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

**WASHINGTON,DC 20549**

 

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** **

**FORM 10-K**

** **

**(Mark One)**
| **ý**                           | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                 |
|--------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                           | ** ** | ** **                                                                                                                                                                                                      |
| ** **                           | ** ** | **for the fiscal year ended September 30, 2005**                                                                                                                                                           |
| ** **                           | ** ** | ** **                                                                                                                                                                                                      |
| **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 value per share**

 

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

 

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

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). YES  ý  NO  o

 

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

 

The aggregate market value of the voting stock held by non-affiliatesof the Registrant on March 31, 2005, based on the closing price on that date of$21.22 on the Nasdaq National Market, was $223,624,190. For the purposes ofcalculating this amount only, all directors and executive officers of theRegistrant have been treated as affiliates.

 

There were 11,308,510 shares of the Registrant’s Common Stock, $0.001par value, outstanding as of December 8, 2005.

 

**Documents Incorporated by Reference.**  Portions of the Registrant’s Proxy Statementrelating to the Registrant’s 2006 Annual Meeting of Stockholders areincorporated by reference into Part III of this Report.

 

 

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**GLADSTONECAPITAL CORPORATION**

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

**SEPTEMBER 30,2005**

** **

**TABLE OFCONTENTS**

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

 

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**FORWARD-LOOKINGSTATEMENTS**

 

*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 such forward-lookingstatements. Such factors include, among others: (1) adverse changes ininterest rates; (2) our failure or inability to establish or maintainreferral arrangements with leveraged buyout funds and venture capital funds togenerate loan opportunities; (3) the loss of one or more of our executiveofficers, in particular David Gladstone, Terry Lee Brubaker, or George StelljesIII; (4) our inability to extend, refinance, or maintain our creditfacilities on terms reasonably acceptable to us, if at all, in future equitycapital resources; (5) our inability to successfully securitize our loanportfolio on terms reasonably acceptable to us, if at all; (6) thedecision of our competitors to aggressively seek to make senior andsubordinated loans to small and medium sized businesses on terms more favorablethan we intend to provide; and (7) those factors described in the “RiskFactors” section of this Form 10-K. We caution readers not to placeundue reliance on any such forward-looking statements, which are made pursuantto the Private Securities Litigation Reform Act of 1995 and, as such, speakonly as of the date made. We undertake no obligation to publicly update orrevise any forward-looking statements, whether as a result of new information,future events or otherwise, after the date of this Form 10-K.*

 

**PART I**

** **

**Item 1. Business**

** **

**About Gladstone Capital Corporation**

 

We are a specialty finance company that was incorporated under theGeneral Corporation Laws of the State of Maryland on May 30, 2001 and thatcommenced its 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. 

 

We seek to achieve a high level of current income by investing in debtsecurities, consisting primarily of senior notes, senior subordinated notes andjunior subordinated notes, of established private businesses that aresubstantially owned by leveraged buyout funds, venture capital funds or familyowned businesses. We also seek to provide our stockholders with long-termcapital growth through the appreciation in the value of warrants or otherequity instruments that we may receive when we make loans. 

 

We seek to invest in small and medium sized private U.S. businessesthat meet certain criteria, including the potential for growth, adequate assetsfor loan collateral, experienced management teams with significant ownershipinterest in the business, adequate capitalization, profitable operations basedon cash flow, substantial ownership by leveraged buyout funds or venturecapital funds and potential opportunities for us to realize appreciation andgain liquidity in our equity positions. We may achieve liquidity through a merger or acquisition of theborrower, a public offering of the borrower’s stock or by exercising our rightto require the borrower to buy back our warrants, though there can be noassurance that we will always have these rights. 

 

We seek to invest primarily in three categories of debt of privatecompanies: 

 

•              *Senior Subordinated Notes. *We seek to invest a majority of our assets in senior subordinatednotes, which may also include “last out tranches” of senior debt.  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 seniornotes.  Although such loans are sometimessecured by significant collateral, the lender is largely dependent on theborrower’s cash flow for repayment. Additionally, lenders often receive warrants to acquire shares of stockin borrowers in connection with these loans. 

 

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•              *Senior Notes.*  Weseek to 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 or warrants to purchase stock of the borrowers.  As such, they generally do not participate inthe equity appreciation of the value of the business.  We intend to make senior loans on a limitedbasis and some of these will only be used as bridge financings.  In most cases, these loans will be refinancedat a later date. 

 

•              *Junior Subordinated Notes.*  Wealso seek to invest a small portion of our assets in junior subordinatednotes.  Holders of junior subordinatednotes are subordinated to the rights of the holders of senior debt and seniorsubordinated debt in their rights to receive principal and interest paymentsfrom the borrower.  The risk profile ofjunior subordinated notes is high, which permits the junior subordinated lenderto obtain higher interest rates and warrants to purchase a greater portion ofthe borrower’s stock.  

 

Approximately 45% of the aggregate value of our investment portfolio asof September 30, 2005 was senior debt, approximately 50% was seniorsubordinated debt, and approximately 5% was junior subordinated debt.  As of September 30, 2005, we hadapproximately $205.4 million invested in 28 portfolio companies.  

 

Our loans typically range from $5 million to $15 million, mature in nomore than seven years, and accrue interest at a fixed or variable rate thatexceeds the prime rate.  Because theseloans will generally be subordinated term debt of private companies whotypically cannot or will not expend the resources to have their debt securitiesrated by a credit rating agency, we expect that most if not all of the debtsecurities we acquire will be unrated. Accordingly, we cannot accurately predict what ratings these loans mightreceive if they were in fact rated, and therefore we cannot determine whetheror not they could be considered to be “investment grade” quality.

 

We have two wholly owned subsidiaries: Gladstone Business Loan LLC,through which we hold our loan investment portfolio, and Gladstone CapitalAdvisers, Inc.

 

**About Gladstone Management Corporation**

 

Ouraffiliate Gladstone Management Corporation (the “Adviser” or “GladstoneManagement”) is our investment adviser and is led by a management team whichhas extensive experience in our lines of business.  Gladstone Management is controlled by DavidGladstone, our chairman and chief executive officer.  Mr. Gladstone is also the chairman and chiefexecutive officer of our Adviser.  TerryLee Brubaker, our vice chairman, chief operating officer and director, is amember of the board of directors of Gladstone Management and its president andchief operating officer.  George StelljesIII, our president, chief investment officer and director, is a member of theboard of directors of Gladstone Management and its executive vice president andchief investment officer.  Harry Brill,our chief financial officer, is the chief financial officer of GladstoneManagement.

 

GladstoneManagement also provides investment advisory and administrative services to ouraffiliates Gladstone Commercial Corporation, a publicly traded real estateinvestment trust; Gladstone Investment Corporation, a publicly tradedregistered investment company; and Gladstone Land Corporation, an agriculturalreal estate company owned by Mr. Gladstone. All of our directors and executive officers serve as either directors orexecutive officers, or both, of Gladstone Commercial Corporation and Gladstone InvestmentCorporation.  In the future, GladstoneManagement may provide investment advisory and administrative services to otherfunds, both public and private, of which it is the sponsor.

 

Wehave been externally managed by Gladstone Management pursuant to an investmentadvisory and administrative agreement since October 1, 2004.  Gladstone Management was organized as acorporation under the laws of the State of Delaware on July 2, 2002, and is aregistered investment adviser under the 1940 Act.  Gladstone Management is headquartered inMcLean, Virginia, a suburb of Washington, DC, and has offices in New York, NewYork, Chicago, Illinois, Pittsburgh, Pennsylvania, Morristown, New Jersey,Lexington, Kentucky and Dallas, Texas.

 

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**Our Investment Strategy**

 

Our strategy is to make loans at favorable interest rates to small and mediumsized businesses that we believe have traditionally been underserved byconventional lenders. Our Adviser uses the loan referral networks ofMessrs. Gladstone, Stelljes and Brubaker and of our Adviser’s managingdirectors to identify and make senior and subordinated loans to selectedbusinesses that we believe do not have sufficient access to traditional sourcesof lending. We make loans to borrowers that need funds to finance growth,restructure their balance sheets or effect a change of control, all of which webelieve are typically underserved by banks and other traditional institutionallenders. We believe that our business strategy will enable us to achieve a highlevel of current income by investing in debt securities, consisting primarilyof senior notes, senior subordinated notes and junior subordinated notes ofestablished private businesses that are backed by leveraged buyout funds,venture capital funds or others. In addition, from time to time we mightacquire existing loans that meet this profile from leveraged buyout funds,venture capital funds and others. We also seek to provide our stockholders withlong-term capital growth through the appreciation in the value of warrants orother equity instruments that we might receive when we make loans. Ourfinancial plan presumes that the net capital gains from the sale of thewarrants (as well as other profit enhancements) we receive in connection withour lending activities will exceed any losses we may experience from loans thatare not repaid. We cannot assure you that we will be able to achieve ourinvestment objectives or that our business strategy will be successful.

 

We target small and medium sized private businesses that meet certaincriteria, including the potential for growth, adequate assets for loancollateral, experienced management teams with significant ownership interest inthe business, adequate capitalization, profitable operations based on cash flowand potential opportunities for us to realize appreciation and gain liquidityin our 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 to buy backour warrants, although we cannot assure you that we will always have theserights.  We can also achieve a similareffect by requiring the borrower to pay us conditional interest, which we referto 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.  We cannot provide assurance that we willalways have a success fee or warrant in place with every investment.  

 

**Investment Process**

** **

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

*** ***

To originate loans, our Adviser’s lending professionals use an extensivereferral network comprised of venture capitalists, leveraged buyout funds,investment bankers, attorneys, accountants, commercial bankers and businessbrokers.  Our Adviser’s lendingprofessionals review informational packages from these and other sources insearch of potential financing opportunities. If a potential opportunity matches our investment objectives, thelending professionals will seek an initial screening of the opportunity fromour Adviser’s investment committee, which is composed of Messrs. Gladstone,Brubaker and Stelljes.  If the applicantpasses this initial screening, the lending professionals will conduct a duediligence investigation of the applicant. Upon completion of the due diligenceinvestigation, the lending professionals create a borrower profile summarizingthe prospective borrower’s historical financial statements, industry andmanagement team and analyzing its conformity to our general investmentcriteria. The lending professionals then present this profile to the investmentcommittee, which must unanimously approve each loan.  Further, each financing is reviewed by themembers of our Board of Directors, a majority of whom are independent underSection 10A(m)(3) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”).

** **

***Prospective portfolio company characteristics***

 

We have identified certain characteristics that we believe areimportant to profitably lend to small and medium sized businesses. The criterialisted below provide general guideposts for our lending and investmentdecisions, although not all of these criteria may be followed in each instance.

 

•              *Growth.* In addition to generating sufficient cashflow to service its debt, a potential borrower generally will be required toestablish its ability to grow its cash flow. Anticipated growth will be a keyfactor in determining the value ascribed to any warrants we acquire inconnection with our loans.

 

•              *Significantsponsor.* We seek businessesin which leveraged buyout funds or venture capital funds have invested. Webelieve that a business in which a substantial equity sponsor has made ameaningful investment is more likely to be a good borrowing candidate.

 

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•              *Liquidationvalue of assets.* Although wedo not generally intend to operate as an asset-based lender, liquidation valueof the assets collateralizing our loans is an important factor in each creditdecision. Emphasis is placed both on tangible assets (e.g., inventory, plant,property and equipment) and intangible assets (e.g., accounts receivable,customer lists, networks, databases and recurring revenue streams).

 

•              *Experiencedmanagement team.* We willgenerally require that each borrower have a management team that is experiencedand properly incentivized through a significant ownership interest in theborrower. We generally will require that a borrower have, at a minimum, astrong chief executive officer and chief financial officer who havedemonstrated the ability to accomplish the borrower’s objectives and implementits business plan.

 

•              *Profitableor near-profitable operations.*We focus on borrowers that are profitable or near-profitable at the operatinglevel. We do not intend typically to lend to, or invest in, start-up or otherearly stage companies, nor do we intend typically to lend to, or invest in,businesses that are experiencing significant operating problems.

 

•              *Exitstrategy.* Prior to making aloan for which we receive a warrant to purchase stock of the borrower or otheryield enhancement, we will analyze the potential for the borrower to experiencea liquidity event that will allow us to realize value for our equity position.Liquidity events include, among other things, an initial public offering, aprivate sale of our financial interest, a merger or acquisition of the borroweror a purchase of our equity position by the borrower or one of itsstockholders.

 

***Extensive Due Diligence***

*** ***

OurAdviser conducts what we believe are extensive due diligence investigations ofour prospective portfolio companies and investment opportunities.  Our due diligence investigation may beginwith a review of publicly available information, and will generally include thefollowing:

 

•      a review of the potential borrower’shistorical and projected financial information; 

•      interviews with management, employees,customers and vendors of the applicant;

•      background checks; and

•      research on the applicant’s products,services or particular industry. 

 

Wealso rely on the long-term relationships that our Adviser’s professionals havewith venture capitalists, leveraged buyout funds, investment bankers,commercial bankers and business brokers, and on the extensive directexperiences of our executive officers and managing directors in providing debtand equity capital to small and medium sized private businesses. Prior toclosing on our investments, additional due diligence may be conducted on ourbehalf by attorneys, accountants or other outside advisers as appropriate.  

 

***Investment Structure***

 

We typically invest in senior, senior subordinated and juniorsubordinated notes. Our loans typically range from $5 million to$15 million, although the size of our investments may vary as our capitalbase changes.  Our loans generally maturein no more than seven years and accrue interest at a fixed or variable ratethat exceeds the prime rate. A number of our loans have a provision that callsfor 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” (or “PIK”)interest, and, when earned, we record PIK income as interest income and add thePIK interest to the principal balance of the loans.

 

To the extent possible, our loans generally are collateralized by asecurity interest in the borrower’s assets. We do not usually have the first claim on these assets. Interestpayments on loans we make will generally be made monthly or quarterly (exceptto the extent of any PIK interest) with amortization of principal generallybeing deferred for several years. The principal amount of the loans and anyaccrued but unpaid interest will generally become due at maturity at five toseven years. We seek to make loans that are accompanied by warrants to purchasestock in the borrowers or other yield enhancement features, such as successfees. These warrants will typically have an exercise price equal to the fairvalue of the portfolio company’s common stock at the time of the loan and entitleus to purchase a modest percentage of the borrower’s stock.  Success fees are conditional interest that ispaid if the borrower is successful. The success fee is calculated as additionalinterest on the loan and is paid upon the occurrence of certain triggeringevents, such as the sale of the borrower. If the event or events do not occur, no success fee will be paid.

 

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Fromtime to time, a portfolio company may request additional financing, providingus with additional lending opportunities. We will consider such requests foradditional financing under the criteria we have established for initialinvestments and we anticipate that any debt securities we acquire in afollow-on financing will have characteristics comparable to those issued in theoriginal financing. In some situations, our failure, inability or decision notto make a follow-on investment may be detrimental to the operations or survivalof a portfolio company, and thus may jeopardize our investment in thatborrower.

 

As noted above, we expect to receive warrants to purchase stock orother yield enhancements in connection with many of our loans. If a financingis successful, not only will our debt securities have been repaid withinterest, but we will be in a position to realize a gain on the accompanyingequity interests or other yield enhancements. The opportunity to realize suchgain may occur if the borrower is sold to new owners or if it makes a publicoffering of its stock. In most cases, we will not have the right to requirethat a borrower undergo an initial public offering by registering securitiesunder the Securities Act of 1933, (the “Securities Act”), but we generally willhave the right to sell our equity interests in any subsequent public offeringby the borrower. Even when we have the right to participate in a borrower’spublic offering, the underwriters might insist, particularly if we own a largeamount of equity securities, that we retain all or a substantial portion of ourshares for a specified period of time. Moreover, we may decide not to sell anequity position even when we have the right and the opportunity to do so. Thus,although we expect to dispose of an equity interest after a certain time,situations may arise in which we hold equity securities for a longer period.

 

***Temporary Investments***

 

Pending investment in the debt of private companies we invest ourotherwise uninvested cash primarily in cash, cash items, government securitiesor high-quality debt securities maturing in one year or less from the time ofinvestment, to which we refer collectively as temporary investments, so that70% of our assets are “qualifying assets”, for purposes of the businessdevelopment company provisions of the 1940 Act. For information regardingregulations to which we are subject and the definition of “qualifying assets,”see “Regulation.” 

 

***Hedging Strategies***

 

Although it has not yet happened, nor do we expect this to happen inthe near future, when one of our portfolio companies goes public, we mayundertake hedging strategies with regard to any equity interests that we mayhave in that company. We may mitigate risks associated with the volatility ofpublicly traded securities by, for instance, selling securities short orwriting or buying call or put options. Hedging against a decline in the valueof such investments in public companies would not eliminate fluctuations in thevalues of 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 line of credit, we have agreed to enter into hedging transactions, suchas interest rate cap agreements, in connection with the borrowings that we makeunder our line of credit.  To date wehold only one interest rate cap agreement. Furthermore, in the event that we securitize a portion of our loanportfolio in the future, we believe that we will likely be required to enterinto similar arrangements with respect to the securitized loans.  Hedging strategies do pose risks to us andour stockholders, however we believe that such activities, because they will belimited to only a portion of our portfolio, are manageable.

 

Section 12(a)(3) of the 1940 Act prohibits us “in contravention ofsuch rules and regulations or orders as [the SEC] may prescribe as necessary orappropriate in the public interest or for the protection of investors . . . toeffect a short sale of any security . . . .” However, todate, the U.S. Securities and Exchange Commission (the “SEC”) has notpromulgated regulations under this statute. It is possible that suchregulations could be promulgated in the future in a way that would require usto change any hedging strategies that we may adopt. We will only engage inhedging activities in compliance with applicable law and regulations.

 

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**Competitive Advantages**

 

A large number of entities compete with us and make the types ofinvestments that we seek to make in small and medium sized privately-ownedbusinesses. Such competitors include private equity funds, leveraged buyoutfunds, venture capital funds, investment banks and other equity and non-equitybased investment funds, and other financing sources, including traditionalfinancial services companies such as commercial banks. Many of our competitorsare substantially larger than we are and have considerably greater financial,technical and marketing resources than we do. For example, some competitors mayhave a lower cost of funds and access to funding sources that are not availableto us. In addition, certain of our competitors may have higher risk tolerancesor different risk assessments, which could allow them to consider a widervariety of investments, establish more relationships and build their marketshares. Furthermore, many of these 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.

 

***Extensive Loan Referral Network***

 

Our executive officers and our Adviser’s managing directors have anextensive referral network of venture capitalists, leveraged buyout funds,investment bankers, attorneys, commercial bankers and business and financialbrokers. We believe that this established network, consisting of relationshipsestablished over many years by Messrs. Gladstone, Stelljes, and Brubakerand our Adviser’s managing directors will generate opportunities to identifyand make senior and subordinated loans to selected businesses that satisfy ourinvestment criteria. We intend to enter into additional informal relationshipswith other leveraged buyout funds and venture capital funds, but we cannotassure you that we will be able to do so or that any such relationships willlead to the origination of loans. 

 

***Seasoned Management Team***

 

David Gladstone, our chairman and chief executive officer, has over25 years of experience in making loans to, and investing in, small and mediumsized companies at Gladstone Capital Corporation, Gladstone InvestmentCorporation, Allied Capital Corporation and American Capital Strategies Ltd.Allied Capital Corporation is a publicly traded subordinated debt lender andAmerican Capital Strategies Ltd. is a publicly traded buyout and subordinateddebt lender.  Mr. Gladstone is no longeraffiliated with Allied Capital Corporation or American Capital Strategies Ltd.  Gladstone Investment Corporation is a newlyestablished fund investing in subordinated loans, mezzanine debt, preferredstock and warrants.

 

Terry Lee Brubaker, our vice chairman and chief operating officer, hasover 25 years of experience in acquisitions and managing companiessubsequent to an acquisition. Prior to joining Gladstone Capital Corporation,he was a member of the management team that designed and implemented theacquisition strategy of James River Corporation.

 

George Stelljes III, our president and chief investment officer has anextensive background in subordinated debt and buyouts and currently overseesthe structuring and arranging of financing for potential investments in smalland medium sized businesses.  

 

Our chief financial officer, Harry Brill, brings significant experiencefrom his role as the chief accounting officer of Allied Capital Corporationwhere he was responsible for the public filings of a family of five publiccompanies and oversaw the preparation of the operating reports and financialstatements of these companies and of three private funds.

 

***Flexible Transaction Structuring***

 

We believe that we are well-positioned to provide financing to smalland medium sized businesses that are undergoing a change of ownership,including management-led and third party leveraged buyouts, and to thosebusinesses that have good growth characteristics. We are not limited by thecapital and other regulatory requirements of the banking and savings and loanindustries and we have relatively low overhead and administrative expenses.Moreover, our strategy of seeking yield enhancements, such as success fees, isintended to closely align our interests with those of our portfolio companies,thereby reducing transaction costs, conveying our commitment to the borrowersand enhancing our attractiveness as a financing source. Perhaps mostimportantly, we believe that we have the experience and expertise to satisfythe financing needs of such businesses. In particular, we believe that we mayrealize a competitive advantage in this area from Mr. Gladstone’s morethan 25 years of experience in financing small to medium sized privatebusinesses, Mr. Stelljes’ many years of financing medium and small businesses,and Mr. Brubaker’s extensive experience in acquisitions and operations. 

 

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Asa business development company, we may not invest in any portfolio company inwhich our affiliates currently have an investment or make any co-investmentswith our affiliates absent an exemptive order from the U.S. Securities andExchange Commission that would allow such co-investment.  We have applied for, and on November 28,2005, the U.S. Securities and Exchange Commission granted, an exemptive order thatpermits us to co-invest with Gladstone Participation Fund, LLC, a newlyorganized fund that will be managed by our Adviser.  The exemptive order provides that our abilityto make any co-investments with Gladstone Participation Fund, LLC is subject tocertain terms, conditions and limitations contained in the exemptionapplication.

** **

**Leverage**

 

For the purpose of making investments other than temporary investmentsand to take advantage of favorable interest rates, we intend to issue seniordebt securities (including borrowings under our current lines of credit) up tothe maximum amount permitted by the 1940 Act. The 1940 Act currently permits usto issue 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 of ourindebtedness 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 registrationstatement with the SEC registering up to $75 million of common stock, preferredstock and debt securities, of which $48.8 million remains available forissuance as of December 13, 2005.  See “Regulationas a Business Development Company—Asset Coverage” for a discussion of ourleveraging constraints. 

 

**Securitization**

** **

On February 3, 2003, we established a wholly-owned subsidiary,Gladstone Business Loan LLC, “Business Loan,” for the purpose of acquiring andholding certain of our loans. Business Loan entered into a credit agreementwith a group of institutional lenders that provides for a $100 millionrevolving credit facility.  We use theseproceeds to make additional loans and increase the size of our loanportfolio.  We currently intend tosecuritize all of the loans held by Business Loan and, if we are able tosecuritize these loans, we will use the proceeds from the securitization to paydown any amounts outstanding under the revolving credit facility.  Our Board of Directors has approved, and weintend to seek, an additional $50 million of availability under this revolvingcredit facility during fiscal year 2006. Any increase in the credit facility would require the consent of thelenders, and there is no guarantee that we will be able to increase the size ofthe credit facility. 

** **

**Ongoing Relationships with and Monitoring of Portfolio Companies**

** **

***Monitoring***

*** ***

OurAdviser’s investment professionals monitor the financial trends of eachportfolio company on an ongoing basis to determine if each is meeting itsrespective business plans and to assess the appropriate course of action foreach company.  We monitor thisinformation regarding the status and performance of each portfolio company, anduse it to evaluate the overall performance of our portfolio, on at least aquarterly basis.

 

OurAdviser employs various methods of evaluating and monitoring the performance ofour investments, which include but are not limited to the following:

 

•      Assessment of success in the portfoliocompany’s overall adherence to its business plan and compliance with covenants;

•      Attendance at and participation in meetingsof the portfolio company’s board of directors;

•      Periodic contact, including formal updateinterviews with portfolio company management, and, if appropriate, thefinancial or strategic sponsor; 

•      Comparison with other companies in theportfolio company’s industry; and

•      Review of monthly and quarterly financialstatements and financial projections for portfolio companies.

 

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***Managerial Assistance***

** **

As a business development company, we make available significantmanagerial assistance to our portfolio companies. Such assistance typicallyinvolves reviewing existing credit facilities, arranging bank financing,arranging equity financing, structuring financing from multiple lenders,structuring financing from equity investors, restructuring existing loans,raising equity and debt capital, closely monitoring the operations of theborrower, participating in its board and management meetings, being availablefor consultation with its officers and providing general organizational andfinancial guidance. Neither we nor our Adviser receives fees in connection withthis managerial assistance.  Our Advisermay receive fees for other services it provides to a portfolio company andthose fees would then be credited against the investment advisory fees that wepay to our Adviser. 

*** ***

***Valuation Process***

 

We carry our assets at fair value. A majority of our loan portfolio consists of securities for which alimited market does not exist and are not publicly traded.  To value these securities, we provide loanportfolio data to Standard & Poor’s Loan Evaluation Service (“S&P”) forits independent review.  S&P providesan independent assessment of the loan portfolio data provided by us andassesses its own data to develop recommendations as to market values for thesesecurities.  Our Board of Directors voteson whether to accept the valuation recommendations presented by S&P.  Furthermore, in the occurrence of an eventcoming to the attention of our Board of Directors subsequent to the S&Pvaluation date, our Board of Directors may alter the S&P valuation in orderto present a more accurate reflection of the fair value of an investment.****Due to the uncertainty inherent in the valuation processfor these securities, such estimates of fair value may differ significantlyfrom the values that would have been obtained had a ready market for thesecurities existed, and the differences could be material. Additionally,changes in the market environment and other events that may occur over the lifeof the investments may cause the gains or losses ultimately realized on theseinvestments to be different than the valuations currently assigned.  Securities in our portfolio that are publiclytraded, if any, are valued at the closing price of the exchange or securitiesmarket on which they are listed on the valuation date (to date there are nopublicly traded securities in our portfolio). Securities in our portfolio whichare not publicly traded on an exchange or securities market, but for which alimited market exists, such as participations in syndicated loans, are valuedat the indicative bid price offered by the syndication agent on the valuationdate.  

 

A substantial portion of our assets will consist of securities carriedat fair market value, as determined by our Board of Directors. Determination offair market values, for those securities and investments not valued by S&P,involves subjective judgment not susceptible to substantiation by auditing procedures.Accordingly, under generally accepted accounting principles, the notes to ourconsolidated financial statements will refer to the uncertainty with respect tothe possible effect of such valuations on our financial statements.

 

The net asset value per share of our outstanding shares is determinedquarterly, as soon as practicable after and as of the end of each calendarquarter, by dividing the value of total assets minus liabilities by the actualnumber of shares outstanding at the date as of which the determination is made.

** **

**Investment Advisory Agreement**

** **

***Current management services and fees***

 

SinceOctober 1, 2004, we have been externally managed pursuant to an investmentadvisory and administrative agreement with Gladstone Management.  Under the agreement, Gladstone Managementdirectly employs all of our personnel and pays its payroll, benefits, andgeneral expenses directly.  Pursuant tothe management agreement, we pay Gladstone Management an annual advisory fee of1.25% of our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.3125%, and an annualadministrative fee of 0.75% of our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly increments of0.1875%.  Fees received by our investmentadviser will be credited against the investment advisory fee. We continue topay direct expenses including, but not limited to, directors fees, legal andaccounting fees, and stockholder related expenses.

 

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***Management services and feesunder the amended and restated investment advisory agreement***

 

On December 2, 2005, ourstockholders approved an amended and restated investment advisory agreementbetween us and Gladstone Management (the “Amended Agreement”). Our Board of Directorsproposed the Amended Agreement to stockholders in order to provide what itconsiders to be more appropriate incentives to reward fund management. When theAmended Agreement becomes effective, we will pay Gladstone Management an annualbase management fee of 2% of our gross assets, which is defined as total assetsless cash and cash equivalents pledged to creditors, as well as a two-partincentive fee.  The first part of theincentive fee is an income-based incentive fee which would reward GladstoneManagement if our quarterly net investment income (before giving effect to anyincentive fee) exceeds 1.75% of our net assets. We will pay GladstoneManagement an income incentive fee with respect to our pre-incentive fee netinvestment income in each calendar quarter as follows:

 

•        no incentive fee in any calendar quarter inwhich our pre-incentive fee net investment income does not exceed the hurdlerate;

 

•        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 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 Agreement, as of the termination date), commencing on the effectivedate of the Amended Agreement, and will equal 20% of our realized capital gainsas of the end of the fiscal year. In determining the capital gains incentivefee payable to Gladstone Management, we will calculate the cumulative aggregaterealized capital gains and cumulative aggregate realized capital losses sinceour inception, and the aggregate unrealized capital depreciation as of the dateof the calculation, as applicable, with respect to each of the investments inour portfolio. 

 

Under the Amended Agreement,we will pay separately for administrative services under an administrationagreement with Gladstone Administration, LLC, a wholly-owned subsidiary of GladstoneManagement, (the “Administration Agreement”). The Administration Agreement provides for payments equal to ourallocable portion of Gladstone Administration’s overhead expenses in performingits obligations under the Administration Agreement, including rent, and ourallocable portion of the salaries and benefits expenses of our chief financialofficer, chief compliance officer and controller and their respectivestaffs.  

 

The same individuals whomanage our portfolio will continue to manage our portfolio under the Amended Agreementand, although the administrative services will be provided pursuant to aseparate administration agreement, we do not expect that our stockholders willnotice any change or diminution in services because of this organizationalseparation.

 

Regulations promulgated bythe Securities and Exchange Commission prohibit business development companiesfrom implementing an incentive advisory fee while having in place a stockoption plan or any outstanding stock options. In connection with the stockholders’ approval of the AmendedAgreement, no further options will be issued under the Amended and Restated2001 Equity Incentive Plan (the “Plan”), and we will terminate the Plan priorto the effectiveness of the Amended Agreement. Further, we will seek the agreement of the holders of all outstandingoptions under the plan to terminate or exercise their outstanding options.  We expect the Amended Agreement to be executed and go into effect on thefirst day of the fiscal quarter following the exercise or termination of theseoptions, or on October 1, 2006, whichever is later. Once the Amended Agreementand Administration Agreement are effective, the current agreement with GladstoneManagement will terminate.

 

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

** **

***Regulated Investment Company Status***

*** ***

In order to maintain the qualification for treatment as a regulatedinvestment company, or RIC, under Subchapter M of the Internal Revenue Code of1986 (the “Code”), we must distribute to our stockholders, for each taxableyear, at least 90% of our investment company taxable income, which is generallyour ordinary income plus short-term capital gains. We refer to this as theannual distribution requirement. We must also meet several additionalrequirements, including:

 

•              **Incomesource requirements.** Atleast 90% of our gross income for each taxable year must be from dividends,interest, payments with respect to securities loans, gains from sales or otherdispositions of securities or other income derived with respect to our businessof investing in securities, and

 

•              **Assetdiversification requirements.**As of the close of each quarter of our taxable year: (1) at least 50% ofthe value of our assets must consist of cash, cash items, US governmentsecurities, the securities of other regulated investment companies and othersecurities to the extent that (a) we do not hold more than 10% of theoutstanding voting securities of an issuer of such other securities and(b) such other securities of any one issuer do not represent more than 5%of our total assets, and (2) no more than 25% of the value of our totalassets may be invested in the securities of one issuer (other than USgovernment securities or the securities of other regulated investmentcompanies), or of two or more issuers that are controlled by us and are engagedin the same or similar or related trades or businesses.

 

If we are unable to qualify for treatment as a RIC, we will be subjectto tax on all of our taxable income at regular corporate rates. We would not beable to deduct distributions to stockholders, nor would we be required to makesuch distributions. Distributions would be taxable to our stockholders asordinary dividend income to the extent of our current and accumulated earningsand profits. Subject to certain limitations under the Code, corporatedistributees would be eligible for the dividends received deduction.

 

Distributions in excess of our current and accumulated earnings andprofits would be treated first as a return of capital to the extent of thestockholder’s tax basis, and then as a gain realized from the sale or exchangeof property. If we fail to meet the RIC requirements for more than twoconsecutive years and then seek to requalify as a RIC, we would be required torecognize a gain to the extent of any unrealized appreciation on our assetsunless we make a special election to pay corporate-level tax on any suchunrealized appreciation recognized during the succeeding 10-year period. Absentsuch special election, any gain we recognized would be deemed distributed toour stockholders as a taxable distribution. If we qualify as a RIC anddistribute to stockholders each year in a timely manner at least 90% of ourinvestment company taxable income, we will not be subject to federal income taxon the portion of our taxable income and gains we distribute to stockholders.We would, however, be subject to a 4% nondeductible federal excise tax if we donot distribute, actually or on a deemed basis, 98% of our income, includingboth ordinary income and capital gains. The excise tax would apply only to theamount by which 98% of our income exceeds the amount of income we distribute,actually or on a deemed basis, to stockholders.

 

We will be subject to regular corporate income tax, currently at ratesup to 35%, on any undistributed income, including both ordinary income andcapital gains. We intend to retain some or all of our capital gains, but todesignate the retained amount as a deemed distribution. In that case, amongother consequences, we will pay tax on the retained amount, each stockholderwill be required to include its share of the deemed distribution in income asif it had been actually distributed to the stockholder and the stockholder willbe entitled to claim a credit or refund equal to its allocable share of the taxwe pay on the retained capital gain. The amount of the deemed distribution netof such tax will be added to the stockholder’s cost basis for its common stock.Since we expect to pay tax on any retained capital gains at our regularcorporate capital gain tax rate, and since that rate is in excess of themaximum rate currently payable by individuals on long-term capital gains, theamount of tax that individual stockholders will be treated as having paid willexceed the tax they owe on the capital gain dividend and such excess may beclaimed as a credit or refund against the stockholder’s other tax obligations.A stockholder that is not subject to US federal income tax or tax on long-termcapital gains would be required to file a US federal income tax return onthe appropriate form in order to claim a refund for the taxes we paid. In orderto utilize the deemed distribution approach, we must provide written notice tothe stockholders prior to the expiration of 60 days after the close of therelevant tax year. We will also be subject to alternative minimum tax, but anytax preference items would be apportioned between us and our stockholders inthe same proportion that dividends, other than capital gain dividends, paid toeach stockholder bear to our taxable income determined without regard to thedividends paid deduction.

 

If we acquire debt obligations that were originally issued at adiscount, which would generally include loans we make that are accompanied bywarrants, that bear interest at rates that are not either fixed rates orcertain qualified variable rates or that are not unconditionally payable atleast annually over the life of the obligation, we will be required to includein taxable income each year a portion of the “original issue discount” thataccrues over the life of the obligation. Such original issue discount will beincluded in our investment company taxable income even though we receive nocash corresponding to such discount amount. As a result, we may be required tomake additional distributions corresponding to such original issue discountamounts in order to satisfy the annual distribution requirement and to continueto qualify as a RIC or to avoid the 4% excise tax. In this event, we may berequired to sell temporary investments or other assets to meet the RICdistribution requirements.

 

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For any period during which we qualify for treatment as a RIC forfederal income tax purposes, distributions to our stockholders attributable toour investment company taxable income generally will be taxable as ordinaryincome to stockholders to the extent of our current or accumulated earnings andprofits. Any distributions in excess of our earnings and profits will first betreated as a return of capital to the extent of the stockholder’s adjustedbasis in his or her shares of common stock and thereafter as gain from the saleof shares of our common stock. Distributions of our long-term capital gains,designated by us as such, will be taxable to stockholders as long-term capitalgains regardless of the stockholder’s holding period for its common stock andwhether the distributions are paid in cash or invested in additional commonstock. Corporate stockholders are generally eligible for the 70% dividendsreceived deduction with respect to ordinary income, but not to capital gainsdividends to the extent such amount designated by us does not exceed thedividends received by us from domestic corporations. Any dividend declared byus in October, November or December of any calendar year, payable tostockholders of record on a specified date in such a month and actually paidduring January of the following year, will be treated as if it were paidby us and received by the stockholders on December 31 of the previousyear. In addition, we may elect to relate a dividend back to the prior taxableyear if we (1) declare such dividend prior to the due date for filing ourreturn for that taxable year, (2) make the election in that return, and(3) distribute the amount in the 12-month period following the close ofthe taxable year but not later than the first regular dividend paymentfollowing the declaration. Any such election will not alter the general rulethat a stockholder will be treated as receiving a dividend in the taxable yearin which the distribution is made, subject to the October, November,December rule described above.

 

The “Jobs and Growth Tax Relief Reconciliation Act of 2003” did notalter the nature of our dividends that we pay to stockholders as taxableordinary income.  Accordingly, ourdividends paid are not eligible for the lower tax rate.

 

**Regulation as a Business Development Company**

 

We are a closed-end, non-diversified management investment company thathas elected to be regulated as a business development company underSection 54 of the 1940 Act. As such, we are subject to regulation underthe 1940 Act. The 1940 Act contains prohibitions and restrictions relating totransactions between business development companies and their affiliates,principal underwriters and affiliates of those affiliates or underwriters andrequires that a majority of the directors be persons other than “interestedpersons,” as defined in the 1940 Act. In addition, the 1940 Act provides thatwe may not change the nature of our business so as to cease to be, or towithdraw our election as, a business development company unless approved by amajority of our outstanding voting securities.

 

We intend to conduct our business so as to retain our status as abusiness development company. In general, a business development company musthave been organized and have its principal place of business in the UnitedStates and must be operated for the purpose of making investments in the typesof securities described in (1) or (2) below.

 

***Qualifying Assets***

 

Under the 1940 Act, a business development company may not acquire anyasset other than assets of the type listed in Section 55(a) of the 1940Act, which are referred to as qualifying assets, unless, at the time theacquisition is made, qualifying assets represent at least 70% of the company’stotal assets. The types of qualifying assets in which we may invest under the1940 Act include, but are not limited to the following:

 

(1)           Securities purchased in transactions notinvolving any public offering from the issuer of such securities, which issueris an eligible portfolio company. An eligible portfolio company is generallydefined in the 1940 Act as any issuer which, first, is organized under the lawsof, and has its principal place of business in, the United States. Second, theissuer must not be an investment company, other than a small businessinvestment company wholly-owned by the business development company. Finally,the issuer may not have any class of securities with respect to which a brokeror dealer may extend margin credit.

 

(2)           Securities of any eligible portfolio companyover which we exercise a controlling influence and for which an affiliate ofours serves as a director.

 

(3)           Securities received in exchange for ordistributed on or with respect to securities described in (1) or(2) above, or pursuant to the exercise of options, warrants or rightsrelating to such securities.

 

(4)           Cash, cash items, government securities orhigh quality debt securities maturing in one year or less from the time ofinvestment.

 

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Securities of public companies are generally not qualifying assetsunless they were acquired in a distribution or in exchange for, or upon theexercise of, a right relating to securities that were qualifying assets.

 

***Asset Coverage***

 

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

 

***Significant Managerial Assistance***

 

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

 

***Fundamental Investment Policies***

** **

We seek to achieve a high level of current income by investing in debtsecurities, consisting primarily of senior notes, senior subordinated notes andjunior subordinated notes of established private businesses that are backed byleveraged buyout funds, venture capital funds or others, with a particularemphasis on senior subordinated notes. We also seek to provide our stockholderswith long-term capital growth through the appreciation in the value of warrantsor other equity instruments that we may receive when we make loans. Thefollowing restrictions, along with these investment objectives, are our onlyfundamental policies, which are policies that may not be changed without theapproval of the holders of the majority of our outstanding voting securities,as defined in the 1940 Act. For a fuller explanation of the regulatoryframework in which we operate, see “Business-Regulation.” The percentagerestrictions set forth below, other than the restriction pertaining to theissuance of senior securities, as well as those contained elsewhere in thisForm 10-K, apply at the time we effect a transaction, and a subsequentchange in a percentage resulting from market fluctuations or any cause otherthan an action by us will not require us to dispose of portfolio securities orto take other action to satisfy the percentage restriction. We will at alltimes conduct our business so as to retain our status as a business developmentcompany. In order to retain that status, we may not acquire any assets (otherthan non-investment assets necessary and appropriate to our operations as abusiness development company) if, after giving effect to such acquisition, thevalue of our “qualifying assets” is less than 70% of the value of our totalassets. We anticipate that the securities we seek to acquire (provided that wecontrol or, through our officers or other participants in the financingtransaction, make significant managerial assistance available to the issuers ofthese securities), as well as temporary investments, will generally bequalifying assets.

 

We may invest up to 100% of our assets in securities acquired directlyfrom issuers in privately negotiated transactions. With respect to suchsecurities, we may, for the purpose of public resale, be deemed an “underwriter”as that term is defined in the Securities Act. We may invest up to 20% of ourassets in securities of a particular issuer. We may exceed this limitation inconnection with bridge financings, although these bridge investments will neverexceed 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.

 

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We will at all times endeavor to conduct our business so as to retainour status as a regulated investment company under Subchapter M of the Code. Inorder to do so, we must meet income source, asset diversification and annualdistribution requirements. We may issue senior securities, such as debt orpreferred stock, to the extent permitted by the 1940 Act for the purpose ofmaking investments, to fund share repurchases, or for temporary emergency orother purposes. For a discussion of the risks associated with the resultingleverage, see “Business—Leverage” and “Risk Factors—Our business is dependentupon external financing which may expose us to the risks associated withleverage.”

 

We will not (1) act as an underwriter of securities of otherissuers (except to the extent that we may be deemed an “underwriter” ofsecurities we purchase that must be registered under the Securities Act beforethey may be offered or sold to the public); (2) purchase or sell realestate or interests in real estate or real estate investment trusts (exceptthat we may (a) purchase and sell real estate or interests in real estatein connection with the orderly liquidation of investments, (b) own thesecurities of companies or participate in a partnership or partnerships thatare in the business of buying, selling or developing real estate, or(c) finance the purchase of real estate by our portfolio companies);(3) sell securities short (except with regard to managing the risks associatedwith publicly-traded securities issued by our portfolio companies);(4) purchase securities on margin (except to the extent that we maypurchase securities with borrowed money); (5) write or buy put or calloptions (except (i) to the extent of warrants or conversion privileges inconnection with our acquisition financing or other investments and rights torequire the issuers of such investments or their affiliates to repurchase themunder certain circumstances, (ii) with regard to managing risks associatedwith publicly-traded securities issued by our portfolio companies, or(iii) with regard to managing the risks associated with interest ratefluctuations); (6) engage in the purchase or sale of commodities orcommodity contracts, including futures contracts (except where necessary inworking out distressed loan or investment situations or in managing the risksassociated with interest rate fluctuations); or (7) acquire more than 3%of the voting stock of, or invest more than 5% of our total assets in, anysecurities issued by any other investment company (except as they may beacquired as part of a merger, consolidation or acquisition of assets). Thatportion of our investments that is in securities issued by other investmentcompanies may subject our stockholders to additional expenses.

 

***Code of Ethics***

 

We and Gladstone Management have each adopted a code of ethics andbusiness conduct applicable to our officers, directors and all employees thatcomplies with the guidelines set forth in Item 406 of Regulation S-K of theSecurities Act.  As required by the 1940Act, this code establishes procedures for personal investments, restrictscertain transactions by our personnel and requires the reporting of certaintransactions and holdings by our personnel. A copy of this code is available for review, free of charge, at ourwebsite at www.GladstoneCapital.com.  Weintend to provide disclosure of any amendments to or waivers of the provisionsof this code by posting information regarding any such amendment or waiver to ourwebsite within four days of its effectiveness.

 

***Compliance Policies and Procedures***

* *

Weand our Adviser have adopted and implemented written policies and proceduresreasonably designed to prevent violation of the federal securities laws, andour Board of Directors is required to review these compliance policies andprocedures annually to assess their adequacy and the effectiveness of theirimplementation.  We have designated achief compliance officer, Paula Novara, who also serves as chief compliance officerfor our Adviser.

 

**Staffing**

 

We do not currently have any employees and do not expect to have anyemployees in the foreseeable future. Currently, services necessary for our business are provided byindividuals who are employees of Gladstone Management pursuant to the terms ofan investment advisory and administrative agreement.  Each of our executive officers is an employeeand executive officer of Gladstone Management. No employee of Gladstone Management will dedicate all of his or her timeto us.  However, we expect that 15-20full time employees of Gladstone Management will spend substantial time on ourmatters during the calendar year 2006. We anticipated that the number of employees of Gladstone Management whodevote time to our matters will increase as we acquire more investments.

 

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Upon the effectiveness of the Amended Agreement and AdministrationAgreement approved by our stockholders on December 2, 2005, accounting andcompliance services will be provided by the same individuals who currentlyprovide these services to us, however these individuals will become employeesof Gladstone Administration and will provide accounting and compliance servicesto us pursuant to the Administration Agreement. All other services will continue to be performed by the same individualsunder the Amended Agreement.** **

 

As of September 30, 2005, Gladstone Management had 30 full-timeemployees.  As of September 30, 2005, abreak-down of Gladstone Management’s 30 full-time employees by functional areais summarized in the table below: 

 
| **Number of Individuals** | ** ** | **Functional Area**                                                                                                             |
|---------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|
|                      |       |                                                                                                                            |
| 4                         |       | Executive  Management (Chief Executive Officer, Chief Operating Officer, Chief  Investment Officer and Chief Financial Officer) |
|                      |       |                                                                                                                            |
| 19                        |       | Investment  Management, Portfolio Management, and Due Diligence                                                                 |
|                      |       |                                                                                                                            |
| 5                         |       | Accounting,  Compliance, Human Resources and Investor Relations                                                                 |
|                      |       |                                                                                                                            |
| 2                         |       | Administration                                                                                                                  |

 

**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 key management personnel and the keymanagement personnel of our Adviser for our future success, particularlyDavid Gladstone, George Stelljes III and Terry Lee Brubaker.**

 

We are dependent on the diligence, skill and network of businesscontacts of our senior management and other management members for the finalselection, structuring, closing and monitoring of our investments. Our futuresuccess depends to a significant extent on the continued service andcoordination of our senior management team, particularly David Gladstone, ourchairman and chief executive officer, George Stelljes III, our president andchief investment officer, and Terry Lee Brubaker, our vice-chairman and chiefoperating officer. The departure of any of our executive officers or keyemployees from us or from our adviser, Gladstone Management, could have amaterial adverse effect on our ability to implement our business strategy andto achieve our investment objectives.

 

**We are dependent on our Adviser’s continued operations and may not finda suitable replacement if our Adviser discontinues operations or terminates theinvestment advisory agreement. **

** **

Wehave no employees.  We expect that ourchief executive officer, chief operating officer, chief investment officer andchief financial officer, and the employees of our Adviser, will not spend allof their time managing our activities and our investment portfolio.  Our executive officers and the employees ofour Adviser may allocate some, or a material portion, of their time tobusinesses and activities that are not related to our business.  We have no separate facilities and arecompletely reliant on our Adviser, which has significant discretion as to theimplementation and execution of our business strategies and risk managementpractices.  We are subject to the risk ofdiscontinuation of our Adviser’s operations or termination of the investmentadvisory agreement and the risk that, upon such event, no suitable replacementwill be found.  We believe that oursuccess depends to a significant extent upon our Adviser and thatdiscontinuation of its operations could have a material adverse effect on ourability to achieve our investment objectives.

 

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**Our incentive fee may induce our adviser to make certain investments,including speculative investments. **

** **

Themanagement compensation structure that will be implemented under the AmendedAgreement with our Adviser may cause our Adviser to invest in high riskinvestments or take other risks.  Inaddition to its management fee, our Adviser will be entitled under the AmendedAgreement to receive incentive compensation based in part upon our achievementof specified levels of income.  Inevaluating investments and other management strategies, the opportunity to earnincentive compensation based on net income may lead our Adviser to place undueemphasis on the maximization of net income at the expense of other criteria,such as preservation of capital, maintaining sufficient liquidity, or managementof credit risk or market risk, in order to achieve higher incentivecompensation.  Investments with higheryield potential are generally riskier or more speculative.  This could result in increased risk to thevalue of our investment portfolio.  

** **

**Wemay be obligated to pay our Adviser incentive compensation even if we incur aloss.**

** **

On December 2,2005, our stockholders approved an amended and restated investment advisoryagreement with our advisor that, when effective, will entitle our Adviser 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 our Adviser incentive compensation for afiscal quarter even if there is a decline in the value of our portfolio or weincur a net loss for that quarter.  Thisagreement will not become effective until certain requirements related tooptions outstanding under our 2001 Equity Incentive Plan are satisfied.  For additional information on incentivecompensation under the Amended Agreement with our Adviser, and the potentialtime of effectiveness of the agreement, see “Business – Investment AdvisoryAgreement.”

 

**Our Adviser’s failure to identify and invest in securities that meetour investment criteria or perform its responsibilities under the investmentadvisory agreement may adversely affect our ability for future growth.**

** **

                Ourability to achieve our investment objectives will depend on our ability togrow, which in turn will depend on our Adviser’s ability to identify and investin securities that meet our investment criteria.  Accomplishing this result on a cost-effectivebasis will be largely a function of our Adviser’s structuring of the investmentprocess, its ability to provide competent and efficient services to us, and ouraccess to financing on acceptable terms. The senior management team of our Adviser has substantialresponsibilities under the investment advisory agreement.  In order to grow, our Adviser will need tohire, 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 for investment opportunities.**

 

A large number of entities compete with us and make the types ofinvestments that we seek to make in small and medium sized privately ownedbusinesses. We compete with a large number of private equity funds, leveragedbuyout funds and venture capital funds, investment banks and other equity andnon-equity based investment funds, and other sources of financing, includingtraditional financial services companies such as commercial banks. Many of ourcompetitors are substantially larger and have considerably greater financial,technical and marketing resources than we do. For example, some competitors mayhave a lower cost of funds and access to funding sources that are not availableto us. In addition, certain of our competitors may have higher risk tolerancesor different risk assessments, which could allow them to consider a widervariety of investments and establish more relationships and build their marketshares. 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.

 

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**Our business model is dependent upon developing and sustaining strongreferral relationships with leveraged buyout funds and venture capital funds.**

 

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

 

**Our loans to small and medium sized borrowers are extremely risky andyou could lose your entire investment.**

 

Loans to small and medium sized borrowers are subject to a number ofsignificant risks including the following:

 

•              **Smalland medium sized businesses may have limited financial resources and may not beable to repay the loans we make to them.** Our strategy includes providing financing to borrowers that typicallyis not readily available to them. While we believe that this provides anattractive opportunity for us to generate profits, this may make it difficultfor the borrowers to repay their loans to us upon maturity. A borrower’sability to repay its loan may be adversely affected by numerous factors,including the failure to meet its business plan, a downturn in its industry ornegative economic conditions. A deterioration in a borrower’s financialcondition and prospects usually will be accompanied by a deterioration in thevalue of any collateral and a reduction in the likelihood of us realizing onany guarantees we may have obtained from the borrower’s management. Although wewill sometimes seek to be the senior, secured lender to a borrower, in most ofour loans we expect to be subordinated to a senior lender, and our interest inany collateral would, accordingly, likely be subordinate to another lender’ssecurity interest.

 

•              **Smalland medium sized businesses typically have narrower product lines and smallermarket shares than large businesses.** Because our target borrowers are smaller businesses, they will tend tobe more vulnerable to competitors’ actions and market conditions, as well asgeneral economic downturns. In addition, our portfolio companies may faceintense competition, including competition from companies with greaterfinancial resources, more extensive development, manufacturing, marketing andother capabilities and a larger number of qualified managerial and technicalpersonnel.

 

•              **Thereis generally little or no publicly available information about thesebusinesses.** Because we seekto make loans to privately owned businesses, there is generally little or nopublicly available operating and financial information about our potentialborrowers. As a result, we rely on our officers, our Adviser and its employeesand consultants to perform due diligence investigations of these borrowers,their operations and their prospects. We may not learn all of the materialinformation we need to know regarding these businesses through ourinvestigations.

 

•              **Smalland medium sized businesses generally have less predictable operating results.** We expect that our borrowers may havesignificant variations in their operating results, may from time to time beparties to litigation, may be engaged in rapidly changing businesses withproducts subject to a substantial risk of obsolescence, may require substantialadditional capital to support their operations, to finance expansion or tomaintain their competitive position, may otherwise have a weak financialposition or may be adversely affected by changes in the business cycle. Ourportfolio companies may not meet net income, cash flow and other coverage teststypically imposed by their senior lenders. A borrower’s failure to satisfyfinancial or operating covenants imposed by senior lenders could lead todefaults and, potentially, foreclosure on its senior credit facility, whichcould additionally trigger cross-defaults in other agreements. If this were tooccur, it is possible that the borrower’s ability to repay our loan would bejeopardized.

 

•              **Smalland medium sized businesses are more likely to be dependent on one or twopersons.** Typically, thesuccess of a small or medium sized business also depends on the managementtalents and efforts of one or two persons or a small group of persons. Thedeath, disability or resignation of one or more of these persons could have amaterial adverse impact on our borrower and, in turn, on us.

 

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•              **Smalland medium sized businesses are likely to have greater exposure to economicdownturns than larger businesses.** We expect that our borrowers will have fewer resources than largerbusinesses and an economic downturn is more likely to have a material adverseeffect on them. If one of our borrowers is adversely impacted by an economicdownturn, its ability to repay our loan would be diminished.

 

•              **Smalland medium sized businesses may have limited operating histories.** While we intend to target stable companieswith proven track records, we may make loans to new companies that meet ourother investment criteria. Borrowers with limited operating histories will beexposed to all of the operating risks that new businesses face and may beparticularly susceptible to, among other risks, market downturns, competitivepressures and the departure of key executive officers.

 

**We may not realize gains from our equity investments and other yieldenhancements.**

 

When we make a subordinated loan, we generally expect to receivewarrants to purchase stock issued by the borrower or other yield enhancements,such as success fees (conditional interest). Our goal is to ultimately disposeof these equity interests and realize gains upon our disposition of suchinterests. We expect that, over time, the gains we realize on these warrantsand other yield enhancements will offset any losses we experience on loandefaults. However, any warrants we receive may not appreciate in value and, infact, may decline in value and any other yield enhancements, such as successfees, may not be realized. Accordingly, we may not be able to realize gainsfrom our equity interests or other yield enhancements and any gains we dorecognize may not be sufficient to offset losses we experience on our loanportfolio.

 

**Because the loans we make and equity securities we receive when we makeloans are not publicly traded, there will be uncertainty regarding the value ofour privately held securities that could adversely affect our determination ofour net asset value.**

 

We expect that very few, if any, of our portfolio loans or equitysecurities, at least initially, will be publicly traded or have a readilydeterminable market value. We value these securities based on a determinationof their fair value, based on recommendations provided by S&P and managementand approved by our Board of Directors. Due to the uncertainty inherent invaluing these securities, our determinations of fair value may differmaterially from the values that would exist if a ready market for thesesecurities existed. Our net asset value could be materially affected if ourdeterminations regarding the fair value of our investments are materiallydifferent from the values that we ultimately realize on our disposal of suchsecurities.

 

**The lack of liquidity of our privately held investments may adverselyaffect our business.**

 

Most of our investments presently consist of, and will continue toconsist of, loans and warrants acquired in private transactions directly fromborrowers or from the originators of loans to such borrowers. Substantially allof the investments we presently hold are, and the investments we expect toacquire in the future will be, subject to restrictions on resale, including, insome instances, legal restrictions, or will otherwise be less liquid thanpublicly traded securities. The illiquidity of our investments may make itdifficult for us to quickly obtain cash equal to the value at which we recordour investments if the need arises. This could cause us to miss importantbusiness opportunities. In addition, if we are required to quickly liquidateall or a portion of our portfolio, we may realize significantly less than thevalue at which we have previously recorded our investments.

 

**Our portfolio will be concentrated in a limited number of companies andindustries, which subjects us to an increased risk of significant loss if anyone of these companies does not repay us or if the industries experiencedownturns.**

 

We intend to have outstanding loans to approximately 20 to 40 portfoliocompanies at any given time. A consequence of a limited number of investmentsis that the aggregate returns we realize may be substantially adverselyaffected by the unfavorable performance of a small number of such loans or asubstantial writedown of any one investment. Beyond our regulatory and incometax diversification requirements, we do not have fixed guidelines for industryconcentration and our investments could potentially be concentrated inrelatively few industries. In addition, while we do not intend to invest 25% ormore of our total assets in a particular industry or group of industries at thetime of investment, it is possible that as the values of our portfoliocompanies change, one industry or a group of industries may comprise in excessof 25% of the value of our total assets. As a result, a downturn in an industryin which we have made multiple loans could have a materially adverse effect onus.

 

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**Our business plan is dependent upon external financing which may exposeus to risks associated with leverage.**

 

Our business will require a substantial amount of cash to operate andgrow. We may acquire such additional capital from the following sources:

 

•              **SeniorSecurities**. We intend to issue debtsecurities, other evidences of indebtedness (including borrowings under ourlines of credit) and possibly preferred stock, up to the maximum amountpermitted by the 1940 Act. The 1940 Act currently permits us, as a businessdevelopment company, to issue debt securities and preferred stock, to which werefer collectively as senior securities, in amounts such that our assetcoverage, as defined in the 1940 Act, is at least 200% after each issuance ofsenior securities. As a result of issuing senior securities, we will be exposedto the risks associated with leverage. Although borrowing money for investmentsincreases the potential for gain, it also increases the risk of a loss. Adecrease in the value of our investments will have a greater impact on thevalue of our common stock to the extent that we have borrowed money to makeinvestments. There is a possibility that the costs of borrowing could exceedthe income we receive on the investments we make with such borrowed funds. Inaddition, our ability to pay dividends or incur additional indebtedness wouldbe restricted if asset coverage is not at least twice our indebtedness. If thevalue of our assets declines, we might be unable to satisfy that test. If thishappens, we may be required to liquidate a portion of our loan portfolio andrepay a portion of our indebtedness at a time when a sale may bedisadvantageous. Furthermore, any amounts that we use to service ourindebtedness will not be available for distributions to our stockholders.

 

•              **CommonStock.** Because we areconstrained in our ability to issue debt for the reasons given above, we aredependent on the issuance of equity as a financing source. If we raiseadditional funds by issuing more common stock or debt securities convertibleinto or exchangeable for our common stock, the percentage ownership of ourstockholders at the time of the issuance would decrease and they may experiencedilution. In addition, any convertible or exchangeable securities that we issuein the future may have rights, preferences and privileges more favorable thanthose 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 our profitability andour hedging strategy may expose us to additional risks.**

** **

We anticipate using a combination of equity and long-term andshort-term borrowings to finance our lending activities. As a result, a portionof our income will depend upon the difference between the rate at which weborrow funds and the rate at which we loan these funds. Certain of our borrowingsmay be at fixed rates and others at variable rates. Ultimately, we expectapproximately 80% of the loans in our portfolio to be at fixed rates andapproximately 20% to be at variable rates determined on the basis of abenchmark prime rate. As of September 30, 2005, our portfolio had approximately16% of the total of the loan portfolio cost at fixed rates, approximately 43%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 38% at variable rates. We will typically seek tohedge against the risk of adverse movement in interest rates on our borrowingsrelative to our portfolio of assets. As required by our warehouse line ofcredit, we hedge against interest rate fluctuations by using standard hedginginstruments such as futures, options and forward contracts. While hedgingactivities may insulate us against adverse fluctuations in interest rates, theymay also limit our ability to participate in the benefits of lower interestrates with respect to the hedged portfolio. Adverse developments resulting fromchanges in interest rates or hedging transactions could have a material adverseeffect on our business, financial condition and results of operations.

 

**Our credit facilities impose certain limitations on us.**

** **

We will have a continuing need for capital to finance our loans. Inorder to maintain RIC status, we will be required to distribute to ourstockholders at least 90% of our ordinary income and short-term capital gainson an annual basis. Accordingly, such earnings will not be available to fundadditional loans. Therefore, we are party to a credit agreement arranged by Deutsche Bank AG as the structuringagent.  The agreement provides us with arevolving credit line facility of $100 million, and we may seek to increase theavailability of credit under the facility to $150 million.  We are also a party to a $15 millionshort-term revolving line of credit with Branch Banking &Trust Company.  In the future, borrowings outstanding onthese credit lines may be repaid with the proceeds we may receive fromsecuritizing some or all of the loans in our portfolio for long-term funding.  These credit line facilities will permit usto fund additional loans and investments as long as we are within theconditions set out in the credit agreement.

 

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As a result of the credit line facilities, we are subject to certainlimitations on the type of loan investments we make, including restrictions ongeographic concentrations, sector concentrations, loan size, payment frequencyand status, and average life. Our failure to satisfy these limitations couldresult in foreclosure by our lenders which would have a material adverse effecton our business, financial condition and results of operations.

 

**Our investments will typically be long term and will require severalyears to realize liquidation events.**

** **

Since we generally intend to make five to seven year term loans and tohold our loans and related warrants or other yield enhancements until the loansmature, you should not expect realization events, if any, to occur over thenear term. In addition, we expect that any warrants or other yield enhancementsthat we receive when we make loans may require several years to appreciate invalue and we cannot give any assurance that such appreciation will occur.

 

**We will be subject to corporate level tax if we are unable to satisfyInternal Revenue Code requirements for RIC qualification.**

** **

To maintain our qualification as a RIC, we must meet income source,asset diversification and annual distribution requirements. The annualdistribution requirement is satisfied if we distribute at least 90% of ourordinary income and short-term capital gains to our stockholders on an annualbasis. Because we use leverage, we are subject to certain asset coverage ratiorequirements under the 1940 Act and could, under certain circumstances, berestricted from making distributions necessary to qualify as a RIC. Warrants wereceive with respect to debt investments will create “original issue discount,”which we must recognize as ordinary income, increasing the amounts we arerequired to distribute to maintain RIC status. Because such warrants will notproduce distributable 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 Tax Considerations—Regulated Investment Company Status.”

 

**There are significant potential conflicts of interest which couldimpact our investment returns.**

 

Our executive officers and directors may serve as officers anddirectors of entities that operate in the same or similar lines of business aswe do. Accordingly, they may have obligations to investors in those entities,the fulfillment of which might not be in the best interests of us or ourstockholders. It is possible that new investment opportunities that meet ourinvestment objectives may come to the attention of one of our executiveofficers or directors, such as Mr. Gladstone, in his role as an officer ordirector of another entity, and, if so, such opportunity might not be offered,or otherwise made available, to us.

 

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

** **

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

 

Amendmentspromulgated in 1998 by the Board of Governors of the Federal Reserve System toRegulation T under the Exchange Act expanded the definition of marginable securityto include any non-equity security. These amendments have raised questions asto whether a private company that has outstanding debt would qualify as aneligible portfolio company.  We believethat substantially all 

 

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of the senior loans,subordinated loans and equity securities that we hold and propose to acquire inthe future should constitute qualifying assets because our current borrowersdid not, and our expected future borrowers will not, at the time of ourinvestment, have outstanding marginable securities. First, we have historicallymade, and expect to continue to make, a large portion of our senior loan andsubordinated loan investments on terms and in circumstances such that thoseinvestments should not under existing legal precedent be “securities” under theExchange Act and therefore should not be marginable securities under RegulationT. Second, we believe that should a different position be taken such that thoseinvestments may be securities, they should still not be marginable securities.In particular, debt instruments that do not trade in a public secondary marketor are not rated investment grade are not margin eligible securities under therules established by the self- regulatory organizations, including the New YorkStock Exchange and National Association of Securities Dealers, that govern theterms on which broker-dealers may extend margin credit. Until the questionsraised by the amendments to Regulation T have been addressed by legislative,administrative or judicial action, we intend to treat as qualifying assets onlythose senior loans and subordinated loans that are not investment grade, do nothave a public secondary market, and are issued by a private issuer that does nothave outstanding a class of margin eligible securities at the time of ourinvestment. Likewise, we will treat equity securities issued by a portfoliocompany as qualifying assets only if such securities are issued by a privatecompany that has no marginable securities outstanding at the time we purchasesuch securities.

 

To date, we donot believe that either the SEC or its staff has taken any position withrespect to our analysis of the issues discussed above. We intend to adjust ourinvestment focus as needed to comply with and/or take advantage of any futureadministrative position, judicial decision or legislative action.

 

The SEC hasproposed amendments to the rules concerning business development companies thatwould clarify that, among other things, companies that do not have a class ofsecurities listed on an exchange or Nasdaq would be considered eligibleportfolio companies.  If these rules areadopted as proposed, it would remove the uncertainty concerning the status ofcertain of our investments as qualifying assets by clarifying that all of ourportfolio companies would be considered eligible portfolio companies.  There can be no guarantee that the SEC willadopt these rules substantially as proposed, if at all.

 

Further,separate and similar legislation, entitled the “Increased Capital Access forGrowing Businesses Act,” has been introduced in both the U.S. House ofRepresentatives and the U.S. Senate.  Ifpassed in current form, the legislation would strike the 1940 Act language thatties the definition of eligible portfolio company to whether a company hasoutstanding marginable securities. In lieu of this language, the legislationwould provide that, among other things, companies that do not have a class ofsecurities listed on a national securities exchange would be consideredeligible portfolio companies.  Thelegislation introduced in the U.S. House of Representatives, H.R. 436, waspassed unanimously and referred to the U.S. Senate Committee on Banking,Housing and Urban Affairs in April 2005. The U.S. Senate bill, S. 1396, was introduced and referred to the U.S.Senate Committee on Banking, Housing and Urban Affairs in July 2005.  There can be no guarantee that thislegislation will be passed and become effective without substantial amendment,if it becomes effective at all. 

 

Unless anduntil the proposed rules or legislation described above are adopted or passed,if there were a court ruling or regulatory decision that conflicts with ourinterpretations, we could lose our status as a business development company orbe precluded from investing in the manner described in this prospectus. This inturn could cause us to lose our status as a RIC. Any of these results wouldhave a material adverse effect on our ability to invest in the manner describedin this prospectus, on our operating results, financial condition and abilityto pay dividends, and on the value of our common stock, For informationregarding the consequences of failure to qualify as a RIC, see “Business –Material U.S. Federal Tax Considerations – Regulated Investment Company Status.”

 

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

 

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

** **

We and ourportfolio companies are subject to regulation by laws at the local, state andfederal levels. These laws and regulations, as well as their interpretation,may be changed 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. As discussed above, there is arisk that certain investments that we intend to treat as qualifying assets willbe determined to not be eligible for such treatment. Any such determinationwould have a material adverse effect on our business.  For additional information regarding theregulations to which we are subject, see “Business—Material U.S. Federal TaxConsiderations—Regulation as a Business Development Company” and “Business**—**Material U.S. Federal Tax Considerations**—**Regulated Investment Company Status.” 

 

**We may experience fluctuation in our quarterly results.**

 

We could experience fluctuations in our quarterly operating results dueto a number of factors including, among others, variations in and the timing ofthe recognition of realized and unrealized gains or losses, 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 dividends or that ourdividends may not grow over time.**

 

Our current intention is to distribute at least 90% of our ordinaryincome and short-term capital gains to our stockholders on a quarterly basis.We expect to retain net realized long-term capital gains to supplement ourequity capital and support the growth of our portfolio, although our Board ofDirectors may determine in certain cases to distribute these gains. We cannotassure you that we will achieve investment results or maintain a tax statusthat will allow or require any specified level of cash distributions oryear-to-year increases in cash distributions.

 

**Prepayments by our portfolio companies could adversely impact ourresults of operations and reduce our return on equity.**

 

In addition to risks associated with delays in investing our capital,we are also subject to the risk that investments that we make in our portfoliocompanies may be repaid prior to maturity. We will first use any proceeds fromprepayments to repay any borrowings outstanding on our lines 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 reinvesting these amounts. As a result, our results ofoperations could be materially adversely affected if one or more of ourportfolio companies elects to prepay amounts owed to us. Additionally,prepayments could negatively impact our return on equity, which could result ina decline in the market price of our common stock.

 

**Provisions of our articles of incorporation and bylaws could detertakeover attempts and adversely impact the price of our shares.**

 

Our articles of incorporation and bylaws and the Maryland GeneralCorporation Law contain provisions that may have the effect of discouraging,delaying or making more difficult a change in control and preventing theremoval of incumbent directors. The existence of these provisions maynegatively impact the price of our shares and may discourage third-party bids.These provisions may reduce any premiums paid to you for our shares.Furthermore, we are subject to Section 3-602 of the Maryland GeneralCorporation Law which governs business combinations with interestedstockholders and could delay or prevent a change in control. In addition, ourBoard of Directors is elected in staggered terms which makes it more difficultfor a hostile bidder to acquire control of us.

 

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**The market price of our shares may fluctuate significantly.**

 

The market price and marketability of our shares may from time to timebe significantly affected by numerous factors, including many over which wehave no control and that may not be directly related to us. These factorsinclude the following:

 

•              price and volume fluctuations in the stockmarket from time to time, which are often unrelated to the operatingperformance of particular companies;

•              significant volatility in the market priceand trading volume of shares of RICs, business development companies or othercompanies in our sector, which is not necessarily related to the operatingperformance of these companies;

•              changes in regulatory policies or taxguidelines, particularly with respect to RICs or business developmentcompanies;

•              loss of BDC status;

•              loss of RIC status;

•              changes in our earnings or variations in ouroperating results;

•              changes in the value of our portfolio ofinvestments;

•              any shortfall in our revenue or net income orany increase in losses from levels expected by securities analysts;

•              departure of key personnel;

•              operating performance of companies comparableto us;

•              short-selling pressure with respect to ourshares or business development companies generally;

•              general economic trends and other externalfactors; and

•              loss of a major funding source.

 

Fluctuations in the trading prices of our shares may adversely affectthe liquidity of the trading market for our shares and, if we seek to raisecapital through future equity financings, our ability to raise such equitycapital.

 

**Shares of closed-end investment companies frequently trade at adiscount from net asset value.**

 

Shares of closed-end investment companies frequently trade at adiscount from net asset value. This characteristic of shares of closed-endinvestment companies is separate and distinct from the risk that our net assetvalue per share will decline. Although shares of our common stock havehistorically traded at a premium to net asset value, there can be no guaranteethat they will continue to do so.

 

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

 

As of September 30, 2005, we had 11,303,510 shares of common stockoutstanding, of which 10,437,903 were freely tradable without restriction. Theremaining 865,607 shares were held by employees of our Adviser, and our officersand directors, most of which were purchased upon exercise of stock options andall of which may currently be resold publicly in compliance with the volumelimitations and other restrictions of Rule 144 of the Securities Act. OnApril 10, 2003 we filed a registration statement to register for publicresale 1,351,668 shares under our Amended and Restated 2001 Equity IncentivePlan (the “Plan”) (including the shares that have already been issued uponoption exercises). Subsequent to the filing of this registration statement, allof these shares are now freely tradable without restriction, although certainof the options have not yet been granted and a portion of the options that havebeen granted are not yet vested and the shares underlying such options will,accordingly, not be eligible for resale until vested. 

 

Further, in connection withthe stockholders’ approval of the Amended Agreement, the Plan will beterminated.  The Amended Agreement maynot become effective until all outstanding options under the Plan areterminated or exercised, thus we plan to seek agreement from all holders ofthese options to exercise or terminate their outstanding options within alimited period of time.  In connectionwith seeking such agreement from our optionholders, we may also accelerate thevesting of all unvested stock options eligible for acceleration underapplicable SEC regulations.  As ofDecember 8, 2005, there are 1,300,498 outstanding options under the Plan, andno further options will be granted. Since our shares underlying these stockoptions have been registered under the Securities Act of 1933 (as amended),upon exercise, the holders of these options will be able to publicly reselltheir shares without restriction.  

 

Sales of substantial amounts of our common stock in the public market,pursuant to such registration statement, such option exercises, underRule 144 or otherwise, or the availability of such shares for sale, couldadversely affect the prevailing market prices for our common stock. If thisoccurs, it could impair our ability to raise additional capital through thesale of equity securities should we desire to do so.

 

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**Available Information:**

 

Copies of our annual reports on Form 10-K, quarterly reports on Form10-Q, current reports on Form 8-K, and amendments, if any, to those reportsfiled pursuant to Section 13(a) or 15(d) of the Exchange Act are availablefree of charge through 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 at 100F 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 2. Properties**

 

We do not own any real estate or otherphysical properties materially important to our operation.  Gladstone Management Corporation is thecurrent leaseholder of all properties in which we operate.  We occupy these premises pursuant to ourinvestment advisory and administrative agreement with Gladstone ManagementCorporation.  Our headquarters are locatedin McLean, Virginia and we also have operations in New York, New York,Morristown, New Jersey, Chicago, Illinois, Pittsburgh, Pennsylvania, Lexington,Kentucky, and Dallas, Texas. 

 

**Item 3. Legal Proceedings**

 

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

 

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

 

No matters were submitted to a vote ofsecurity holders during the fourth quarter of the fiscal year endedSeptember 30, 2005.

 

23

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**PART II**

 

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

 

Our common stock is traded on the Nasdaq NationalMarket under the symbol “GLAD.” The following table reflects, by quarter, thehigh and low closing prices per share of our common stock on the NasdaqNational Market for each fiscal quarter during the last two fiscal years.

 

| ** ** | ** ** | **Quarter  Ended** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------|------------|--------------------|------------|----------|------------|---------|------------|
|       |       |               |       |     |       |    |       |
| 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   |       |
| FY 2004    |       | 09/30/04           |       | 23.71    |       | 20.05   |       |
|       |       | 06/30/04           |       | 22.55    |       | 19.16   |       |
|       |       | 03/31/04           |       | 23.50    |       | 21.34   |       |
|       |       | 12/31/03           |       | 22.84    |       | 19.55   |       |
|            |            |                    |            |          |            |         |            |  |  |

 

As of November 18, 2005, there wereapproximately 19,000 beneficial owners of our Common Stock.

 

**Dividends**

 

We currently intend to distribute in the formof cash dividends a minimum of 90% of our ordinary income and short-termcapital gains, if any, on a quarterly basis to our stockholders. Since thebeginning of fiscal year 2004, dividends were declared quarterly and paidmonthly.  Amounts presented for eachfiscal quarter of 2005 and 2004 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 for each quarter of the last two fiscal years:

 

| ** ** | ** ** | **Quarter  Ended** | ** ** | **Cash Dividend  Per Share** | ** ** |
|------------|------------|--------------------|------------|------------------------------|------------|
|       |       |               |       |                         |       |
| FY 2005    |       | 09/30/05           |       | $                            | 0.405      |   |
|       |       | 06/30/05           |       | 0.390                        |       |
|       |       | 03/31/05           |       | 0.360                        |       |
|       |       | 12/31/04           |       | 0.360                        |       |
| FY 2004    |       | 09/30/04           |       | 0.360                        |       |
|       |       | 06/30/04           |       | 0.345                        |       |
|       |       | 03/31/04           |       | 0.330                        |       |
|       |       | 12/31/03           |       | 0.330                        |       |
|            |            |                    |            |                              |            |  |

 

**Recent Sales of Unregistered Securities**

 

There were no unregistered salesof securities during the fiscal year ended September 30, 2005.

 

**Securities Authorized for Issuance UnderEquity Compensation Plans**

 

This information is provided in Item 12 “SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters” of this Form 10-K.

 

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**Item 6. Selected Financial Data**

 

The following selected financial data for thefiscal years ended September 30, 2005, 2004, 2003, 2002 and the period May30, 2001 (Inception) through September 30, 2001 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.

 

**GLADSTONECAPITAL CORPORATION**

**SELECTEDFINANCIAL DATA**

** **
| ** **                                                        | ** ** | **Year Ended  September 30,  2005** | ** **  | **Year Ended  September 30,  2004** | ** ** | **Year Ended  September 30,  2003** | ** ** | **Year Ended  September 30,  2002** | ** **  | **Period May 30,  2001 (Inception)  Through  September 30,  2001** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------|-------------|-------------------------------------|------------|-------------------------------------|------------|-------------------------------------|-------------|--------------------------------------------------------------------|------------|
|                                                              |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Total Investment Income                                           |       | $                                   | 23,949,759  |                                | $          | 20,395,968                          |       | $                                   | 15,154,874  |                                                               | $          | 10,455,703 |   | $ | 394,855 |   |
| Total Expenses                                                    |       | $                                   | 7,531,436   |                                | $          | 7,103,193                           |       | $                                   | 3,858,953   |                                                               | $          | 2,839,102 |   | $ | 487,499 |   |
| Net Investment Income (Loss)                                      |       | $                                   | 17,286,145  |                                | $          | 13,292,775                          |       | $                                   | 11,295,921  |                                                               | $          | 7,616,601 |   | $ | (92,644 | ) |
| Net Increase (Decrease) in Net Assets  Resulting from Operations  |       | $                                   | 15,490,682  |                                | $          | 10,570,290                          |       | $                                   | 11,073,581  |                                                               | $          | 7,616,601 |   | $ | (92,644 | ) |
|                                                              |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Per Share Data:                                                   |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Net Increase (Decrease) in Net Assets  Resulting from Operations: |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Basic                                                             |       | $                                   | 1.37        |                                | $          | 1.05                                |       | $                                   | 1.10        |                                                               | $          | 0.76 |   | $ | (0.03 | ) |
| Diluted                                                           |       | $                                   | 1.33        |                                | $          | 1.02                                |       | $                                   | 1.09        |                                                               | $          | 0.75 |   | $ | (0.03 | ) |
| Cash Distributions Declared per Share                             |       | $                                   | 1.515       |                                | $          | 1.365                               |       | $                                   | 1.10        |                                                               | $          | 0.81 |   | $ | — |   |
|                                                              |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Statement of Assets and Liabilities Data:                         |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Total Assets                                                      |       | $                                   | 205,793,094 |                                | $          | 215,333,727                         |       | $                                   | 214,566,663 |                                                               | $          | 172,922,039 |   | $ | 132,205,486 |   |
| Total Net Assets                                                  |       | $                                   | 151,610,683 |                                | $          | 152,226,655                         |       | $                                   | 130,802,382 |                                                               | $          | 130,663,273 |   | $ | 131,249,144 |   |
|                                                              |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Other Data:                                                       |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Number of Portfolio Companies at Period End                       |       | 28                                  |        | 16                                  |       | 11                                  |       | 7                                   |        | NONE                                                               |       |
| Principal Amount of Loan Originations (1)                         |       | $                                   | 143,794,006 |                                | $          | 86,267,500                          |       | $                                   | 47,011,278  |                                                               | $          | 97,705,054 |   | NONE |   |
| Principal Amount of Loan Repayments (1)                           |       | $                                   | 88,019,136  |                                | $          | 47,158,995                          |       | $                                   | 18,005,827  |                                                               | $          | 18,387,191 |   | NONE |   |
| Total Return (2)                                                  |       | 5.93                                | %           | 24.40                               | %          | 21.74                               | %          | 9.60                                | %           | 7.60                                                               | %          |
|                                                              |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| Weighted Average Yield on Investments (3):                        |       |                                |        |                                |       |                                |       |                                |        |                                                               |       |
| With PIK Interest (4)                                             |       | 12.36                               | %           | 13.78                               | %          | 13.86                               | %          | 14.79                               | %           | N/A                                                                |       |
| Without PIK Interest (4)                                          |       | 12.23                               | %           | 13.44                               | %          | 13.14                               | %          | 13.82                               | %           | N/A                                                                |       |

 

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

 

(2)           Forthe fiscal years ended September 30, 2005 and September 30, 2004, the totalreturn equals the increase of the ending market value over the beginning marketvalue plus monthly dividends divided by the monthly beginning marketvalue.  For the fiscal year endedSeptember 30, 2003 and prior periods, total return equals the increase of theending market value over the beginning market value, plus distributions,divided by the beginning market value. The return for 2001 has not beenannualized.

 

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

 

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

 

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**Item 7. Management’s Discussion and Analysis of Financial Condition andResults 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**

 

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

 

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

 

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

 

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

 

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

 

Original issuediscounts (“OID”) arise when we make a loan and receive an equity interest inthe borrower at the same time.  To theextent that the price paid for the equity is not at market value, we mustallocate part 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.

 

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In addition, as a business developmentcompany under the 1940 Act, we are required to make available significantmanagerial assistance to our portfolio companies. Prior to the externalizationof our management on October 1, 2004, the start of the 2005 fiscal year, weprovided these services through our wholly-owned subsidiary, Gladstone CapitalAdvisers, Inc.  Since theexternalization of our management on October 1, 2004, our investment adviser,Gladstone Management Corporation (“Gladstone Management”), began to providethese services on our behalf through its officers who are also ourofficers.  In addition, GladstoneManagement provides other services to our portfolio companies, for which itreceives fees, in connection with our investments.  The fees for these services are generallypaid to Gladstone Management in part at the time a prospective portfoliocompany signs a non-binding term sheet with us (as further described in thefollowing paragraph), with the remainder paid at the closing of the investment.These fees are generally non-recurring, however in some instances they may havea recurring component which is also paid to Gladstone Management.  Any such fees received, with the exception ofthe recurring fees, by Gladstone Management are credited against the managementadvisory fee payable to Gladstone Management pursuant to the terms of ouradvisory agreement, which has the effect of reducing our expenses to the extentof any such fees received by Gladstone Management.  The specific services Gladstone Managementprovides vary by portfolio company, but generally include a wide variety ofservices to the portfolio companies such as investment banking 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.  Prior to the start of fiscalyear 2005, Gladstone Capital Advisers, Inc. provided these services andreceived these fees and we have recorded fees for these services as fee incomefor the periods in which these fees were earned by us.

 

Prior tomaking an investment, we ordinarily enter into a non-binding term sheet withthe potential borrower. These non-binding term sheets are generally subject toa number of conditions, including but not limited to the satisfactorycompletion of our due diligence investigations of the potential borrower’sbusiness and reaching agreement on the legal documentation for the loan. Uponexecution of the non-binding term sheet, the potential borrower generally paysGladstone Management a non-refundable fee for its services rendered through thedate of the non-binding term sheet. Prior to the externalization of ourmanagement on October 1, 2004, we recognized this as fee revenue upon executionof the non-binding term sheet. Effective October 1, 2004, these fees arereceived by Gladstone Management and are offset against amounts due toGladstone Management, which has the effect of reducing our expenses to theextent of any such fees received by Gladstone Management.

 

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

 

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

 

During thefiscal year ended September 30, 2005, we extended, directly or throughparticipations, approximately $143.8 million of new loans to a total of 23companies.  Also, during the fiscal yearended September 30, 2005, nine borrowers repaid their loans ahead ofcontractual maturity and we sold two loan investments for an aggregate returnof capital of approximately $71.0 million and we received scheduled contractualprincipal repayments of approximately $17.0 million, for total principalrepayments of approximately $88.0 million. Since our initial public offering in August 2001, we have made 73****different loans to, or investments in, 48****companies for a total of approximately $362.9****million, before giving effect to principalrepayments on investments and divestitures.

 

We are continuously working toward theconsummation of more loan origination and syndicated investments in an effortto grow our loan portfolio. These prospective loans are subject to, among otherthings, the satisfactory completion of our due diligence investigation of eachborrower, acceptance of terms and structure and attainment of necessaryconsents. With respect to each prospective loan, we will only agree to providethe loan if, among other things, the results of our due diligenceinvestigations are satisfactory, the terms and conditions of the loan areacceptable and all necessary consents are received. Our management hasinitiated its due diligence investigations of the potential borrowers, howeverwe cannot assure you that we will not discover facts in the course ofcompleting our due diligence that would render a particular investmentimprudent or that any of these loans will actually be made.

 

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**External Adviser**

 

EffectiveOctober 1, 2004, pursuant to our advisory agreement with Gladstone Management,we pay Gladstone Management an annual advisory fee of 1.25% of our total assets(as reduced by cash and cash equivalents pledged to creditors), payable inquarterly computed 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 computed increments of 0.1875%. This fee isthen directly reduced by the amount of loan servicing fees paid to GladstoneManagement and any other fees received by Gladstone Management from ourborrowers and potential borrowers.  Wecontinue to pay direct expenses including, but not limited to, directors’ fees,legal and accounting fees, stockholder related expenses, and directors andofficers insurance.  

 

Effective July 12, 2004, Gladstone Management assumed theresponsibility for servicing our loan portfolio pursuant to a loan servicingagreement with Gladstone Business Loan LLC (“Business Loan”). GladstoneManagement services these loans in return for a 1.5% annual fee, based on themonthly aggregate outstanding loan balance of the loans pledged under thefacility.  Prior to July 12, 2004, ourloans were serviced under a similar agreement between Business Loan andGladstone Capital Advisers, Inc., our wholly-owned subsidiary, although thefees from these intercompany transactions were eliminated through theconsolidation of our financial results with those of Business Loan andGladstone Capital Advisers, Inc.

 

Prior to theexternalization of our management, we were party to an expense sharingarrangement with Gladstone Management, which during such time served as the externaladviser to Gladstone Commercial Corporation (“Gladstone Commercial”), a realestate investment trust affiliated with us. Under this expense sharingarrangement, Gladstone Management reimbursed Gladstone Capital Advisers, Inc.for a portion of our total payroll and benefits expenses (based on thepercentage of total hours worked by each of our employees on GladstoneCommercial matters). Gladstone Management also reimbursed Gladstone CapitalAdvisers, Inc. for its pro-rata portion of all other general expenses (based onthe percentage of total hours worked by all of our employees on GladstoneCommercial matters). Gladstone Management further passed its share of theseexpenses along to Gladstone Commercial under a separate advisory agreement.  At September 30, 2004, Gladstone Managementowed us $109,639 of reimbursements recorded in fees due from affiliate, all ofwhich was subsequently paid.  Followingour engagement of Gladstone Management on October 1, 2004, the first day of our2005 fiscal year, Gladstone Management now directly employs all of ourpersonnel and pays its payroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement betweenGladstone Capital Advisers, Inc. and Gladstone Management terminated upon theexternalization of our management on October 1, 2004.

 

On December 2, 2005, ourstockholders approved a proposal to enter into an amended and restatedinvestment advisory agreement (the “Amended Agreement”) with GladstoneManagement and an administration agreement (the “Administration Agreement”)between the Company and Gladstone Administration, LLC (the “Administrator”), awholly-owned subsidiary of the Adviser.

 

The Amended Agreementprovides for an annual base management fee equal to 2% of our assets and anincome-based incentive fee which will reward the Adviser if our quarterly netinvestment income (before giving effect to the incentive fee) exceeds 1.75% ofour net assets.  The agreement alsoprovides for a capital gains-based incentive fee, whereby the Adviser willreceive a fee equal to 20% of our realized capital gains (net of realizedcapital losses and unrealized capital depreciation).  Under the Administration Agreement, theCompany will pay separately for its allocable portion of the Administrator’soverhead expenses in performing its obligations, including rent, and theCompany’s allocable portion of the salaries and benefits expenses of its chieffinancial officer, chief compliance officer and controller and their respectivestaffs.

 

In connection with theapproval of the Amended Agreement, we will terminate our Amended and Restated2001 Equity Incentive Plan (the “Plan”), and seek agreement from all holders ofstock options to exercise or terminate their options within a limited period oftime.  The Amended Agreement and theAdministration Agreement will become effective upon the later of (i) October 1,2006, or (ii) the first day of the first fiscal quarter following the date thatall existing stock options are exercised. The Amended Agreement and AdministrationAgreement will not become effective as long as the Plan is in effect or as longas there are any outstanding stock options. The current investment advisory agreement with Gladstone Management willcontinue in effect until these new agreements become effective.

 

**Off-Balance Sheet Arrangements**

** **

We do not have any significant off-balance sheet arrangements asdefined in Item 303(a)(4)(ii) of SEC Regulation S-K as ofSeptember 30, 2005.

 

28

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**Critical Accounting Policies**

 

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

 

**Investment Valuation**

 

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

 

*GeneralValuation Policy:* We value our investment portfolioeach quarter. We carry our investments at fair value, as determined in goodfaith by our Board of Directors. Securities that are publicly traded, if any, are valued at the closingprice of the exchange or securities market on which they are listed on thevaluation date. Securities which are not traded on a public exchange orsecurities market, but for which a limited market exists and that have beenrated by a NRSRO (as defined below), such as certain participations insyndicated loans, are valued at the indicative bid price offered by thesyndication agent on the valuation date.

 

Debt andequity securities that are not publicly traded, for which a limited market doesnot exist, or for which a limited market exists but that have not been rated bya NRSRO (or for which we have various degrees of trading restrictions) arevalued at fair value as determined in good faith by our Board of Directors.  In making the good faith determination of thevalue of these securities, we start with the cost basis of the security, whichincludes the amortized original issue discount, and PIK interest, if any.  We then apply the methods set out below in “ValuationMethods.”  Members of our portfoliomanagement team prepare the valuations of our investments in portfoliocompanies using the most recent portfolio company financial statements andforecasts.  These individuals alsoconsult 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 operationalissues.  Due to the uncertainty inherentin the valuation process, such estimates of fair value may differ significantlyfrom the values that would have been obtained had a ready market for thesecurities existed, and the differences could be material.  Additionally, changes in the marketenvironment and other events that may occur over the life of the investmentsmay cause the gains or losses ultimately realized on these investments to bedifferent than the valuations currently assigned.  There is no single standard for determiningfair value in good faith, as fair value depends upon circumstances of eachindividual case.  In general, fair valueis the amount that we might reasonably expect to receive upon the current saleof the security.

 

We currentlyengage Standard & Poor’s Loan Evaluation Service (S&P) to help evaluatethe value of the majority of our loan securities (other than those which arepublicly traded or for which a limited market exists, as described above), aswell as for evaluations on success fees (conditional interest included in someloan securities).  We and S&P onlyevaluate the value of a success fee if the probability of receiving the successfee on a given loan is above 6-8%, a threshold of significance, in which case avalue is assigned.  Upon completing ourcollection of data with respect to the investments (including the informationdescribed under “Credit Information,” the risk ratings of the loans describedunder “Loan Grading and Risk Rating” and the factors described under “ValuationMethods”), this valuation data is presented to S&P.  S&P makes its independent assessment ofthe data that we have assembled and assesses its own data to determine marketvalues for the securities.  With regardto its work, S&P has issued the following paragraph:

 

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

 

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With ourassessment and S&P value estimates as a backdrop, our Board of Directorsvotes to accept or not accept the analyses and values recommended by managementand S&P.  At September 30, 2005 andSeptember 30, 2004, the Board of Directors elected to accept the valuationsrecommended by S&P on the loans in our portfolio as denoted on the Scheduleof Investments as of September 30, 2005 and September 30, 2004 in ourconsolidated financial statements. Subsequent to September 30, 2005, the fairvalue of our investment in ARI Holdings, Inc. was reduced from the valueproposed by S&P because the investment was sold in November 2005 at a valueless than that indicated by S&P on September 30, 2005.  Our Board of Directors determined to reducethe value proposed by S&P to the value of the sale price and as such thesale price of the investment is reflected in the fair value on our Schedule ofInvestments as of September 30, 2005 in our consolidated financial statements.  

 

Because thereis a delay between when we close a loan and when the loan can be evaluated byS&P, new loans are not valued immediately by S&P; rather, the Board of Directorsmakes its own determination about the value of these loans in accordance withour valuation policy.  Because S&Pdoes not provide values for mortgage loans or equity securities, our Board of Directorsalso determines the fair value of these investments using our valuation policywithout the input of S&P.

 

*CreditInformation:*****Wemonitor a wide variety of key credit statistics that provide informationregarding our portfolio companies to help us assess credit quality andportfolio performance.  We require ourportfolio companies to provide annual audited and either monthly or quarterlyunaudited financial statements.  Usingthese statements, we calculate and evaluate the credit statistics.  For purposes of analyzing the financialperformance of our portfolio companies, we may make certain adjustments totheir cash flow statements to reflect the pro forma results of a companyconsistent with a change of control transaction, to reflect anticipated costsavings resulting from a merger or restructuring, costs related to new productdevelopment, compensation to previous owners, and other acquisition orrestructuring related items.  For thoseinvestments for which S&P prepares valuation recommendations, we providethis credit information to S&P for its use in preparing itsrecommendations.  For those investmentsfor which S&P does not prepare valuation recommendations, management usesthis credit information in connection with its preparation of valuationrecommendations. 

* *

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

 

We seek tohave our risk rating system mirror the risk rating systems of major risk ratingorganizations such as those provided by nationally recognized statistical ratingorganizations (“NRSRO”) as defined in Rule 2a-7 under the 1940 Act. While weseek to mirror the NRSRO systems, we cannot provide any assurance that our riskrating system provides the same risk rating as a NRSRO. The following chart isan estimate of the relationship of our risk rating system to the designationsused by two NRSROs as they risk rate debt securities of major companies.  Because we have established our system torate debt securities of companies that are unrated by any NRSRO, there can beno assurance that the correlation to the NRSRO set out below is accurate. It isour understanding that most debt securities of middle market companies do notexceed the grade of BBB on a NRSRO scale, so there would be no debt securitiesin the middle market that would meet the definition of AAA, AA or A.  Therefore, our scale begins with thedesignation BBB as the best risk rating.

 

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

 

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

 

Theabove scale gives an indication of the probability of default and the magnitudeof the loss if there is a default. At September 30, 2004, the average debtsecurity was risk rated 7.6 for all debt securities and the weighted averagerisk rating was 7.6 for all debt securities. The following table lists the risk ratings for all of the debtsecurities by quarter during the fiscal year ended September 30, 2005:  

 

| **Rating**        | ** ** | **December 31, 2004** | ** ** | **March 31, 2005** | ** ** | **June 30, 2005** | ** ** | **September 30, 2005** | ** ** |
|-------------------|------------|----------------------------|------------|-------------------------|------------|------------------------|------------|-----------------------------|------------|
| Average           |       | 7.2                        |       | 7.2                     |       | 7.1                    |       | 6.7                         |       |
| Weighted  Average |       | 7.2                        |       | 7.2                     |       | 7.2                    |       | 6.7                         |       |
| Highest           |       | 10.0                       |       | 10.0                    |       | 10.0                   |       | 9.0                         |       |
| Lowest            |       | 5.0                        |       | 5.0                     |       | 5.0                    |       | 5.0                         |       |

 

The above scale gives an indication of the probability of default andthe magnitude of the loss if there is a default.  Our policy is to stop accruinginterest on an investment if we determine that interest is no longercollectible.  At September 30, 2004,no payments were past due on any of our debt securities.  At September 30, 2005, ARI Holdings, Inc. waspast due on its payments and was placed on non-accrual.  We do not risk rate our equity securities.

* *

*ValuationMethods:*  Fordebt securities, we first determine if the debt security is publicly traded(i.e., if it is listed on an exchange or securities market).  If it is publicly traded, then we determinethe value based on the closing price for the security on the exchange orsecurities market on which it is listed on the valuation date.  If the security is not publicly traded, but alimited market for the security exists, such as for a participation in asyndicated loan, then we value it at the indicative bid price offered by thesyndication agent on the valuation date. At September 30, 2005, none of the debt securities in our portfolio werepublicly traded and there was a limited market for 12 debt securities in ourportfolio.  At September 30, 2004, wedetermined that none of the debt securities in our portfolio were publiclytraded and that there was a limited market for five debt securities in ourportfolio.  

 

For debtsecurities that are not publicly traded, for which there is no market, or forwhich there is a market but have not been rated by a NRSRO, we begin with therisk rating designation of the security described above.  Using the risk rating designation above, weseek to determine the value of the security as if we intended to sell thesecurity in a current sale.  To determinethe current sale price of the security, we consider some or all of thefollowing factors:

 

•      financial standing of theissuer of the security;

•      comparison of the businessand financial plan of the issuer with actual results;

•      the cost of the security;

•      the size of the securityheld as it relates to the liquidity of the market for such securities;

•      contractual restrictions onthe disposition of the security;

•      pending public offering ofthe issuer of the security;

 

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•      pending reorganizationactivity affecting the issuer such as mergers or debt restructuring;

•      reported prices of similarsecurities of the issuer or comparable issuers;

•      ability of the issuer toobtain needed financing;

•      changes in the economyaffecting the issuer;

•      recent purchases or sale ofa security of the issuer;

•      pricing by other buyers orsellers of similar securities;

•      financial statements of theborrower;

•      reports from portfoliocompany senior management and ownership;

•      the type of security;

•      cost at date of purchase;

•      size of holding;

•      discount from market valueof unrestricted securities of the same class at the time of purchase;

•      special reports prepared byanalysts;

•      information as to anytransactions or offers with respect to the security;

•      existence of mergerproposals or tender offers affecting the securities;

•      the collateral;

•      the issuer’s ability to makepayments;

•      the current and forecastedearnings of the issuer;

•      sales to third parties ofsimilar securities;

•      statistical ratios comparedto lending standards;

•      statistical ratios comparedto other similar securities; and 

•      other pertinent factors.

 

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

 

Forconvertible debt, equity, success fees or other equity-like securities, wefirst determine if there is any market for the security.  If there is a market, then we determine thevalue based on the market prices for the security, even if that market is notrobust.  At September 30, 2005 andSeptember 30, 2004, there was no market for any of the equity securities weowned.  If there is no market for theequity securities, then we use the same information we would use for a debtsecurity valuation described above, except risk-rating, as well as standardvaluation techniques used by major valuation firms to value the equitysecurities of private companies.  Thesevaluation techniques consist of discounted cash flow of the expected sale pricein the future, valuation of the securities based on recent sales in comparabletransactions, and a review of similar companies that are publicly traded andthe market multiple of their equity securities. At September 30, 2005 and September 30, 2004, we had $37,000 invested,at cost, in equity securities compared to our debt portfolio with a cost basisof $205,338,554 and $149,152,306, respectively.

 

At September30, 2005, we had total unrealized depreciation of $6,231,296, which was mainlycomposed of unrealized depreciation in our senior subordinated term debtinvestment in Finn Corporation (excluding the warrants) of $3,150,000, oursenior subordinated term debt investment in Xspedius Communications of$1,493,182, and our senior term debt in ARI Holdings, Inc. of $1,053,939 (whichwas subsequently sold at the September 30, 2005 reflected fair value), partiallyoffset by unrealized appreciation, most notably on, the value of our warrantsof Finn Corporation, which had an unrealized appreciation of $645,114 and oursenior term debt investment in Woven Electronics Corporation, which hadunrealized appreciation of $431,436. This aforementioned unrealized appreciation plus unrealized appreciationof $625,955 on certain other investments, primarily in our originated loaninvestments and certain syndicate participations, most notably Infor GlobalSolutions, which had unrealized appreciation of $248,750, which resulted inoverall net unrealized depreciation of $4,528,791.  

 

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

 

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**Tax Status**

 

*Federal Income Taxes*

 

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

 

**Revenue Recognition**

 

*Interest Income Recognition*

 

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

 

*Payment in Kind Interest*

 

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

 

*Fee Income*

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies by providingsignificant guidance and counsel concerning the management, operations, orbusiness objective and policies of the respective portfolio company. Prior toOctober 1, 2004, we provided managerial assistance to our portfolio companiesin connection with our investments through our wholly-owned subsidiary,Gladstone Capital Advisers, Inc. Effective October 1, 2004, we began providing these and other servicesthrough our external adviser, Gladstone Management.  Currently, neither we nor Gladstone Managementreceive fees in connection with managerial assistance. However, effective October1, 2004 our adviser, Gladstone Management, receives the fees for the otherservices it provides, and those fees for other services are credited to theinvestment advisory fees due to Gladstone Management.  These other fees are generally paid toGladstone Management in part at the time a prospective portfolio company signsa non-binding term sheet with us, with the remainder paid at the closing of theinvestment.  These fees are generallynon-recurring, are recognized as revenue when earned and are paid directly toGladstone Management by the borrower or potential borrower, effective October1, 2004 and for all future periods.  Theservices Gladstone Management provides vary by investment, but generallyinclude a wide variety of services to the portfolio companies such asinvestment 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.  Anyservices of this nature subsequent to the closing would generally generate aseparate fee at the time of completion. From time to time, we are invited toparticipate as a co-lender in a transaction. In the event that we do notprovide significant services in connection with our investment, loan fees paiddirectly to Gladstone Management in such situations are deferred and amortizedover the life of the loan.  

 

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**RESULTS OF OPERATIONS**

** **

*COMPARISON OF THE FISCAL YEARSENDED SEPTEMBER 30, 2005 AND SEPTEMBER 30, 2004*

* *

**Operating Income**

** **

Operating income for the fiscal year endedSeptember 30, 2005 was $23.9 million as compared to $20.4 million for thefiscal year ended September 30, 2004. This increase is primarily a result of a rise in interest income from anincrease of approximately $143.8 million of new investments from the prior yearand the collection of approximately $1.2 million of exit fees upon the fullrepayment of a portfolio company investment.

 

Interest income from our investments in debtsecurities of private companies was approximately $22.4 million, including $394,000of PIK interest, for the fiscal year ended September 30, 2005 as comparedto $18.2 million for the fiscal year ended September 30, 2004,including $553,000 of PIK interest.  Thisincrease was primarily the result of approximately $143.8 million of newinvestments for the fiscal year ended September 30, 2005 and thecollection of $1.2 million of exit fees upon the full repayment of a portfoliocompany investment.  The decrease in PIKincome for the fiscal year ended September 30, 2005 was the result of scheduledprincipal repayments for one loan containing a PIK provision and an earlyrepayment for another loan containing a PIK provision.

 

The weighted average yield on our portfoliofor the fiscal year ended September 30, 2005 was 12.23% (without givingeffect to PIK interest) and 12.36% (after giving effect to PIK interest). Theweighted average yield on our portfolio for the fiscal year endedSeptember 30, 2004 was 13.44% (without giving effect to PIK interest) and13.78% (after giving effect to PIK interest). The yields were computed based on the cost value of the investmentportfolios.

 

Interest income from invested cash and cashequivalents for the fiscal year ended September 30, 2005 was approximately$33,000, as compared to approximately $84,000 for the fiscal year endedSeptember 30, 2004. This decrease was primarily caused by a decrease incash balances as a result of $143.8 million of new investments and generallymaintaining less cash on hand and using borrowed funds to fund new investments.

 

No fee income was recorded for the fiscalyear ended September 30, 2005, as compared to approximately $1.1 million forthe fiscal year ended September 30, 2004. This decrease was the result of the externalization of our management,effective October 1, 2004, through the engagement of our affiliate, GladstoneManagement, to serve as our external adviser. Gladstone Management receives allfees in connection with our investments and prospective investments, which feesare offset against the advisory fee payable to Gladstone Management.  Fee income for the fiscal year endedSeptember 30, 2004 consisted primarily of investment banking and annualreview fees received in connection with investments we closed during the 2004fiscal year. During the fiscal year ended September 30, 2004, the fee incomewas mainly attributable to the closing of the Gammill, Inc., Woven ElectronicsCorp., Benetech, Inc. Mistras Holdings Corp. ($1.0 million investment), A andG, Inc. and Allied Extruders, Inc. investments, in the approximate aggregateamount of $52.8 million.

 

Prepayment fees and other income wasapproximately $1.1 million for the fiscal year ended September 30, 2005and $573,000 for the fiscal year ended September 30, 2004.  For the fiscal year ended September 30, 2005,this consisted of approximately $1.0 million of early principal payment penaltyfees and approximately $24,000 of waiver fees for certain loan covenants.  For the fiscal year ended September 30,2004, this amount was comprised of $545,000 of early principal payment penaltyfees, $17,000 of waiver fees for certain loan covenants, and $11,000 inup-front fees for a proposed investment. 

 

**Operating Expenses**

** **

Operatingexpenses for the fiscal year ended September 30, 2005 were approximately $7.5million, as compared to approximately $7.1 million for the fiscal year endedSeptember 30, 2004. This increase****wasmainly a result of an increase in interest expense, stockholder related costsand professional 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 fee incurred as a result of thisexternalization.

 

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Loan servicing fees of approximately $2.5 million were incurred for thefiscal year ended September 30, 2005. These fees were incurred in connection with a loan servicing agreementbetween Gladstone Business Loan LLC (“Business Loan”) and Gladstone Management,which became effective July 12, 2004. These fees were directly credited against the amount of the managementfee due to Gladstone Management.  Duringthe fiscal year ended September 30, 2004, loan servicing fees of approximately$502,000 were incurred from the period July 12, 2004, the date that GladstoneManagement began to service our loan portfolio, since prior to that the loanportfolio was serviced under a similar agreement with Gladstone Capital AdvisersInc., our wholly-owned subsidiary, and the fees Business Loan paid to GladstoneCapital Advisers, Inc. were eliminated upon consolidation of our financialresults.

 

EffectiveOctober 1, 2004, we entered into an advisory agreement with Gladstone Managementwhereby Gladstone Management serves as our external adviser.  As compensation for the services of GladstoneManagement, we pay Gladstone Management an annual advisory fee of 1.25% oftotal assets (as reduced by cash and cash equivalents pledged to creditors),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 continue 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, GladstoneManagement provides the managerial assistance and other services to ourportfolio companies that we previously provided through our wholly-ownedsubsidiary Gladstone Capital Advisers, and likewise Gladstone Managementdirectly receives any fees for such services. Any such fees are credited directly against the 2% management feepayable to Gladstone Management.  The 2%management fee is also directly reduced by the amount of the monthly loanservicing fees we pay to Gladstone Management. Overall, the management fee dueto Gladstone Management cannot exceed 2% of total assets (as reduced by cashand cash equivalents pledged 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 three months ended September 30, 2005, June 30, 2005, March 31, 2005 andDecember 31, 2004, based on the quarterly increment of 0.50% (0.3125% quarterlyadvisory fee plus 0.1875% quarterly administrative fee):

 
| ** **                                                       | ** ** | **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 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 Gladstone Management:                   |       | 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)*  *This amount representsborrowings under one of our lines of credit that were held in cash and cashequivalents as of March 31, 2005 and December 31, 2004, for each respective quarter,for the purpose of satisfying our asset diversification requirements under theInternal Revenue Code. There were no borrowings outstanding for this purpose atSeptember 30, 2005 or at June 30, 2005. Solely for the purposes of calculating the amount of the management feedue to Gladstone Management, we treat any such amounts as “cash and cashequivalents pledged to creditors” under the terms of our advisory agreementwith Gladstone Management.  As a result,such amounts are deducted from our total assets for purposes of computing theasset base upon which the management fee is determined.*

 

Professionalfees, 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.

 

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Amortizationof deferred financing costs, in connection with our lines of credit, wereapproximately $386,000 for the fiscal year ended September 30, 2005 andapproximately $1.4 million 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 in September2004.

 

Interestexpense for the fiscal year ended September 30, 2005 was approximately $1,775,000as compared to approximately $742,000 for the fiscal year ended September 30,2004.  This increase is a result ofincreased borrowings under our lines of credit during the fiscal year endedSeptember 30, 2005, which borrowings were used, in part, to finance ourincreased investments, and to a lesser extent, an increase in the interestrate.

 

Stockholderrelated costs for the fiscal year ended September 30, 2005 were approximately$220,000, as compared to approximately $140,000 for the fiscal year endedSeptember 30, 2004.  Stockholder relatedcosts include such recurring items as transfer agent fees, securities fees,electronic filing fees and printing and mailing of annual reports and proxystatements to stockholders.

 

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

 

Insuranceexpense for the fiscal year ended September 30, 2005 was approximately$178,000, as compared to approximately $258,000 for the fiscal year endedSeptember 30, 2004. The decrease is primarily the result of the externalizationof our management.  Effective October 1,2004, Gladstone Management pays general insurance expenses directly and suchinsurance coverage is included in the services we receive in consideration forthe 2% management fee we pay to Gladstone Management.  Insurance expense incurred during the fiscalyear ended September 30, 2005 represents the amortization of our directors andofficers insurance premiums, which are expenses for which we continue to beresponsible following the externalization of our management.

 

EffectiveOctober 1, 2004, all of our employees became employees of Gladstone Managementand therefore no salaries or benefit expenses were incurred by us for thefiscal year ended September 30, 2005, as compared to approximately $2.6 millionfor the fiscal year ended September 30, 2004. We reimburse Gladstone Management for its employee services as part ofthe annual advisory and administrative fees payable under the advisoryagreement.

 

EffectiveOctober 1, 2004, our external adviser, Gladstone Management, began to pay rentdirectly, and therefore for the fiscal year ended September 30, 2005 no rentexpense was incurred by us as compared to approximately $139,000 of rentexpense for the fiscal year ended September 30, 2004.  General overhead expenses, such as rent, arealso included as part of the management fee to Gladstone Management.

 

General andadministrative expenses were approximately $236,000 for the fiscal year endedSeptember 30, 2005, as compared to approximately $702,000 for the fiscal yearended September 30, 2004. This decrease****isprimarily a result of Gladstone Management handling general overhead typeexpenses.  The expenses for the fiscalyear ended September 30, 2005 primarily represent direct expenses such astravel related specifically to our portfolio companies, loan evaluationservices for our portfolio companies, press releases and backup servicerexpenses.

 

**Income TaxExpense**

** **

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 managerial assistance and other fees.  During the fiscal year ended September 30,2005, Gladstone Capital Advisers incurred aggregate federal and state incometaxes of $209,278 resulting from taxable income it received during the 2004fiscal year.  Following theexternalization of our management effective October 1, 2004, substantially allrevenues previously received by Gladstone Capital Advisers are now received byGladstone Management.  As a result, we donot anticipate incurring significant tax expense as a result of the activitiesof Gladstone Capital Advisers in the future.

 

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**RealizedGain on Sale of Investment**

 

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

 

**NetUnrealized Depreciation on Derivative**

 

As a result ofthe decline in fair market value of our interest rate cap agreement, werecorded net unrealized depreciation on derivative of approximately $39,000 forthe fiscal 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. 

 

**NetUnrealized Appreciation (Depreciation) on Investments**

 

For the fiscalyear ended September 30, 2005, we recorded net unrealized depreciation oninvestments of approximately $1.8 million as compared to net unrealizeddepreciation of approximately $2.5 million for the fiscal year ended September30, 2004.  The increase in unrealizeddepreciation is mainly attributable to the decrease in the value of the Finnsenior subordinated term debt of approximately $3.2 million, a decline ofapproximately $1.5 million in the fair value of Xspedius and a decline in thevalue of ARI Holdings, Inc. of approximately $1.1 million, partially offset byappreciation of approximately $645,000 in the value of the Finn warrant, andthe fair value of the success fee on Woven Electronics of approximately $348,000as well as unrealized appreciation on certain of our syndicated loan participations.

 

**Net Increase in Net Assets from Operations**

 

Overall, we realized a net increase in netassets resulting from operations of approximately $15.5 million for the fiscalyear ended September 30, 2005.  Based ona weighted average of 11,292,466 (basic) and 11,609,146 (diluted) sharesoutstanding, our net increase in net assets from operations per weightedaverage common share for the fiscal year ended September 30, 2005 was $1.37(basic) and $1.33 (diluted).

 

For the fiscal year endedSeptember 30, 2004, we realized a net increase in net assets resulting from operations ofapproximately $10.6 million.  Based on aweighted average of 10,101,341 (basic) and 10,344,388 (diluted) sharesoutstanding, our net increase in net assets resulting from operations per weightedaverage common share for the fiscal year ended September 30, 2004 was $1.05(basic) and $1.02 (diluted).

 

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

* *

**Operating Income**

** **

Operating income for the fiscal year ended September 30,2004 was $20.4 million as compared to $15.2 million for the fiscal year endedSeptember 30, 2003.  This increaseis primarily a result of a rise in interest income from an increase ofapproximately $86.3 million of new investments from the prior year and thecollection of approximately $1.8 million of exit fees upon the full repaymentof three portfolio company investments.

 

Interest income from our investments in debtsecurities of private companies was approximately $18.2 million, including $553,000of PIK interest, for the fiscal year ended September 30, 2004 as comparedto $13.2 million for the fiscal year ended September 30, 2003,including $781,000 of PIK interest.  Thisincrease was primarily the result of approximately $86.3 million of newinvestments for the fiscal year ended September 30, 2004 and thecollection of $1.8 million of exit fees upon the full repayment of threeportfolio company investments.  Thedecrease in PIK income for the fiscal year ended September 30, 2004 was the resultof scheduled principal repayments for one loan containing the PIK provision.

 

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

 

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

 

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

 

Fee income was approximately $1.1 million forthe fiscal year ended September 30, 2004 and $886,000 for the fiscal yearended September 30, 2003.  Fee incomefor each of the fiscal years ended September 30, 2004 and 2003 consistedprimarily of investment banking and review fees received in connection withinvestments we closed during the respective fiscal year. During the fiscal yearended September 30, 2004, the increase was mainly attributable to theclosing of the Gamill, Inc., Woven Electronics Corp., Benetech, Inc. MistrasHoldings Corp. ($1.0 million investment), A and G, Inc. and Allied Extruders,Inc. investments, in the approximate aggregate amount of $52.8 million, ascompared to the fiscal year ended September 30, 2003 closings of WingstopRestaurants, America’s Water Heater Rentals, Fugate and Associates, MistrasHoldings Corp. ($15.0 million investment), and ARI Holdings Inc. investments inthe approximate aggregate amount of $47.0 million.

 

Prepayment fees and other income wasapproximately $573,000 for the fiscal year ended September 30, 2004 and $117,000for the fiscal year ended September 30, 2003.  For the fiscal year ended September 30,2004, this amount was comprised of $545,000 of early principal payment penaltyfees, $17,000 in waiver fees for certain loan covenants, and $11,000 inup-front fees for a proposed investment. For the fiscal year ended September 30, 2003, this amount was comprisedof $60,000 in waiver fees for certain loan covenants, $30,000 in earlyprincipal payment penalty fees, $25,000 in up-front fees for a proposedinvestment and $2,000 in other income.

 

**Operating Expenses**

** **

Operating expenses for the fiscal year ended September 30,2004 were approximately $7.1 million, compared to approximately $3.9million for the fiscal year ended September 30, 2003. This increase wasprimarily a result of the increase in salaries and benefits, professional fees,directors’ fees, financing fees incurred in connection with the credit linefacility we established in fiscal year 2003 and the line of credit entered intoin June 2004, as well as interest and loan servicing expenses.

 

Salaries and benefits for the fiscal yearended September 30, 2004 were approximately $2.6 million, as comparedto approximately $2.0 million for the fiscal year ended September 30, 2003.The primary reason for the increase was the Board of Directors’ declaration ofan $800,000 performance-based bonus during the fiscal year ended September 30,2004.  Although during the fiscal yearended September 30, 2004, salaries and benefits were allocated in accordancewith an expense sharing arrangement with Gladstone Management Corporation thatallocated expenses to Gladstone Management Corporation based on each employee’stime spent on Gladstone Commercial Corporation’s matters, no portion of thisbonus was allocated to Gladstone Management Corporation as it was solelyattributable to the performance of Gladstone Capital Corporation.  Without giving effect to the bonus, salariesand benefits slightly decreased as compared to the fiscal year ended September30, 2003.  Although employee head countincreased from the prior fiscal year, the cost of the increase was offset by thesavings attributable to the expense sharing arrangement with GladstoneManagement Corporation. 

 

Rent expense for the fiscal year endedSeptember 30, 2004 was approximately $139,000 as compared to $210,000 forthe fiscal year ended September 30, 2003. This decrease in rent was due to the expense sharing arrangement withGladstone Management, which allocated general expenses to Gladstone Managementbased on the ratio of all employees’ time spent of Gladstone CommercialCorporation’s matters to total time spent. 

 

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

 

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

 

General insurance expense for the fiscal year ended September 30,2004 was approximately $259,000 as compared to $276,000 for the fiscal yearended September 30, 2003.  Althoughoverall premiums have increased, the general insurance expense decreased forthe fiscal year ended September 30, 2004 as compared to the fiscal year endedSeptember 30, 2003 as a result of the expense sharing arrangement with GladstoneManagement which allocated general expenses to Gladstone Management based on aratio of all employees’ time spent of Gladstone Commercial Corporation’s matterto total time spent. 

 

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

 

Financing fees for the fiscal year ended September 30, 2004 wereapproximately $1.4 million compared to financing fees for the fiscal year endedSeptember 30, 2003 of approximately $222,000.  These fees represent the amortization ofcertain capitalized costs in connection with establishing the lines ofcredit.  In May 2003, we entered into awarehouse line of credit with CIBC World Markets Inc. The interest of CIBCWorld Markets Inc. was subsequently assigned to Deutsche Bank AG in September2004.  As a result of this transaction,approximately $1.2 million of capitalized fees were expensed.  Some of the increase in financing fees is aresult of the incurrence of financing fees related to this line of credit forthe full fiscal year ended September 30, 2004, as compared to a shorter periodof time during the fiscal year ended September 30, 2003.  Monthly fees associated with the line ofcredit are included in these financing fees. We also entered into an operating line of credit with Branch Banking andTrust Company (“BB&T”) in June 2004, and likewise incurred certaintransaction costs which are amortized into financing fees.  The fiscal year ended September 30, 2003 wasthe first year in which these charges were incurred.  

 

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

 

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

 

General and administrative expenses, consisting primarily of officeoperations, travel and data communications, for the fiscal year endedSeptember 30, 2004 were approximately $702,000, as compared toapproximately $507,000 for the fiscal year ended September 30, 2003. Theseincreases were largely related to the recruiting and addition of several newemployees, the expansion of our operations, as well as the disposal of inactivefixed assets, and an increase in depreciation due to the addition of newcomputers for new employees.  Despitethese increases, depreciation expense decreased overall due to the sale of allfixed assets to Gladstone Management on July 1, 2004 at net book value, and assuch no depreciation was recorded for the last fiscal quarter of the fiscalyear ended September 30, 2004.  Certaingeneral and administrative expenses were allocated in accordance with theexpense sharing arrangement with Gladstone Management, which allocated generalexpense to Gladstone Management based on the ratio of all employees’ time spenton Gladstone Commercial Corporation matters which partially offset the increasein these general and administrative expenses.

 

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

 

During the fiscal year ended September 30, 2004, we bought and soldshortly thereafter a $1.0 million investment in Metokote Corporation for a gainof $12,500.

 

As a result ofthe decline in fair market value of our interest rate cap agreement, werecorded net unrealized depreciation of approximately $214,000 for the fiscalyear ended September 30, 2004.  Therewere no derivatives in place during the previous fiscal year.

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

 

**Net Increase in Net Assets from Operations**

 

We had a net increase in net assets resulting from operations ofapproximately $10.6 million for the fiscal year ended September 30,2004. Based on a weighted-average of 10,101,341 (basic) and 10,344,388(diluted) shares outstanding, our net increase in net assets resulting fromoperations per common share for the fiscal year ended September 30, 2003was $1.05 (basic) and $1.02 (diluted).

 

We had a net increase in net assets resulting from operations ofapproximately $11.1 million for the fiscal year ended September 30,2003. Based on a weighted-average of 10,072,677 (basic) and 10,188,488(diluted) shares outstanding, our net increase in net assets resulting fromoperations per common share for the fiscal year ended September 30, 2003was $1.10 (basic) and $1.09 (diluted).

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

At September 30, 2005, we had investments in debt securities, or loansto or syndicated participations in, 28 private companies, totalingapproximately $205.4 million (cost basis) of total assets, which includesapproximately $254,000 in accrued PIK interest income for the fiscal year endedSeptember 30, 2005.  AtSeptember 30, 2004, we had investments in debt securities, or loans to orsyndicated participations in, sixteen private companies totaling approximately$149.2 million (cost basis), including approximately $553,000 in accrued PIK interest.  At September 30, 2003, we hadinvestments in debt securities of, or loans to, eleven private companies,totaling approximately $109.5 million of total investment assets,including approximately $807,000 in accrued PIK interest.  PIK interest is described in “Overview,” andis added to our carrying value of our investments.

 

*During the fiscal years ended September 30,2005 and September 30, 2004, the following investment activity occurred duringeach quarter of the respective fiscal year:*

 

| **Quarter Ended**  | ** ** | **New Investments** | ** **  | **Principal Repayments** | ** ** | **Gain on Disposal** | ** ** |
|--------------------|------------|---------------------|-------------|--------------------------|------------|----------------------|------------|
|               |       |                |        |                     |       |                 |       |
| 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               |       | —               |       |
|               |       | $                   | 143,794,006 |                     | $          | 88,019,136           |       | $ | 29,750 |   |

 

| **Quarter Ended**  | ** ** | **New Investments** | ** ** | **Principal Repayments** | ** ** | **Gain on Disposal** | ** ** |
|--------------------|------------|---------------------|------------|--------------------------|------------|----------------------|------------|
|               |       |                |       |                     |       |                 |       |
| 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               |       | —               |       |
|               |       | $                   | 86,267,500 |                     | $          | 47,158,995           |       | $ | 12,500 |   |

 

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

 

| **Fiscal Year Ended September 30,** | ** ** | **Amount** | ** **  |
|-------------------------------------|------------|------------|-------------|
|                                |       |       |        |
| 2006                                |       | $          | 18,405,925  |   |
| 2007                                |       | 27,729,206 |        |
| 2008                                |       | 23,459,590 |        |
| 2009                                |       | 29,797,766 |        |
| 2010                                |       | 45,022,499 |        |
| Thereafter                          |       | 60,960,568 |        |
|                                |       | $          | 205,375,554 |   |

 

Net cash provided by operating activities forthe fiscal year ended September 30, 2005, consisting primarily of the itemsdescribed in “Results of Operations”, was approximately $15.6 million ascompared to net cash provided by operating activities of approximately $13.5million for the fiscal year ended September 30, 2004.  Net cash used in investing activities wasapproximately $76.3 million for the fiscal year ended September 30, 2005 andmainly consisted of new investments of approximately $143.8 million and therepayment of the repurchase agreement of approximately $21.3 million, partiallyoffset by principal repayments of approximately $88.0 million.  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.  

 

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During the fiscal year ended September 30,2005, cash and cash equivalents decreased from approximately $66.0 million atthe beginning of the year to approximately $504,000 at the end of theyear.  This decrease was largely theresult of the purchase of new investments, the repayment of the repurchaseagreement in October 2004 and also the payment of dividends throughout thefiscal year ended September 30, 2005.

 

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

 

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

 

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

 

On September 29, 2004, we entered into a repurchase agreement (the “FBWRepurchase Agreement”) with Ferris Baker Watts, Incorporated for $44,984,950.On September 30, 2004, this amount was reduced to $21,345,997 with theapplication of the net proceeds from a public offering of our commonstock.  This remaining balance wassettled on October 1, 2004.  The FBWRepurchase 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 FBWRepurchase Agreement was 4.25% for a cost of $7,831. In the future, we may usea similar form of repurchase agreement as an investment option or in order tosatisfy certain asset diversification requirements and maintain our status as aRIC under Subchapter M of the Internal Revenue Code.

 

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

 

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

 

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

 

Aggregate dividends declared and paid for the 2003 fiscal year wereapproximately $11.1 million.  Thisresulted in our net investment income exceeding the dividends related to our2003 fiscal year by $0.3 million. 

 

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

 

**Revolving Credit Facility**

 

Through our wholly-owned subsidiary Gladstone Business Loan LLC (“BusinessLoan”), the Company has obtained a $100 million revolving credit facility.  On May 19, 2003, the Company executed aPurchase and Sale Agreement pursuant to which it agreed to sell certain loansto Business Loan in consideration of a membership interest therein.  Simultaneously, Business Loan executed aCredit Agreement with CIBC World Markets Inc. (“CIBC”), as administrativeagent, and others, pursuant to which Business Loan pledged the loans purchasedfrom the Company to secure future advances by certain institutionallenders.  On September 28, 2004, CIBCassigned its interest in the credit facility to Deutsche Bank AG, which maturedon May 26, 2005 and was renewed for one year, due to mature on May 26, 2006 fora fee of $105,000 (as renewed, the “DB Facility”). Interest rates charged onthe advances 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, 2005, the outstanding principal balance under this credit facility wasapproximately $53.0 million at an interest rate of 3.71%, as compared to theoutstanding principal balance under this credit facility of approximately $25.7million at an interest rate of 3.29% at September 30, 2004.  Available borrowings are subject to variousconstraints imposed by Deutsche Bank AG, based on the aggregate loan balancepledged by Business Loan, which varies as loans or added and repaid, regardlessof whether such repayments are early prepayment or are made as contractuallyrequired.  At September 30, 2005, theremaining borrowing capacity available under the DB Facility was approximately$37.8 million.  We are in the process ofnegotiating a renewal of this DB Facility, however there can be no guaranteethat we will be able to renew the DB Facility on terms that are favorable tous, if at all.  In the event that we arenot able to renew or refinance the DB Facility this could have a materialadverse impact on our liquidity and ability to fund new investments.  In October 2005, our Board of Directorsapproved a resolution to seek to increase this credit facility to $150 million.

 

The facility contains covenants that require Business Loan to maintainits status as a separate entity; prohibit certain significant corporatetransactions (such as mergers, consolidations, liquidations or dissolutions);and restrict material changes to the Company’s credit and collectionpolicies.  The facility also restrictssome of the terms and provisions (including interest rates, terms to maturityand payments schedules) and limits the borrower and industry concentrations ofloans that are eligible to secure advances. As of September 30, 2005, Business Loan was in compliance with allof the facility covenants.  We currentlyintend to securitize all of the loans held by Business Loan and if we are ableto do so, we will use the proceeds from the securitization to pay down anyamounts then outstanding under the revolving credit facility.  

 

The administrative agent also requires that any interest or principalpayments on pledged loans be remitted directly by the borrower into a lockboxaccount with the Bank of New York as custodian. Deutsche Bank AG is also the trustee of the account and once a monthremits the collected funds to the Company. For the fiscal year ended September30, 2005, the amount due from custodian increased by approximately $1.4 millionas compared to September 30, 2004.

 

Gladstone Management, our affiliated external adviser, services theloans pledged under the DB Facility.  Asa condition to this servicing arrangement, we executed a performance guarantypursuant to which we guaranteed that Gladstone Management would comply fullywith all of its obligations under the facility. The performance guarantyrequires us to maintain a minimum net worth of $100 million and to maintain “assetcoverage” with respect to “senior securities representing indebtedness” of atleast 200%, in accordance with Section 18 of the 1940 Act.  As of September 30, 2005, we were incompliance with our covenants under the performance guaranty.

 

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In June 2004, we entered into a $15.0 million line of credit agreementwith Branch Banking and Trust Company (“BB&T Agreement”) which matured onJune 1, 2005 and which was modified to extend the maturity date to December 31,2005.  Interest on outstanding borrowingsis based upon the one month LIBOR plus 2.5% per annum.  The unused portion of the line of credit issubject to a fee of 0.2% per annum.  TheBB&T Agreement requires the Company to meet and maintain certain covenantsand ratios with respect to leverage and liquidity. As of September 30, 2005,there were no borrowings outstanding under the BB&T line of credit.  As of September 30, 2004, there was $15.0million outstanding under the BB&T line of credit at an interest rate of4.34%.  At September 30, 2005, we werein compliance with all covenants under the BB&T Agreement.

 

The following table shows our significant contractual obligations forthe repayment of debt and payment of other contractual obligations as ofSeptember 30, 2005:

 
| ** **                                                                                   | ** ** | **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)                                                              |       | $                          | 53,034,064 |   | $ | 53,034,064 |   | — |   | — |   | — |   |
| Capital  Lease Obligations                                                                   |       | —                     |       | — |   | — |   | — |   | — |   |
| Operating Lease  Obligations                                                                 |       | —                     |       | — |   | — |   | — |   | — |   |
| Purchase  Obligations (2)                                                                    |       | 12,000,000                 |       | 12,000,000 |   | — |   | — |   | — |   |
| Other Long-Term Liabilities Reflected on  the Registrant’s Balance Sheet under GAAP (3) |       | 391,322                    |       | 391,322 |   | — |   | — |   | — |   |
| Total                                                                                        |       | $                          | 65,425,386 |   | $ | 65,425,386 |   | — |   | — |   | — |   |

 

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(1)           Thelong-term debt obligations represent borrowings under our DB Facility line ofcredit that were outstanding at September 30, 2005.  This line of credit is scheduled to mature onMay 26, 2006.  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)           The purchaseobligations reflected in the above table represent commitments outstanding asof September 30, 2005 to fund two loan investments which were subsequentlyclosed in October and November 2005.

 

(3)           Pursuant tothe investment advisory and administrative agreement with Gladstone Management,we are obligated to make certain payments to Gladstone Management on aquarterly basis.  Payments under the investmentadvisory and administrative agreement consist of an annual advisory fee of1.25% of our total assets (as reduced by cash and cash equivalents pledged tocreditors), payable in quarterly increments of 0.3125%, and an annualadministrative fee of 0.75% of our total assets (as reduced by cash and cashequivalents pledged to creditors), payable in quarterly increments of 0.1875%.  As the payments under the investment advisoryand administrative agreement will vary based on changes in our total assetsduring any given payment period, we cannot accurately predict the amount ofpayments under the advisory agreement. We are also responsible under Gladstone Business Loan to pay GladstoneManagement a loan servicing fee at an annual rate of 1.5% of the monthlyaggregate outstanding loan balance of the loans pledged under the DB Facility.For the fiscal year ended September 30, 2005, the amount of fees incurred by uswhich were payable to Gladstone Management were $2,832,271, of which $391,322was outstanding as of September 30, 2005. Since the investment advisory and administrative agreement is based ontotal assets outstanding at each quarter end and the loan servicing fee isbased on the monthly aggregate outstanding loan balance, it is not feasible atthis time to determine the amount of future payments under these agreements. Aswe expect to continue to make more investments in future fiscal years, we expectthat the amount of our total assets may increase, and thus, the contractualobligations attributable to advisory fee payments under the advisory agreementare likely to increase and likewise, as the loan portfolio increases ordecreases as a result of new loans, or principal repayments, the amount of theloan servicing fee will adjust accordingly.

 

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

 

We are subjectto financial market risks, including changes in interest rates.  We expectthat ultimately approximately 20% of the loans in our portfolio will be made atfixed rates, with approximately 80% made at variable rates.  Currently ourportfolio has approximately 16% of the total of the loan portfolio cost basisat fixed rates, approximately 43% of the total loan portfolio cost basis atvariable rates with a floor, approximately 3% of the total loan portfolio costbasis at a variable rate with a floor and ceiling, and the remaining 38% of thetotal loan portfolio cost basis at variable rates. 

 

In addition,we have two variable rate borrowing facilities. We have a $100 million revolving credit facility with Deutsche Bank AGwhich matures in May 2006.  We also havea $15 million line of credit agreement with Branch Banking and Trust Companywhich matures in December 2005.

 

In February2004, we entered into an interest rate cap agreement in order to fulfill anobligation under our Deutsche Bank AG line of credit to enter into certain hedgingtransactions in connection with our borrowings under the line of credit. We purchased this interest rate cap agreement with a notional amount of$35 million for a one-time, up-front payment of $304,000.  The interestrate cap agreement entitles us to receive payments, if any, equal to the amountby which interest payments on $35 million at the point which one month LIBOR exceed the payments on $35 million at5%.  The cap expires in February 2009.  This interest rate capagreement effectively caps our interest payments on our line of creditborrowing, up to the notional amount of the interest rate cap, at five percent. This mitigates our exposure to increases in interest rates on ourborrowings on our lines of credit, which are at variable rates.  At September 30, 2005, the cap agreement hada fair market value of $50,253 and a current notional amount of $27.5million.  At September 30, 2005, the one monthLIBOR rate was approximately 3.86%.

 

To illustratethe potential impact of changes in interest rates on our net increase in netassets resulting from operations, we have performed the following analysis,which assumes that our balance sheet remains constant and no further actionsbeyond the interest rate cap agreement are taken to alter our existing interestrate sensitivity.  Under this analysis, ahypothetical increase in the one month LIBOR by 1% would increase our netincrease in net assets resulting from operations by approximately $1.3 millionor 8.3%, over the next twelve months, compared to the net increase in netassets resulting from operations for the twelve months ended September 30,2005.  A hypothetical decrease in the onemonth LIBOR by 1% would decrease net increase in net assets resulting fromoperations by approximately $1.3 million, or 8.3%, over the next twelve months,compared to the net increase in net assets resulting from operations for thetwelve months ended September 30, 2005. 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 eventthat we securitize a portion of our loan portfolio, we believe that we willlikely be required to enter into further hedging arrangements in the futurewith respect to securitized loans.  Whilehedging activities may mitigate our exposure to adverse fluctuations ininterest rates, certain hedging transactions that we may enter into in the future,such as interest rate swap agreements, may also limit our ability toparticipate in the benefits of lower interest rates with respect to ourportfolio of investments.

 

45

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**Item 8. Financial Statements andSupplementary Data**

 

**Index to Consolidated Financial Statements**

 
| Report of Independent Registered Public Accounting Firm                                                                                        |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Statements of Assets and Liabilities as of  September 30, 2005 and September 30, 2004                                   |   |
| Consolidated  Schedules of Investments as of September 30, 2005 and September 30,  2004                                              |   |
| Consolidated Statements of Operations for the years ended September  30, 2005, September 30, 2004, and September 30, 2003            |   |
| Consolidated Statements of Changes in Net Assets for the years ended  September 30, 2005, September 30, 2004, and September 30, 2003 |   |
| Consolidated Statements of Cash Flows for the years ended September  30, 2005, September 30, 2004, and September 30, 2003            |   |
| Financial  Highlights for the years ended September 30, 2005, September 30, 2004, and  September 30, 2003                                      |   |
| Notes to Consolidated Financial Statements                                                                                                     |   |

 

**Management’s Report on the Financial Statements**

 

Our management is responsible for the preparation, integrity andobjectivity of the accompanying consolidated financial statements and therelated financial information.  Thefinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America and necessarilyinclude certain amounts that are based on estimates and informed judgments. Ourmanagement also prepares the related financial information included in thisAnnual Report on Form 10-K and is responsible for its accuracy and consistencywith the financial statements. 

 

The consolidated financial statements have been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,who conducted their audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). The independent registeredpublic accounting firm’s responsibility is to express an opinion as to thefairness with which such financial statements present our financial position,results of operations and cash flows in accordance with accounting principlesgenerally accepted in the United States.

 

**Management’s Annual Report on Internal Control over Financial Reporting**

 

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting as defined in Rule 13a-15(f) under the Securities ExchangeAct of 1934. Our internal control over financial reporting is designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles and include those policies andprocedures 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. 

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Therefore, even those systems determined to be effectivecan provide only reasonable assurance with respect to financial statementpreparation and presentation. 

 

Under the supervision andwith the participation of our management, we assessed the effectiveness of ourinternal control over financial reporting as of September 30, 2005, usingthe criteria set forth by the Committee of Sponsoring Organizations of theTreadway Commission (COSO) in Internal Control—Integrated Framework. Based onits assessment, management has concluded that our internal control overfinancial reporting was effective as of September 30, 2005. 

 

46

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**Report of Independent Registered PublicAccounting Firm**

 

To the Stockholders and Board of Directors of

Gladstone Capital Corporation:

** **

We have completed an integrated audit ofGladstone Capital Corporation’s 2005 consolidated financial statements and ofits internal control over financial reporting as of September 30, 2005 andaudits of its 2004 and 2003 consolidated financial statements in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Our opinions, based on our audits, are presented below.

 

Consolidated financial statementsand financial statement schedules

 

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in allmaterial respects, the financial position of Gladstone Capital Corporation atSeptember 30, 2005 and September 30, 2004, and the results of its operationsand its cash flows for each of the three years in the period ended September30, 2005 in conformity with accounting principles generally accepted in theUnited States of America.  In addition, in our opinion, the financial statementschedules listed in the accompanying index present fairly, in all materialrespects, the information set forth therein when read in conjunction with therelated consolidated financial statements. These financial statements and financial statement schedules arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements and financial statement schedules****basedon our audits.  We conducted our auditsof these statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit of financialstatements includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, in our opinion, management’s assessment, included in Management’sAnnual Report on Internal Control Over Financial Reporting appearing under item9A, that the Company maintained effective internal control over financialreporting as of September 30, 2005 based on criteria established in *Internal Control - Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), isfairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of September 30, 2005, based oncriteria established in *Internal Control -Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment 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 Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions. 

 

A company’s internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.  A company’s internal controlover financial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations 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. 

 

47

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Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

 
| /s/ PricewaterhouseCoopers LLP |   |
|--------------------------------|--------|
| McLean, Virginia               |
| December 13, 2005              |

 

48

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF ASSETS ANDLIABILITIES**

 
| ** **                                                                                                                               | ** ** | **September 30,  2005** | ** **  | **September 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-------------------------|------------|
|                                                                                                                                     |       |                    |        |                    |       |
| ASSETS                                                                                                                                   |       |                    |        |                    |       |
| Investments  at fair value (Cost 9/30/2005: $205,375,554; 9/30/2004: $149,189,306)                                                       |       | $                       | 200,846,763 |                    | $          | 146,446,240 |   |
| Cash and  cash equivalents                                                                                                               |       | 503,776                 |        | 15,969,890              |       |
| Cash and  cash equivalents pledged to creditors                                                                                          |       | —                  |        | 49,984,950              |       |
| Interest  receivable – investments in debt securities                                                                               |       | 1,406,212               |        | 837,336                 |       |
| Interest  receivable – officers                                                                                                     |       | 27,067                  |        | 112,960                 |       |
| Due from  custodian                                                                                                                      |       | 2,624,074               |        | 1,203,079               |       |
| Due from  affiliate                                                                                                                      |       | —                  |        | 109,639                 |       |
| Deferred  financing fees                                                                                                                 |       | 70,000                  |        | 350,737                 |       |
| Prepaid  assets                                                                                                                          |       | 177,848                 |        | 191,676                 |       |
| Other assets                                                                                                                             |       | 137,354                 |        | 127,220                 |       |
| TOTAL ASSETS                                                                                                                             |       | $                       | 205,793,094 |                    | $          | 215,333,727 |   |
|                                                                                                                                     |       |                    |        |                    |       |
| LIABILITIES                                                                                                                              |       |                    |        |                    |       |
| Accounts  payable                                                                                                                        |       | $                       | 205,600     |                    | $          | 105,921 |   |
| Fees due to  affiliate                                                                                                                   |       | 391,322                 |        | 113,511                 |       |
| Borrowings  under lines of credit                                                                                                        |       | 53,034,064              |        | 40,743,547              |       |
| Accrued  expenses and deferred liabilities                                                                                               |       | 350,665                 |        | 798,096                 |       |
| Funds held  in escrow                                                                                                                    |       | 200,760                 |        | —                  |       |
| Repurchase  agreement                                                                                                                    |       | —                  |        | 21,345,997              |       |
| Total  Liabilities                                                                                                                       |       | 54,182,411              |        | 63,107,072              |       |
| Net Assets                                                                                                                               |       | $                       | 151,610,683 |                    | $          | 152,226,655 |   |
|                                                                                                                                     |       |                    |        |                    |       |
| ANALYSIS OF  NET ASSETS                                                                                                                  |       |                    |        |                    |       |
| Common stock, $0.001 par value, 50,000,000  shares authorized and 11,303,510 and 11,278,510 shares issued and  outstanding, respectively |       | $                       | 11,304      |                    | $          | 11,279 |   |
| Capital in  excess of par value                                                                                                          |       | 164,610,873             |        | 164,294,781             |       |
| Notes  receivable – officers                                                                                                        |       | (8,745,781              | )           | (9,432,678              | )          |
| Net  unrealized depreciation on investments                                                                                              |       | (4,528,791              | )           | (2,743,066              | )          |
| Unrealized  depreciation on derivative                                                                                                   |       | (253,747                | )           | (214,259                | )          |
| Realized  gain on sale of investments                                                                                                    |       | 42,250                  |        | 12,500                  |       |
| Distributions  less than net investment income                                                                                           |       | 474,575                 |        | 298,098                 |       |
| Total Net  Assets                                                                                                                        |       | $                       | 151,610,683 |                    | $          | 152,226,655 |   |
| Net Assets  Per Share                                                                                                                    |       | $                       | 13.41       |                    | $          | 13.50 |   |

 

*The accompanying notes are an integral partof these consolidated financial statements.*

 

49

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OF INVESTMENTS**

**SEPTEMBER 30, 2005**

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

 

50

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

 

51

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| **Company (1)**               | ** ** | **Industry**                       | ** ** | **Investment  (2)**               | ** ** | **Cost**  |            | **Fair  Value** | ** ** |
|-------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|-----------|-----------------|-----------------|------------|
| Woven Electronics Corporation |       | Custom electrical cable assemblies |       | Senior Term Debt (4) (6) (10)     |       |      |            |            |       |
|                          |       |                               |       | (11.5%, Due 3/2009)               |       | 8,344,999 |            | 8,776,435       |       |
|                          |       |                               |       |                              |       |      |            |            |       |
| Xspedius Communications LLC   |       | Service-telecommunications         |       | Senior Subordinated Term Debt (6) |       |      |            |            |       |
|                          |       |                               |       | (14.3%, Due 3/2010)               |       | 5,972,727 |            | 4,479,545       |       |
|                          |       |                               |       |                              |       |      |            |            |       |
| **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 Standard & Poor’s Loan EvaluationServices.

(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 successfee with a $347,986 fair value and no cost basis.

(11) Non-income producingat September 30, 2005.

(12) Subsequent toSeptember 30, 2005, the entire investment in the portfolio company was sold atthe fair value reflected herein. 

 

*The accompanying notes are an integral partof these consolidated financial statements.*

 

52

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OF INVESTMENTS**

**SEPTEMBER 30, 2004**

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

 

53

----

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

 

----

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

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

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

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

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

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

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

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

 

*The accompanying notes are an integral partof these consolidated financial statements.*

 

54

----

 

**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                              | ** ** | **Year Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| INVESTMENT INCOME                                                                       |       |                         |       |   |   |   |   |
| Interest income – investments                                                      |       | $                            | 22,407,605 |   | $ | 18,176,617 |   | $ | 13,248,415 |   |
| Interest income – cash and cash equivalents                                        |       | 32,807                       |       | 84,273 |   | 466,316 |   |
| Interest income – notes receivable from  employees                                 |       | 444,170                      |       | 443,658 |   | 437,737 |   |
| Fee income (Refer to Note 10)                                                           |       | —                       |       | 1,118,106 |   | 885,500 |   |
| Prepayment fees and other income                                                        |       | 1,065,177                    |       | 573,314 |   | 116,906 |   |
| Total investment income                                                                 |       | 23,949,759                   |       | 20,395,968 |   | 15,154,874 |   |
|                                                                                    |       |                         |       |   |   |   |   |
| EXPENSES                                                                                |       |                         |       |   |   |   |   |
| Loan servicing (Refer to Note 12)                                                       |       | 2,549,728                    |       | 501,670 |   | — |   |
| Management fee (Refer to Notes 11 and 12)                                               |       | 1,359,643                    |       | — |   | — |   |
| Professional fees                                                                       |       | 725,336                      |       | 579,599 |   | 409,826 |   |
| Amortization of deferred financing costs                                                |       | 385,737                      |       | 1,373,415 |   | 222,038 |   |
| Interest                                                                                |       | 1,774,629                    |       | 741,621 |   | — |   |
| Stockholder related costs                                                               |       | 220,445                      |       | 140,090 |   | 143,273 |   |
| Directors fees                                                                          |       | 101,843                      |       | 112,210 |   | 73,647 |   |
| Insurance                                                                               |       | 178,214                      |       | 258,358 |   | 275,511 |   |
| Salaries and benefits                                                                   |       | —                       |       | 2,554,490 |   | 2,018,004 |   |
| Rent                                                                                    |       | —                       |       | 139,399 |   | 209,864 |   |
| General and administrative                                                              |       | 235,861                      |       | 702,341 |   | 506,790 |   |
| Expenses before credit from Gladstone  Management                                       |       | 7,531,436                    |       | 7,103,193 |   | 3,858,953 |   |
| Credit to management fee for fees collected  by Gladstone Management (Refer to Note 11) |       | (1,077,100                   | )          | — |   | — |   |
| Total expenses net of credit to management  fee                                         |       | 6,454,336                    |       | 7,103,193 |   | 3,858,953 |   |
| NET INVESTMENT INCOME BEFORE INCOME TAXES                                               |       | 17,495,423                   |       | 13,292,775 |   | 11,295,921 |   |
| Income tax expense                                                                      |       | 209,278                      |       | — |   | — |   |
| NET INVESTMENT INCOME                                                                   |       | 17,286,145                   |       | 13,292,775 |   | 11,295,921 |   |
|                                                                                    |       |                         |       |   |   |   |   |
| REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:                                     |       |                         |       |   |   |   |   |
| Realized gain on sale of investment                                                     |       | 29,750                       |       | 12,500 |   | — |   |
| Unrealized depreciation on derivative                                                   |       | (39,488                      | )          | (214,259 | ) | — |   |
| Net unrealized depreciation on investments                                              |       | (1,785,725                   | )          | (2,520,726 | ) | (222,340 | ) |
| Net loss on investments                                                                 |       | (1,795,463                   | )          | (2,722,485 | ) | (222,340 | ) |
|                                                                                    |       |                         |       |   |   |   |   |
| NET INCREASE IN NET ASSETS RESULTING FROM  OPERATIONS                                   |       | $                            | 15,490,682 |   | $ | 10,570,290 |   | $ | 11,073,581 |   |
|                                                                                    |       |                         |       |   |   |   |   |
| NET INCREASE IN NET ASSETS RESULTING FROM  OPERATIONS PER COMMON SHARE:                 |       |                         |       |   |   |   |   |
| Basic                                                                                   |       | $                            | 1.37       |   | $ | 1.05 |   | $ | 1.10 |   |
| Diluted                                                                                 |       | $                            | 1.33       |   | $ | 1.02 |   | $ | 1.09 |   |
|                                                                                    |       |                         |       |   |   |   |   |
| WEIGHTED AVERAGE SHARES OF COMMON STOCK  OUTSTANDING:                                   |       |                         |       |   |   |   |   |
| Basic                                                                                   |       | 11,292,466                   |       | 10,101,341 |   | 10,072,677 |   |
| Diluted                                                                                 |       | 11,609,146                   |       | 10,344,388 |   | 10,188,488 |   |

 

*The accompanying notes are an integral partof these consolidated financial statements.*

 

55

----

 

**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF CHANGES IN NETASSETS**

 
| ** **                                                         | ** ** | **Year Ended September 30,** | ** **  |
|--------------------------------------------------------------------|------------|------------------------------|-------------|
| ** **                                                         | ** ** | **2005**                     | ** **  | **2004** | ** ** | **2003** | ** ** |
| *Operations:*                                                      |       |                         |        |   |   |   |   |
| Net investment income                                              |       | $                            | 17,286,145  |   | $ | 13,292,775 |   | $ | 11,295,921 |   |
| Net realized gain on sale of investments                           |       | 29,750                       |        | 12,500 |   | — |   |
| Unrealized depreciation on derivatives                             |       | (39,488                      | )           | (214,259 | ) | — |   |
| Net unrealized depreciation on investments                         |       | (1,785,725                   | )           | (2,520,726 | ) | (222,340 | ) |
| Net increase in net assets from operations                         |       | 15,490,682                   |        | 10,570,290 |   | 11,073,581 |   |
|                                                               |       |                         |        |   |   |   |   |
| *Capital transactions:*                                            |       |                         |        |   |   |   |   |
| Distributions to stockholders                                      |       | (17,109,668                  | )           | (12,578,583 | ) | (11,082,328 | ) |
| Tax return of capital to stockholders                              |       | —                       |        | (1,207,143 | ) | — |   |
| Issuance of common stock under shelf  offering                     |       | —                       |        | 24,855,525 |   | — |   |
| Shelf offering costs                                               |       | (111,233                     | )           | (476,168 | ) | — |   |
| Issuance of common stock under stock option  plan                  |       | 427,350                      |        | 707,090 |   | 150,000 |   |
| Note receivable issued from sale of common  stock                  |       | (157,100                     | )           | (549,990 | ) | (150,000 | ) |
| Repayment of principal on employee notes                           |       | 843,997                      |        | 103,252 |   | 147,856 |   |
| (Decrease) increase in net assets from  capital share transactions |       | (16,106,654                  | )           | 10,853,983 |   | (10,934,472 | ) |
|                                                               |       |                         |        |   |   |   |   |
| Total (decrease) increase in net assets                            |       | (615,972                     | )           | 21,424,273 |   | 139,109 |   |
| Net assets at beginning of year                                    |       | 152,226,655                  |        | 130,802,382 |   | 130,663,273 |   |
| Net assets at end of year                                          |       | $                            | 151,610,683 |   | $ | 152,226,655 |   | $ | 130,802,382 |   |

* *

*The accompanying notes are an integral partof these consolidated financial statements.*

 

56

----

 

**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                                    | ** ** | **Year Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                                                                      |       |                         |       |   |   |   |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| Net increase in net assets resulting from  operations                                                                         |       | $                            | 15,490,682 |   | $ | 10,570,290 |   | $ | 11,073,581 |   |
| Adjustments to reconcile net increase in  net assets resulting from operations to net cash provided by operating  activities: |       |                         |       |   |   |   |   |
| Depreciation                                                                                                                  |       | —                       |       | 24,356 |   | 29,310 |   |
| Net amortization of premiums and discounts                                                                                    |       | (1,635                       | )          | 2,036 |   | — |   |
| Amortization of deferred financing costs                                                                                      |       | 385,737                      |       | 1,303,776 |   | — |   |
| Unrealized depreciation on derivative                                                                                         |       | 39,488                       |       | 214,259 |   | — |   |
| Change in net unrealized depreciation                                                                                         |       | 1,785,725                    |       | 2,520,726 |   | 222,340 |   |
| (Increase) decrease in interest receivable                                                                                    |       | (482,983                     | )          | 201,259 |   | (352,018 | ) |
| (Increase) decrease in funds due from  custodian                                                                              |       | (1,420,995                   | )          | 3,921 |   | (1,207,000 | ) |
| Decrease (increase) in prepaid assets                                                                                         |       | 13,828                       |       | 201,275 |   | (34,996 | ) |
| Decrease (increase) in due from affiliate                                                                                     |       | 109,639                      |       | (67,508 | ) | (42,131 | ) |
| (Increase) decrease in other assets                                                                                           |       | (49,622                      | )          | 33,188 |   | (42,485 | ) |
| Increase in accounts payable                                                                                                  |       | 99,679                       |       | 82,674 |   | 23,247 |   |
| Increase in fees due to affiliate                                                                                             |       | 277,811                      |       | — |   | — |   |
| Decrease in accrued expenses and deferred  liabilities                                                                        |       | (447,431                     | )          | (1,053,418 | ) | 1,020,065 |   |
| Increase in funds held in escrow                                                                                              |       | 200,760                      |       | — |   | — |   |
| Increase in investment balance due to  payment in kind interest                                                               |       | (409,743                     | )          | (552,944 | ) | (806,088 | ) |
| Net cash provided by operating activities                                                                                     |       | 15,590,940                   |       | 13,483,890 |   | 9,883,825 |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                                     |       |                         |       |   |   |   |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| Purchase of investments                                                                                                       |       | (143,794,006                 | )          | (86,267,500 | ) | (47,011,278 | ) |
| Principal repayments on investments                                                                                           |       | 88,019,136                   |       | 47,158,995 |   | 18,005,827 |   |
| Proceeds from repurchase agreements                                                                                           |       | —                       |       | 285,099,546 |   | 245,070,973 |   |
| Repayment of repurchase agreements                                                                                            |       | (21,345,997                  | )          | (342,202,549 | ) | (205,820,693 | ) |
| Receipt of principal on notes receivable -  officers                                                                          |       | 843,997                      |       | 103,252 |   | 147,856 |   |
| Sale (purchase) of furniture &  equipment - net                                                                           |       | —                       |       | 117,365 |   | (82,344 | ) |
| Net cash (used in) provided by investing  activities                                                                          |       | (76,276,870                  | )          | (95,990,891 | ) | 10,310,341 |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                                     |       |                         |       |   |   |   |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| Net proceeds from issuance of common shares                                                                                   |       | —                       |       | 24,379,357 |   | — |   |
| Borrowings from the lines of credit                                                                                           |       | 155,000,000                  |       | 114,743,547 |   | — |   |
| Repayments on the lines of credit                                                                                             |       | (142,709,483                 | )          | (74,000,000 | ) | — |   |
| Deferred financing fees                                                                                                       |       | (105,000                     | )          | (567,649 | ) | (1,086,864 | ) |
| Shelf offering costs                                                                                                          |       | (111,233                     | )          | — |   | — |   |
| Distributions paid                                                                                                            |       | (17,109,668                  | )          | (17,112,735 | ) | (9,870,409 | ) |
| Purchase of derivative                                                                                                        |       | —                       |       | (304,000 | ) | — |   |
| Exercise of employee stock options                                                                                            |       | 270,250                      |       | 157,100 |   | — |   |
| Net cash (used in) provided by financing  activities                                                                          |       | (4,765,134                   | )          | 47,295,620 |   | (10,957,273 | ) |
|                                                                                                                          |       |                         |       |   |   |   |   |
| **NET (DECREASE) INCREASE IN CASH AND CASH  EQUIVALENTS (1)**                                                                 |       | (65,451,064                  | )          | (35,211,381 | ) | 9,236,893 |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF  PERIOD**                                                                           |       | 65,954,840                   |       | 101,166,221 |   | 91,929,328 |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                                                                  |       | $                            | 503,776    |   | $ | 65,954,840 |   | $ | 101,166,221 |   |
|                                                                                                                          |       |                         |       |   |   |   |   |
| **CASH PAID DURING PERIOD FOR INTEREST**                                                                                      |       | $                            | 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                  |       | $                            | 157,100    |   | $ | 549,990 |   | $ | 150,000 |   |

 

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(1)   Cash and cash equivalents consist of demanddeposits and highly liquid investments with original maturities of three monthsor less when purchased.

 

*The accompanying notes are an integral partof these consolidated financial statements.*

 

57

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**GLADSTONE CAPITAL CORPORATION**

**FINANCIAL HIGHLIGHTS**

 
| ** **                                            | ** ** | **Year Ended September 30,** | ** **  |
|-------------------------------------------------------|------------|------------------------------|-------------|
| ** **                                            | ** ** | **2005**                     | ** **  | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                         |        |   |   |   |   |
| Per Share Data (1)                                    |       |                         |        |   |   |   |   |
| Net asset value at beginning of period                |       | $                            | 13.50       |   | $ | 12.97 |   | $ | 12.97 |   |
| *Income from investment operations:*                  |       |                         |        |   |   |   |   |
| Net investment income (2)                             |       | 1.53                         |        | 1.32 |   | 1.12 |   |
| Realized gain on sale of investment (2)               |       | —                       |        | — |   | — |   |
| Net unrealized loss on investments (2)                |       | (0.16                        | )           | (0.25 | ) | (0.02 | ) |
| Net unrealized loss on derivatives (2)                |       | —                       |        | (0.02 | ) | — |   |
| Total from investment operations                      |       | 1.37                         |        | 1.05 |   | 1.10 |   |
| Less distributions:                                   |       |                         |        |   |   |   |   |
| Distributions from net investment income              |       | (1.52                        | )           | (1.25 | ) | (1.10 | ) |
| Tax return of capital distribution                    |       | —                       |        | (0.12 | ) | — |   |
| Total distributions                                   |       | (1.52                        | )           | (1.37 | ) | (1.10 | ) |
| Issuance of common stock under shelf  offering        |       | —                       |        | 0.99 |   | — |   |
| Issuance of common stock under stock option  plan     |       | 0.02                         |        | 0.01 |   | — |   |
| Offering costs and underwriting discount              |       | (0.01                        | )           | (0.16 | ) | — |   |
| Repayment of principal on notes receivable            |       | 0.07                         |        | 0.01 |   | — |   |
| Dilutive effect of share issuance                     |       | (0.02                        | )           | — |   | — |   |
| Net asset value at end of period                      |       | $                            | 13.41       |   | $ | 13.50 |   | $ | 12.97 |   |
|                                                  |       |                         |        |   |   |   |   |
| Per share market value at beginning of  period        |       | $                            | 22.71       |   | $ | 19.45 |   | $ | 16.88 |   |
| Per share market value at end of period               |       | 22.55                        |        | 22.71 |   | 19.45 |   |
| Total Return (3)                                      |       | 5.93                         | %           | 24.40 | % | 21.74 | % |
| Shares outstanding at end of period                   |       | 11,303,510                   |        | 11,278,510 |   | 10,081,844 |   |
|                                                  |       |                         |        |   |   |   |   |
| Ratios/Supplemental Data                              |       |                         |        |   |   |   |   |
| Net assets at end of period                           |       | $                            | 151,610,683 |   | $ | 152,226,655 |   | $ | 130,802,382 |   |
| Average net assets                                    |       | $                            | 151,897,549 |   | $ | 130,385,129 |   | $ | 132,196,505 |   |
| Ratio of expenses to average net assets (4)           |       | 5.10                         | %           | 5.45 | % | 2.92 | % |
| Ratio of net expenses to average net assets  (5)      |       | 4.39                         | %           | 5.45 | % | 2.92 | % |
| Ratio of net investment income to average  net assets |       | 11.38                        | %           | 10.20 | % | 8.38 | % |

 

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(1)           Basic per share data.

(2)           Based on weighted average basic per share data.

(3)           Total return equals the increase of the ending market value overthe beginning market value plus monthly dividends divided by the monthlybeginning market value, assuming monthly dividend reinvestment.

(4)           Ratio of expenses to average net assets is computed using expensesbefore credit from Gladstone Management and including income tax expense.

(5)           Ratio of net expenses to average net assets is computed usingtotal expenses net of credits to management fee and including income taxexpense.

 

*THE ACCOMPANYINGNOTES ARE AN INTEGRAL PART TO THESE CONSOLIDATED FINANCIAL STATEMENTS.*

 

58

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**GLADSTONE CAPITAL CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30, 2005**

 

**Note 1. Organization**

 

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

 

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

 

The Company isexternally managed by Gladstone Management Corporation (“Gladstone Management”),an unconsolidated affiliate of the Company.

 

**Note 2. Summary of SignificantAccounting Policies**

 

*Basis of Presentation*

 

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

 

*Use of Estimates*

 

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

 

*Reclassifications*

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

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents consist of demand deposits and highly liquidinvestments with original maturities of three months or less when purchased.Cash and cash equivalents are carried at cost which approximates fair value asof September 30, 2005 and September 30, 2004. Cash and cash equivalentspledged to creditors as of September 30, 2004 consists of the UnitedStates Treasury Bill that collateralizes the Company’s Repurchase Agreement.

 

*Concentration of Credit Risk*

 

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

 

59

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*Investment Valuation*

 

TheCompany carries its investments at fair value, as determined by its Board ofDirectors.  Securities that are publiclytraded are valued at the closing price on the valuation date.  Securities for which a limited market exists,such as participations in syndicated loans, are valued at the indicative bidprice on the valuation date from the respective originating syndication agent’strading desk.  Debt and equity securitiesthat are not publicly traded are valued at fair value as determined in goodfaith by the Board of Directors. The Company currently engages Standard &Poor’s Loan Evaluation Service (S&P) to perform independent valuations ofits investments.  The Board of Directorsuses the recommended valuations as prepared by S&P as a component of thefoundation for the final fair value determination.  In making such determination, the Board ofDirectors values non-convertible debt securities at cost plus amortizedoriginal issue discount plus payment in kind (“PIK”) interest, if any, unlessadverse factors lead to a determination of a lesser valuation.  In valuing convertible debt, equity, successor exit fees or other equity like securities, the Board of Directors determinesthe fair value based on the collateral, the issuer’s ability to make payments,the earnings of the issuer, sales to third parties of similar securities, thecomparison to publicly traded securities, discounted cash flow and otherpertinent factors.  Due to the uncertaintyinherent in the valuation process, such estimates of fair value may differsignificantly from the values that would have resulted had a ready market forthe securities existed, and the differences could be material. Additionally,changes in the market environment and other events that may occur over the lifeof the investments may cause the gains ultimately realized on these investmentsto be different than the valuation currently assigned.  Because there is a lag between when theCompany closes a loan and when the loan can be evaluated by S&P, new loansare not valued immediately by S&P; rather, the Board of Directors makes itsown determination about the value of the loan in accordance with the Company’svaluation policy without the input of S&P. Because S&P does not perform independent valuations of mortgageloans or equity securities, the Board of Directors also determines the fairvalue of these investments without the input of S&P.  The Board of Directors considers a number ofqualitative and quantitative factors in current market conditions whenperforming valuations.

 

*Interest Income Recognition*

 

Interest income, adjusted for amortization of premiums and accretion ofdiscounts, is recorded on the accrual basis to the extent that such amounts areexpected to be collected. The Company stops accruing interest on itsinvestments when it is determined that interest is no longer collectible.  Conditional interest or a success fee isrecorded when earned upon full repayment of a loan investment.

 

*Payment in Kind Interest*

 

The Company has loans in its portfolio which contain a payment in kind(“PIK”) provision. The PIK interest, computed at the contractual rate specifiedin each loan agreement, is added to the principal balance of the loan andrecorded as income. To maintain the Company’s status as a RIC, this non-cashsource of income must be paid out to stockholders in the form of dividends,even though the Company has not yet collected the cash. For the years endedSeptember 30, 2005, September 30, 2004 and September 30, 2003, theCompany recorded PIK income of $394,985, $553,409, and $781,407, respectively. 

 

*Fee Income*

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies. The 1940 Actdefines managerial assistance as the service made available to a portfoliocompany to provide “significant guidance and counsel concerning the management,operations, or business objectives 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, Gladstone Management.  Neitherthe Company nor its external investment adviser, Gladstone Management, chargesa fee for managerial assistance. However, in the past the Company and, since October 1, 2004, GladstoneManagement, have provided other services to portfolio companies in addition tomanagerial assistance.  These otherservices include a wide variety of services to the portfolio companies such asinvestment 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. Gladstone Management is charging for these services and is crediting thefunds received from these other services to the Company as a credit against theinvestment advisory fee due from the Company under the investment advisoryagreement.  Such fees are normally paidin part at the time of signing a non-binding letter of intent, with theremainder paid upon completion of the services, and are generallynon-recurring.  

 

60

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*Property and Equipment*

 

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

* *

*Stock Options*

 

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

 

In December2004, the Financial Accounting Standards Board (“FASB”) approved the revisionof SFAS 123, “Accounting for Stock-Based Compensation, and issued the revisedSFAS Statement No. 123(R), “Share-Based Payment.”  SFAS 123(R) effectively replaces SFAS 123,and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”  (Please refer to *NewAccounting Pronouncements*below for explanation of financialstatement impact.) 

 

*Advisory Agreement with Gladstone Management Corporation*

 

Effective October 1, 2004, pursuant to the advisory agreement withGladstone Management, an unconsolidated affiliate of the Company, wherebyGladstone Management would serve as an external adviser to the Company.  As compensation for the services of GladstoneManagement, the Company pays Gladstone Management an annual advisory fee of1.25% of the Company’s total assets (as reduced by cash and cash equivalentspledged to creditors), payable in quarterly increments of 0.3125%, and anannual administrative fee of 0.75% of the Company’s total assets (as reduced bycash and cash equivalents pledged to creditors), payable in quarterlyincrements of 0.1875%, for a total aggregate annual fee of 2%. The Companycontinues to pay direct expenses including, but not limited to, directors’fees, legal and accounting fees, stockholder related expenses and directors andofficers insurance.

 

Gladstone Management services the loans held by Business Loan, inreturn for which, Gladstone Management receives a 1.5% annual fee based on themonthly aggregate balance of loans held by Business Loan.  Since the Company owns these loans, all loanservicing fees paid to Gladstone Management are also credited directly againstthe 2% management fee.  These creditsreduce the amount of the investment advisory fee.  Under the advisory agreement, GladstoneManagement also provides the managerial assistance and other services that theCompany previously made available to its portfolio companies through itswholly-owned subsidiary Gladstone Capital Advisers, Inc.  To the extent that Gladstone Managementreceives any fees directly from a portfolio company for such services,Gladstone Management credits these fees directly against the 2% management feeOverall, the management fee due to Gladstone Management cannot exceed 2% oftotal assets (as reduced by cash and cash equivalents pledged to creditors)during any given fiscal year.  

 

In July 2003,the Company entered into an expense sharing arrangement with GladstoneManagement, a registered investment adviser that serves as the external adviserto Gladstone Commercial Corporation, a real estate investment trust, anaffiliate. Under this expense sharing arrangement, Gladstone Managementreimbursed 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). Gladstone Management alsoreimbursed Gladstone 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). Gladstone Management further passed its share ofthese expenses along to Gladstone Commercial under a separate advisoryagreement. As a result of this expense sharing arrangement, certain expenses,such as rent and insurance, declined during the fiscal year ended September 30,2004.** **Followingthe engagement of Gladstone Management on October 1, 2004, the first day of the2005 fiscal year, Gladstone Management now directly employs all personneland pays the payroll, benefits, and general expenses directly.  Thus, the expense sharing arrangement betweenGladstone Capital Advisers and Gladstone Management terminated upon theexternalization of management on October 1, 2004.

 

61

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The Company was self-managed and therefore did not incur managementfees payable to third parties during the fiscal years ended September 30, 2004and September 30, 2003.

 

*Federal Income Taxes*

 

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

 

*Dividends*

 

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

 

*New Accounting Pronouncements*

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement (“SFAS”)No. 123(R), “Share-Based Payments”, which effectively replaced SFAS No.123, “Accounting for Stock-Based Compensation” and superseded AccountingPrinciples Board Opinion (“APB”) No. 25, “Accounting for Stock Issued toEmployees”. SFAS 123(R) requires that companies record the fair value of theirstock-based compensation arrangements on the date they are granted toemployees, as a liability or as a component of equity, depending on whether theobligations can be settled in cash or stock. Regardless of treatment asliabilities or equity, these amounts must be expensed over the vesting periodof the compensation arrangements. Under SFAS 123(R), the Company will berequired to select a valuation technique, or option-pricing model that meets thecriteria as stated in the standard. Allowable valuation models include a binomial model and the Black-Scholesmodel.  The Company is required to adoptthe provisions of SFAS 123(R) at the start of the 2006 fiscal year.  The Company has historically providedpro-forma disclosures pursuant to SFAS No. 123 and SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure” as if the fair valuemethod of accounting for stock options had been applied, assuming use of theBlack-Scholes option-pricing model and that all option grants were recorded atfair value.  There was no cumulativeeffect of the accounting change recognized as a result of the adoption of SFASNo. 123(R) and the Company is using the modified prospective method, whichaccounts prospectively for new stock-based compensation arrangement and theunvested portion of existing arrangements. This will result in the Company expensing approximately $320,000 thatwould previously have been presented in a pro-forma disclosure and alsoincludes the amount of accelerated vesting expense as a result of thestockholder approval of the Amended Advisory Agreement. (Please refer to Note16. Subsequent Events for an explanation of the Amended Advisory Agreement.)

 

In May 2005, the FASB issuedSFAS No. 154, “Accounting Changes and Error Corrections”, a replacement of APBOpinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting AccountingChanges in Interim Financial Statements” and changes the requirements for theaccounting for and reporting of a change in accounting principle.  SFAS 154 applies to all voluntary changes inaccounting principle and also applies to changes required by an accountingpronouncement in the unusual instance that the pronouncement does not includespecific transition provisions.  SFAS 154requires retrospective application to prior periods’ financial statements ofchanges in accounting principle.  SFAS154 is effective for accounting changes and corrections of errors made infiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections oferrors made in fiscal years beginning after the date of issuance.  The Company is required to adopt theprovisions of SFAS 154, as applicable, beginning in fiscal year 2007.  The Company does not expect thispronouncement to have a material impact on the Company’s financial position ornet increase to net assets resulting from operations. 

 

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**Note 3. Common Stock Transactions**

** **
| ** **                                        | ** ** | **Common Stock** | ** ** |
|---------------------------------------------------|------------|------------------|------------|
| ** **                                        | ** ** | **Shares**       | ** ** | **Amount** | ** ** |
| Balance at September 30, 2002                     |       | 10,071,844       |       | $ | 10,072 |   |
| Issuance of Common Stock Under Stock Option  Plan |       | 10,000           |       | 10 |   |
| 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 |   |

 

**Note 4. Stock Option Plan**

 

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

 

Options granted under the 2001 Plan may be either incentive stockoptions or nonstatutory stock options.  The option exercise price is equal to the market price on the date ofthe grant.  For the options grantedduring fiscal year 2005, 3% vest immediately, 50% vest one year after the grantdate and 47% vest on the second year anniversary of the grant date. For theoptions granted during fiscal year 2004, 50% vest after one year after thegrant date and the remaining 50% vest on the second year anniversary of thegrant date. A portion of the options granted during the fiscal years endedSeptember 30, 2003 and September 30, 2002 and each option grantedduring the period from inception through September 30, 2001 vest asfollows: one-half of the number of shares issuable upon exercise of the optionvested immediately on the grant date and the remaining shares vest on the datethat is one year after the grant date. The remaining options granted during thefiscal year ended September 30, 2002 vest as follows: 60% of the sharesissuable upon exercise of the options vested immediately on the grant date andthe remaining shares vest on the date that is one year after the grant date.  Some of the options granted during the fiscalyear ended September 30, 2003 vested at 25% on the grant date, 25% twomonths after the grant date, 25% seven months after the grant date and thefinal 25% vest one year and two months after the grant date.

 

The Company currently accounts for the issuance of stock optionsthrough the Amended and Restated 2001 Equity Incentive Plan (the “Plan”) inaccordance with APB 25.  In connectionwith the externalization of the Company’s management, all of its officers andemployees became direct employees of Gladstone Management Corporation as ofOctober 1, 2004, the start of fiscal year 2005. However, these individuals continue to be eligible to receive stockoptions under the Plan.  EffectiveOctober 1, 2004, the Company accounted for any options granted to employees ofGladstone Management Corporation, who qualify as leased employees of theCompany under FIN 44, “Accounting for Certain Transactions Involving StockCompensation, an Interpretation of APB Opinion No. 25.”

 

In December 2004, the FASB issued SFAS 123(R).  The new standard is effective for awards thatare granted, modified, or settled in cash for annual periods beginning afterJune 15, 2005.  The adoption of SFAS123(R) will require the Company to begin expensing unvested or newly grantedstock options as compensation cost on October 1, 2005, the start of the Company’s2006 fiscal year. 

 

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| ** **                                                                                                  | ** ** | **Year Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                        |       |                         |       |   |   |   |   |
| Net increase in net assets resulting from  operations                                                       |       |                         |       |   |   |   |   |
| As reported:                                                                                                |       | $                            | 15,490,682 |   | $ | 10,570,290 |   | $ | 11,073,581 |   |
|                                                                                                        |       |                         |       |   |   |   |   |
| Deduct: Total stock-based compensation  expense determined using the fair value based method for all awards |       | (297,391                     | )          | (1,687,199 | ) | (1,576,555 | ) |
|                                                                                                        |       |                         |       |   |   |   |   |
| Pro forma net increase in net assets  resulting from operations per share                                   |       | $                            | 15,193,291 |   | $ | 8,883,091 |   | $ | 9,497,026 |   |
|                                                                                                        |       |                         |       |   |   |   |   |
| As reported - basic                                                                                         |       | $                            | 1.37       |   | $ | 1.05 |   | $ | 1.10 |   |
| As reported - diluted                                                                                       |       | $                            | 1.33       |   | $ | 1.02 |   | $ | 1.09 |   |
|                                                                                                        |       |                         |       |   |   |   |   |
| Pro forma-basic                                                                                             |       | $                            | 1.35       |   | $ | 0.88 |   | $ | 0.94 |   |
| Pro forma-diluted                                                                                           |       | $                            | 1.31       |   | $ | 0.86 |   | $ | 0.93 |   |

 

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 30,2005, 2004 and 2003.

 

| **Assumptions:**         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       | 3.41     | %          | 2.41     | %          | 0.95     | %          |
| Expected  life           |       | 3 years  |       | 3 years  |       | 3 years  |       |
| Expected  volatility     |       | 17.67    | %          | 16.91    | %          | 17.71    | %          |
| Expected  dividend yield |       | 6.07     | %          | 6.67     | %          | 6.79     | %          |

 

The weighted average per share fair value based on the Black-Scholesoption pricing model of options granted during the fiscal years ended September30, 2005, 2004 and 2003, were $1.71, $1.24, and $2.29, respectively.

 

A summary of the status of the Company’s 2001 Plan from September 30,2003 through September 30, 2005 is as follows:

 
| ** **                                                                            | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|
|                                                                                  |       |       |       |                                 |       |
| Options outstanding at September 30, 2003,  of which 841,664 shares were exercisable  |       | 981,664    |       | $                                    | 15.71      |   |
| Granted                                                                               |       | 325,500    |       | $                                    | 22.20      |   |
| Exercised                                                                             |       | (46,666    | )          | $                                    | 15.15      |   |
|                                                                                  |       |       |       |                                 |       |
| Options outstanding at September 30, 2004,  of which 897,496 shares 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      |   |

 

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A detailed summary of the stock options outstanding at fiscal yearsended September 30, 2005, September 30, 2004 and September 30, 2003is presented in the following table:

 
| **Fiscal Year Ended** | ** ** | **Range of Exercise Prices** | ** ** | **Stock Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life (Years)** | ** ** |
|-----------------------|------------|------------------------------|------------|--------------------------------|------------|-----------------------------------------------------------|------------|
|                  |       |                         |       |                           |       |                                                      |       |
| September 30,  2005   |       | $15.00 - $24.39              |       | 1,307,998                      |       | 7.03                                                      |       |
| September  30, 2004   |       | $15.00 - $22.84              |       | 1,260,498                      |       | 7.88                                                      |       |
| September  30, 2003   |       | $15.00 - $19.56              |       | 981,664                        |       | 8.33                                                      |       |

 

During the fiscal year ended September 30, 2005, the Company issued25,000 shares, 10,000 to a director and 15,000 to two employees pursuant tostock option exercises, in exchange for cash of $270,250 and one full recoursenote receivable of $157,100. During the fiscal year ended September 30,2004, the Company issued 46,666 shares of common stock to three employees pursuantto a stock option exercise, in exchange for cash of $157,100 and two fullrecourse notes receivable of $549,990.  Duringthe fiscal year ended September 30, 2003, the Company issued 10,000 sharesof common stock to an employee pursuant to a stock option exercise, in exchangefor a full recourse note receivable of $150,000.  These transactions were effected pursuant tothe 2001 Plan, which allows the Company to lend its employees funds to pay forthe exercise of stock options. All loans made under this arrangement are fullysecured by the value of the common stock purchased. Interest is charged andpaid on such loans at the market rate as determined based on individualfinancial positions.

 

**Note 5. Commitments and Contingencies**

 

At September 30, 2005, the Company was party to a signed andnon-binding term sheet for one potential investment for $10.0 million and also receivedan allocation for a $2.0 million syndicate loan participation. The futurescheduled contractual payments at September 30, 2005 are as follows:

 
| ** **                  | ** ** | ** ** | ** ** | **Payment Due by Period** | ** ** |
|-----------------------------|------------|------------|------------|---------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **Less than 1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than   5 Years** | ** ** |
|                        |       |       |       |                      |       |   |   |   |   |   |   |
| Investments                 |       | 12,000,000 |       | 12,000,000                |       |   |   |   |   |   |   |
| Total                       |       | $          | 12,000,000 |                      | $          | 12,000,000 |   | $ | — |   | $ | — |   | $ | — |   |
|                             |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |

 

All prospective investments are subject to, among other things, thesatisfactory completion of the Company’s due diligence investigation of eachborrower, acceptance of terms and structure and receipt of necessary consents.With respect to each prospective loan, the Company will only agree to providethe loan if, among other things, the results of its due diligenceinvestigations are satisfactory, the terms and conditions of the loan areacceptable and all necessary consents are received. The Company has initiatedits due diligence investigations of the potential borrowers, however there canbe no guarantee that facts will not be discovered in the course of completingthe due diligence that would render a particular investment imprudent or thatany of these investments will actually be made.

 

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**Note 6. Net Increase in Net AssetsResulting 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 2005, September 30, 2004, and September 30, 2003:

 
| ** **                                                                                      | ** ** | **Year Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                            |       |                         |       |   |   |   |   |
| Numerator for basic and diluted net  increase in net assets resulting from operations per share |       | $                            | 15,490,682 |   | $ | 10,570,290 |   | $ | 11,073,581 |   |
|                                                                                            |       |                         |       |   |   |   |   |
| Denominator for basic weighted average  shares                                                  |       | 11,292,466                   |       | 10,101,341 |   | 10,072,677 |   |
| Dilutive effect of stock options                                                                |       | 316,680                      |       | 243,047 |   | 115,811 |   |
| Denominator for diluted weighted average  shares                                                |       | 11,609,146                   |       | 10,344,388 |   | 10,188,488 |   |
|                                                                                            |       |                         |       |   |   |   |   |
| Basic net increase in net assets resulting  from operations per share                           |       | $                            | 1.37       |   | $ | 1.05 |   | $ | 1.10 |   |
|                                                                                            |       |                         |       |   |   |   |   |
| Diluted net increase in net assets resulting  from operations per share                         |       | $                            | 1.33       |   | $ | 1.02 |   | $ | 1.09 |   |

 

**Note 7. Related Party Transactions**

 

The Company has provided loans to employees for the exercise of optionsunder the 2001 Plan. The loans require the quarterly payment of interest at themarket rate of interest in effect at the date of issue, have varying terms notexceeding nine years and have been recorded as a reduction of stockholders’equity. The loans are evidenced by full recourse notes that are due uponmaturity or 60 days following termination of employment, and the shares ofcommon stock purchased with the proceeds of the loan are posted as collateral. Duringthe fiscal year ended September 30, 2005, the Company issued a loan to oneemployee for $157,100 for exercise of stock options and received the fullrepayment of three loans that were issued during fiscal years 2001, 2003, and2004. 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 issued during fiscal year 2002. During thefiscal year ended September 30, 2003, the Company issued a $150,000 loanto an employee for the exercise of options and received the final payment for aloan issued during fiscal year 2001. The Company recognized interest incomefrom all employee stock option loans of $444,170, $443,658 and $437,737 duringthe fiscal years ended September 30, 2005, September 30, 2004 andSeptember 30, 2003, respectively. The outstanding principal balances dueon all employee stock option loans at September 30, 2005, September 30,2004, and September 30, 2003 were $8,745,781, $9,432,678, and $8,985,940,respectively.

 

During the fiscal year ended September 30, 2003, the Company paidpersonnel recruiting fees totaling $2,269 to Snelling & Associates and$4,625 to Medical Funding Corporation. Anthony W. Parker, a director of the Company is the President ofSnelling & Associates and is the founder, Chairman and President of MedicalFunding Corporation. There were no such transactions during the fiscal yearsended September 30, 2005 and September 30, 2004.

 

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

 

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**Note 8. Repurchase Agreement**

 

A repurchase agreement involves the purchase by an investor, such asthe Company, of a specified security and the simultaneous agreement by theseller to repurchase it at an agreed upon future date and at a price which isgreater than the purchase price by an amount that reflects an agreed-uponinterest rate. Such interest rate is effective for the period of time duringwhich the investor’s money is invested in the arrangement and is related tocurrent market interest rates rather than the coupon rate on the purchasedsecurity. The Company requires the continual maintenance by its custodian orthe correspondent in its account with the Federal Reserve/Treasury Book EntrySystem of underlying securities in an amount at least equal to the repurchaseprice. If the seller were to default on its repurchase obligation, the Companymight suffer a loss to the extent that the proceeds from the sale of theunderlying securities were less than the repurchase price. A seller’s bankruptcycould delay or prevent a sale of the underlying securities.

 

The Company had no outstanding repurchase agreement at 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 theRepurchase Agreement was 4.25% for a cost of $7,831.

 

**Note 9. Dividends**

 

Thefollowing table illustrates the 2005 and 2004 fiscal year monthly dividends pershare:

 

| **Fiscal  Year** | ** ** | **Record Date**    | ** ** | **Payment Date**   | ** ** | **Dividend per  Share** | ** ** |
|------------------|------------|--------------------|------------|--------------------|------------|-------------------------|------------|
| 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      |       | $                       | 0.13       |   |
|             |       | May 13, 2005       |       | May 27, 2005       |       | $                       | 0.13       |   |
|             |       | April 15, 2005     |       | April 29, 2005     |       | $                       | 0.13       |   |
|             |       | March 18, 2005     |       | March 31, 2005     |       | $                       | 0.12       |   |
|             |       | February 11, 2005  |       | February 28, 2005  |       | $                       | 0.12       |   |
|             |       | January 14, 2005   |       | January 28, 2005   |       | $                       | 0.12       |   |
|             |       | December 17, 2004  |       | December 30, 2004  |       | $                       | 0.12       |   |
|             |       | November 17, 2004  |       | November 30, 2004  |       | $                       | 0.12       |   |
|             |       | October 18, 2004   |       | October 29, 2004   |       | $                       | 0.12       |   |
|             |       |               |       | Annual Total:      |       | $                       | 1.515      |   |
|             |       |               |       |               |       |                    |       |
| 2004             |       | September 17, 2004 |       | September 30, 2004 |       | $                       | 0.12       |   |
|             |       | August 18, 2004    |       | August 31, 2004    |       | $                       | 0.12       |   |
|             |       | July 19, 2004      |       | July 30, 2004      |       | $                       | 0.12       |   |
|             |       | June 17, 2004      |       | June 30, 2004      |       | $                       | 0.115      |   |
|             |       | May 17, 2004       |       | May 28, 2004       |       | $                       | 0.115      |   |
|             |       | April 19, 2004     |       | April 30, 2004     |       | $                       | 0.115      |   |
|             |       | March 18, 2004     |       | March 31, 2004     |       | $                       | 0.11       |   |
|             |       | February 16, 2004  |       | February 27, 2004  |       | $                       | 0.11       |   |
|             |       | January 19, 2004   |       | January 30, 2004   |       | $                       | 0.11       |   |
|             |       | December 18, 2003  |       | December 31, 2003  |       | $                       | 0.11       |   |
|             |       | November 17, 2003  |       | November 28, 2003  |       | $                       | 0.11       |   |
|             |       | October 20, 2003   |       | October 31, 2003   |       | $                       | 0.11       |   |
|             |       |               |       | Annual Total:      |       | $                       | 1.365      |   |

 

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Aggregate dividends declared and paid for the 2005 fiscal year wereapproximately $17.1 million which were declared based on an estimate of netinvestment income for the year.  Netinvestment income exceeded dividends declared by approximately $0.2 million.  

 

Aggregate dividends declared and paid for the 2004 fiscal year wereapproximately $13.8 million which were declared based on an estimate of netinvestment income for the year.  Sincenet investment income was lower than projected, due to the expensing of certainprepaid assets associated with financing fees surrounding the line of credit,it lead to dividends exceeding net investment income for the year byapproximately $0.5 million.  Therefore, approximately$1.2 million of the 2004 dividends were treated as a tax return of capital tothe Company’s stockholders.

** **

**Note 10. Fee Income**

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies. The 1940 Actdefines managerial assistance as the service made available to a portfoliocompany to provide “significant guidance and counsel concerning the management,operations, or business objectives 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, Gladstone Management.  Neitherthe Company nor its external investment adviser, Gladstone Management, chargesa fee for managerial assistance. However, in the past the Company and, since October 1, 2004, GladstoneManagement, have provided other services to portfolio companies in addition tomanagerial assistance.  These otherservices include a wide variety of services to the portfolio companies such asinvestment 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. Gladstone Management is charging for these services and is crediting thefunds received from these other services to the Company as a credit against theinvestment advisory fee due from the Company under the investment advisoryagreement.  Such fees are normally paidin part at the time of signing a non-binding letter of intent, with theremainder paid upon completion of the services, and are generally non-recurring.  For the fiscal year ended September 30, 2005,the Company recorded no revenue from fees since, as described above, these feeswere remitted by the borrower directly to Gladstone Management.  For the fiscal years ended September 30,2004, and September 30, 2003, these fees totaled $1,118,106 and $885,500,respectively.

 

While Gladstone Management began receiving all fees in connection withthe Company’s investments as of October 1, 2004, such fees received byGladstone Management are credited to the Company as a reduction of the advisoryfee payable to Gladstone Management under the advisory agreement between theCompany and Gladstone Management.  Forthe fiscal year ended September 30, 2005, Gladstone Management received$1,077,100 for fees for services rendered to portfolio companies. None of thesefees were for managerial assistance even though Gladstone Management providedmanagerial assistance to many of the Company’s portfolio companies.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the fiscal year ended September 30, 2005was reduced by $1,077,100 in respect of these fees received by GladstoneManagement.

 

**Note11. Advisory Agreement with Gladstone Management Corporation**

 

EffectiveOctober 1, 2004, the Company entered into an advisory agreement with GladstoneManagement, an unconsolidated affiliate of the Company, whereby GladstoneManagement serves as an external adviser to the Company.  As compensation for the services of GladstoneManagement, the Company pays Gladstone Management 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 annual fee of 2.0% (0.50% quarterly) of total assets (asreduced by cash and cash equivalents pledged to creditors). The Company continuesto pay direct expenses including, but not limited to, directors’ fees, legaland accounting fees, stockholder related expenses, and directors and officersinsurance.

 

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GladstoneManagement services the loans held by Business Loan, in return for which,Gladstone Management receives a 1.5% annual fee based on the monthly aggregatebalance of loans held by Business Loan. Since the Company owns these loans, all loan servicing fees paid toGladstone Management are also credited directly against the 2% managementfee.  These credits reduce the amount ofthe investment advisory fee and are shown above the direct credits line item inthe table below.  For each of the threemonth periods ended September 30, 2005, June 30, 2005, March 31, 2005 andDecember 31, 2004, these loan servicing fees totaled $745,263, $687,971,$585,542 and $530,952, respectively, all of which were credited against the 2%management fee in order to derive the management fee which is presented as theline item management fee in the consolidated statement of operations.  Under the advisory agreement, GladstoneManagement also provides the managerial assistance and other services that theCompany previously made available to its portfolio companies through itswholly-owned subsidiary Gladstone Capital Advisers, Inc.  To the extent that Gladstone Managementreceives any fees directly from a portfolio company for such services,Gladstone Management credits these fees directly against the 2% management feeand these amounts are shown in the table below as a credit to the managementfee.  For the three months endedSeptember 30, 2005, June 30, 2005, March 31, 2005 and December 31, 2004,Gladstone Management recorded $100,000, $240,600, $450,000 and $286,500,respectively, of such fees and credited this amount against the 2% managementfee received from the Company and reflected on the consolidated statement ofoperations as credit to management fees for fees collected by GladstoneManagement.  Overall, the management feedue to Gladstone Management cannot exceed 2% of total assets (as reduced bycash and cash equivalents pledged to creditors) during any given fiscalyear.  Because the Company was internallymanaged at all times prior to October 1, 2004, no management fee was recordedfor the three months ended September 30, 2004, June 30, 2004, March 31, 2004 orDecember 31, 2003.  

 

Thefollowing table sets forth the quarterly computation of the management fee forthe three months ended September 30, 2005, June 30, 2005, March 31, 2005 andDecember 31, 2004, based on the quarterly increment of 0.50% (0.3125% quarterlyadvisory fee and 0.1875% quarterly administrative fee):

 
| ** **                                                 | ** ** | **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 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 Gladstone  Management:             |       | 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)*  *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, respectivelyof each quarterly computation, for the purpose of satisfying the Company’sasset diversification requirements under the 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 Gladstone Management, the Company treatsany such amounts as “cash and cash equivalents pledged to creditors” under theterms of the Company’s advisory agreement with Gladstone Management.  As a result, such amounts are deducted fromthe Company’s total assets for purposes of computing the asset base upon whichthe management fee is determined.*

 

**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 matured inJune 2005 and was extended through December 31, 2005.  Interest on outstanding borrowings is basedupon the one month London Interbank Offered Rate (“LIBOR”) plus 2.5% perannum.  The unused portion of the line ofcredit is subject to a fee of 0.2% per annum. The BB&T Agreement requires the Company to meet and maintain certaincovenants and ratios with respect to leverage and liquidity. As of September30, 2005, there were no borrowings outstanding under the BB&T line ofcredit and $15.0 million of available borrowings.  At September 30, 2005 the Company was incompliance with all covenants under the BB&T Agreement.

 

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Through its wholly-owned subsidiary Gladstone Business Loan LLC (“BusinessLoan”), the Company has a $100 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 2005, the Companyrenewed its line of credit through May 26, 2006.  As of September 30, 2005, the outstandingprincipal balance under the DB Facility was approximately $53.0 million at aninterest rate of 3.7%.  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, 2005, the remainingborrowing capacity available under the DB Facility was approximately $37.8million.

 

The DB Facility contains covenants that require Business Loan tomaintain its status as a separate entity; prohibit certain significantcorporate transactions (such as mergers, consolidations, liquidations ordissolutions); and restrict material changes to the Company’s credit andcollection policies.  The DB Facilityalso restricts some of the terms and provisions (including interest rates,terms to maturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of September 30, 2005, Business Loan wasin compliance with all of the facility covenants. 

 

The administrative agent also requires that any interest or principal paymentson pledged loans be remitted directly by the borrower into a lockbox accountwith the Bank of New York as custodian. Deutsche Bank AG is also the trustee of the account and once a monthremits the collected funds to the Company. At September 30, 2005, the amountdue from custodian was $2,624,074 and at September 30, 2004, the amount duefrom custodian was $1,203,079.

 

Effective July 12, 2004, Gladstone Management, the Company’s affiliatedexternal adviser also services the loans pledged under the DB Facility.  As a condition to this servicing arrangement,the Company executed a performance guaranty pursuant to which it guaranteedthat Management would comply fully with all of its obligations under the DBFacility.  The performance guarantyrequires the Company to maintain a minimum net worth of $100 million and tomaintain “asset coverage” with respect to “senior securities representingindebtedness” of at least 200%, in accordance with Section 18 of the 1940Act.  As of September 30, 2005, the Companywas in compliance with all covenants under the performance guaranty.  Gladstone Management services these loans foran annual fee of 1.5% of the monthly aggregate outstanding loan balance of theloans pledged under the DB Facility.  Forthe fiscal year ended September 30, 2005, the Company recorded loan servicingfees of $2,549,728.  At September 30,2005, the Company owed $207,619 of unpaid loan servicing fees to GladstoneManagement, which are recorded in fees due to affiliate.  At September 30, 2004, the Company owed$113,511 in loan servicing fees to Gladstone Management, recorded in fees dueto affiliate.  For the fiscal year endedSeptember 30, 2004, loan servicing fees were $501,670, which represents 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.

 

While Gladstone Management began receiving loan servicing fees as ofJuly 12, 2004, such loan servicing fees received by Gladstone Management arecredited to the Company’s advisory fee payable to Gladstone Management underthe advisory agreement between the Company and Gladstone Management.  Accordingly, the advisory fee payable by theCompany to Gladstone Management for the fiscal year ended September 30, 2005was reduced by $2,549,728 in respect of these fees received by GladstoneManagement.

** **

**Note 13. Interest Rate Cap Agreement**

 

Pursuant tothe Deutsche Bank AG line of credit, the Company has an interest rate capagreement that effectively limits the interest rate on a portion of theborrowings under the line of credit. 

 

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

 

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In February2004, the Company entered into an interest rate cap agreement with a notionalamount of $35.0 million at a cost of $304,000. The interest rate cap agreement’s current notional amount is $27.5million with a current fair value of approximately $50,253 which is recorded inother assets on the Company’s consolidated balance sheet at September 30, 2005.  At September 30, 2004, the interest rate capagreement had a fair value of $89,741. 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%.

** **

**Note 14. 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.  

 

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.

** **

**Note 15. Deferred Compensation Plan**

 

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

 

Effective October 1, 2004, Gladstone Management assumed sponsorship ofthe 401(k) Plan pursuant to a corporate resolution.  There were no expenses incurred for thefiscal year ended September 30, 2005 related to the 401(k) Plan.

 

**Note 16.  Subsequent Events**

 

In October 2005, the Company sold its senior subordinated term andfirst mortgage loans in Marcal Paper Mills, Inc. for a total aggregate loss ofapproximately $127,000, also purchased an additional $2.0 million participationin Puerto Rico Cable Acquisition Company, Inc. and an additional $1,382,114participation in Polar Corporation, and Mistras Holdings Corporation repaid$500,000 of it’s $1.0 million senior term debt and refinanced the balance byadding it to the $4.8 million senior term debt. In November 2005, the Company sold its senior term loan in ARI Holdings,Inc. for a realized loss of approximately $1.1 million. With the sale of theabove mentioned investments and the collection of schedule principal repayments,the Company repaid approximately $20.0 million of its outstanding borrowings onthe DB Facility, or approximately 38%, of the borrowings outstanding atSeptember 30, 2005.  In November 2005,the Company extended a loan to Doe & Ingalls, a distributor of high purityspecialty chemicals for $10.0 million with proceeds from borrowings under theline of credit.  In December 2005,Regency Gas Services LLC repaid its entire $5.0 million investment.

 

*Special Proxy Meeting*

On December 2, 2005, theCompany’s stockholders approved a proposal to enter into an amended andrestated investment advisory agreement (the “Amended Advisory Agreement”) withGladstone Management (the “Adviser”) and an administration agreement (the “AdministrationAgreement”) between the Company and Gladstone Administration, LLC (the “Administrator”),a wholly-owned subsidiary of the Adviser.

 

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The Amended AdvisoryAgreement provides for an annual base management fee equal to 2% of the Company’sassets and an income-based incentive fee which will reward the Adviser if theCompany’s quarterly net investment income (before giving effect to theincentive fee) exceeds 1.75% of net assets. The agreement also provides for a capital gains-based incentive fee,whereby the Adviser will receive a fee equal to 20% of the Company’s realizedcapital gains (net of realized capital losses and unrealized capitaldepreciation).  Under the AdministrationAgreement, the Company will pay separately for its allocable portion of theAdministrator’s overhead expenses in performing its obligations, includingrent, and the Company’s allocable portion of the salaries and benefits expensesof its chief financial officer, chief compliance officer and controller and theirrespective staffs.  

 

In connection with theapproval of the Amended Advisory Agreement, the Company will terminate theAmended and Restated 2001 Equity Incentive Plan (the “Plan”), and seekagreement from all holders of stock options to exercise or terminate theiroptions within a limited period of time. The Amended Advisory Agreement and the Administration Agreement willbecome effective upon the later of (i) October 1, 2006, or (ii) the first dayof the first fiscal quarter following the date that all existing stock optionsare exercised. The Amended Advisory Agreement and Administration Agreement willnot become effective as long as the Plan is in effect or as long as there areany outstanding stock options.  Thecurrent investment advisory agreement with Gladstone Management will continuein effect until these new agreements become effective. 

 

**Note 17.Selected Quarterly Data (Unaudited)**

 
| ** **                                            | ** ** | **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 |   |

 
| ** **                                            | ** ** | **Year Ended September 30, 2004**     | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                            | ** ** | **Quarter Ended  December 31,  2003** | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended June 30, 2004** | ** ** | **Quarter Ended  September 30,  2004** | ** ** |
|                                                  |       |                                  |       |   |   |   |   |   |   |
| Total Investment Income                               |       | $                                     | 3,967,949  |   | $ | 4,367,920 |   | $ | 6,709,810 |   | $ | 5,350,289 |   |
| Net Investment Income                                 |       | 2,938,636                             |       | 3,126,625 |   | 4,725,564 |   | 2,501,950 |   |
| Net Increase in Net Assets Resulting From  Operations |       | 1,381,074                             |       | 2,828,583 |   | 5,609,893 |   | 750,740 |   |
|                                                  |       |                                  |       |   |   |   |   |   |   |
| Basic Earnings per Weighted Average Common  Share     |       | $                                     | 0.14       |   | $ | 0.28 |   | $ | 0.56 |   | $ | 0.07 |   |
| Diluted Earning per Weighted Average Common  Share    |       | $                                     | 0.13       |   | $ | 0.27 |   | $ | 0.54 |   | $ | 0.08 |   |

 

72

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**Item 9. Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

Notapplicable.

 

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

 

a)  Disclosure Controls andProcedures

 

As ofSeptember 30, 2005 (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 Financial Reporting

 

Our managementis responsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rule 13a-15(f).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan evaluation of the effectiveness of our internal control over financialreporting based on the framework in *Internal Control -Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on our evaluation under theframework in *Internal Control - Integrated Framework*,our management concluded that our internal control over financial reporting waseffective as of September 30, 2005. 

 

Our management’sassessment of the effectiveness of our internal control over financialreporting as of September 30, 2005 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 Public Accounting Firmlocated in Item 8 of this form 10K.

 

d)Change in Internal Control over Financial Reporting

 

There were no changes in internal controls for the period endedSeptember 30, 2005 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

**Item 9B. Other Information.**

 

Not applicable.

 

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**PART III**

 

We will file a definitive Proxy Statement for our 2006 AnnualMeeting of Stockholders (the “2006 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 2006 Proxy Statement that specifically address the items set forthherein are incorporated by reference.

 

**Item 10. Directors and Executive Officers ofthe Registrant**

 

The information required by Item 10 is hereby incorporated by referencefrom our 2006 Proxy Statement under the captions “Election of Directors” and “Section 16(a)Beneficial Ownership Reporting Compliance.”

 

**Item 11. Executive Compensation**

 

The information required by Item 11 is hereby incorporated by referencefrom our 2006 Proxy Statement under the caption “Compensation of Directors andExecutive Officers.”

 

**Item 12. Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

 

The information required by Item 12 is hereby incorporated by referencefrom our 2006 Proxy Statement under the caption “Security Ownership of CertainBeneficial Owners and Management.”

 

**Item 13. Certain Relationships and RelatedTransactions**

 

The information required by Item 13 is hereby incorporated by referencefrom our 2006 Proxy Statement under the caption “Certain Transactions.”

 

**Item 14. Principal Accountant Fees andServices.**

 

The information required by Item 14 is hereby incorporated by referencefrom our 2006 Proxy Statement under the caption “Audit Fees.”

 

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**PART IV**

 

**Item 15. Exhibits and Financial StatementSchedules**

 

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

 

1.             Thefollowing financial statements are filed herewith:

 
| Report of Independent Registered Public  Accounting Firm                                                                                       |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Statements of Assets and  Liabilities as of September 30, 2005 and September 30, 2004                                   |   |
| Consolidated Schedule of Investments as of September 30,  2005                                                                       |   |
| Consolidated Schedule of Investments as of September 30,  2004                                                                       |   |
| Consolidated Statements of Operations for  the years ended September 30, 2005, September 30, 2004 and  September 30, 2003            |   |
| Consolidated Statements of Changes in Net  Assets for the years ended September 30, 2005, September 30, 2004 and  September 30, 2003 |   |
| Consolidated Statements of Cash Flows for  the years ended September 30, 2005, September 30, 2004 and  September 30, 2003            |   |
| Notes to Consolidated Financial Statements                                                                                                     |   |

 

2.             Financialstatement schedules

 

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

 

3.             Exhibits

 

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

 
| 3.1   |   | Articles of Amendment and Restatement of the Articles of  Incorporation, incorporated by reference to Exhibit a.2 to Pre-Effective  Amendment No. 1 to the Registration Statement on Form N-2 (File  No. 333-63700), filed July 27, 2001.                                                                                                            |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | By-laws, incorporated by reference to Exhibit b to Pre-Effective  Amendment No. 1 to the Registration Statement on Form N-2 (File  No. 333-63700), filed July 27, 2001.                                                                                                                                                                              |
| 3.3   |   | Amendment to By-laws, incorporated by reference to Exhibit 3.3 to the  Company’s Quarterly Report on Form 10-Q for the quarter ended December 31,  2003 (File No. 814-00237), filed February 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* |   | Employment Agreement, dated June 25, 2001, between the Company  and David Gladstone, incorporated by reference to Exhibit k.2 to  Pre-Effective Amendment No. 1 to the Registration Statement on  Form N-2 (File No. 333-63700), filed July 27, 2001.                                                                                           |
| 10.2* |   | Employment Agreement, dated July 23, 2001, between the Company  and Terry Lee Brubaker, incorporated by reference to Exhibit k.3 to  Pre-Effective Amendment No. 1 to the Registration Statement on  Form N-2 (File No. 333-63700), filed July 27, 2001.                                                                                        |
| 10.3* |   | Amendment to Employment Agreement, dated August 8, 2001, between  the Company and David Gladstone, incorporated by reference to  Exhibit k.4 to Pre-Effective Amendment No. 2 to the Registration  Statement on Form N-2 (File No. 333-63700), filed August 10,  2001.                                                                          |
| 10.4* |   | Employment Agreement, dated September 12, 2002, between the  Company and George Stelljes III, incorporated by reference to  Exhibit k.5 to Registration Statement on Form N-2 (File  No. 333-100385), filed October 7, 2002.                                                                                                                         |

 

75

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

 

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| 10.24  |   | Third Amendment to  Employment Agreement dated April 22, 2004 between the Company and David  Gladstone, incorporated by reference to Exhibit k.17 to Post-Effective  Amendment No. 2 to the Registration Statement on Form N-2 (File No.  333-100385), filed July 15, 2004.                     |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25  |   | Second Amendment to  Employment Agreement dated May 6, 2004 between the Company and Terry Lee Brubaker,  incorporated by reference to Exhibit k.18 to Post-Effective Amendment No. 2  to the Registration Statement on Form N-2 (File No. 333-100385), filed July  15, 2004.                    |
| 10.26  |   | Second Amendment to Employment Agreement  dated May 6, 2004 between the Company and George Stelljes III, incorporated  by reference to Exhibit k.19 to Post-Effective Amendment No. 2 to the  Registration Statement on Form N-2 (File No. 333-100385), filed July 15,  2004.                   |
| 10.27  |   | Loan Agreement dated as  of June 22, 2004 between the Company and Branch Banking and Trust Company,  incorporated by reference to Exhibit k.20 to Post-Effective Amendment No. 2  to the Registration Statement on Form N-2 (File No. 333-100385), filed July  15, 2004.                        |
| 10.28  |   | Amendment No. 4 to Credit Agreement dated as of September 28, 2004,  incorporated by reference to Exhibit 10.1 to the Company’s Current Report on  Form 8-K (File no. 814-00237), filed on October 1, 2004.                                                                                |
| 10.29  |   | 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. |
| 10.30  |   | 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.                              |
|   |   |                                                                                                                                                                                                                                                                                            |
| 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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*              Denotesmanagement contract or compensatory plan or arrangement.

 

77

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
| ** **                   | **GLADSTONE CAPITAL CORPORATION** |
|------------------------------|-----------------------------------|
| ** **                   | ** **                        | ** ** |
| Date: December 13, 2005 | By:                               | /s/ HARRY BRILL |
|                         |                              | Harry Brill |
|                         |                              | Chief Financial Officer and Treasurer |

 

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 13, 2005 | By:    | /s/ DAVID GLADSTONE                                                                           |
|------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                         |   | David Gladstone                                                                               |
|                         |   | Chief Executive Officer and Chairman of the Board of Directors  (principal executive officer) |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ TERRY LEE BRUBAKER                                                                        |
|                         |   | Terry Lee Brubaker                                                                            |
|                         |   | Vice Chairman, Chief Operating Officer and Director                                      |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ HARRY BRILL                                                                               |
|                         |   | Harry Brill                                                                                   |
|                         |   | Chief Financial Officer  (principal financial and accounting officer)                         |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ GEORGE STELLJES, III                                                                      |
|                         |   | George Stelljes, III                                                                          |
|                         |   | President, Chief Investment Officer and Director                                              |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ DAVID A.R. DULLUM                                                                         |
|                         |   | David A.R. Dullum                                                                             |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ ANTHONY W. PARKER                                                                         |
|                         |   | Anthony W. Parker                                                                             |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ MICHELA A. ENGLISH                                                                        |
|                         |   | Michela A. English                                                                            |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ PAUL ADELGREN                                                                             |
|                         |   | Paul Adelgren                                                                                 |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ MAURICE COULON                                                                            |
|                         |   | Maurice Coulon                                                                                |
|                         |   | Director                                                                                      |
|                         |   |                                                                                          |
| Date: December 13, 2005 | By:    | /s/ JOHN OUTLAND                                                                              |
|                         |   | John Outland                                                                                  |
|                         |   | Director                                                                                      |

 

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