      |
|                               |       |                             |       | (14.4%, Due 3/2009)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Country Road                       |       | Service-telecommunications       |       | Senior Subordinated Term Debt (5) (6) |       | 5,961,594 |       | 6,015,000      |
| Communications LLC                 |       |                             |       | (13.3%, Due 7/2013)                   |       |      |       |           |
| Country Road Management, Inc.      |       |                             |       |                                  |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Defiance Stamping Company          |       | Manufacturing-trucking parts     |       | Senior Term Debt (3) (5)              |       | 6,325,000 |       | 6,332,906      |
|                               |       |                             |       | (13.3%, Due 4/2010)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Doe & Ingalls Management LLC   |       | Distributor-specialty chemicals  |       | Senior Term Debt (5)                  |       | 4,700,000 |       | 4,723,500      |
| Doe & Ingalls of North         |       |                             |       | (9.8%, Due 11/2010)                   |       |      |       |           |
| Carolina Operating LLC             |       |                             |       | Senior Term Debt (3) (5)              |       | 4,500,000 |       | 4,516,875      |
| Doe & Ingalls of Florida       |       |                             |       | (13.3%, Due 11/2010)                  |       |      |       |           |
| Operating LLC                      |       |                             |       |                                  |       |      |       |           |
| Doe & Ingalls of Virginia      |       |                             |       |                                  |       |      |       |           |
| Operating LLC                      |       |                             |       |                                  |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Express Courier International,     |       | Service-ground delivery and      |       | Line of Credit (7)                    |       | —    |       | —         |
| Inc.                               |       | logistics                        |       | (9.6%, Due 6/2009)                    |       |      |       |           |
|                               |       |                             |       | Senior Term Debt (5)                  |       | 4,700,000 |       | 4,700,000      |
|                               |       |                             |       | (9.6%, Due 6/2011)                    |       |      |       |           |
|                               |       |                             |       | Senior Term Debt (3) (5)              |       | 3,950,000 |       | 3,950,000      |
|                               |       |                             |       | (11.8%, Due 6/2011)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Finn Corporation                   |       | Manufacturing-landscape          |       | Common Stock Warrants                 |       | 37,000    |       | 709,431        |
|                               |       | equipment                        |       |                                  |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| FR X Ohmstede Holdings, LLC        |       | Service & Manufacturing-heat |       | Senior Term Debt (6)                  |       | 3,000,000 |       | 3,026,250      |
| FR X Ohmstede Acquisitions Co.     |       | exchangers                       |       | (8.5%, Due 8/2013)                    |       |      |       |           |
|                               |       |                             |       | Senior Subordinated Term Debt (6)     |       | 3,012,369 |       | 3,030,000      |
|                               |       |                             |       | (12.5%, Due 8/2014)                   |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
|                               |       |                             |       |                                  |       |      |       |           |
| Global Materials                   |       | Manufacturing-steel wool         |       | Senior Term Debt (3) (5)              |       | 5,300,000 |       | 5,233,750      |
| Technologies, Inc.                 |       | products and metal fibers        |       | (14.3%, Due 11/2009)                  |       |      |       |           |
|                                    |            |                                  |            |                                       |            |           |            |                |  |  |

 

49

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| Company (1)                             | ** ** | **Industry**                     | ** ** | **Investment (2)**                   | ** ** | **Cost**  | ** ** | **Fair Value** |
|-----------------------------------------|------------|----------------------------------|------------|--------------------------------------|------------|-----------|------------|----------------|
| It’s Just Lunch International, LLC |       | Service-dating service           |       | Line of Credit (12) (5)              |       | 200,000   |       | 199,500        |
|                                    |       |                             |       | (9.2%, Due 6/2009)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (13) (5)            |       | 3,300,000 |       | 3,291,750      |
|                                    |       |                             |       | (9.6%, Due 6/2011)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (3) (14)            |       | —    |       | —         |
|                                    |       |                             |       | (11.8%, Due 6/2011)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| John Henry  Holdings, Inc.              |       | Manufacturing-packaging          |       | Senior Subordinated Term Debt (6)    |       | 8,000,000 |       | 8,000,000      |
| Multi Packaging  Solutions, Inc.        |       | products                         |       | (12.5%, Due 6/2011)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| LocalTel, Inc.                          |       | Service-yellow pages             |       | Line of Credit (5) (15)              |       | 350,000   |       | 343,000        |
|                                    |       | publishing                       |       | (9.8%, Due 6/2009)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (5)                 |       | 2,687,500 |       | 2,633,750      |
|                                    |       |                             |       | (9.8%, Due 6/2011)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (3) (5)             |       | 2,750,000 |       | 2,695,000      |
|                                    |       |                             |       | (12.3%, Due 6/2011)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| Mistras Holdings  Corp.                 |       | Service & Manufacturing-     |       | Senior Term Debt (3) (5)             |       | 9,499,999 |       | 9,737,499      |
|                                    |       | nondestructive testing           |       | (11.5%, Due 8/2008)                  |       |      |       |           |
|                                    |       | instruments, systems             |       | Senior Term Debt (4) (5) (18)        |       | 5,250,001 |       | 5,620,124      |
|                                    |       | and services                     |       | (12.5%, Due 8/2008)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| Network Solutions  LLC                  |       | Service-internet domain registry |       | Senior Term Debt (6)                 |       | 4,464,358 |       | 4,499,747      |
|                                    |       | and host                         |       | (10.4%, Due 1/2012)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| Northern Contours                       |       | Manufacturing-veneer and         |       | Senior Subordinated Term Debt (5)    |       | 7,000,000 |       | 7,017,500      |
| Northern Contours                       |       | laminate components              |       | (12.3%, Due 5/2010)                  |       |      |       |           |
| of Kentucky, Inc.                       |       |                             |       |                                 |       |      |       |           |
| Norcon Holding  LLC                     |       |                             |       |                                 |       |      |       |           |
| Norcon Lewis LLC                        |       |                             |       |                                 |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| PROFITSystems  Acquisition Co.          |       | Service-design and develop       |       | Line of Credit (17)                  |       | —    |       | —         |
| PROFITSystems,  Inc.                    |       | ERP software                     |       | (9.6%, Due 7/2009)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (5)                 |       | 3,100,000 |       | 3,100,000      |
|                                    |       |                             |       | (9.6%, Due 7/2011)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (5)                 |       | 2,900,000 |       | 2,900,000      |
|                                    |       |                             |       | (11.8%, Due 7/201) (3)               |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| Puerto Rico Cable                       |       | Service-telecommunications       |       | Senior Subordinated Term Debt (5)(6) |       | 7,813,274 |       | 7,775,183      |
| Acquisition  Company, Inc.              |       |                             |       | (11.6%, Due 1/2012)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| QCE, LLC (d/b/a  Quiznos Corp.)         |       | Service-restaurant franchisor    |       | Senior Term Debt (6)                 |       | 3,010,713 |       | 2,977,538      |
|                                    |       |                             |       | (7.6%, Due 5/2013)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (3) (6)             |       | 3,045,560 |       | 3,033,750      |
|                                    |       |                             |       | (11.1%, Due 11/2013)                 |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| RCS Management  Holding Co.             |       | Service-healthcare supplies      |       | Senior Term Debt (3) (5)             |       | 3,000,000 |       | 3,003,750      |
|                                    |       |                             |       | (9.8%, Due 1/2011)                   |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (4) (5)             |       | 3,000,000 |       | 3,003,750      |
|                                    |       |                             |       | (12.3%, Due 1/2011)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| RedPrairie  Holding, Inc.               |       | Service-design and develop       |       | Senior Term Debt (6)                 |       | 3,990,000 |       | 3,990,000      |
| RedPrairie  Corporation                 |       | supply chain software            |       | (8.4%, Due 7/2012)                   |       |      |       |           |
| Blue Cube  Software, Inc.               |       |                             |       | Senior Subordinated Term Debt (6)    |       | 2,000,000 |       | 2,005,000      |
|                                    |       |                             |       | (11.9%, Due 1/2013)                  |       |      |       |           |
|                                    |       |                             |       |                                 |       |      |       |           |
| SCPH Holdings,  Inc.                    |       | Manufacturing-underwater         |       | Credit Facility (8)                  |       | —    |       | —         |
| Sea Con Phoenix,  Inc.                  |       | and harsh environment            |       | (9.8%, Due 2/2007)                   |       |      |       |           |
| Phoenix Optix,  Inc.                    |       | components                       |       | Senior Term Debt (5)                 |       | 2,625,000 |       | 2,631,563      |
|                                    |       |                             |       | (10.3%, Due 2/2010)                  |       |      |       |           |
|                                    |       |                             |       | Senior Term Debt (3) (5)             |       | 2,887,500 |       | 2,898,328      |
|                                    |       |                             |       | (13.3%, Due 2/2010)                  |       |      |       |           |

 

50

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| Company (1)                  | ** ** | **Industry**                  | ** ** | **Investment (2)**                | ** ** | **Costs**  | ** **      | **Fair Value** |
|------------------------------|------------|-------------------------------|------------|-----------------------------------|------------|------------|-----------------|----------------|
| SCS Acquisition Corp.        |       | Service-chemically treated    |       | Senior Term Debt (3) (5) (9)      |       | 6,250,000  |            | 6,257,812      |
|                         |       | equipment distribution        |       | (9.3%, Due 12/2011)               |       |       |            |           |
|                         |       |                          |       | Senior Term Debt (3) (5) (10)     |       | 6,568,750  |            | 6,576,961      |
|                         |       |                          |       | (11.3%, Due 12/2011)              |       |       |            |           |
|                         |       |                          |       |                              |       |       |            |           |
| Thibaut Acquisition Co.      |       | Design and Disbtribution-wall |       | Credit Facility (11)              |       | —     |            | —         |
|                         |       | coverings                     |       | (9.8%, Due 1/2011)                |       |       |            |           |
|                         |       |                          |       | Senior Term Debt (5)              |       | 3,325,000  |            | 3,325,000      |
|                         |       |                          |       | (9.8%, Due 1/2011)                |       |       |            |           |
|                         |       |                          |       | Senior Term Debt (3) (5)          |       | 3,000,000  |            | 3,000,000      |
|                         |       |                          |       | (12.3%, Due 1/2011)               |       |       |            |           |
|                         |       |                          |       |                              |       |       |            |           |
| Visual Edge Technology, Inc. |       | Service-office supplies       |       | Senior Subordinated Term Debt (5) |       | 5,000,000  |            | 4,987,500      |
| Graphic Enterprises, Inc.    |       | distribution                  |       | (13.3%, Due 8/2011)               |       |       |            |           |
| Copeco, Inc.                 |       |                          |       |                              |       |       |            |           |
|                         |       |                          |       |                              |       |       |            |           |
| Westlake Hardware, Inc.      |       | Retail-hardware and variety   |       | Senior Subordinated Term Debt (5) |       | 15,000,000 |            | 14,981,250     |
| WHI Holding Corp.            |       |                          |       | (12.6%, Due 1/2011)               |       |       |            |           |
|                         |       |                          |       |                              |       |       |            |           |
| Winchester Electronics       |       | Manufacturing-high bandwidth  |       | Senior Term Debt (3) (5)          |       | 6,000,000  |            | 6,007,500      |
|                         |       | connectors and cables         |       | (12.3%, Due 6/2012)               |       |       |            |           |
|                         |       |                          |       |                              |       |       |            |           |
| Xspedius Communications LLC  |       | Service-telecommunications    |       | Senior Subordinated Term Debt (5) |       | 5,157,821  |            | 5,306,110      |
|                         |       |                          |       | (15.8%, Due 3/2010)               |       |       |            |           |
| **Total:**                   |       | ** **                    |       | ** **                        | ** ** | **$**      | **216,202,986** | ** **     | **$** | **217,642,750** |
|                              |            |                               |            |                                   |            |            |                 |                |  |  |

----

(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, 2006 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)    Fair value was basedon valuation prepared and provided by SPSE.

(6)    Marketable securities,such as syndicated loans, are valued based on the indicative bid price, as ofSeptember 30, 2006 from the respective originating syndication agent’s tradingdesk.

(7)    Availability under thecredit facility totals $1,500,000.  Therewere no borrowings outstanding at September 30, 2006.

(8)    Availability under thecredit facility totals $500,000.  Therewere no borrowings outstanding at September 30, 2006.

(9)    Availability under thedebt facility totals $7,500,000. The outstanding balance of the debt facilitywas $6,375,000 at September 30, 2006.

(10)  Availability under thedebt facility totals $7,500,000. The outstanding balance of the debt facilitywas $6,587,500 at September 30, 2006.

(11)  Availability under thecredit facility totals $1,000,000.  Therewere no borrowings outstanding at September 30, 2006.

(12)  Availability under thecredit facility totals $750,000. Borrowings of $200,000 were outstanding at September 30, 2006.

(13)  The company may borrowan additional $500,000 under the senior term debt facility, subject to certainconditions including Gladstone Capital’s approval.

(14)  The company may borrowan additional $2,250,000 under the senior term debt facility, subject tocertain conditions including Gladstone Capital’s approval.

(15)  Availability under thecredit facility totals $3,000,000. Borrowings of $350,000 were outstanding at September 30, 2006.

(16)  Availability under thecredit facility totals $1,500,000.  Therewere no borrowings outstanding at September 30, 2006

(17)  Availability under thecredit facility totals $1,250,000.  Therewere no borrowings outstanding at September 30, 2006

(18)  Includes a success feewith a fair value of $742,000 and no cost basis.

 

*The accompanyingnotes are an integral part of these consolidated financial statements.*

51

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED SCHEDULE OF INVESTMENTSSEPTEMBER 30, 2005**
| Company (1)                   | ** ** | **Industry**                         | ** ** | **Investment (2)**                | ** ** | **Cost**   | ** ** | **Fair Value** |
|-------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|------------|------------|----------------|
|                          |       |                                 |       |                              |       |       |       |           |
| Advanced Homecare             |       |                                 |       |                              |       |       |       |           |
| Management, Inc.              |       | Home health nursing services         |       | Senior Subordinated Term Debt (6) |       | $          | 7,500,000  |           | $ | 7,500,000 |
|                          |       |                                 |       | (12.6%, Due 12/2010)              |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Allied Extruders, Inc.        |       | Polyethylene film manufacturer       |       | Senior Term Debt (3)              |       | 3,950,000  |       | 3,964,813      |
|                          |       |                                 |       | (12.3%, Due 7/2009)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| ARI Holdings, Inc. (11) (12)  |       | Manufacturing-auto parts             |       | Senior Term Debt                  |       | 3,933,939  |       | 2,880,000      |
|                          |       |                                 |       | (12.8%, Due 2/2008)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Badanco Acquisition Corp.     |       | Manufacturing-luggage                |       | Senior Term Debt (6)              |       | 6,615,019  |       | 6,615,019      |
|                          |       |                                 |       | (9.2%, Due 2/2010)                |       |       |       |           |
|                          |       |                                 |       | Senior Term Debt (3)(6)           |       | 8,650,000  |       | 8,650,000      |
|                          |       |                                 |       | (12.2%, Due 2/2010)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Benetech, Inc.                |       | Dust management systems for the      |       | Senior Term Debt (6)              |       | 2,762,500  |       | 2,783,219      |
|                          |       | coal and electric utility industries |       | (8.7%, Due 5/2009)                |       |       |       |           |
|                          |       |                                 |       | Senior Term Debt (3) (6)          |       | 3,209,375  |       | 3,249,492      |
|                          |       |                                 |       | (11.7%, Due 5/2009)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Consolidated Bedding, Inc.    |       | Manufacturing-mattresses             |       | Senior Subordinated Term Debt (6) |       | 2,927,382  |       | 2,898,968      |
|                          |       |                                 |       | (13.0%, Due 3/2009)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Country Road                  |       | Service-telecommunications           |       | Senior Subordinated Term Debt     |       | 5,955,942  |       | 6,060,000      |
| Communications LLC            |       |                                 |       | (11.6%, Due 7/2013)               |       |       |       |           |
| Country Road Management, Inc. |       |                                 |       |                              |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Coyne International           |       | Industrial services                  |       | Senior Term Debt (3) (5) (6)      |       | 6,375,052  |       | 6,367,083      |
| Enterprises                   |       |                                 |       | (13.0%, PIK 2%, Due 7/2007)       |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Defiance Stamping             |       | Manufacturing-trucking parts         |       | Senior Term Debt (3)              |       | 6,325,000  |       | 6,332,906      |
| Company                       |       |                                 |       | (11.7%, Due 4/2010)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Finn Corporation              |       | Manufacturing-landscape equipment    |       | Senior Subordinated Term Debt (6) |       | 10,500,000 |       | 7,350,000      |
|                          |       |                                 |       | (13.0%, Due 2/2006)               |       |       |       |           |
|                          |       |                                 |       | Common Stock Warrants             |       | 37,000     |       | 682,114        |
|                          |       |                                 |       |                              |       |       |       |           |
| Gammill, Inc.                 |       | Designer and assembler of quilting   |       | Senior Term Debt (6)              |       | 3,771,427  |       | 3,771,427      |
|                          |       | machines and accessories             |       | (9.5%, Due 12/2008)               |       |       |       |           |
|                          |       |                                 |       | Senior Term Debt (3) (6)          |       | 4,690,625  |       | 4,667,172      |
|                          |       |                                 |       | (12.0%, Due 12/2008)              |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Global Materials              |       | Manufacturing-steel wool             |       | Senior Term Debt (3) (6)          |       | 5,500,000  |       | 5,486,250      |
| Technologies, Inc.            |       | products and metal fibers            |       | (13.0%, Due 11/2009)              |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| Infor Global Solutions Ltd.   |       | Enterprise application solutions     |       | Senior Subordinated Term Debt (7) |       | 6,821,250  |       | 7,070,000      |
|                          |       |                                 |       | (11.0%, Due 4/2012)               |       |       |       |           |
|                          |       |                                 |       |                              |       |       |       |           |
| John Henry Holdings, Inc.     |       | Manufacturing-packaging              |       | Senior Subordinated Term Debt(6)  |       | 7,067,923  |       | 7,064,500      |
|                          |       | products                             |       | (11.0%, Due 6/2011)               |       |       |       |           |
|                               |            |                                      |            |                                   |            |            |            |                |  |  |

 

52

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| Company (1)                   | ** ** | **Industry**                                   | ** ** | **Investment (2)**                            | ** ** | **Cost**  | ** ** | **Fair Value** |
|-------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|-----------|------------|----------------|
| Marcal Paper Mills, Inc. (12) |       | Manufacturing-paper products                   |       | Senior Subordinated Term Debt (6)             |       | $         | 6,275,000  |           | $ | 6,149,500 |
|                          |       |                                           |       | (13.0%, Due 12/2006)                          |       |      |       |           |
|                          |       |                                           |       | First Mortgage Loan (5)                       |       | 9,277,877 |       | 9,277,877      |
|                          |       |                                           |       | (16%, PIK 1%, Due 12/2006)                    |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Mistras Holdings Corp.        |       | Nondestructive testing                         |       | Senior Term Debt (3) (6)                      |       | 9,666,666 |       | 9,461,249      |
|                          |       | instruments, systems                           |       | (10.5%, Due 8/2008)                           |       |      |       |           |
|                          |       | and services                                   |       | Senior Term Debt (3) (6)                      |       | 4,833,334 |       | 4,724,584      |
|                          |       |                                           |       | (12.5%, Due 8/2008)                           |       |      |       |           |
|                          |       |                                           |       | Senior Term Debt (3) (6)                      |       | 1,000,000 |       | 982,500        |
|                          |       |                                           |       | (13.5%, Due 8/2008)                           |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Northern Contours             |       | Manufacturing-veneer and                       |       | Senior Subordinated Term Debt (8)             |       | 7,000,000 |       | 7,000,000      |
| Northern Contours             |       | laminate components                            |       | (10.7%, Due 5/2010)                           |       |      |       |           |
| of Kentucky, Inc.             |       |                                           |       |                                          |       |      |       |           |
| Norcon Holding LLC            |       |                                           |       |                                          |       |      |       |           |
| Norcon Lewis LLC              |       |                                           |       |                                          |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Penn Engineering &        |       | Manufacturing-fractional                       |       | Senior Subordinated Term Debt (8)             |       | 5,009,524 |       | 5,050,000      |
| Manufacturing  Corp.          |       | horsepower engines                             |       | (10.0%, Due 5/2012)                           |       |      |       |           |
| PN Merger Sub Inc.            |       |                                           |       |                                          |       |      |       |           |
| PEM Holding Co.               |       |                                           |       |                                          |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Polar Corporation             |       | Manufacturing-trailer parts                    |       | Senior Subordinated Term Debt (6)             |       | 8,609,566 |       | 8,627,500      |
|                          |       |                                           |       | (10.3%, Due 6/2010)                           |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Puerto Rico Cable             |       | Service-telecommunications                     |       | Senior Subordinated Term Debt                 |       | 5,050,182 |       | 5,075,000      |
| Acquisition Company, Inc.     |       |                                           |       | (10.3%, Due 1/2012)                           |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Regency Gas Services LLC      |       | Midstream gas gathering and                    |       | Senior Subordinated Term Debt (7)             |       | 5,029,188 |       | 5,037,500      |
|                          |       | processing                                     |       | (9.9%, Due 12/2010)                           |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Santana Plastics              |       | Manufacturing-polyethylene bathroom partitions |       | Senior Term Debt (3)(6)  (11.7%, Due 11/2009) |       | 6,000,000 |       | 6,007,500      |
|                          |       |                                           |       | Senior Term Debt (4)(6)                       |       |      |       |           |
|                          |       |                                           |       | (13.0%, Due 11/2009)                          |       | 1,950,000 |       | 1,952,438      |
|                          |       |                                           |       |                                          |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| SCPH Holdings, Inc.           |       | Manufacturing-underwater and                   |       | Credit Facility (9)                           |       | —    |       | —         |
| Sea Con Phoenix, Inc.         |       | harsh environment components                   |       | (8.0%, Due 3/2006)                            |       |      |       |           |
| Phoenix Optix, Inc.           |       |                                           |       | Senior Term Debt (3)(6)                       |       | 3,237,500 |       | 3,241,547      |
|                          |       |                                           |       | (8.7%, Due 2/2010)                            |       |      |       |           |
|                          |       |                                           |       | Senior Term Debt (6)                          |       | 3,000,000 |       | 3,003,750      |
|                          |       |                                           |       | (12.0%, Due 2/2010)                           |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Survey Sampling               |       | Service-telecommunications                     |       | Senior Subordinated Term Debt (6)             |       | 4,514,105 |       | 4,539,375      |
|                          |       |                                           |       | (11.0%, Due 5/2012)                           |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Tech Lighting LLC             |       | Manufacturing-low voltage                      |       | Senior Subordinated Term Debt (6)             |       | 9,012,452 |       | 9,067,500      |
|                          |       | lighting systems                               |       | (10.4%, Due 10/2010)                          |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
| Visual Edge Technology, Inc.  |       | Service-office supplies distribution           |       | Senior Subordinated Term Debt                 |       | 5,000,000 |       | 5,000,000      |
| Graphic Enterprises, Inc.     |       |                                           |       | (11.7%, Due 8/2011)                           |       |      |       |           |
| Copeco, Inc.                  |       |                                           |       |                                          |       |      |       |           |
|                          |       |                                           |       |                                          |       |      |       |           |
|                               |            |                                                |            |                                               |            |           |            |                |  |  |

 

53

----

 
| Company (1)                 | ** ** | **Industry**               | ** ** | **Investment (2)**                | ** ** | **Cost**  | ** **      | **Fair Value** |
|-----------------------------|------------|----------------------------|------------|-----------------------------------|------------|-----------|-----------------|----------------|
| Woven Electronics           |       | Custom electrical cable    |       | Senior Term Debt (4) (6) (10)     |       | $         | 8,344,999       |           | $ | 8,776,435 |
| Corporation                 |       | assemblies                 |       | (11.5%, Due 3/2009)               |       |      |            |           |
|                        |       |                       |       |                              |       |      |            |           |
| Xspedius Communications LLC |       | Service-telecommunications |       | Senior Subordinated Term Debt (6) |       | 5,972,727 |            | 4,479,545      |
|                        |       |                       |       | (14.3%, Due 3/2010)               |       |      |            |           |
| **Total:**                  |       | ** **                 |       | ** **                        | ** ** | **$**     | **205,375,554** | ** **     | **$** | **200,846,763** |

----

(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, 2005 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 SPSE.

(7)    Marketable securitiesare valued based on the bid price, as of September 30, 2005, from therespective originating syndication agent’s trading desk.

(8)    Investment was valuedat cost due to recent acquisition.

(9)    Availability under thecredit facility totals $500,000.  Therewere no borrowings outstanding at September 30, 2005.

(10)  Includes a success feewith a $347,986 fair value and no cost basis.

(11)  Non-income producing atSeptember 30, 2005.

(12)  Subsequent to September 30, 2005, the entireinvestment in the portfolio company was sold at the fair value reflectedherein.

*The accompanying notes are anintegral part of these consolidated financial statements.*

54

----

 

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS**
| ** **                                                                              | ** ** | **Year Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| INVESTMENT INCOME                                                                       |       |                                        |       |   |   |   |   |
| Interest income  — investments                                                     |       | $                                           | 25,646,746 |   | $ | 22,407,605 |   | $ | 18,176,617 |   |
| Interest income  — cash and cash equivalents                                       |       | 38,381                                      |       | 32,807 |   | 84,273 |   |
| Interest income  — notes receivable from employees                                 |       | 441,341                                     |       | 444,170 |   | 443,658 |   |
| Fee income  (Refer to Note 10)                                                          |       | —                                      |       | — |   | 1,118,106 |   |
| Prepayment fees  and other income                                                       |       | 773,378                                     |       | 1,065,177 |   | 573,314 |   |
| Total investment  income                                                                |       | 26,899,846                                  |       | 23,949,759 |   | 20,395,968 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| EXPENSES                                                                                |       |                                        |       |   |   |   |   |
| Loan servicing  (Refer to Note 12)                                                      |       | 2,907,875                                   |       | 2,549,728 |   | 501,670 |   |
| Management fee  (Refer to Note 11)                                                      |       | 1,266,875                                   |       | 1,359,643 |   | — |   |
| Professional  fees                                                                      |       | 548,326                                     |       | 725,336 |   | 579,599 |   |
| Amortization of  deferred financing fees                                                |       | 140,143                                     |       | 385,737 |   | 1,373,415 |   |
| Interest expense                                                                        |       | 3,238,615                                   |       | 1,774,629 |   | 741,621 |   |
| Stockholder  related costs                                                              |       | 303,709                                     |       | 220,445 |   | 140,090 |   |
| Directors fees                                                                          |       | 116,212                                     |       | 101,843 |   | 112,210 |   |
| Insurance  expense                                                                      |       | 206,554                                     |       | 178,214 |   | 258,358 |   |
| Salaries and benefits                                                                   |       | —                                      |       | — |   | 2,554,490 |   |
| Rent                                                                                    |       | —                                      |       | — |   | 139,399 |   |
| Stock option  compensation                                                              |       | 285,318                                     |       | — |   | — |   |
| Other expenses                                                                          |       | 484,722                                     |       | 235,861 |   | 702,341 |   |
| Expenses before  credit from Gladstone Management                                       |       | 9,498,349                                   |       | 7,531,436 |   | 7,103,193 |   |
| Credit to  management fee for fees collected by Gladstone Management (Refer to Note 11) |       | (2,051,000                                  | )          | (1,077,100 | ) | — |   |
| Total expenses  net of credit to management fee                                         |       | 7,447,349                                   |       | 6,454,336 |   | 7,103,193 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| NET INVESTMENT INCOME  BEFORE INCOME TAXES                                              |       | 19,452,497                                  |       | 17,495,423 |   | 13,292,775 |   |
| Income tax  expense                                                                     |       | 101,917                                     |       | 209,278 |   | — |   |
| NET INVESTMENT INCOME                                                                   |       | 19,350,580                                  |       | 17,286,145 |   | 13,292,775 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| REALIZED AND UNREALIZED  GAIN (LOSS) ON INVESTMENTS:                                    |       |                                        |       |   |   |   |   |
| Net realized  (loss) gain on sale of investments                                        |       | (903,945                                    | )          | 29,750 |   | 12,500 |   |
| Realized gain on  settlement of derivative                                              |       | 15,014                                      |       | — |   | — |   |
| Unrealized  appreciation (depreciation) on derivative                                   |       | 31                                          |       | (39,488 | ) | (214,259 | ) |
| Net unrealized  appreciation (depreciation) on investments                              |       | 5,968,555                                   |       | (1,785,725 | ) | (2,520,726 | ) |
| Net gain (loss)  on investments                                                         |       | 5,079,655                                   |       | (1,795,463 | ) | (2,722,485 | ) |
|                                                                                    |       |                                        |       |   |   |   |   |
| NET INCREASE IN NET  ASSETS RESULTING FROM OPERATIONS                                   |       | $                                           | 24,430,235 |   | $ | 15,490,682 |   | $ | 10,570,290 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| NET INCREASE IN NET  ASSETS RESULTING FROM OPERATIONS PER COMMON SHARE:                 |       |                                        |       |   |   |   |   |
| Basic                                                                                   |       | $                                           | 2.15       |   | $ | 1.37 |   | $ | 1.05 |   |
| Diluted                                                                                 |       | $                                           | 2.10       |   | $ | 1.33 |   | $ | 1.02 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| WEIGHTED AVERAGE SHARES  OF COMMON STOCK OUTSTANDING:                                   |       |                                        |       |   |   |   |   |
| Basic                                                                                   |       | 11,381,378                                  |       | 11,292,466 |   | 10,101,341 |   |
| Diluted                                                                                 |       | 11,615,922                                  |       | 11,609,146 |   | 10,344,388 |   |

 

*The accompanying notes are an integralpart of these consolidated financial statements.*

55

----

**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS**
| ** **                                                         | ** ** | **Year Ended September,** | ** **  |
|--------------------------------------------------------------------|------------|-------------------------------------|-------------|
| ** **                                                         | ** ** | **2006**                            | ** **  | **2005** | ** ** | **2004** | ** ** |
| *Operations:*                                                      | * *   | * *                            | * *    | * * | * * | * * | * * |
| Net investment income                                              |       | $                                   | 19,350,580  |   | $ | 17,286,145 |   | $ | 13,292,775 |   |
| Net realized (loss) gain on sale of investments                    |       | (903,945                            | )           | 29,750 |   | 12,500 |   |
| Realized gain on settlement of derivative                          |       | 15,014                              |        | — |   | — |   |
| Unrealized appreciation (depreciation) on derivative               |       | 31                                  |        | (39,488 | ) | (214,259 | ) |
| Net unrealized appreciation (depreciation) on  investments         |       | 5,968,555                           |        | (1,785,725 | ) | (2,520,726 | ) |
| Net increase in net assets from operations                         |       | 24,430,235                          |        | 15,490,682 |   | 10,570,290 |   |
|                                                               |       |                                |        |   |   |   |   |
| *Capital  transactions:*                                           | * *   | * *                            | * *    | * * | * * | * * | * * |
| Distributions to stockholders                                      |       | (18,628,597                         | )           | (17,109,668 | ) | (12,578,583 | ) |
| Tax return of capital to shareholders                              |       | —                              |        | — |   | (1,207,143 | ) |
| Stock option compensation                                          |       | 285,318                             |        | — |   | — |   |
| Issuance of common stock under stock option plan                   |       | 16,375,375                          |        | 427,350 |   | 707,090 |   |
| Repayment of principal on employee notes                           |       | 189,943                             |        | 843,997 |   | 103,252 |   |
| Note receivable issued from sale of common stock                   |       | (1,692,470                          | )           | (157,100 | ) | (549,990 | ) |
| Issuance of common stock under shelf offering                      |       | —                              |        | — |   | 24,855,525 |   |
| Shelf offering costs                                               |       | —                              |        | (111,233 | ) | (476,168 | ) |
| (Decrease) increase in net assets from capital share  transactions |       | (3,470,431                          | )           | (16,106,654 | ) | 10,853,983 |   |
|                                                               |       |                                |        |   |   |   |   |
| Total increase  (decrease) in net assets                           |       | 20,959,804                          |        | (615,972 | ) | 21,424,273 |   |
| Net assets at  beginning of year                                   |       | 151,610,683                         |        | 152,226,655 |   | 130,802,382 |   |
| Net assets at  end of period                                       |       | $                                   | 172,570,487 |   | $ | 151,610,683 |   | $ | 152,226,655 |   |

 

*The accompanying notes are anintegral part of these consolidated financial statements.*

56

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**GLADSTONE CAPITAL CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                                                             | ** ** | **Year Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net increase in net assets resulting from operations                                                                                   |       | $                                           | 24,430,235 |   | $ | 15,490,682 |   | $ | 10,570,290 |   |
| Adjustments to reconcile net increase in net assets  resulting from operations to net cash provided by (used in) operating activities: |       |                                        |       |   |   |   |   |
| Purchase of investments                                                                                                                |       | (135,954,879                                | )          | (143,794,006 | ) | (86,267,500 | ) |
| Principal repayments on investments                                                                                                    |       | 124,009,929                                 |       | 88,019,136 |   | 47,158,995 |   |
| Proceeds from repurchase agreements                                                                                                    |       | —                                      |       | — |   | 285,099,546 |   |
| Repayment of repurchase agreements                                                                                                     |       | —                                      |       | (21,345,997 | ) | (342,202,549 | ) |
| Depreciation                                                                                                                           |       | —                                      |       | — |   | 24,356 |   |
| Net amortization of premiums and discounts                                                                                             |       | (137,239                                    | )          | (1,635 | ) | 2,036 |   |
| Amortization of deferred financing fees                                                                                                |       | 135,143                                     |       | 385,737 |   | 1,303,776 |   |
| Stock compensation expense                                                                                                             |       | 285,318                                     |       | — |   | — |   |
| Realized loss on investments                                                                                                           |       | 1,329,458                                   |       | — |   | — |   |
| Unrealized (appreciation) depreciation on derivative                                                                                   |       | (31                                         | )          | 39,488 |   | 214,259 |   |
| Change in net unrealized (appreciation) depreciation  on investments                                                                   |       | (5,968,555                                  | )          | 1,785,725 |   | 2,520,726 |   |
| Decrease (increase) in interest receivable                                                                                             |       | 941                                         |       | (482,983 | ) | 201,259 |   |
| (Increase) decrease in funds due from custodian                                                                                        |       | (963,078                                    | )          | (1,420,995 | ) | 3,921 |   |
| (Increase) decrease in prepaid assets                                                                                                  |       | (48,897                                     | )          | 13,828 |   | 201,275 |   |
| Decrease (increase) in due from affiliate                                                                                              |       | —                                      |       | 109,639 |   | (67,508 | ) |
| Decrease (increase) in other assets                                                                                                    |       | (76,125                                     | )          | (49,622 | ) | 33,188 |   |
| (Decrease) increase in accounts payable                                                                                                |       | (17,822                                     | )          | 99,679 |   | 82,674 |   |
| Increase in interest payable                                                                                                           |       | 63,823                                      |       | — |   | — |   |
| Increase (decrease) in accrued expenses and deferred  liabilities                                                                      |       | 370,622                                     |       | (447,431 | ) | (1,053,418 | ) |
| (Decrease) increase in fees due to affiliate                                                                                           |       | (150,959                                    | )          | 277,811 |   | — |   |
| Increase in funds held in escrow                                                                                                       |       | 2,433                                       |       | 200,760 |   | — |   |
| Increase in investment balance due to payment in  kind interest                                                                        |       | (74,701                                     | )          | (409,743 | ) | (552,944 | ) |
| Net cash provided by (used in) operating activities                                                                                    |       | 7,235,616                                   |       | (61,529,927 | ) | (82,727,618 | ) |
|                                                                                                                                   |       |                                        |       |   |   |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Receipt of principal on notes receivable - employees                                                                                   |       | 189,943                                     |       | 843,997 |   | 103,252 |   |
| Sale of furniture & equipment, net                                                                                                 |       | —                                      |       | — |   | 117,365 |   |
| Net cash provided by investing activities                                                                                              |       | 189,943                                     |       | 843,997 |   | 220,617 |   |
|                                                                                                                                   |       |                                        |       |   |   |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net proceeds from the issuance of common shares                                                                                        |       | —                                      |       | — |   | 24,379,357 |   |
| Borrowings from the lines of credit                                                                                                    |       | 146,740,000                                 |       | 155,000,000 |   | 114,743,547 |   |
| Repayments on the lines of credit                                                                                                      |       | (149,781,064                                | )          | (142,709,483 | ) | (74,000,000 | ) |
| Distributions paid                                                                                                                     |       | (18,628,598                                 | )          | (17,109,668 | ) | (17,112,735 | ) |
| Exercise of employee stock options                                                                                                     |       | 14,682,905                                  |       | 270,250 |   | 157,100 |   |
| Deferred financing fees                                                                                                                |       | (210,834                                    | )          | (105,000 | ) | (567,649 | ) |
| Purchase of derivative                                                                                                                 |       | —                                      |       | — |   | (304,000 | ) |
| Shelf offering costs                                                                                                                   |       | —                                      |       | (111,233 | ) | — |   |
| Net cash (used in) provided by financing activities                                                                                    |       | (7,197,591                                  | )          | (4,765,134 | ) | 47,295,620 |   |
|                                                                                                                                   |       |                                        |       |   |   |   |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1)**                                                                          |       | 227,968                                     |       | (65,451,064 | ) | (35,211,381 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                                                    |       | 503,776                                     |       | 65,954,840 |   | 101,166,221 |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                                                                          |       | $                                           | 731,744    |   | $ | 503,776 |   | $ | 65,954,840 |   |
|                                                                                                                                   |       |                                        |       |   |   |   |   |
| **CASH  PAID DURING PERIOD FOR INTEREST**                                                                                              |       | $                                           | 3,174,492  |   | $ | 1,662,309 |   | $ | 672,449 |   |
| **CASH  PAID DURING PERIOD FOR INCOME TAXES**                                                                                          |       | $                                           | —     |   | $ | 138,678 |   | $ | — |   |
| **NON-CASH  FINANCING ACTIVITIES**                                                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Notes receivable issued  in exchange for common stock associated with the exercise of employee stock  options                          |       | $                                           | 1,692,470  |   | $ | 157,100 |   | $ | 549,990 |   |

----

(1)   Cash and cash equivalentsconsist of demand deposits and highly liquid investments with originalmaturities of three months or less when purchased.

*The accompanying notes are anintegral part of these consolidated financial statements.*

57

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**GLADSTONE CAPITAL CORPORATIONFINANCIAL HIGHLIGHTS**
| ** **                                            | ** ** | **Year Ended September 30,** | ** **  |
|-------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                            | ** ** | **2006**                                    | ** **  | **2005** | ** ** | **2004** | ** ** |
| Per Share Data  (1)                                   |       |                                        |        |   |   |   |   |
| Net asset value at beginning of period                |       | $                                           | 13.41       |   | $ | 13.50 |   | $ | 12.97 |   |
| *Income from investment operations:*                  | * *   | * *                                    | * *    | * * | * * | * * | * * |
| Net investment income (2)                             |       | 1.70                                        |        | 1.53 |   | 1.32 |   |
| Realized loss on sale of investments (2)              |       | (0.08                                       | )           | — |   | — |   |
| Net unrealized gain (loss) on investments (2)         |       | 0.53                                        |        | (0.16 | ) | (0.25 | ) |
| Net unrealized loss on derivative (2)                 |       | —                                      |        | — |   | (0.02 | ) |
| Total from investment operations                      |       | 2.15                                        |        | 1.37 |   | 1.05 |   |
| Less distributions:                                   |       |                                        |        |   |   |   |   |
| Distributions from net investment income              |       | (1.64                                       | )           | (1.52 | ) | (1.25 | ) |
| Tax return of capital distribution                    |       | —                                      |        | — |   | (0.12 | ) |
| Total distributions                                   |       | (1.64                                       | )           | (1.52 | ) | (1.37 | ) |
| Issuance of common stock under shelf offering         |       | —                                      |        | — |   | 0.99 |   |
| Issuance of common stock under stock option plan      |       | 1.19                                        |        | 0.02 |   | 0.01 |   |
| Stock compensation expense                            |       | 0.02                                        |        | — |   | — |   |
| Repayment of principal on notes receivable            |       | 0.02                                        |        | 0.07 |   | 0.01 |   |
| Dilutive effect of share issuance (6)                 |       | (1.13                                       | )           | (0.01 | ) | — |   |
| Offering costs                                        |       | —                                      |        | (0.02 | ) | (0.16 | ) |
| Net asset value at end of period                      |       | $                                           | 14.02       |   | $ | 13.41 |   | $ | 13.50 |   |
|                                                  |       |                                        |        |   |   |   |   |
| Per share market value at beginning of period         |       | $                                           | 22.55       |   | $ | 22.71 |   | $ | 19.45 |   |
| Per share market value at end of period               |       | 22.01                                       |        | 22.55 |   | 22.71 |   |
| Total return (3)                                      |       | 5.21%                                       |        | 5.93% |   | 24.40% |   |
| Shares outstanding at end of period                   |       | 12,305,008                                  |        | 11,303,510 |   | 11,278,510 |   |
|                                                  |       |                                        |        |   |   |   |   |
| Ratios/Supplemental  Data                             |       |                                        |        |   |   |   |   |
| Net assets at end of period                           |       | $                                           | 172,570,487 |   | $ | 151,610,683 |   | $ | 152,226,655 |   |
| Average net assets (7)                                |       | $                                           | 155,867,538 |   | $ | 151,897,549 |   | $ | 130,385,129 |   |
| Ratio of expenses to average net assets (4)           |       | 6.16%                                       |        | 5.10% |   | 5.45% |   |
| Ratio of net expenses to average net assets (5)       |       | 4.84%                                       |        | 4.39% |   | 5.45% |   |
| Ratio of net  investment income to average net assets |       | 12.42%                                      |        | 11.38% |   | 10.20% |   |

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(1)    Based on actual sharesoutstanding at the end of the corresponding period.

(2)    Based on weightedaverage basic per share data.

(3)    Total return equalsthe increase of the ending market value over the beginning market value plusmonthly dividends divided by the monthly beginning market value, assumingmonthly dividend reinvestment.

(4)    Ratio of expenses toaverage net assets is computed using expenses before credit from GladstoneManagement and including income tax expense.

(5)    Ratio of net expensesto average net assets is computed using total expenses net of credits tomanagement fee and including income tax expense.

(6)    Represents theanti-dilutive impact of (i) the other components in the changes in netassets and (ii) the different share amounts used in calculating per sharedata as a result of calculating certain per share data based upon the weightedaverage basic shares outstanding during the period and certain per share databased on the shares outstanding as of a period end or transaction date.

(7)    Averagenet assets are computed using the average balance of net assets at the end ofeach reporting month.

*THE ACCOMPANYING NOTES ARE AN INTEGRAL PARTOF THESE CONSOLIDATED FINANCIAL STATEMENTS.*

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**GLADSTONE CAPITAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSSEPTEMBER 30, 2006**

**Note 1. Organization**

Gladstone CapitalCorporation (the “Company”) was incorporated under the General Corporation Lawsof the State of Maryland on May 30, 2001 as a closed-end investmentcompany. The Company has elected to be treated as a business developmentcompany under the Investment Company Act of 1940, as amended (“the 1940 Act”).In addition, the Company has elected to be treated for tax purposes as aregulated investment company, or RIC, under the Internal Revenue Code of 1986,as amended (the “Code”). The Company’s investment objectives are to achieve ahigh level of current income by investing in debt and equity securities ofestablished private businesses.

Gladstone BusinessLoan LLC (“Business Loan”), a wholly-owned subsidiary of the Company, wasestablished on February 3, 2003 for the purpose of holding the Company’sportfolio of loan investments.  GladstoneCapital Advisers, Inc. is also a wholly-owned subsidiary. The financialstatements of the subsidiaries are consolidated with those of the Company.

The Company isexternally managed by Gladstone Management Corporation (“GMC” or “Adviser”), anunconsolidated affiliate of the Company.

**Note 2. Summary of Significant Accounting Policies**

*Basisof Presentation*

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly-owned subsidiaries. All significant intercompany balances andtransactions have been eliminated.

*Useof Estimates*

The consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) thatrequire management to make estimates and assumptions that affect the amountsreported in the financial statements and accompanying notes. Actual results maydiffer from those estimates.

*Reclassifications*

Certain amounts inthe prior years’ financial statements have been reclassified to conform to thecurrent year presentation with no effect to net increase in net assetsresulting from operations.

*Cashand Cash Equivalents*

Cash and cashequivalents consist of demand deposits and highly liquid investments withoriginal maturities of three months or less when purchased. Cash and cash equivalentsare carried at cost which approximates fair value as of September 30, 2006and September 30, 2005.

*Concentrationof Credit Risk*

The Company placesits cash and cash equivalents with financial institutions and, at times, cashheld in checking accounts may exceed the Federal Deposit Insurance Corporationinsured limit.

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*InvestmentValuation*

The Company carries itsinvestments at fair value, as determined by its Board of Directors.  Securities that are publicly traded arevalued 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 from the respective originating syndication agent’strading desk.  Debt and equity securitiesthat are not publicly traded are valued at fair value. The Company’s Board ofDirectors has established a valuation policy and consistently applied valuationprocedures used to determine the fair value of these securities quarterly.  These procedures for the determination ofvalue of many of the Company’s debt securities rely on the opinions of valuesubmitted to us by Standard & Poor’s Securities Evaluations, Inc. (“SPSE”).SPSE will only evaluate the debt portion of the Company’s investments for whichit specifically requests evaluation, and may decline to make requestedevaluations for any reason in its sole discretion.  SPSE opinions of value are submitted to theBoard of Directors along with GMC’s supplemental assessment and recommendationregarding valuation of each of these investments. The Board of Directors thenreviews whether GMC has followed its established procedures for determinationsof fair value, and votes to accept or not accept the recommended valuation ofthe Company’s investment portfolio. The Company’s fair valuation proceduresprovide for valuation of non-convertible debt securities at cost plus amortizedoriginal issue discount plus paid in kind (“PIK”) interest, if any, unlessadverse factors lead to a determination of a lesser valuation.  The fair value of convertible debt, equity,success or exit fees or other equity like securities is determined based on thecollateral, the issuer’s ability to make payments, the earnings of the issuer,sales to third parties of similar securities, the comparison to publicly tradedsecurities, discounted cash flow and other pertinent factors.  Due to the uncertainty inherent in thevaluation process, such estimates of fair value may differ significantly fromthe values that would have resulted had a ready market for the securitiesexisted, and the differences could be material. Additionally, changes in themarket environment and other events that may occur over the life of theinvestments may cause the gains ultimately realized on these investments to bedifferent than the valuation currently assigned.  Because there is a delay between when theCompany closes an investment and when the investment can be evaluated by SPSE,new investments are not valued immediately by SPSE; rather, management makesits own determination about the value of these investments in accordance withthe Company’s valuation policy without the input of SPSE during the specificquarter in which the investment closes. Because SPSE does not perform independent valuations of mortgage loansor equity securities, the Company also determines the fair value of theseinvestments without the input of SPSE. The Company considers a number of qualitative and quantitative factorsin current market conditions when performing valuations.  The Board of Directors is ultimatelyresponsible for setting the fair value and disclosure of investments in thefinancial statements.

*InterestIncome Recognition*

Interest income,adjusted for amortization of premiums and accretion of discounts, is recordedon the accrual basis to the extent that such amounts are expected to becollected. The Company stops accruing interest on its investments when it isdetermined that interest is no longer collectible.  Conditional interest or a success fee isrecorded when earned upon full repayment of a loan investment.

*Paidin Kind Interest*

The Company hasloans in its portfolio which contain a paid in kind (“PIK”) provision. The PIKinterest, computed at the contractual rate specified in each loan agreement, isadded to the principal balance of the loan and recorded as income. To maintainthe Company’s status as a RIC, this non-cash source of income must be paid outto stockholders in the form of dividends, even though the Company has not yetcollected the cash. For the years ended September 30, 2006, September 30,2005 and September 30, 2004, the Company recorded PIK income of $63,217,$394,985, and $553,409, respectively.

*Fee Income*

The 1940 Actrequires that a business development company make available managerial assistanceto its portfolio companies. The 1940 Act defines managerial assistance as theservice made available to a portfolio company to provide “significant guidanceand counsel concerning the management, operations, or business objectives andpolicies of a portfolio company.”  Priorto the start of fiscal year 2005, the Company provided managerial assistanceand other services to its portfolio companies through its wholly-ownedsubsidiary, Gladstone Capital Advisers, Inc. and therefore recorded managerialassistance and other fee revenue in connection with these activities.  Effective October 1, 2004, the Company offersmanagerial assistance and other services to its portfolio companies through itsexternal investment adviser, GMC. Neither the Company nor its external investment adviser, GMC, charges afee for managerial assistance.  However,in the past the Company and, since October 1, 2004, GMC, have provided otherservices to portfolio companies in addition to managerial assistance.  These other services include a wide varietyof services to the portfolio companies such as investment banking services,arranging bank financing, arranging equity financing, structuring financingfrom multiple lenders and investors, reviewing existing credit facilities, restructuringexisting loans, raising equity and debt capital, turnaround management, mergerand acquisition services and recruiting new management personnel.  GMC is charging for these services and iscrediting the funds received from these other services to the Company as acredit against the investment advisory fee due from the Company under theinvestment advisory agreement.  Such feesare normally paid in part at the time of signing a non-binding letter ofintent, with the remainder paid upon completion of the services, and aregenerally non-recurring.

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*RealizedGain or Loss and Unrealized Appreciation or Depreciation of PortfolioInvestments*

Realized gain or loss is recognized when an investment is disposed ofand is computed as the difference between the Company’s cost basis in theinvestment at the disposition date and the net proceeds received from suchdisposition.  Unrealized appreciation ordepreciation displays the difference between the fair market value of theinvestment and the cost basis of such investment.

*StockOptions*

In December 2004, theFinancial Accounting Standards Board (“FASB”) approved the revision ofStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting forStock-Based Compensation, and issued the revised SFAS Statement No. 123(R), “Share-BasedPayment.”  SFAS No. 123(R) effectivelyreplaces SFAS No. 123, and supersedes Accounting Principles Board Opinion (“APB”)No. 25, “Accounting for Stock Issued to Employees” (APB 25)”.  SFAS 123(R) is effective for awards that aregranted, modified, or settled in cash for annual periods beginning after June15, 2005.  The Company adopted SFAS No.123(R) on October 1, 2005 using the modified prospective approach.

*AdvisoryAgreement with GMC*

SinceOctober 1, 2004, the Company has been externally managed pursuant to acontractual investment advisory arrangement with GMC, an unconsolidatedaffiliate of the Company and a registered investment adviser, under which GMC has directly employed all of the Company’spersonnel and paid its payroll, benefits, and general expenses directly.  The Company’s initial advisory agreement withGMC was in place through September 30, 2006 (the “Initial Advisory Agreement”).  Pursuant to the Initial Advisory Agreement, theCompany paid GMC an annual advisory fee of 1.25% of its 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% ofits total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.1875%.  GMC’s Board of Directors agreed to waive, forthe quarters ending June 30, 2006 and September 30, 2006, the annual advisoryfee of 1.25% to 0.5% for those senior syndicated loans in which the Companyalready has syndicated second lien participations.  On October1, 2006, the Company entered into an amended and restated investmentadvisory agreement (the “Amended Advisory Agreement”) with GMC and anadministration agreement (the “Administration Agreement”) with GladstoneAdministration.  (Please refer to Note 11.Advisory Agreement with GMC.)

GMC services theloans held by Business Loan, in return for which, GMC receives a 1.5% annualfee based on the monthly aggregate balance of loans held by Business Loan.  Since the Company owns these loans, all loanservicing fees paid to GMC are also credited directly against the 2% managementfee.  These credits reduce the amount ofthe investment advisory fee.  Under theadvisory agreement, GMC also provides the managerial assistance and otherservices that the Company previously made available to its portfolio companiesthrough its wholly-owned subsidiary Gladstone Capital Advisers, Inc.  To the extent that GMC receives any feesdirectly from a portfolio company for such services, GMC credits these feesdirectly against the 2% management fee. Effective in April 2006, GMC’s Board of Directors voluntarily waived theadvisory fee on a temporary basis by reducing the 1.25% annual fee to 0.5% perannum applicable only to the senior syndicated loans in which the Companyalready has a second lien position. Overall, the management fee due to GMC cannot exceed 2% of total assets(as reduced by cash and cash equivalents pledged to creditors) during any givenfiscal year.

InJuly 2003, the Company entered into an expense sharing arrangement with GMCthat serves as the external adviser to Gladstone Commercial Corporation, a realestate investment trust, an affiliate. Under this expense sharing arrangement,GMC reimbursed Gladstone Capital Advisers for a portion of total payroll andbenefits expenses (based on the percentage of total hours worked by each of theCompany’s employees on Gladstone Commercial matters). GMC also reimbursedGladstone Capital Advisers for its pro rata portion of all other generalexpenses (based on the percentage of total hours worked by all employees onGladstone Commercial matters). GMC further passed its share of these expensesalong to Gladstone Commercial under a separate advisory agreement. As a resultof this expense sharing arrangement, certain expenses, such as rent andinsurance, declined during the fiscal year ended September 30, 2004.** **Followingthe engagement of GMC on October 1, 2004, the first day of the 2005 fiscalyear, GMC now directly employs all personnel and pays the payroll,benefits, and general expenses directly. Thus, the expense sharing arrangement between Gladstone Capital Advisersand GMC terminated upon the externalization of management on October 1, 2004.

The Company wasself-managed and therefore did not incur management fees payable to thirdparties during the fiscal year ended September 30, 2004.

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*Propertyand Equipment*

Property and equipmentwere carried at cost and depreciated using the straight-line method over theestimated useful lives of the related assets ranging from three to fiveyears.  On July 1, 2004, the Company soldits fixed assets at net book value to GMC.

*FederalIncome Taxes*

The Companyintends to continue to qualify for treatment as a RIC under Subchapter M of theCode. As a RIC, the Company is not subject to federal income tax on the portionof its taxable income and gains distributed to stockholders. To qualify as aRIC, the Company is required to distribute to its stockholders at least 90% ofinvestment company taxable income, as defined by the Code.

*Dividends*

Distributions tostockholders are recorded on the ex-dividend date. The Company is required topay out at least 90% of its ordinary income and short-term capital gains foreach taxable year as a dividend to its stockholders in order to maintain itsstatus as a RIC under Subtitle A, Chapter 1 of Subchapter M of the Code. It isthe policy of the Company to pay out as a dividend up to 100% of those amounts.The amount to be paid out as a dividend is determined by the Board of Directorseach quarter and is based on the annual earnings estimated by the management ofthe Company. Based on that estimate, a dividend is declared each quarter and ispaid out monthly over the course of the respective quarter. At year-end theCompany may pay a bonus dividend, in addition to the monthly dividends, toensure that it has paid out at least 90% of its ordinary income and short-termcapital gains for the year. The Company has a policy of retaining long-termcapital gains, if any, and not paying them out as dividends.  If the Company decides to retain long-termcapital gains, the portion of the retained capital gains will be subject to 35%tax.

*NewAccounting Pronouncements*

In October 2005, theFinancial Accounting Standards Board (“FASB”) released FASB Staff PositionNo. FAS 123(R)-2 (“FSP FAS 123(R)-2”), “*PracticalAccommodation to the Application of Grant Date as Defined in FASB StatementNo. 123(R).”* FSP FAS 123(R)-2 provides guidance on theapplication of grant date as defined in Statement of Financial AccountingStandards (“SFAS”) No. 123(R)*.*The FASB addresses the notion of “mutual understanding,” specifically that amutual understanding shall be presumed to exist at the date the award isapproved in accordance with the relevant corporate governance requirements if,the award is a unilateral grant and therefore the recipient does not have theability to negotiate the terms and conditions of the award with the employerand, the key terms and conditions of the award are expected to be communicatedto an individual recipient within a relatively short time period for the dateof approval. The Company applied FSP FAS 123(R)-2 in conjunction with theadoption of SFAS No. 123(R) on October 1, 2005.

In May 2005, the FASBissued SFAS No. 154, “*Accounting Changes andError Corrections*”, a replacement of APB Opinion No. 20, “*Accounting Changes*”, and SFAS No. 3, “*ReportingAccounting Changes in Interim Financial Statements*” and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  SFAS 154 applies to allvoluntary changes in accounting principle and also applies to changes requiredby an accounting pronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions.  SFAS 154 requires retrospective applicationto prior periods’ financial statements of changes in accounting principle.  SFAS 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005.  Early adoption is permitted foraccounting changes and corrections of errors made in fiscal years beginningafter the date of issuance.  The Companyis required to adopt the provisions of SFAS 154, as applicable, beginning infiscal year 2007.  The Company iscurrently evaluating the effect of this statement.

In February 2006, theFASB issued SFAS No. 155, *“Accountingfor Certain Hybrid Financial Instruments, an amendment of FASB statementsNo. 133 and 140”* (SFAS No. 155). SFAS No. 155 allowsfinancial instruments that have embedded derivatives to be accounted for as awhole (eliminating the need to bifurcate the derivative from its host) as longas the entire instrument is valued on a fair value basis. The statement alsoresolves and clarifies other specific SFAS No. 133 and SFAS No. 140related issues. SFAS No. 155 is effective for all financial instrumentsacquired or issued after the beginning of an entity’s first fiscal year thatbegins after September 15, 2006. The Company will be required to adoptSFAS No. 155 on October 1, 2006. The Company is currently evaluatingthe effect of this statement.

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In June 2006, the FASBissued FASB Interpretation No. 48, “*Accountingfor Uncertainty in Income Taxes—an interpretation of FASB StatementNo. 109,”* which clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordancewith SFAS No. 109, “*Accounting forIncome Taxes*.” This Statement shall be effective as of the beginningof an entity’s first fiscal year that begins after December 15, 2006. TheCompany will adopt this Interpretation effective January 1, 2007. TheCompany does not expect that this pronouncement will have a material impact onits consolidated financial statements.

InSeptember 2006, the FASB issued SFAS No. 157, *“Fair ValueMeasurements”* (SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for measuringfair value in accordance with GAAP, and expands disclosures about fair valuemeasurements.  SFAS No. 157 appliesbroadly to securities and other types of assets and liabilities.  SFAS No. 157 is effective for financial statementsissued for fiscal years beginning after November 15, 2007 and interim periodswithin that fiscal year.  The Companywill be required to adopt SFAS No. 157 on October 1, 2008 and does not expectit to have a material impact on its consolidated financial statements since theCompany currently values all portfolio investments at fair value.

In September 2006, theSEC issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108addresses how the effects of prior year uncorrected misstatements should beconsidered when quantifying misstatements in current year financial statementsand requires registrantsto consider the effect of all carry over and reversing effects of prior yearmisstatements when quantifying errors in current year financial statements.SAB 108 does not change the SEC’s previous guidance in SAB No. 99, “*Materiality*,” on evaluating themateriality of misstatements. A registrant applying the new guidance for thefirst time that identifies material errors in existence at the beginning of thefirst fiscal year ending after November 15, 2006, may correct those errorsthrough a one-time cumulative effect adjustment to beginning-of-year retainedearnings. The cumulative effect alternative is available only if theapplication of the new guidance results in a conclusion that a material errorexists as of the beginning of the first fiscal year ending afterNovember 15, 2006, and those misstatements were determined to beimmaterial based on a proper application of the registrant’s previous methodfor quantifying misstatements. The Company does not expect that thispronouncement will have a material impact on its consolidated financialstatements

**Note 3.Common Stock Transactions**

Transactions in common stock were as follows:

|                                                   | ** ** | **Common Stock** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **Shares**            | ** ** | **Amount** | ** ** |
| Balance at  September 30, 2003                    |       | 10,081,844            |       | $ | 10,082 |   |
| Issuance of  Common Stock Under Shelf Offering    |       | 1,150,000             |       | 1,150 |   |
| Issuance of  Common Stock Under Stock Option Plan |       | 46,666                |       | 47 |   |
| Balance at  September 30, 2004                    |       | 11,278,510            |       | $ | 11,279 |   |
|                                              |       |                  |       |   |   |
| Issuance of  Common Stock Under Stock Option Plan |       | 25,000                |       | $ | 25 |   |
| Balance at  September 30, 2005                    |       | 11,303,510            |       | $ | 11,304 |   |
|                                              |       |                  |       |   |   |
| Issuance of  Common Stock Under Stock Option Plan |       | 1,001,498             |       | 1,001 |   |
| Balance at September  30, 2006                    |       | 12,305,008            |       | $ | 12,305 |   |

 

The balance of common stock at September 30, 2006 does not include 5,000shares resulting from the exercise of stock options on September 29, 2006 thatwere not issued by the Company’s transfer agent until October 1, 2006.

**Note 4.Stock Option Plan**

Prior to itstermination on September 30, 2006, the Company had in place the Amended andRestated 2001 Equity Incentive Plan (the “2001 Plan”). The Company hadauthorized 2,000,000 shares of capital stock for the issuance of options underthe 2001 Plan to employees and directors. Options granted under the 2001 Planoriginally may have been exercised during a term not to exceed ten years fromthe date of grant. Only employees of the Company and its affiliates wereeligible to receive incentive stock options and both employees and non-employeedirectors were eligible to receive nonstatutory stock options under the 2001Plan.

Options grantedunder the 2001 Plan were either incentive stock options or nonstatutory stockoptions.   The option exercise price wasequal to the market price on the date of the grant.  For the options granted during fiscal year2006, all vested immediately, 2005, 3% vested immediately, 50% vested one yearafter the grant date and 47% vested on the second year anniversary of the grantdate. For the options granted during fiscal year 2004, 50% vested after oneyear after the grant date and the remaining 50% vested on the second yearanniversary of the grant date. Prior to the termination of the 2001 Plan, thevesting of all unvested stock options were accelerated on April 11, 2006.

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004) (“SFASNo. 123(R)”) *Share-based Payment*.SFAS No. 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*and supersedesAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB No. 25”)*.*SFAS No. 123(R) is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005.  The Company adopted SFASNo. 123(R) on October 1, 2005 using the modified prospectiveapproach. Under the modified prospective approach, stock-based compensationexpense will be

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recorded for theunvested portion of previously issued awards that remain outstanding atOctober 1, 2005 using the same estimate of the grant date fair value andthe same attribution method used to determine the pro forma disclosure underSFAS No. 123. SFAS No. 123(R) also requires that all share-basedpayments to employees after October 1, 2005, including employee stockoptions, be recognized in the financial statements as stock-based compensationexpense based on the fair value on the date of grant.  Accordingly, prior period amounts have notbeen restated.

For the fiscal year endedSeptember 30, 2006, the Company recorded stock option compensation expense forthe cost of stock options issued under the 2001 Plan of $285,318. The Company’sexpensing of stock options decreased both basic and diluted net increase to netassets resulting from operations per share by $0.03 and $0.02, respectively,for the fiscal year ended September 30, 2006. Additionally, SFAS No. 123(R) states that any potential taxbenefits associated with incentive stock options should be recognized only atthe time of settlement if those options settle through a disqualifyingdisposition. Thus, the related stock-based compensation expense must be treatedas a permanent difference until that time which in turn, results in an increaseto the Company’s effective tax rate.  TheCompany does not record tax benefits associated with the expensing of stockoptions since the Company intends to qualify as a RIC under Subchapter M of theCode and as such the Company is not subject to federal income tax on theportion of its taxable income and gains distributed to stockholders, providedthat at least 90% of the taxable income is distributed.

The Companyaccounted for the issuance of stock options through the 2001 Plan in accordancewith APB 25 during fiscal years 2005 and 2004. In connection with the externalization of the Company’s management, allof its officers and employees became direct employees of GMC as of October 1,2004, the start of fiscal year 2005. However, these individuals continued to be eligible to receive stockoptions under the 2001 Plan.  EffectiveOctober 1, 2004, the Company accounted for any options granted to employees ofGMC, who qualify as leased employees of the Company under FIN 44, *“Accounting for Certain Transactions Involving Stock Compensation, anInterpretation of APB Opinion No. 25.”*

Under the provisions of APB No. 25, the Company was not requiredto recognize compensation expense for the cost of stock options issued underthe 2001 Plan. The following table illustrates the effect on net increase tonet assets resulting from operations and net increase to net assets resultingfrom operations per share for the fiscal years ended September 30, 2005 andSeptember 30, 2004, as if the Company had applied the fair value recognitionprovisions of SFAS No. 123, as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation-Transitionand Disclosure”:*

|                                                                                                              | ** ** | **Year Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
|                                                                                                         |       |                                        |       |   |   |
| Net increase in  net assets resulting from operations                                                        |       |                                        |       |   |   |
| As reported:                                                                                                 |       | $                                           | 15,490,682 |   | $ | 10,570,290 |   |
|                                                                                                         |       |                                        |       |   |   |
| Deduct: Total  stock-based compensation expense determined using the fair value based method  for all awards |       | (297,391                                    | )          | (1,687,199 | ) |
|                                                                                                         |       |                                        |       |   |   |
| Pro forma net  increase in net assets resulting from operations per share                                    |       | $                                           | 15,193,291 |   | $ | 8,883,091 |   |
|                                                                                                         |       |                                        |       |   |   |
| As reported -  basic                                                                                         |       | $                                           | 1.37       |   | $ | 1.05 |   |
| As reported -  diluted                                                                                       |       | $                                           | 1.33       |   | $ | 1.02 |   |
|                                                                                                         |       |                                        |       |   |   |
| Pro forma - basic                                                                                            |       | $                                           | 1.35       |   | $ | 0.88 |   |
| Pro forma - diluted                                                                                          |       | $                                           | 1.31       |   | $ | 0.86 |   |

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option pricing model with the following weightedaverage assumptions used for grants in the fiscal years ended September 30,2006, 2005 and 2004.

| Assumptions:             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       | 4.23%    |       | 3.41%    |       | 2.41%    |       |
| Expected life            |       | 3 years  |       | 3 years  |       | 3 years  |       |
| Expected  volatility     |       | 23.00%   |       | 17.67%   |       | 16.91%   |       |
| Expected dividend yield  |       | 7.65%    |       | 6.07%    |       | 6.67%    |       |

 

The weightedaverage per share fair value based on the Black-Scholes option pricing model ofoptions granted during the fiscal years ended September 30, 2006, 2005 and2004, were $1.89, $1.71, and $1.24, respectively.

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A summary of the status of the Company’s 2001 Plan from September 30,2004 through September 30, 2006 is as follows:

|                                                                                       | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|
| Options  outstanding at September 30, 2004, of which 897,496 shares were exercisable  |       | 1,260,498  |       | $                                              | 17.44      |   |
| Granted                                                                               |       | 74,500     |       | $                                              | 24.05      |   |
| Exercised                                                                             |       | (25,000    | )          | $                                              | 17.09      |   |
| Forfeited                                                                             |       | (2,000     | )          | $                                              | 22.55      |   |
| Options outstanding  at September 30, 2005, of which 1,307,998 shares are exercisable |       | 1,307,998  |       | $                                              | 17.81      |   |
| Granted                                                                               |       | 2,500      |       | $                                              | 21.17      |   |
| Exercised                                                                             |       | (1,006,498 | )          | $                                              | 16.27      |   |
| Forfeited                                                                             |       | (304,000   | )          | $                                              | 22.94      |   |
| Options  outstanding at September 30, 2006                                            |       | —     |       |                                           |       |

 

A detailed summary of the stock options outstanding at fiscal yearsended September 30, 2006, September 30, 2005 and September 30, 2004is presented in the following table:

| Fiscal Year Ended | ** ** | **Range of  Exercise Prices** | ** ** | **Stock Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life (Years)** | ** ** |
|-----------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|--------------------------------------------------------------------------|------------|
| September 30, 2006          |       | —                                  |       | —                              |       | —                                                                   |       |
| September 30, 2005          |       | $15.00 - $24.3                          | 9          | 1,307,998                           |       | 7.03                                                                     |       |
| September 30, 2004          |       | $15.00 - $22.8                          | 4          | 1,260,498                           |       | 7.88                                                                     |       |

 

During the fiscalyear ended September 30, 2006, the Company issued 1,006,498 shares, 823,332 toexecutives and directors and 183,166 to ten employees pursuant to stock optionexercises, in exchange for cash of $14,682,905 and four full recourse notesreceivable of $1,692,470. During the fiscal year ended September 30, 2005, theCompany issued 25,000 shares; 10,000 to a director and 15,000 to two employeespursuant to stock option exercises, in exchange for cash of $270,250 and onefull recourse note receivable of $157,100. During the fiscal year endedSeptember 30, 2004, the Company issued 46,666 shares of common stock tothree employees pursuant to stock option exercises, in exchange for cash of$157,100 and two full recourse notes receivable of $549,990.  These transactions were effected pursuant tothe 2001 Plan, which allowed 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.

On December 2, 2005, theCompany held a special meeting of stockholders in which the stockholders votedto approve a proposal to enter into an amended and restated investment advisoryagreement (the “Amended Advisory Agreement”) with GMC and an administrationagreement (the “Administration Agreement”) between the Company and GladstoneAdministration LLC, a wholly-owned subsidiary of GMC.

The Amended AdvisoryAgreement includes an incentive advisory fee, and regulations promulgated bythe SEC prohibit business development companies from implementing an incentiveadvisory fee while having in place a stock option plan or any outstanding stockoptions.  Thus, in connection with theapproval of the Amended Advisory Agreement, and pursuant to an offer approvedby the Board of Directors on April 11, 2006, the Company extended an offer toits then-current stock option holders to amend the terms of all outstandingstock options under the 2001 Plan to accelerate the contractual expiration dateof these options to September 30, 2006. The offer was filed with the SEC on April 12, 2006, was conducted inaccordance with the federal tender offer rules and regulations, and was conditionedupon the acceptance by 100% of the stock option holders.  The Board of Directors also accelerated infull the vesting of all outstanding options other than options held by thenon-employee Directors effective April 11, 2006, resulting in acceleratedvesting of 34,500 outstanding options. On May 31, 2006, 100% of the stock option holders accepted the tenderoffer, and on September 30, 2006, all outstanding stock options and the 2001Plan were terminated.

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**Note 5.Commitments and Contingencies**

At September 30, 2006, the Company was party to a signed andnon-binding term sheet for one potential investment for $9.0 million and $7.2million in four syndicate loan participations. The future scheduled contractualpayments at September 30, 2006 were as follows:

|                                  | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|----------------------------------|------------|------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **Less than  1 Year**          | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|                             |       |       |       |                                     |       |   |   |   |   |   |   |
| Investments                      |       | $          | 16,226,000 |                                     | 16,226,000 |   | — |   | — |   | — |   |
| Total                            |       | $          | 16,226,000 |                                     | $          | 16,226,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                                  |            |            |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

All prospectiveinvestments are subject to, among other things, the satisfactory completion ofthe Company’s due diligence investigation of each borrower, acceptance of termsand structure and receipt of necessary consents. With respect to eachprospective loan, the Company will only agree to provide the loan if, amongother things, the results of its due diligence investigations are satisfactory,the terms and conditions of the loan are acceptable and all necessary consentsare received. The Company has initiated its due diligence investigations of thepotential borrowers, however there can be no guarantee that facts will not bediscovered in the course of completing the due diligence that would render aparticular investment imprudent or that any of these investments will actuallybe made.

At September 30,2006, the Company had unpaid federal and state withholding taxes of $1,803,283related to the exercise of non-qualified stock options during the third andfourth quarters of fiscal 2006.  These withholding taxes were unfunded bythe optionees at September 30, 2006 and as a result a corresponding receivableis recorded on the consolidated statements of assets and liabilities atSeptember 30, 2006.  During the first fiscal quarter of 2007 the Companyremitted the entire tax withholding liability to the respective taxingauthorities and it has received substantially all of the amounts due from theoptionees.

**Note 6.Net Increase in Net Assets Resulting from Operations per Share**

The following table sets forth the computation of basic and diluted netincrease in net assets resulting from operations per share for the fiscal yearended September 2006, September 30, 2005, and September 30, 2004:

|                                                                         | ** ** | **Year ended September 30,** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                    |       |                                        |       |   |   |   |   |
| Numerator for  basic and diluted net increase in                        |       | $                                           | 24,430,235 |   | $ | 15,490,682 |   | $ | 10,570,290 |   |
| net assets  resulting from operations per share                         |       |                                        |       |   |   |   |   |
|                                                                    |       |                                        |       |   |   |   |   |
| Denominator for  basic weighted average shares                          |       | 11,381,378                                  |       | 11,292,466 |   | 10,101,341 |   |
| Dilutive effect  of stock options                                       |       | 234,544                                     |       | 316,680 |   | 243,047 |   |
| Denominator for  diluted weighted average shares                        |       | 11,615,922                                  |       | 11,609,146 |   | 10,344,388 |   |
|                                                                    |       |                                        |       |   |   |   |   |
| Basic net  increase in net assets resulting from operations per share   |       | $                                           | 2.15       |   | $ | 1.37 |   | $ | 1.05 |   |
|                                                                    |       |                                        |       |   |   |   |   |
| Diluted net increase in  net assets resulting from operations per share |       | $                                           | 2.10       |   | $ | 1.33 |   | $ | 1.02 |   |

 

**Note 7.Related Party Transactions**

The Company hasprovided loans to employees for the exercise of options under the 2001 Plan.The loans require the quarterly payment of interest at the market rate ofinterest in effect at the date of issue, have varying terms not exceeding nineyears and have been recorded as a reduction of net assets. The loans areevidenced by full recourse notes that are due upon maturity or 60 daysfollowing termination of employment, and the shares of common stock purchasedwith the proceeds of the loan are posted as collateral. During the fiscal yearended September 30, 2006, the Company issued four loans to three employees for$1,692,470 for the exercise of stock options and received the full repayment ofone loan that was issued in fiscal year 2002. During the fiscal year ended September 30, 2005, the Company issued aloan to one employee for $157,100 for exercise of stock options and receivedthe full repayment of three loans that were issued during fiscal years 2001,2003, and 2004. During the fiscal year ended September 30, 2004, the Company issued$549,990 in loans to two employees for the exercise of options and received thefull repayment of a loan that was 

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issued duringfiscal year 2002. The Company recognized interest income from all employeestock option loans of $441,341, $444,170, and $443,658 during the fiscal yearsended September 30, 2006, September 30, 2005 and September 30,2004, respectively. The outstanding principal balances due on all employeestock option loans at September 30, 2006 and September 30, 2005 were$10,248,308 and $8,745,781, respectively.

On July 1, 2004,the Company sold its fixed assets at cost, net of accumulated depreciation toGMC.

**Note 8.Repurchase Agreement**

A repurchaseagreement involves the purchase by an investor, such as the Company, of aspecified security and the simultaneous agreement by the seller to repurchaseit at an agreed upon future date and at a price which is greater than thepurchase price by an amount that reflects an agreed-upon interest rate. Suchinterest rate is effective for the period of time during which the investor’smoney is invested in the arrangement and is related to current market interestrates rather than the coupon rate on the purchased security. The Companyrequires the continual maintenance by its custodian or the correspondent in itsaccount with the Federal Reserve/Treasury Book Entry System of underlyingsecurities in an amount at least equal to the repurchase price. If the sellerwere to default on its repurchase obligation, the Company might suffer a lossto the extent that the proceeds from the sale of the underlying securities wereless than the repurchase price. A seller’s bankruptcy could delay or prevent asale of the underlying securities.

The Company had nooutstanding repurchase agreement at September 30, 2006 or September 30,2005.  On September 29, 2004, the Companyentered into a repurchase agreement (the “Repurchase Agreement”) with FerrisBaker Watts for $44,984,950. On September 30, 2004, this amount was reduced to$21,345,997 with the application of the net proceeds from the public offeringof common stock.  This remaining balancewas settled on October 1, 2004.  TheRepurchase Agreement was recorded at cost and was fully collateralized by aUnited States Treasury Bill with a fair value of $50,000,000, a carrying valueof $49,984,950 that matured on October 7, 2004 and earned interest of $2,133.  The interest rate on the Repurchase Agreementwas 4.25% for a cost of $7,831.

**Note 9.Dividends**

Thefollowing table illustrates the 2006 and 2005 fiscal year monthly dividends pershare:

| Fiscal  Year | ** ** | **Record Date** | ** ** | **Payment Date** | ** ** | **Dividend per  Share** | ** ** |
|--------------|------------|----------------------|------------|-----------------------|------------|------------------------------|------------|
| 2006         |       | September  21, 2006  |       | September  29, 2006   |       | $0.140                       |       |
|         |       | August  23, 2006     |       | August  31, 2006      |       | $0.140                       |       |
|         |       | July  21, 2006       |       | July  31, 2006        |       | $0.140                       |       |
|         |       | June  22, 2006       |       | June  30, 2006        |       | $0.135                       |       |
|         |       | May  22, 2006        |       | May  31, 2006         |       | $0.135                       |       |
|         |       | April  20, 2006      |       | April  28, 2006       |       | $0.135                       |       |
|         |       | March  23, 2006      |       | March  31, 2006       |       | $0.135                       |       |
|         |       | February  20, 2006   |       | February  28, 2006    |       | $0.135                       |       |
|         |       | January  19, 2006    |       | January  31, 2006     |       | $0.135                       |       |
|         |       | December  21, 2005   |       | December  30, 2005    |       | $0.135                       |       |
|         |       | November  21, 2005   |       | November  30, 2005    |       | $0.135                       |       |
|         |       | October  21, 2005    |       | October  31, 2005     |       | $0.135                       |       |
|         |       |                 |       | Annual  Total:        |       | $1.635                       |       |
|         |       |                 |       |                  |       |                         |       |
| 2005         |       | September  22, 2005  |       | September  30, 2005   |       | $0.135                       |       |
|         |       | August  23, 2005     |       | August  31, 2005      |       | $0.135                       |       |
|         |       | July  21, 2005       |       | July  29, 2005        |       | $0.135                       |       |
|         |       | June  16, 2005       |       | June  30, 2005        |       | $0.130                       |       |
|         |       | May  13, 2005        |       | May  27, 2005         |       | $0.130                       |       |
|         |       | April  15, 2005      |       | April  29, 2005       |       | $0.130                       |       |
|         |       | March  18, 2005      |       | March  31, 2005       |       | $0.120                       |       |
|         |       | February  11, 2005   |       | February  28, 2005    |       | $0.120                       |       |
|         |       | January  14, 2005    |       | January  28, 2005     |       | $0.120                       |       |
|         |       | December  17, 2004   |       | December  30, 2004    |       | $0.120                       |       |
|         |       | November  17, 2004   |       | November  30, 2004    |       | $0.120                       |       |
|         |       | October  18, 2004    |       | October  29, 2004     |       | $0.120                       |       |
|         |       |                 |       | Annual Total:         |       | $1.515                       |       |

 

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Aggregatedividends declared and paid for the 2006 fiscal year were approximately $18.6million which were declared based on an estimate of net investment income forthe year.  Net investment income,including realized gains exceeded dividends declared by approximately $0.2million.

Aggregatedividends declared and paid for the 2005 fiscal year were approximately $17.1million which were declared based on an estimate of net investment income forthe year.  Net investment income,including realized gains exceeded dividends declared by approximately $0.2million.

**Note 10.Fee Income**

The 1940 Actrequires that a business development company make available managerialassistance to its portfolio companies. The 1940 Act defines managerialassistance as the service made available to a portfolio company to provide “significantguidance and counsel concerning the management, operations, or businessobjectives and policies of a portfolio company.”  Prior to the start of fiscal year 2005, theCompany provided managerial assistance and other services to its portfoliocompanies through its wholly-owned subsidiary, Gladstone Capital Advisers, Inc.and therefore recorded managerial assistance and other fee revenue inconnection with these activities. Effective October 1, 2004, the Company offers managerial assistance andother services to its portfolio companies through its external investmentadviser, GMC.  Neither the Company norGMC currently charges a fee for managerial assistance.  However, in the past the Company and, sinceOctober 1, 2004, GMC, have provided other services to portfolio companies inaddition to managerial assistance.  Theseother services include a wide variety of services to the portfolio companiessuch as investment banking services, arranging bank financing, arranging equityfinancing, structuring financing from multiple lenders and investors, reviewingexisting credit facilities, restructuring existing loans, raising equity anddebt capital, turnaround management, merger and acquisition services andrecruiting new management personnel.  GMCis charging for these services and is crediting the funds received from theseother services to the Company as a credit against the investment advisory feedue from the Company under the investment advisory agreement.  Such fees are normally paid in part at thetime of signing a non-binding letter of intent, with the remainder paid uponcompletion of the services, and are generally non-recurring.  For the fiscal years ended September 30, 2006and September 30, 2005, the Company recorded no revenue from fees since, asdescribed above, these fees were remitted by the borrower directly to GMC.  For the fiscal year ended September 30, 2004,these fees totaled $1,118,106.

While GMC beganreceiving all fees in connection with the Company’s investments as of October1, 2004, such fees received by GMC are credited to the Company as a reductionof the advisory fee payable to GMC under the advisory agreement between theCompany and GMC.  For the fiscal yearsended September 30, 2006 and September 30, 2005, GMC received $2,051,000 and$1,077,100, respectively, for fees for services rendered to portfoliocompanies. None of these fees were for managerial assistance even though GMCprovided managerial assistance to many of the Company’s portfoliocompanies.  Accordingly, the advisory feepayable by the Company to GMC for the fiscal year ended September 30, 2006 andSeptember 30, 2005 were reduced by $2,051,000 and $1,077,100, respectively, inrespect of these fees received by GMC.

**Note11. Advisory Agreement with GMC**

Since October 1, 2004,the Company has been externally managed pursuant to a contractual investmentadvisory arrangement with GMC, an unconsolidated affiliate of the Company and aregistered investment adviser, under which GMChas directly employed all of the Company’s personnel and paid its payroll,benefits, and general expenses directly. The Company’s initial advisory agreement with GMC was in place throughSeptember 30, 2006 (the “Initial Advisory Agreement”).  Pursuant to the Initial Advisory Agreement, theCompany paid GMC an annual advisory fee of 1.25% of its 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% ofits total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.1875%.  GMC’s Board of Directors agreed to waive, forthe quarters ending June 30, 2006 and September 30, 2006, the annual advisoryfee of 1.25% to 0.5% for those senior syndicated loans in which the Companyalready has syndicated second lien participations.  Under the Initial Advisory Agreement, theCompany paid all of its direct expenses, including, but not limited to,directors’ fees, legal and accounting fees, stockholder related expenses, anddirectors and officers insurance.

GMCservices the loans held by Business Loan, in return for which GMC receives a1.5% annual fee based on the monthly aggregate balance of loans held by BusinessLoan.  Since the Company owns theseloans, all loan servicing fees paid to GMC are also credited directly againstthe 2% management fee.  These creditsreduce the amount of the investment advisory fee and are shown above the directcredits line item in the table below. Under the advisory agreement, GMC also provides the managerialassistance and other services that the Company previously made available to itsportfolio companies through its wholly-owned subsidiary Gladstone CapitalAdvisers, Inc.  To the extent that GMCreceives any fees directly from a portfolio company for such services, GMCcredits these fees directly against the 2% management fee and these amounts areshown in the table below as a credit to the management fee.  Overall, the management fee due to GMC cannotexceed 2% of total assets (as reduced by cash and cash equivalents pledged tocreditors) during any given fiscal year. Because the Company was internally managed at all times prior to October1, 2004, no management fee was recorded prior to that date.

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Thefollowing tables set forth the quarterly computation of the management fee forthe fiscal years ended September 30, 2006 and 2005 based on the quarterlyincrement of 0.50% (0.3125% quarterly advisory fee and 0.1875% quarterly administrativefee):
| ** **                                                          | ** ** | **September 30,** | ** **  | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** **  |
|---------------------------------------------------------------------|------------|------------------------|-------------|-------------------|------------|--------------------|------------|-----------------------|-------------|
| ** **                                                          | ** ** | **2006**               | ** **  | **2006**          | ** ** | **2006**           | ** ** | **2005**              | ** **  |
| **Fee:**                                                            |       |                   |        |              |       |               |       |                  |        |
| Total assets at                                                     |       | $                      | 223,979,932 | (f)               | $          | 207,265,095        |       | $                     | 217,404,695 |   | $ | 211,823,244 |   |
| Less: Senior  syndicated loans subject to reduced fee               |       | (11,011,616            | )(a)        | (3,018,897        | )(a)       | —             |       |                  |        |
| Less: Borrowings  under line of credit at                           |       | —                 |        | —            |       | —             |       | (15,000,000           | )(d)        |
| Total assets  subject to quarterly fee of 0.50% as of               |       | 212,968,316            |        | 204,246,198       |       | 217,404,695        |       | 196,823,244           |        |
| Quarterly fee  rate                                                 |       | 0.50%                  |        | 0.50%             |       | 0.50%              |       | 0.50%                 |        |
| Management fee  before senior syndicated loan advisory fee          |       | 1,064,841              |        | 1,021,231         |       | 1,087,023          |       | 984,116               |        |
| Total senior  syndicated loan advisory fee at quarterly rate 0.125% |       | 13,765                 | (b)         | 3,774             | (b)        | —             |       | —                |        |
| Gross management  fee before loan servicing fee credit              |       | 1,078,606              |        | 1,025,005         |       | 1,087,023          |       | 984,116               |        |
| Less: loan  servicing fee from Business Loan                        |       | 763,851                |        | 693,965           |       | 734,644            |       | 715,415               |        |
| Management fee before credit:                                       |       | 314,755                |        | 331,040           |       | 352,379            |       | 268,701               |        |
| **Direct  Credit to Management Fee:**                               |       |                   |        |              |       |               |       |                  |        |
| Fee revenue  recorded by GMC:                                       |       | 289,000                |        | 539,000           |       | 673,000            |       | 550,000               |        |
| Net management  fee for the three months ended (c):                 |       | $                      | 25,755      |              | $          | (207,960           | )          | $                     | (320,621    | ) | $ | (281,299 | ) |
|                                                                |       |                   |        |              |       |               |       |                  |        |

 
| ** **                                             | ** ** | **September 30,** | ** **  | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** **  |
|--------------------------------------------------------|------------|-------------------|-------------|--------------|------------|---------------|------------|------------------|-------------|
| ** **                                             | ** ** | **2005**          | ** **  | **2005**     | ** ** | **2005**      | ** ** | **2004**         | ** **  |
| **Fee:**                                               |       |              |        |         |       |          |       |             |        |
| Total assets                                           |       | $                 | 205,793,094 |         | $          | 209,320,463   |       | $                | 213,753,998 |   | $ | 194,085,591 |   |
| Less: Borrowings  under line of credit                 |       | —            |        | —       |       | (18,644,179   | )(e)       | (22,435,000      | )(e)        |
| Total assets  subject to quarterly fee of 0.50% as of  |       | 205,793,094       |        | 209,320,463  |       | 195,109,819   |       | 171,650,591      |        |
| Quarterly fee  rate                                    |       | 0.50%             |        | 0.50%        |       | 0.50%         |       | 0.50%            |        |
| Gross management  fee before loan servicing fee credit |       | 1,028,965         |        | 1,046,602    |       | 975,549       |       | 858,254          |        |
| Less: loan  servicing fee from Business Loan           |       | 745,263           |        | 687,971      |       | 585,542       |       | 530,952          |        |
| Management fee before credit:                          |       | 283,702           |        | 358,631      |       | 390,007       |       | 327,302          |        |
| **Direct  Credit to Management Fee:**                  |       |              |        |         |       |          |       |             |        |
| Fee revenue  recorded by GMC:                          |       | 100,000           |        | 240,600      |       | 450,000       |       | 286,500          |        |
| Net management  fee for the three months ended:        |       | $                 | 183,702     |         | $          | 118,031       |       | $                | (59,993     | ) | $ | 40,802 |   |

----

*(a)  In April 2006, GMC’s Board of Directorswaived on a temporary basis the annual advisory fee from 1.25% to 0.5% (0.125%quarterly) for those senior syndicated loans in which the Company also holds asyndicated second lien position.*

*(b)  This amount represents the reduced quarterlyadvisory fee applicable only to the senior syndicated loans.*

*(c)  If the amount presented is in parentheses itdenotes the amount is due back to the Company from GMC; if the amount ispositive, it indicates that the Company owes GMC the stated amount.*

*(d)*  *This amount representsborrowings under one of the Company’s lines of credit that were held in cashand cash equivalents as of December 31, 2005. The $15.0 million was to be used to fund a new loan investment, howeverthe investment did not fund until January 2006. Solely for the purposes of calculating the amount of the management feedue to GMC, the Company treats any such amounts as “cash and cash equivalentspledged to creditors” under the terms of its advisory agreement with GMC.  As a result, such amounts are deducted fromits total assets for purposes of computing the asset base upon which themanagement fee is determined.*

*(e)*  *This amount representsborrowings under one of the Company’s lines of credit that were held in cashand cash equivalents as of March 31, 2005 and December 31, 2004, for thepurpose of satisfying its asset diversification requirements under theCode.  Solely for the purposes ofcalculating the amount of the management fee due to GMC, the Company treats anysuch amounts as “cash and cash equivalents pledged to creditors” under theterms of its advisory agreement with GMC. As a result, such amounts are deducted from the Company’s total assetsfor purposes of computing the asset base upon which the management fee isdetermined.*

*(f)  Excludes amounts due from employees inconnection with tax withholdings related to the exercise of non-qualified stockoptions during the third and fourth quarters of fiscal 2006. (See Note 5)*

On October 1, 2006, the Company entered into anamended and restated investment advisory agreement (the “Amended AdvisoryAgreement”) with GMC and an administration agreement (the “AdministrationAgreement”) with Gladstone Administration. Under the Amended AdvisoryAgreement, the Company pays GMC an annual base management fee of 2% of itsaverage gross assets, which is defined as total assets less cash and cashequivalents pledged to creditors calculated as of the end of the two mostrecently completed fiscal quarters, in addition to a two-part incentivefee.  The first part of the incentive feeis an income-based incentive fee which rewards GMC if the Company’s quarterlynet investment income (before giving effect to any incentive fee) exceeds 1.75%of the Company’s net assets (the “hurdle rate”). The Company will pay GMC anincome incentive fee with respect to its pre-incentive fee net investmentincome in each calendar quarter as follows:

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·    no incentive fee in any calendar quarter inwhich pre-incentive fee net investment income does not exceed the hurdle rate(7% annualized);

·    100% of pre-incentive fee net investmentincome with respect to that portion of such pre-incentive fee net investmentincome, if any, that exceeds the hurdle rate but is less than 2.1875% in anycalendar quarter (8.75% annualized); and

·    20% of the amount of pre-incentive fee netinvestment income, if any, that exceeds 2.1875% in any calendar quarter (8.75%annualized).

The second part of theincentive fee is a capital gains incentive fee that will be determined andpayable in arrears as of the end of each fiscal year (or upon termination ofthe Amended Advisory Agreement, as of the termination date), commencing onOctober 1, 2006, and will equal 20% of the Company’s realized capital gains asof the end of the fiscal year. In determining the capital gains incentive feepayable to GMC, the Company will calculate the cumulative aggregate realizedcapital gains and cumulative aggregate realized capital losses since itsinception, and the aggregate unrealized capital depreciation as of the date ofthe calculation, as applicable, with respect to each of the investments in itsportfolio.

GMC’s Board of Directorshas agreed to waive, for the fiscal quarter ending December 31, 2006, theannual 2.0% base management fee to 0.5% for senior syndicated loanparticipations.

Inaddition to the base management and incentive fees under the Amended AdvisoryAgreement, certain fees received by GMC from the Company’s portfolio companieswere credited against the investment advisory fee under the Initial AdvisoryAgreement, and will continue to be paid to GMC and credited under the AmendedAdvisory Agreement.  In addition, theCompany will continue to pay its direct expenses including, but not limited to,directors fees, legal and accounting fees, and stockholder related expensesunder the Amended Advisory Agreement.

Under the AmendedAdvisory Agreement, the Company pays separately for administrative servicesunder the Administration Agreement. The Administration Agreement provides forpayments equal to the Company’s allocable portion of Gladstone Administration’soverhead expenses in performing its obligations under the AdministrationAgreement, including but not limited to rent, and the Company’s allocableportion of the salaries and benefits expenses of its chief financial officer,chief compliance officer and controller and their respective staffs.

**Note 12.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 originallymatured in June 2005 and had been extended through December 31, 2006.  On June 22, 2006, the Company terminated theBB&T Agreement due to infrequent borrowings. Interest on outstandingborrowings was based upon the one month London Interbank Offered Rate (“LIBOR”)plus 2.5% per annum.  The unused portionof the line of credit was subject to a fee of 0.2% per annum during the periodin which the BB&T Agreement was outstanding.

Through BusinessLoan, the Company has a $150 million revolving credit facility (the “DBFacility) with Deutsche Bank AG, as administrative agent, pursuant to whichBusiness Loan pledged the loans it holds to secure future advances by certaininstitutional lenders. The interest rate charged on the advances under the DBFacility is based on LIBOR, the Prime Rate or the Federal Funds Rate, dependingon market conditions, and adjusts periodically. In May 2006, the Companyrenewed its line of credit through May 25, 2007. In September 2006, the Companyincreased its capacity in the DB Facility from $100 million to $150million.  As of September 30, 2006, theoutstanding principal balance under the DB Facility was approximately $50.0million at an interest rate of 5.4%. Available borrowings are subject to various constraints imposed byDeutsche Bank AG, based on the aggregate loan balance pledged by Business Loan,which varies as loans are added and repaid, regardless of whether suchrepayments are early prepayment or are made as contractually required.  At September 30, 2006, the remainingborrowing capacity available under the DB Facility was approximately $100.0million.

The DB Facilitycontains covenants that require Business Loan to maintain its status as aseparate entity; prohibit certain significant corporate transactions (such asmergers, consolidations, liquidations or dissolutions); and restrict materialchanges to the Company’s credit and collection policies.  The DB Facility also restricts some of theterms and 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, 2006, Business Loan was in compliance with all of the facilitycovenants.

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The administrativeagent also requires that any interest or principal payments on pledged loans beremitted directly by the borrower into a lockbox account with the Bank of NewYork as custodian.  Deutsche Bank AG isalso the trustee of the account and once a month remits the collected funds tothe Company. At September 30, 2006, the amount due from custodian was$3,587,152 and at September 30, 2005, the amount due from custodian was$2,624,074.

Effective July 12,2004, GMC, the Company’s affiliated external adviser also services the loanspledged under the DB Facility.  As acondition to this servicing arrangement, the Company executed a performanceguaranty pursuant to which it guaranteed that Management would comply fullywith all of its obligations under the DB Facility.  The performance guaranty requires the Companyto maintain a minimum net worth of $100 million and to maintain “asset coverage”with respect to “senior securities representing indebtedness” of at least 200%,in accordance with Section 18 of the 1940 Act.  As of September 30, 2006, the Company was incompliance with all covenants under the performance guaranty.  GMC services these loans for an annual fee of1.5% of the monthly aggregate outstanding loan balance of the loans pledgedunder the DB Facility.  Effective inApril 2006, GMC’s Board of Directors voluntarily agreed to waive, on atemporary basis, the annual servicing fee rate for those senior syndicatedloans in which the Company already has a second lien position to 0.5%.  For the fiscal year ended September 30, 2006,the Company recorded loan servicing fees of $2,907,875 and owed $214,608 ofunpaid loan servicing fees to GMC, recorded in fees due to affiliate.  For the fiscal year ended September 30, 2005,the Company recorded loan servicing fees of $2,549,728.  At September 30, 2005, the Company owed$207,619 of unpaid loan servicing fees to GMC, which are recorded in fees dueto affiliate.  For the fiscal year endedSeptember 30, 2004, loan servicing fees were $501,670, which represented theperiod July 12, 2004 through September 30, 2004 as prior to July 12, 2004, theloans pledged under the DB Facility were serviced by Gladstone CapitalAdvisers, Inc., wholly-owned subsidiary of the Company.

Loan servicingfees received by GMC are credited to the Company’s advisory fee payable to GMCunder the advisory agreement between the Company and GMC.  Accordingly, the advisory fee payable by theCompany to GMC for the fiscal year ended September 30, 2006 and September 30,2005 was reduced by $2,907,875 and $2,549,728, respectively, in respect ofthese fees received by GMC.

**Note 13.Interest Rate Cap Agreement**

Pursuant to the DeutscheBank AG line of credit, the Company has an interest rate cap agreement thateffectively limits the interest rate on a portion of the borrowings under theline of credit.

The use of a cap involvesrisks that are different from those associated with ordinary portfoliosecurities transactions.  Cap agreementsmay 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.

In February 2004, theCompany entered into an interest rate cap agreement with a notional amount of$35.0 million at a cost of $304,000.  Theinterest rate cap agreement’s current notional amount is $16.4 million with acurrent fair value of $50,284 which is recorded in other assets on the Company’sconsolidated balance sheet at September 30, 2006.  At September 30, 2005, the interest rate capagreement had a fair value of $50,253. The Company records changes in the fair value of the interest rate capagreement monthly based on the current market valuation at month end asunrealized depreciation or appreciation on derivative on the Company’sconsolidated statement of operations. The interest rate cap agreement expiresin February 2009. The agreement provides that the Company’s floating interestrate or cost of funds on a portion of the portfolio’s borrowings will be cappedat 5% when the LIBOR rate is in excess of 5%. During the fiscal year ended September 30, 2006, the Company recorded$15,014 of income from the interest rate cap agreement recorded as a realizedgain on the settlement of derivative on the Company’s consolidated statementsof operations.  The Company did notrecognize any income from the interest rate cap agreement during the fiscalyears ended September 30, 2005 and September 30, 2004.

**Note14. Federal and State Income Taxes**

TheCompany has historically operated, and intends to continue to operate, in amanner to qualify for treatment as a RIC under Subchapter M of the Code.  As a RIC, the Company is not subject tofederal or state income tax on the portion of its taxable income and gainsdistributed to stockholders.  To qualifyas a RIC, the Company is required to distribute to its stockholders at least90% of investment company taxable income, as defined by the Code and as such noincome tax provisions have been recorded for the individual companies ofGladstone Capital Corporation and Gladstone Business Loan LLC.

During the fiscal yearended September 30, 2006, the Company recorded $101,917 in tax expense inconnection with penalties incurred on misclassified revenue on its fiscal year2004 corporate tax return.

GladstoneCapital Advisers, Inc., a wholly-owned subsidiary of Gladstone CapitalCorporation, is subject to federal and state income taxation on the income ithas recorded such as fees received from portfolio companies resulting inaggregate federal and state income taxes of $209,278 during the fiscal yearended September 30, 2005.

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**Note 15.Deferred Compensation Plan**

The Companyadopted a deferred compensation plan (the “401(k) Plan”) effectiveJanuary 1, 2002 which permits an employee to defer the lesser of 75% ofhis or her total annual compensation or the applicable Internal Revenue Service(IRS) annual limit. As of September 30, 2004, the Company funded $50,630 incontributions to the 401(k) Plan. For the fiscal year ended September 30, 2004,the Company recorded $48,502 in expenses related to the 401(k) Plan. EffectiveOctober 1, 2004, GMC assumed sponsorship of the 401(k) Plan pursuant to acorporate resolution.  There were noexpenses incurred for the fiscal year ended September 30, 2006 or September 30,2005 related to the 401(k) Plan.

**Note16.  Subsequent Events**

*Dividends*

On October 10, 2006, theCompany’s Board of Directors declared the following monthly dividends which itbelieves were and will be paid, as applicable, from ordinary income:
| **Declaration Date** | ** ** | ** **         | ** ** | **Record Date** | ** ** | **Payment Date** | ** ** | **Dividend per Share** | ** ** |
|---------------------------|------------|--------------------|------------|----------------------|------------|-----------------------|------------|----------------------------------|------------|
| October 10, 2006          |       | October  23, 2006  |       | October  31, 2006    |       | $                     | 0.14       |                             |
| October 10, 2006          |       | November  21, 2006 |       | November  30, 2006   |       | $                     | 0.14       |                             |
| October 10, 2006          |       | December 20, 2006  |       | December 29, 2006    |       | $                     | 0.14       |                             |

 

*AmendedAdvisory Agreement and Administration Agreement*

On October1, 2006, the Company entered into the Amended Advisory Agreement with GMC, andthe Administration Agreement with Gladstone Administration.

Underthe terms of the Amended Advisory Agreement, GMC will continue to manage theinvestment and reinvestment of the Company’s assets, including identifying,evaluating, and structuring such investments; continuously review, superviseand administer the Company’s investment program to determine in its discretionthe securities to be purchased or sold and the portion of the Company’s assetsto be held un-invested; offer to provide significant managerial assistance tothe issuers of securities in which the Company is invested as required by theInvestment Company Act of 1940, as amended; arrange debt financing for theCompany; provide the Company with all required records concerning GMC’s effortson behalf of the Company; and provide regular reports to the Company’s Boardconcerning GMC’s activities on behalf of the Company.

TheAmended Advisory Agreement provides for an annual base management fee equal to2% of the Company’s assets and an income-based incentive fee which will rewardGMC if the Company’s quarterly net investment income (before giving effect tothe incentive fee) exceeds 1.75% of net assets. The agreement also provides foran annual capital gains-based incentive fee, whereby GMC will receive an annualfee equal to 20% of the Company’s realized capital gains (net of realizedcapital losses and unrealized capital depreciation since inception of the Company).These incentive fees are intended to replace the Company’s equity incentiveplan and stock options, which have been terminated in connection with theCompany’s entrance into the Amended Advisory Agreement and AdministrationAgreement.

Underthe terms of the Administration Agreement, Administration will manage theCompany’s day-to-day operations and administration, record keeping andregulatory compliance functions. The Company will pay separately foradministrative services under the Administration Agreement, which payments willbe equal to the Company’s allocable portion of Administration’s overheadexpenses in performing its obligations under the Administration Agreement,including rent, and the Company’s allocable portion of the salaries andbenefits expenses of its chief financial officer, chief compliance officer,controller and their respective staffs.

The Amended Advisory and Administration Agreementswere approved by the Company’s stockholders at a special meeting on December 2,2005.

*InvestmentActivity*

Subsequent toSeptember 30, 2006, the Company extended $9.2 million in loans to PrecisionInc., an industrial machinery components manufacturer, extended $975,000 inrevolver borrowings to 2 existing portfolio companies and funded additionalterm loans of $1.0 million to 2 portfolio companies.  The Company also purchased 12 syndicated loanparticipations for approximately $25.2 million.

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Also subsequent toSeptember 30, 2006, the Company received principal repayments of approximately$1,682,000 on 8 existing portfolio company loans.  In addition, the Company received the fullrepayment of loans to Mistras Holdings Corp. and Xspedius Communications, LLCin the approximate amounts of $14.8 million and $5.2 million, respectively.

**Note 17. Selected Quarterly Data (Unaudited)**
| ** **                                            | ** ** | **Year Ended September 30, 2006** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                            | ** ** | **Quarter Ended  December 31,  2005**       | ** ** | **Quarter Ended  March 31,  2006** | ** ** | **Quarter Ended  June 30,  2006** | ** ** | **Quarter Ended  September 30,  2006** | ** ** |
|                                                  |       |                                                  |       |   |   |   |   |   |   |
| Total Investment  Income                              |       | $                                                     | 6,030,319  |   | $ | 7,000,700 |   | $ | 6,522,816 |   | $ | 7,346,011 |   |
| Net Investment  Income                                |       | 4,442,414                                             |       | 5,203,816 |   | 4,788,082 |   | 4,916,268 |   |
| Net Increase in  Net Assets Resulting From Operations |       | 8,233,349                                             |       | 5,590,381 |   | 5,543,076 |   | 5,063,429 |   |
|                                                  |       |                                                  |       |   |   |   |   |   |   |
| Basic Earnings  per Weighted Average Common Share     |       | $                                                     | 0.73       |   | $ | 0.49 |   | $ | 0.49 |   | $ | 0.44 |   |
| Diluted Earning  per Weighted Average Common Share    |       | $                                                     | 0.71       |   | $ | 0.48 |   | $ | 0.48 |   | $ | 0.43 |   |

 
| ** **                                            | ** ** | **Year Ended September 30, 2005** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                            | ** ** | **Quarter Ended  December 31,  2004**       | ** ** | **Quarter Ended  March 31,  2005** | ** ** | **Quarter Ended  June 30,  2005** | ** ** | **Quarter Ended  September 30,  2005** | ** ** |
|                                                  |       |                                                  |       |   |   |   |   |   |   |
| Total Investment  Income                              |       | $                                                     | 6,078,401  |   | $ | 5,886,529 |   | $ | 6,127,226 |   | $ | 5,857,603 |   |
| Net Investment  Income                                |       | 4,677,404                                             |       | 4,431,258 |   | 4,372,426 |   | 3,805,057 |   |
| Net Increase in  Net Assets Resulting From Operations |       | 4,944,948                                             |       | 4,275,378 |   | 3,934,153 |   | 2,336,203 |   |
|                                                  |       |                                                  |       |   |   |   |   |   |   |
| Basic Earnings  per Weighted Average Common Share     |       | $                                                     | 0.44       |   | $ | 0.38 |   | $ | 0.35 |   | $ | 0.21 |   |
| Diluted Earning per  Weighted Average Common Share    |       | $                                                     | 0.43       |   | $ | 0.37 |   | $ | 0.34 |   | $ | 0.20 |   |

 

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

Notapplicable.

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

a)  Disclosure Controls and Procedures

As ofSeptember 30, 2006 (the end of the period covered by this report), we,including our Chief Executive Officer and Chief Financial Officer, evaluatedthe effectiveness and design and operation of our disclosure controls andprocedures.  Based on that evaluation,our management, including the Chief Executive Officer and Chief FinancialOfficer, concluded that our disclosure controls and procedures were effectivein timely alerting management, including the Chief Executive Officer and ChiefFinancial Officer, of material information about us required to be included inperiodic SEC filings.  However, inevaluation the disclosure controls and procedures, management recognized thatany controls and procedures, no matter how well designed and operated canprovide only reasonable assurance of achieving the desired control objectives,and management necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

b) Management’s Annual Report on Internal Control Over FinancialReporting

Ourmanagement is responsible for establishing and maintaining adequate internal controlover financial reporting as defined in Rule 13a-15(f) under the SecuritiesExchange Act of 1934. Our internal control over financial reporting is designedto provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles and include thosepolicies and procedures that: (1) pertain to the maintenance of records that inreasonable detail accurately and fairly reflect our transactions and thedispositions of our assets; (2) provide reasonable assurance that ourtransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat our receipts and expenditures are being made only in accordance withappropriate authorizations; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof our assets that could have a material effect on our financial statements. 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Therefore, even those systems determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation. 

Underthe supervision and with the participation of our management, we assessed theeffectiveness of our internal control over financial reporting as of September30, 2006, using the criteria set forth by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) in Internal Control—IntegratedFramework. Based on its assessment, management has concluded that our internalcontrol over financial reporting was effective as of September 30, 2006.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of September 30, 2006 has been audited by PricewaterhouseCoopersLLP, an independent registered public accounting firm, as stated in theirreport which is included herein.

c) Attestation Report of the Registered Public Accounting Firm

Refer to the Report of Independent Registered PublicAccounting Firm located in Item 8 of this form 10K.

d) Change in Internal Control over Financial Reporting

There were no changes in internal controls for theperiod ended September 30, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

**Item 9B. Other Information.**

Not applicable.

 

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**PART III**

We willfile a definitive Proxy Statement for our 2007 Annual Meeting ofStockholders (the “2007 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 2007 Proxy Statement that specifically address the items set forthherein are incorporated by reference.

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

The informationrequired by Item 10 is hereby incorporated by reference from our 2007 ProxyStatement under the captions “Election of Directors” and “Section 16(a)Beneficial Ownership Reporting Compliance.”

**Item 11. Executive Compensation**

The informationrequired by Item 11 is hereby incorporated by reference from our 2007 ProxyStatement under the caption “Compensation of Directors and Executive Officers.”

**Item 12. Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters**

The informationrequired by Item 12 is hereby incorporated by reference from our 2007 ProxyStatement under the caption “Security Ownership of Certain Beneficial Ownersand Management.”

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

The informationrequired by Item 13 is hereby incorporated by reference from our 2007 ProxyStatement under the caption “Certain Transactions.”

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

The informationrequired by Item 14 is hereby incorporated by reference from our 2007 ProxyStatement under the caption “Audit Fees.”

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**PART IV**

**Item 15. Exhibits and Financial Statement Schedules**

**a.             DOCUMENTS FILED AS PART OF THISREPORT**

1.             The following financial statements are filed herewith:
| Report of Independent  Registered Public Accounting Firm                                                                                       |   |   |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Consolidated Statements of Assets and Liabilities as  of September 30, 2006 and September 30, 2005                                   |   |   |   |
| Consolidated Schedule of Investments as of  September 30, 2006                                                                       |   |   |   |
| Consolidated Schedule of Investments as of  September 30, 2005                                                                       |   |   |   |
| Consolidated Statements of Operations for the years  ended September 30, 2006, September 30, 2005 and September 30, 2004             |   |   |   |
| Consolidated Statements of Changes in Net Assets for  the years ended September 30, 2006, September 30, 2005 and  September 30, 2004 |   |   |   |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2006, September 30, 2005 and September 30, 2004             |   |   |   |
| Financial  Highlights for the years ended September 30, 2006, September 30, 2005 and  September 30, 2004                                       |   |   |   |
| Notes to Consolidated Financial Statements                                                                                                     |   |   |   |

 

2.             Financial statement schedules

No financialstatement schedules are filed herewith because (1) such schedules are notrequired or (2) the information has been presented in the aforementionedfinancial 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 17, 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   |   | 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.                                                                                                        |
| 10.2   |   | 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.                                                                                                         |
| 10.3   |   | 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.                                                                                                            |
| 10.4   |   | 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.                                                            |
| 10.5   |   | 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.                                                                                                                   |
| 10.6   |   | 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.                                                                                                         |

 

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|        | ** ** | ** **                                                                                                                                                                                                                                                                                                                        |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.7   |       | 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.                                                                   |
| 10.8   |       | 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.                                                                                                                 |
| 10.9   |       | Trademark  License Agreement between Gladstone Management Corporation and Gladstone  Capital Corporation, incorporated by reference to Exhibit 10.29 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended December 31,  2004 (File No. 814-00237), filed February 9, 2005.                                  |
| 10.10  |       | Amendment No. 5,  Consent and Waiver to Credit Agreement dated as of May 27, 2005, incorporated  by reference to Exhibit 10.30 to the Company’s Quarterly Report on Form 10-Q  for the quarter ended June 30, 2005 (File No. 814-00237), filed August  3,2005.                                                               |
| 10.11  |       | Amended and  Restated Credit Agreement by and among Gladstone Business Loan LLC, Deutsche  Bank AG, and certain other parties, dated as of May 26, 2006, incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (File  No. 814-00237), filed on May 30, 2006.                                |
| 10.12* |       | Joint Directors  Nonqualified Excess Plan of Gladstone Commercial Corporation, Gladstone  Capital Corporation and Gladstone Investment Corporations, dated as of July  11, 2006, incorporated by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K (File No. 814-00237), filed on July 12, 2006.        |
| 10.13  |       | Custodian  Agreement between Gladstone Capital Corporation and The Bank of New York,  dated as of May 5, 2006, incorporated by reference to Exhibit 10.3 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006  (File No. 814-00237), filed August 1, 2006.                                    |
| 10.14  |       | Amendment No. 1 to Amended and Restated Credit  Agreement by and among Gladstone Business Loan LLC, Deutsche Bank AG, and  certain other parties, dated as of September 22, 2006, incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (File  No. 814-00237), filed on September 22, 2006. |
| 10.15* |       | Amended and Restated Investment Advisory and  Management Agreement between Gladstone Capital Corporation and Gladstone  Management Corporation, dated as of October 1, 2006 incorporated by reference to  Exhibit 99.1 to the Company’s Current Report on Form 8-K (File No.  814-00237), filed on October 5, 2006.          |
| 10.16* |       | Administration Agreement between Gladstone Capital  Corporation and Gladstone Administration, LLC, dated as of October 1, 2006  incorporated by reference to Exhibit 99.1 to the Company’s Current Report on  Form 8-K (File No. 814-00237), filed on October 5, 2006.                                                       |
| 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     |       | Consent of PricewaterhouseCoopers 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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*              Denotes management contract or compensatory plan orarrangement.

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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 6, 2006 |       | By:                               |   | /s/ HARRY BRILL |
|                   |       |                              |   | Harry Brill |
|                   |       |                              |   | Chief Financial Officer |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacity and on the dates indicated.
| Date: December 6, 2006 |   | By:    |   | /s/ DAVID GLADSTONE                                                                           |
|------------------------|--------|--------|--------|-----------------------------------------------------------------------------------------------|
|                   |   |   |   | David Gladstone                                                                               |
|                   |   |   |   | Chief Executive Officer and Chairman of the Board of  Directors (principal executive officer) |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ TERRY LEE BRUBAKER                                                                        |
|                   |   |   |   | Terry Lee Brubaker                                                                            |
|                   |   |   |   | Vice Chairman, Chief Operating Officer  and Director                                     |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ HARRY BRILL                                                                               |
|                   |   |   |   | Harry Brill                                                                                   |
|                   |   |   |   | Chief Financial Officer (principal financial and  accounting officer)                         |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ GEORGE STELLJES III                                                                       |
|                   |   |   |   | George Stelljes III                                                                           |
|                   |   |   |   | President, Chief Investment Officer and Director                                              |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ DAVID A.R. DULLUM                                                                         |
|                   |   |   |   | David A.R. Dullum                                                                             |
|                   |   |   |   | Director                                                                                      |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ ANTHONY W. PARKER                                                                         |
|                   |   |   |   | Anthony W. Parker                                                                             |
|                   |   |   |   | Director                                                                                      |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ MICHELA A. ENGLISH                                                                        |
|                   |   |   |   | Michela A. English                                                                            |
|                   |   |   |   | Director                                                                                      |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ PAUL ADELGREN                                                                             |
|                   |   |   |   | Paul Adelgren                                                                                 |
|                   |   |   |   | Director                                                                                      |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ MAURICE COULON                                                                            |
|                   |   |   |   | Maurice Coulon                                                                                |
|                   |   |   |   | Director                                                                                      |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ JOHN OUTLAND                                                                              |
|                   |   |   |   | John Outland                                                                                  |
|                   |   |   |   | Director                                                                                      |
|                   |   |   |   |                                                                                          |
| Date: December 6, 2006 |   | By:    |   | /s/ GERARD MEAD                                                                               |
|                   |   |   |   | Gerard Mead                                                                                   |
|                   |   |   |   | Director                                                                                      |

 

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