** **

**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, 2003**                                                                                                                                                           |
|                                 |   |                                                                                                                                                                                                             |
| **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.) |
|                                                            |   |   |
| **1616 Anderson Road, Suite 208  McLean, Virginia**             |   | **22102** |
| (Address of principal executive offices)                        |   | (Zip Code) |
|                                                            |   |   |
| **(703) 286-7000**                                         |
| (Registrant’s telephone number, including  area code)      |

 

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

 

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

 

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

 

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

 

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

YES  ý  NO  o

 

The aggregate market value of the voting stock held by non-affiliatesof the Registrant on March 31, 2003, based on the closing price on that date of$16.18 on the Nasdaq National Market, was $151,129,970. For the purposes ofcalculating this amount only, all directors and executive officers of theRegistrant have been treated as affiliates.

 

There were 10,081,844 shares of the Registrant’s Common Stock, $0.001par value, outstanding as of December 9, 2003.

 

**DocumentsIncorporated by Reference.**  Portions of the Registrant’s Proxy Statement relating to theRegistrant’s 2004 Annual Meeting of Stockholders are incorporated by referenceinto Part III of this Report.

 

 

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**GLADSTONE CAPITAL CORPORATION**

**FORM 10-K FOR THE FISCAL YEAR**

**ENDED SEPTEMBER 30, 2003**

** **

**TABLE OF CONTENTS**

 
| 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 and Related Stockholder Matters                 |   |
|       | 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                                                                    |   |
| 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                             |   |
|       | Item 13  | Certain  Relationships and Related Transactions                                             |   |
|       | Item 14  | Principal  Accountant Fees and Services                                                     |   |
| PART IV    | Item 15  | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K                      |   |
| SIGNATURES |     |

 

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**PART I**

** **

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

 

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

 

David Gladstone, our chairman and chiefexecutive officer, has over 25 years of experience in making loans to, andinvesting in, small and medium-sized companies at Gladstone CapitalCorporation, Allied Capital Corporation and American CapitalStrategies Ltd. Allied Capital Corporation is a publicly tradedsubordinated debt lender and American Capital Strategies is a publicly tradedbuyout and subordinated debt lender.  Mr. Gladstone is no longer affiliated with AlliedCapital Corporation or American Capital Strategies Ltd.

 

Terry Lee Brubaker, our president and chiefoperating officer, has over 25 years of experience in acquisitions andmanaging companies subsequent to an acquisition. Prior to joining GladstoneCapital Corporation, he was a member of the management team that designed andimplemented the acquisition strategy of James River Corporation.

 

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

 

In addition to Messrs. Gladstone andBrubaker, we currently have a chief investment officer, George Stelljes III,and six principals who are involved in structuring and arranging financing forsmall and medium-sized businesses. As our business expands, we plan to hireadditional principals with business lending experience. We believe that theexpertise of our investing principals will help us to be successful in lendingto small and medium-sized businesses.

 

We typically make loans to companies that aresubstantially owned by leveraged buyout funds, venture capital funds, or familyowned businesses. Messrs. Gladstone and Brubaker have an extensivereferral network of venture capitalists, leveraged buyout funds, investmentbankers, attorneys, commercial bankers and business and financial brokers. Webelieve that these entities have been, and will continue to be, an importantsource of loan opportunities. We intend to enter into additional informalrelationships with other leveraged buyout funds and venture capital funds, butwe can not assure you that we will be able to do so or that any suchrelationships will lead to the origination of loans.

 

We have two wholly owned subsidiaries,Gladstone Advisers, Inc., through which we conduct our day-to-dayadministrative functions and provide managerial assistance to our portfoliocompanies and Gladstone Business Loan LLC, which owns the loan investmentportfolio of Gladstone Capital Corporation.

 

**STRATEGY**

 

Our strategy is to make loans at favorable interestrates to small and medium-sized businesses that we believe have traditionallybeen underserved by conventional lenders. We use the loan referral networks ofMessrs. Gladstone, Stelljes and Brubaker and of our principals to identifyand make senior and subordinated loans to selected businesses that we believedo not have sufficient access to traditional sources of lending. We make loansto borrowers that need funds to finance growth, restructure their balancesheets or effect a change of control, all of which we believe are typicallyunderserved by banks and other traditional institutional lenders. We believethat our business strategy will enable us to achieve a high level of currentincome by investing in debt securities, consisting primarily of senior notes,senior subordinated notes and junior subordinated notes, of established privatebusinesses that are backed by leveraged buyout

 

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funds, venture capital funds or others. In addition, from time to timewe might acquire existing loans that meet this profile from leveraged buyoutfunds, venture capital funds and others. We also seek to provide ourstockholders with long-term capital growth through the appreciation in thevalue of warrants or other equity instruments that we might receive when wemake loans. Our financial plan presumes that (1) the net capital gainsfrom the sale of the warrants (as well as other profit enhancements) we receivein connection with our lending activities will exceed any losses we mayexperience from loans that are not repaid, and (2) the managerialassistance fee income we derive from assisting our portfolio companies willprovide us with a source of revenue that approximates our operating expenses(excluding interest expense). We cannot assure you that we will be able toachieve our investment objectives or that our business strategy will besuccessful.

 

We believe that we are well-positioned toprovide financing to small and medium-sized businesses that are undergoing achange of ownership, including management-led and third party leveragedbuyouts, and to those businesses that have good growth characteristics. We arenot burdened with the capital and other regulatory requirements of the bankingand savings and loan industries and we have relatively low overhead andadministrative expenses. Moreover, our strategy of accepting warrants topurchase stock of our borrowers and other yield enhancements, such as successfees, is intended to closely align our interests with those of our portfoliocompanies, thereby reducing transaction costs, conveying our commitment to theborrowers and enhancing our attractiveness as a financing source. Perhaps mostimportantly, we believe that we have the experience and expertise to satisfy thefinancing needs of such businesses. In particular, we believe that we benefitfrom Mr. Gladstone’s 25 years of experience in financing small tomedium-sized private businesses, Mr. Stelljes’ many years of financing mediumand small businesses, and Mr. Brubaker’s extensive experience inacquisitions and operations to realize a competitive advantage. We believe thatour established network of loan referral sources, consisting of relationshipsestablished over many years by Messrs. Gladstone, Stelljes, and Brubakerand our principals will generate opportunities to identify and make senior andsubordinated loans to selected businesses that satisfy our investment criteria.We intend to enter into additional informal relationships with leveraged buyoutfunds and venture capital funds, but we can not give any assurance that we willbe able to do so. We target small and medium-sized private businesses that meetcertain criteria, including the potential for growth, adequate assets for loancollateral, experienced management teams with significant ownership interest inthe business, adequate capitalization, profitable operations based on 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 can not assure you that we will always have theserights.

 

As a business development company, we makeavailable significant managerial assistance to our portfolio companies. Suchassistance will typically involve structuring financing for the business,closely monitoring the operations of each borrower, participating in its boardand management meetings, being available for consultation with its officers andproviding organizational and financial guidance.

 

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

 

Because our loans will generally consist ofsubordinated debt of private companies who typically cannot or will not expendthe resources to have their debt securities rated by a credit rating agency, weexpect that most, if not all, of the debt securities we acquire will 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 though wemay not have the first claim on these assets. Interest payments on loans wemake will generally be 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 will generally become due at maturity at five to seven years. We willfocus on making loans accompanied by warrants to purchase stock in theborrowers. These warrants will typically have an exercise price equal to thefair value of the portfolio company’s common stock at the time of the loan andentitle us to purchase a modest percentage of the borrower’s stock.

 

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From time to time, a portfolio company mayrequest additional financing, providing us with additional lendingopportunities. We will consider such requests for additional financing underthe criteria we have established for initial investments and we anticipate thatany debt securities we acquire in a follow-on financing will havecharacteristics comparable to those issued in the original financing. In somesituations, our failure, inability or decision not to make a follow-oninvestment may be detrimental to the operations or survival of a portfoliocompany and thus jeopardize our investment in that borrower.

 

As noted above, we expect to receive warrants, to purchasestock, or other yield enhancements in many of our borrowers. If a financing issuccessful, not only will our debt securities have been repaid with interest,but we will be in a position to realize a gain on the accompanying equityinterests or other yield enhancements. The opportunity to realize such gain mayoccur if the borrower is sold to new owners or if it makes a public offering ofits stock. In most cases, we will not have the right to require that a borrowerundergo an initial public offering by registering securities under theSecurities Act of 1933, to which we refer as the Securities Act, but wegenerally will have the right to sell our equity interests in any subsequentpublic offering by the borrower. Even when we have the right to participate ina borrower’s public offering, the underwriters might insist, particularly if weown a large amount of equity securities, that we retain all or a substantialportion of our shares for a specified period of time. Moreover, we may decidenot to sell an equity position even when we have the right and the opportunityto do so. Thus, although we expect to dispose of an equity interest after acertain time, situations may arise in which we hold equity securities for a longerperiod.

 

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

 

In addition to the put rights and unlockingrights described above, when one of our portfolio companies does go public, wemay undertake hedging strategies with regard to our equity interests in it. Wemay mitigate risks associated with the volatility of publicly traded securitiesby, for instance, selling securities short or writing or buying call or putoptions. Hedging against a decline in the value of such investments in publiccompanies would not eliminate fluctuations in the values of such investments orprevent losses if the values of such investments decline, but would establishother investments designed to gain from those same developments. Therefore, byengaging in hedging transactions we can moderate the decline in the value ofour hedged investments in public companies. However, such hedging transactionswould also limit our opportunity to gain from an increase in the value of ourinvestment in the public company. Pursuant to our line of credit, we haveagreed to enter into hedging transactions, such as interest rate swaps inconnection with the borrowings that we make under the line of credit, which wecurrently expect to begin making in the near future.  Such transactions will effectively convert our fixed rateportfolio loans into variable rate loans in an effort to mitigate our exposureto increases in interest rates on our borrowings on the line of credit, whichwill be at variable rates.  Furthermore,in the event that we securitize a portion of our loan portfolio in the future,we believe that we will likely be required to enter into similar arrangementswith respect to the securitized loans. Hedging strategies do pose risks to us and our stockholders, however webelieve that such activities, because they will be limited to only a portion ofour portfolio, are manageable.

 

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

 

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**SELECTIONOF LOAN OPPORTUNITIES**

 

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

 

•              **Growth.** In addition togenerating sufficient cash flow to service its debt, a potential borrowergenerally will be required to establish its ability to grow its cash flow.Anticipated growth will be a key factor in determining the value ascribed tothe warrants we acquire in connection with many of our loans.

 

•              **Significant sponsor.** We seekbusinesses in which leveraged buyout funds or venture capital funds haveinvested. We believe that a business that has a substantial equity sponsor thathas made a meaningful investment is a good borrowing candidate.

 

•              **Liquidation value of assets.**Although we do not generally intend to operate as an asset-based lender,liquidation value of the assets collateralizing our loans is an importantfactor in each credit decision. 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 revenuestreams).

 

•              **Experienced management team.**We will generally require that each borrower have a management team that isexperienced and properly incentivized through a significant ownership interestin the borrower. We generally will require that a borrower have, at a minimum,a strong chief executive officer and chief financial officer who havedemonstrated the ability to accomplish the borrower’s objectives and implementits business plan.

 

•              **Profitable or near-profitableoperations.** We focus on borrowers that are profitable ornear-profitable at the operating level. We do not intend typically to lend to,or invest in, start-up or other early stage companies, nor do we intendtypically to lend to, or invest in, businesses that are experiencingsignificant operating problems.

 

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

 

**LoanOrigination Process**

 

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

 

**ApprovalProcess**

 

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

 

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**TEMPORARYINVESTMENTS**

 

Pending investment in other types of“qualifying assets,” we invest our otherwise uninvested cash primarily in cash,cash items, government securities or high-quality debt securities maturing inone year or less from the time of investment, to which we refer collectively astemporary investments, so that 70% of our assets are qualifying assets. Forinformation regarding regulations to which we are subject and the definition of“qualifying assets,” see “Regulation.” Typically, we invest in US Treasurybills or in repurchase obligations of a “primary dealer” in governmentsecurities, as designated by the Federal Reserve Bank of New York, or of anyother dealer whose credit has been established to the satisfaction of our boardof directors. There is no percentage restriction on the proportion of ourassets that may be invested in such repurchase agreements. A repurchaseagreement involves the purchase by an investor, such as us, of a specifiedsecurity and the simultaneous agreement by the seller to repurchase it at anagreed-upon future date and at a price which is greater than the purchase priceby an amount that reflects an agreed-upon interest rate. Such interest rate iseffective for the period of time during which the investor’s money is investedin the arrangement and is related to current market interest rates rather thanthe coupon rate on the purchased security. Our custodian, or the correspondentin its account with the Federal Reserve/Treasury Book Entry System, will berequired to constantly maintain underlying securities in an amount at leastequal to the repurchase price. If the seller were to default on its repurchaseobligation, we might suffer a loss to the extent that the proceeds from thesale of the underlying security were less than the repurchase price. A seller’sbankruptcy could delay or prevent a sale of the underlying securities. Ourboard of directors has established procedures, which it will reviewperiodically, requiring us to monitor the creditworthiness of the dealers withwhich we enter into repurchase agreement transactions.

 

**COMPETITION**

 

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

 

**EMPLOYEES**

 

We currently have fifteen employees. Webelieve that our relations with our employees are excellent. We intend to hireadditional professionals with business lending experience as our business growsand to maintain a relatively low level of overhead by outsourcing most jobfunctions not directly related to marketing, underwriting our investments orexecutive management.

 

**LEVERAGE**

 

For the purpose of making investments otherthan temporary investments and to take advantage of favorable interest rates,we intend to issue senior debt securities, up to the maximum amount permittedby the 1940 Act. The 1940 Act currently permits us to issue senior debtsecurities and preferred stock, to which we refer collectively as seniorsecurities, in amounts such that our asset coverage, as defined in the 1940Act, is at least 200% after each issuance of senior securities. We may alsoincur such indebtedness to repurchase our common stock. As a result of issuingsenior securities, we would become exposed to the risks of leverage. Althoughborrowing money for investments increases the potential for gain, it alsoincreases the risk of a loss. A decrease in the value of our investments willhave a greater impact on the value of our common stock if we borrow money tomake investments. There is a possibility that the costs of borrowing couldexceed the income we receive on the investments we make with such borrowedfunds. In addition, our ability to pay dividends or incur additionalindebtedness would be restricted if asset coverage is less than twice ourindebtedness. If the value of our assets declines, we might be unable tosatisfy that test. If this happens, we may be required to liquidate a portion ofour loan portfolio and

 

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 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 for distributionsto our stockholders. Our board of directors is authorized to provide for theissuance of preferred stock with such preferences, powers, rights andprivileges as it deems appropriate, except that such an issuance must adhere tothe requirements of the 1940 Act. See “Regulation—Business DevelopmentCompany—Asset Coverage” for a discussion of leveraging constraints. We do notintend to leverage ourselves so long as we hold cash or temporary investmentsin an amount sufficient to fund the investments, other than temporaryinvestments.

 

**SECURITIZATION**

 

On February 3, 2003, Gladstone BusinessLoan, LLC, (“Business Loan”) a wholly-owned subsidiary of Gladstone CapitalCorporation, was established for the purpose of acquiring and holding certainloans originated by us. On May 19, 2003, Business Loan entered into acredit agreement with a group of institutional lenders that provides a $100million revolving credit facility, the proceeds of which will be used byBusiness Loan to purchase our loans.      The sale of our loans to Business Loan will makeavailable funds which we can use to make additional loans and increase the sizeof our loan portfolio.  We currentlyintend to securitize all of the loans held by Business Loan and will use theproceeds from the securitization to pay down any amounts outstanding under therevolving credit facility.

 

**INVESTMENTOBJECTIVES AND POLICIES**

 

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

 

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

 

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

 

We will not (1) act as an underwriter ofsecurities of other issuers (except to the extent that we may be deemed an“underwriter” of securities we purchase that must be registered under theSecurities Act before they may be offered or sold to the public);(2) purchase or sell real estate or interests in real estate or realestate investment trusts (except that we may (a) purchase and sell realestate or interests in real estate in connection with the orderly liquidationof investments, (b) own the securities of companies or participate in apartnership or partnerships that are in the business of buying, selling ordeveloping real estate, or (c) finance the purchase of real estate by ourportfolio

 

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companies); (3) sell securities short (except with regard tomanaging the risks associated with publicly-traded securities issued by ourportfolio companies); (4) purchase securities on margin (except to theextent that we may purchase securities with borrowed money); (5) write orbuy put or call options (except (i) to the extent of warrants orconversion privileges in connection with our acquisition financing or otherinvestments and rights to require the issuers of such investments or theiraffiliates to repurchase them under certain circumstances, (ii) withregard to managing risks associated with publicly-traded securities issued byour portfolio companies, or (iii) with regard to managing the risksassociated with interest rate fluctuations); (6) engage in the purchase orsale of commodities or commodity contracts, including futures contracts (exceptwhere necessary in working out distressed loan or investment situations or inmanaging the risks associated with interest rate fluctuations); or(7) acquire more than 3% of the voting stock of, or invest more than 5% ofour total assets in, any securities issued by any other investment company (exceptas they may be acquired as part of a merger, consolidation or acquisition ofassets). That portion of our investments that is in securities issued by otherinvestment companies may subject our stockholders to additional expenses.

 

**INVESTMENTADVISOR**

 

We have no investment advisor and areinternally managed by our executive officers under the supervision of our boardof directors.

 

**REGULATION**

 

We are a closed-end, non-diversified,management investment company that has elected to be regulated as a businessdevelopment company under Section 54 of the 1940 Act. As such, we aresubject to regulation under the 1940 Act. The 1940 Act contains prohibitionsand restrictions relating to transactions between business developmentcompanies and their affiliates, principal underwriters and affiliates of thoseaffiliates or underwriters and requires that a majority of the directors bepersons other than “interested persons,” as defined in the 1940 Act. Inaddition, the 1940 Act provides that we may not change the nature of ourbusiness so as to cease to be, or to withdraw our election as, a businessdevelopment company unless approved by a majority of our outstanding votingsecurities.

 

**RegulatedInvestment Company**

 

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

 

•              **Income source requirements.**At least 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

 

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

 

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

 

If we acquire debt obligations that wereoriginally issued at a discount, which would generally include loans we makethat are accompanied by warrants, that bear interest at rates that are noteither fixed rates or certain qualified variable rates or that are notunconditionally payable at least annually over the life of the obligation, wewill be required to include in taxable income each year a portion of the“original issue discount” that accrues over the life of the obligation. Suchoriginal issue discount will be included in our investment company taxableincome even though we receive no cash corresponding to such discount amount. Asa result, we may be required to make additional distributions corresponding tosuch original issue discount amounts in order to satisfy the annualdistribution requirement and to continue to qualify as a RIC or to avoid the 4%excise tax. In this event, we may be required to sell temporary investments orother assets to meet the RIC distribution requirements.

 

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

 

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The recently signed “Jobs and Growth TaxRelief Reconciliation Act of 2003” did not alter the nature of our dividendsthat we pay to stockholders as taxable ordinary income.  Accordingly, our dividends paid are noteligible for the lower tax rate.

 

**BusinessDevelopment Company**

 

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

 

**QualifyingAssets**.  Under the 1940 Act, a business developmentcompany may not acquire any asset other than assets of the type listed inSection 55(a) of the 1940 Act, which are referred to as qualifying assets,unless, at the time the acquisition is made, qualifying assets represent atleast 70% of the company’s total assets. The principal categories of qualifyingassets relevant to our business are the following:

 

(1)           Securities purchased intransactions not involving any public offering from the issuer of suchsecurities, which issuer is an eligible portfolio company. An eligibleportfolio company is generally defined in the 1940 Act as any issuer which,first, is organized under the laws of, and has its principal place of businessin, the United States. Second, the issuer must not be an investment company,other than a small business investment company wholly-owned by the businessdevelopment company. Finally, the issuer may not have any class of securitieswith respect to which a broker or dealer may extend margin credit.

 

(2)           Securities of anyeligible portfolio company over which we exercise a controlling influence andfor which an affiliate of ours serves as a director.

 

(3)           Securities received inexchange for or distributed on or with respect to securities described in(1) or (2) above, or pursuant to the exercise of options, warrants orrights relating to such securities.

 

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

 

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

 

**AssetCoverage**.  We are permitted, under specifiedconditions, to issue multiple classes of indebtedness and one class of stocksenior to our common stock if our asset coverage, as defined in the 1940 Act,is at least 200% immediately after each such issuance. In addition, whilesenior securities are outstanding, we must make provisions to prohibit anydistribution to our stockholders or the repurchase of such securities or sharesunless we meet the applicable asset coverage ratios at the time of thedistribution or repurchase. We may also borrow amounts up to 5% of the value ofour total assets for temporary purposes. The 1940 Act requires, among otherthings, that (1) immediately after issuance and before any dividend ordistribution is made with respect to our common stock or before any purchase ofcommon stock is made, the preferred stock, together with all other seniorsecurities, must not exceed an amount equal to 50% of our total assets afterdeducting the amount of such dividend, distribution or purchase price, as thecase may be, and (2) the holders of shares of preferred stock, if any areissued, must be entitled as a class to elect two directors at all times and toelect a majority of the directors if dividends on the preferred stock are inarrears by two years or more.

 

**SignificantManagerial Assistance**.  For portfolio securitiesto be qualifying assets for the 70% test described above, the businessdevelopment company must either exercise a controlling influence over theissuer of the securities or must make available to the issuer of the securitiessignificant managerial assistance. However, with respect to certain but not allsuch securities, where the business development company purchases suchsecurities in conjunction with one or more other persons acting together, oneof the other persons in the group may make available such managerialassistance, or the business development company may exercise such controljointly. Making available significant managerial assistance means, among otherthings, any arrangement whereby the business development company, through itsdirectors, officers or employees, offers to provide, and, if accepted, does soprovide, significant guidance and counsel concerning the management, operationsor business objectives and policies of a portfolio company.

 

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**Determinationof Net Asset Value**

 

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

 

We carry our investments at fair value, basedon valuations voted on by our Board of Directors. A majority of the loanportfolio is reviewed by Standard & Poor’s Loan Evaluation Service(S&P).  S&P provides anindependent assessment of the loan portfolio data and assess its own data todetermine market values for the securities. The Board of Directors votes to accept the valuation recommendationspresented by S&P.  Securities thatare publicly traded, if any, are valued at the closing price on the valuationdate (to date there are no publicly traded securities in our portfolio). Due tothe uncertainty inherent in the valuation process, such estimates of fair valuemay differ significantly from the values that would have been obtained had aready market for the securities existed, and the differences could be material.Additionally, changes in the market environment and other events that may occurover the life of the investments may cause the gains or losses ultimatelyrealized on these investments to be different than the valuations currentlyassigned.

 

A substantial portion of our assets willconsist of securities carried at fair market value, as determined by our Boardof Directors. Determination of fair market values, for those securities andinvestments not valued by S&P, involves subjective judgment not susceptibleto substantiation by auditing procedures. Accordingly, under current auditingstandards, the notes to our consolidated financial statements will refer to theuncertainty with respect to the possible effect of such valuations on ourfinancial statements.

 

**Codeof Ethics**

 

As required by the 1940 Act, we have adopteda code of ethics that establishes procedures for personal investments andrestricts certain transactions by our personnel. We have also adopted a code ofethics that complies with the guidelines set forth in Item 406 of RegulationS-K of the Securities Act.  A copy ofthis code is available for review, free of charge, at our website atwww.GladstoneCapital.com.

 

**RISKFACTORS**

 

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

 

**Weare a new company with a limited operating history.**

 

We were incorporated in May 2001 and, todate, have only made investments in thirteen companies. Thus far, we haveconducted only limited operations as a lender to small and medium sizedcompanies. In addition, we are subject to all of the business risks anduncertainties associated with any new business enterprise. We may not meet ourinvestment objectives and the value of your investment in us may declinesubstantially or be reduced to zero.

 

**Weare dependent upon our key management personnel for our future success,particularly David Gladstone, George Stelljes and Terry Lee Brubaker.**

 

We are dependent on the diligence, skill andnetwork of business contacts of our senior management and other managementmembers for the final selection, structuring, closing and monitoring of ourinvestments. Our future success depends to a significant extent on thecontinued service and coordination of our senior management team, particularlyDavid Gladstone, our chairman and chief executive officer, George Stelljes, ourchief investment officer, and Terry Lee Brubaker, our president and chiefoperating officer. The departure of any of our executive officers or keyemployees could have a material adverse effect on our ability to implement ourbusiness strategy and to achieve our investment objectives.

 

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**Ourfinancial condition and results of operations will depend on our ability toeffectively manage our future growth.**

 

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

 

**Weoperate in a highly competitive market for investment opportunities.**

 

A large number of entities compete with usand make the types of investments that we seek to make in small and mediumsized privately owned businesses. We compete with a large number of privateequity funds, leveraged buyout funds and venture capital funds, investmentbanks and other equity and non-equity based investment funds, and other sourcesof financing, including traditional financial services companies such ascommercial banks. Many of our competitors are substantially larger and haveconsiderably greater financial, technical and marketing resources than we do.For example, some competitors may have a lower cost of funds and access tofunding sources that are not available to us. In addition, certain of ourcompetitors may have higher risk tolerances or different risk assessments, whichcould allow them to consider a wider variety of investments and establish morerelationships and build their market shares. Furthermore, many of our potentialcompetitors are not subject to the regulatory restrictions that the 1940 Actimposes on us as a business development company. We cannot assure you that thecompetitive pressures we face will not have a material adverse effect on ourbusiness, financial condition and results of operations. Also, as a result ofthis competition, we may not be able to take advantage of attractive investmentopportunities from time to time and there can be no assurance that we will beable to identify and make investments that satisfy our investment objectives orthat we will be able to fully invest our available capital.

 

**Ourbusiness model is dependent upon the development of strong referralrelationships with leveraged buyout funds and venture capital funds.**

 

We are dependent upon informal relationships with leveraged buyoutfunds, venture capital funds, and traditional lending institutions to provideus with deal flow.  If we fail tomaintain our relationship with such funds or institutions, or if we fail toestablish strong referral relationships with other funds, we will not be ableto grow our portfolio of loans and fully execute our business plan.

 

**Ourloans to small and medium sized borrowers are extremely risky and you couldlose your entire investment.**

 

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

 

•              **Small and medium sized businesses mayhave limited financial resources and may not be able to repay the loans we maketo them.** Our strategy includes providing financing to borrowers thattypically is not readily available to them. While we believe that this providesan attractive opportunity for us to generate profits, this may make itdifficult for the borrowers to repay their loans to us upon maturity. Aborrower’s ability to repay its loan may be adversely affected by numerousfactors, including the failure to meet its business plan, a downturn in itsindustry or negative economic conditions. A deterioration in a borrower’sfinancial condition and prospects usually will be accompanied by adeterioration in the value of any collateral and a reduction in the likelihoodof us realizing on any guarantees we may have obtained from the borrower’smanagement. Although we will sometimes seek to be the senior, secured lender toa borrower, in most of our loans we expect to be subordinated to a seniorlender, and our interest in any collateral would, accordingly, likely besubordinate to another lender’s security interest.

 

•              **Small and medium sized businessestypically have narrower product lines and smaller market shares than largebusinesses.** Because our target borrowers are smaller businesses,they will tend to be more vulnerable to competitors’ actions and marketconditions, as well as general economic downturns. In addition, our portfoliocompanies may face intense competition, including competition from companieswith greater financial resources, more extensive development, manufacturing,marketing and other capabilities and a larger number of qualified managerialand technical personnel.

 

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•              **There is generally little or no publiclyavailable information about these businesses.** Because we seek tomake 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, other employees andconsultants to perform due diligence investigations of these borrowers, theiroperations and their prospects. We may not learn all of the materialinformation we need to know regarding these businesses through ourinvestigations.

 

•              **Small and medium sized businessesgenerally have less predictable operating results.** We expect thatour borrowers may have significant variations in their operating results, mayfrom time to time be parties to litigation, may be engaged in rapidly changingbusinesses with products subject to a substantial risk of obsolescence, mayrequire substantial additional capital to support their operations, to financeexpansion or to maintain their competitive position, may otherwise have a weakfinancial position or may be adversely affected by changes in the businesscycle. Our portfolio companies may not meet net income, cash flow and othercoverage tests typically imposed by their senior lenders. A borrower’s failureto satisfy financial or operating covenants imposed by senior lenders couldlead to defaults and, potentially, foreclosure on its senior credit facility,which could additionally trigger cross-defaults in other agreements. If thiswere to occur, it is possible that the borrower’s ability to repay our loanwould be jeopardized.

 

•              **Small and medium sized businesses aremore likely to be dependent on one or two persons.** 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.

 

•              **Small and medium sized businesses arelikely to have greater exposure to economic downturns than larger businesses.**We expect that our borrowers will have fewer resources than larger businessesand an economic downturn is more likely to have a material adverse effect onthem. If one of our borrowers is adversely impacted by an economic downturn,its ability to repay our loan would be diminished.

 

•              **Small and medium sized businesses mayhave limited operating histories.** While we intend to target stablecompanies with proven track records, we may make loans to new companies thatmeet our other investment criteria. Borrowers with limited operating historieswill be exposed to all of the operating risks that new businesses face and maybe particularly susceptible to, among other risks, market downturns,competitive pressures and the departure of key executive officers.

 

**Wemay not realize gains from our equity investments.**

 

When we make a subordinated loan, wegenerally expect to receive warrants to purchase stock issued by the borrower.Our goal is to ultimately dispose of these equity interests and realize gainsupon our disposition of such interests. We expect that, over time, the gains werealize on these warrants will offset any losses we experience on loandefaults. However, the warrants we receive may not appreciate in value and, infact, may decline in value. Accordingly, we may not be able to realize gainsfrom our equity interests and any gains we do recognize on the disposition ofequity interests may not be sufficient to offset losses we experience on our loanportfolio.

 

**Becausethe loans we make and equity securities we receive when we make loans are notpublicly traded, there will be uncertainty regarding the value of our privatelyheld securities that could adversely affect our determination of our net assetvalue.**

 

None 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 approvedby our board of directors. Due to the uncertainty inherent in valuing thesesecurities, our determinations of fair value may differ materially from thevalues that would exist if a ready market for these securities existed. Our netasset value could be materially affected if our determinations regarding thefair value of our investments are materially different from the values that weultimately realize on our disposal of such securities.

 

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**Thelack of liquidity of our privately held securities may adversely affect ourbusiness.**

 

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

 

**Ourportfolio will be concentrated in a limited number of companies and industries,which subjects us to an increased risk of significant loss if any one of thesecompanies does not repay us or if the industries experience downturns.**

 

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

 

**Ourbusiness plan is dependent upon external financing which may expose us to risksassociated with leverage.**

 

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

 

•              **Senior Securities**. We intend to issue debt securities,other evidences of indebtedness and possibly preferred stock, up to the maximumamount permitted by the 1940 Act. The 1940 Act currently permits us, as abusiness development company, to issue debt securities and preferred stock, towhich we refer collectively as senior securities, in amounts such that ourasset coverage, as defined in the 1940 Act, is at least 200% after eachissuance of senior securities. As a result of issuing senior securities, wewill be exposed to the risks associated with leverage. Although borrowing moneyfor investments increases the potential for gain, it also increases the risk ofa loss. A decrease in the value of our investments will have a greater impacton the value of our common stock if we borrow money to make investments. Thereis a possibility that the costs of borrowing could exceed the income we receiveon the investments we make with such borrowed funds. In addition, our abilityto pay dividends or incur additional indebtedness would be restricted if assetcoverage is not at least twice our indebtedness. If the value of our assetsdeclines, we might be unable to satisfy that test. If this happens, we may berequired to liquidate a portion of our loan portfolio and repay a portion ofour indebtedness at a time when a sale may be disadvantageous. Furthermore, anyamounts that we use to service our indebtedness will not be available fordistributions to our stockholders.

 

•              **Common Stock.** 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.

 

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•              **Securitization.** In additionto issuing securities to raise capital as described above, we anticipate thatin the future we will securitize our loans to generate cash for funding newinvestments. An inability to successfully securitize our loan portfolio couldlimit our ability to grow our business, fully execute our business strategy andimpact our profitability. Moreover, successful securitization of our loanportfolio might expose us to losses as the loans in which we do not plan tosell interests will be those that are riskier and more apt to generate losses.

 

**Achange in interest rates may adversely affect our profitability and our hedgingstrategy may expose us to additional risks.**

 

We anticipate using a combination of equityand long-term and short-term borrowings to finance our lending activities. As aresult, a portion of our income will depend upon the difference between therate at which we borrow funds and the rate at which we loan these funds.Certain of our borrowings may be at fixed rates and others at variable rates.Currently, we expect approximately 50% of the loans in our portfolio to be atfixed rates and approximately 50% to be at variable rates determined on thebasis of a benchmark prime rate. We will typically seek to hedge against the riskof adverse movement in interest rates on our borrowings relative to ourportfolio of assets. We expect to hedge against interest rate fluctuations byusing standard hedging instruments such as futures, options and forwardcontracts. While hedging activities may insulate us against adversefluctuations in interest rates, they may also limit our ability to participatein the benefits of lower interest rates with respect to the hedged portfolio.Adverse developments resulting from changes in interest rates or hedgingtransactions could have a material adverse effect on our business, financialcondition and results of operations.

 

**Ourcredit facility imposes certain limitations on us.**

 

We will have a continuing need for capital tofinance our loans. In order to maintain RIC status, we will be required todistribute to our stockholders at least 90% of our ordinary income andshort-term capital gains on an annual basis. Accordingly, such earnings willnot be available to fund additional loans. Therefore, we have entered into a credit agreement arranged byCIBC World Markets Corporation as the structuring agent.  The agreement provides us with a revolvingcredit line facility of $100 million. In the future, this credit line will be replaced with the proceeds wemay receive from securitizing some or all of the loans in our portfolio forlong term funding.  This credit linefacility will permit us to fund additional loans and investments as long as weare within the conditions set out in the credit agreement.

 

As a result of the credit line facility, weare subject to certain limitations including restrictions on geographicconcentrations, sector concentrations, loan size, payment frequency and status,and average life.

 

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

 

**Ourinvestments will typically be long term and it may require several years torealize liquidation events.**

 

Since we generally intend to make five toseven year term loans and to hold our loans and related warrants until theloans mature, you should not expect realization events, if any, to occur overthe near term. In addition, we expect that any warrants that we receive when wemake loans may require several years to appreciate in value and we cannot giveany assurance that such appreciation will occur.

 

**Wewill be subject to corporate level tax if we are unable to satisfy InternalRevenue Code requirements for RIC qualification.**

 

To maintain our qualification as a RIC, wemust meet income source, asset diversification and annual distributionrequirements. The annual distribution requirement is satisfied if we distributeat least 90% of our ordinary income and short-term capital gains to ourstockholders on an annual basis. Because we intend to use leverage, we aresubject to certain asset coverage ratio requirements under the 1940 Act andcould, under certain circumstances, be restricted from making distributionsnecessary to qualify as a RIC. Warrants we receive with respect to debtinvestments will create “original issue discount,” which we must recognize asordinary income, increasing the amounts we are required to distribute tomaintain RIC status. Because such warrants will not produce distributable cashfor us at the same time as we are required to make distributions in respect ofthe related original issue discount, we will need to use cash from othersources to satisfy such distribution requirements. The asset diversificationrequirements must be met at the end of each calendar quarter. If we fail to

 

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meet these tests, we may need to quickly dispose of certain investmentsto prevent the loss of RIC status. Since most of our investments will beilliquid, such dispositions, if even possible, may not be made at pricesadvantageous to us and, in fact, may result in substantial losses. If we failto qualify as a RIC for any reason and become fully subject to corporate incometax, the resulting corporate taxes could substantially reduce our net assets,the amount of income available for distribution, and the actual amountdistributed. Such a failure would have a material adverse effect on us and ourshares. For additional information regarding asset coverage ratio and RICrequirements, see “Business—Leverage,” and “Regulation.”

 

**Thereare significant potential conflicts of interest which could impact ourinvestment returns.**

 

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

 

**Changesin laws or regulations governing our operations may adversely affect ourbusiness.**

 

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

 

**Wemay experience fluctuation in our quarterly results.**

 

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

 

**Thereis a risk that you may not receive dividends or that our dividends may not growover time.**

 

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

 

**Failureto deploy capital may reduce our return on equity.**

 

In the past, we have experienced delays ininvesting the proceeds of our initial public offering as compared to theoriginal timetable that we expected at the time of our initial public offering.As of September 30, 2003, we have invested approximately $130.5 million(including the maximum aggregate amount outstanding under an $8 millionline of credit in favor of one of our portfolio companies, that hassubsequently been retired) of the approximately $131 million raised in ourinitial public offering, which closed on August 29, 2001. If we fail toinvest our capital effectively, our return on equity may be negativelyimpacted, which could result in a decline in the market price of our commonstock.

 

15

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**Prepaymentsby our portfolio companies could adversely impact our results of operations andreduce our return on equity.**

 

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

 

**Provisionsof our articles of incorporation and bylaws could deter takeover attempts andadversely impact the price of our shares.**

 

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

 

**Themarket price of our shares may fluctuate significantly.**

 

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

 

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

 

•              significant volatility in the marketprice and trading volume of shares of RICs, business development companies orother companies in our sector, which is not necessarily related to theoperating performance of these companies;

 

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

 

•              loss of RIC status;

 

•              changes in our earnings or variations inour operating results;

 

•              changes in the value of our portfolio ofinvestments;

 

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

 

•              departure of key personnel;

 

•              operating performance of companiescomparable to us;

 

•              short-selling pressure with respect toour shares or business development companies generally;

 

•              general economic trends and otherexternal factors; and

 

•              loss of a major funding source.

 

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

 

16

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**Sharesof closed-end investment companies frequently trade at a discount from netasset value.**

 

Shares of closed-end investment companiesfrequently trade at a discount from net asset value. This characteristic ofshares of closed-end investment companies is separate and distinct from therisk that our net asset value per share will decline. It is not possible topredict whether our common stock will trade at, above, or below net assetvalue.

 

**Salesof substantial amounts of our common stock in the public market may have anadverse effect on the market price of our common stock.**

 

As of September 30, 2003 we have10,081,844 shares of common stock outstanding, of which 9,221,775 are freelytradable without restriction. The remaining 860,069 shares are held byemployees, officers and directors, most of which were purchased upon exerciseof stock options and all of which may currently be resold publicly incompliance with the volume limitations and other restrictions of Rule 144of the Securities Act. On April 10, 2003 we filed a registration statementto register for public resale 1,351,668 shares under our Amended and Restated2001 Equity Incentive Plan (including the shares that have already been issuedupon option exercises). Subsequent to the filing of this registrationstatement, all of these shares are now freely tradable without restriction,although certain of the options have not yet been granted and a portion of theoptions that have been granted are not yet vested and the shares underlyingsuch options will, accordingly, not be eligible for resale until vested. Salesof substantial amounts of our common stock in the public market, pursuant tosuch registration, under Rule 144 or otherwise, or the availability ofsuch shares for sale, could adversely affect the prevailing market prices forour common stock. If this occurs, it could impair our ability to raiseadditional capital through the sale of equity securities should we desire to doso.

 

**Available Information:**

 

Copies of our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments, ifany, to those reports filed pursuant to Section 13(a) or 15(d) of theExchange Act are available free of charge through our website atwww.GladstoneCapital.com.  A request forany of these reports may also be submitted to us by writing:  Corporate Secretary, Gladstone CapitalCorporation, 1616 Anderson Road, Suite 208, McLean, VA 22102.

 

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

 

We do not own any real estate or otherphysical properties materially important to our operation. Our headquarters arelocated in McLean, Virginia where we occupy our office space pursuant to alicense agreement that expires on October 31, 2004.  We also lease office space in New York Citypursuant to a service agreement that expires on August 31, 2004.

 

**Item 3****. LegalProceedings**

 

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

 

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

 

No matters were submitted to a vote ofsecurity holders during the fourth quarter of the fiscal year endedSeptember 30, 2003.

 

17

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**PARTII**

 

**Item 5****. Market forRegistrant’s Common Equity and Related Stockholder Matters**

 

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

 

|    |   | **Quarter  Ended** |   | **High** |   | **Low** |   |
|---------|--------|--------------------|--------|----------|--------|---------|--------|
|    |   |               |   |     |   |    |   |
| FY 2003 |   | 09/30/03           |   | $        | 20.52  |    | $      | 18.76 |   |
|    |   | 06/30/03           |   | 20.50    |   | 16.25   |   |
|    |   | 03/31/03           |   | 16.78    |   | 15.55   |   |
|    |   | 12/31/02           |   | 17.00    |   | 14.90   |   |
| FY 2002 |   | 09/30/02           |   | 18.74    |   | 16.00   |   |
|    |   | 06/30/02           |   | 19.52    |   | 17.10   |   |
|    |   | 03/31/02           |   | 18.05    |   | 16.60   |   |
|    |   | 12/31/01           |   | 19.10    |   | 15.90   |   |
|         |        |                    |        |          |        |         |        |  |  |

 

 

As of November 12, 2003, there wereapproximately 8,860 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. The followingtable reflects, by quarter, the dividends per share that we have declared onour common stock for each quarter of the last two fiscal years:

 

|    |   | **Quarter  Ended** |   | **Cash Dividend  Per Share** |   |
|---------|--------|--------------------|--------|------------------------------|--------|
|    |   |               |   |                         |   |
| FY 2003 |   | 09/30/03           |   | $                            | 0.33   |   |
|    |   | 06/30/03           |   | 0.29                         |   |
|    |   | 03/31/03           |   | 0.25                         |   |
|    |   | 12/31/02           |   | 0.23                         |   |
| FY 2002 |   | 09/30/02           |   | 0.21                         |   |
|    |   | 06/30/02           |   | 0.21                         |   |
|    |   | 03/31/02           |   | 0.21                         |   |
|    |   | 12/31/01           |   | 0.18                         |   |
|         |        |                    |        |                              |        |  |

 

**RecentSales of Unregistered Securities**

 

There were no unregistered salesof securities during the fiscal year ended September 30, 2003.

 

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**Item 6****. SelectedFinancial Data**

 

The following selected financial data for thefiscal year ended September 30, 2003 is derived from our consolidatedfinancial statements which have been audited by PricewaterhouseCoopers LLP,independent accountants.  The followingselected financial data for the fiscal year ended September 30, 2002 andthe period ended September 30, 2001 are derived from our consolidatedfinancial statements which have been audited by Ernst & Young LLP,independent accountants. The data should be read in conjunction with ourconsolidated financial statements and notes thereto and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this report.

 

**GLADSTONE CAPITAL CORPORATION**

 

**SELECTED FINANCIAL DATA**

** **

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

 

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(1)           Includes alloriginations/prepayments related to a line of credit to one of our portfoliocompanies.

 

(2)           Total return equals theincrease of the ending market value over the beginning market value, plusdistributions, divided by the beginning market value. The return for 2001 hasnot been annualized.

 

(3)           Weighted average yieldon investments equals interest income on investments divided by the averageinvestment balance throughout the year.

 

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

 

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

 

*The following analysis of our financial condition and results ofoperations should be read in conjunction with our financial statements and thenotes thereto contained elsewhere in this Form 10-K.*

 

**FORWARD-LOOKINGSTATEMENTS**

 

*All statements contained herein, other than historical facts, mayconstitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. These statements may relate to,among other things, future events or our future performance or financialcondition. In some cases, you can identify forward-looking statements byterminology such as “may,” “might,” “believe,” “will,” “provided,”“anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,”“should,” “would,” “if,” “seek,” “possible,” “potential” or the negative ofsuch terms or comparable terminology. These forward-looking statements involveknown and unknown risks, uncertainties and other factors that may cause ouractual results, levels of activity, performance or achievements to bematerially different from any future results, levels of activity, performanceor achievements expressed or implied by such forward-looking statements. Suchfactors include, among others: (1) adverse changes in interest rates;(2) our failure or inability to establish or maintain referralarrangements with leveraged buyout funds and venture capital funds to generateloan opportunities; (3) the loss of one or more of our executive officers,in particular David Gladstone or Terry Lee Brubaker; (4) our inability toestablish or maintain a credit facility on terms reasonably acceptable to us,if at all; (5) our inability to successfully securitize our loan portfolioon terms reasonably acceptable to us, if at all; (6) the decision of ourcompetitors to aggressively seek to make senior and subordinated loans to smalland medium-sized businesses on terms more favorable than we intend to provide;and (7) those factors described in the “Risk Factors” section of thisForm 10-K. We caution readers not to place undue reliance on any suchforward-looking statements, which are made pursuant to the Private SecuritiesLitigation Reform Act on 1995 and, as such, speak only as of the date made. Weundertake no obligation to publicly update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise,after the date of 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.

 

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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.

 

In addition, as a business developmentcompany under the 1940 Act, we are required to make available significantmanagerial assistance to our portfolio companies. We provide these services,for which we receive fees, through our wholly-owned subsidiary, GladstoneAdvisers, Inc. Such fees are typically paid in part at the time aprospective portfolio company signs a non-binding term sheet with us, with theremainder paid at the closing of the investments. These fees are generallynon-recurring, however in some instances they may have a recurring component.The specific services we provide vary by portfolio company, but generallyconsist of 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 and providing general financial advice. Werecord these fees as managerial assistance fee revenue in the period in whichthe fees are earned.

 

Our business plan calls for managerialassistance fee revenue to equal or exceed our operating expenses (excludinginterest expense). During the fiscal years ended September 30, 2003 and2002, we recorded managerial assistance fee revenue of $0.9 million and $1.7million, respectively. However, during the fiscal years endedSeptember 30, 2003 and 2002, operating expenses (excluding interest expense)exceeded managerial assistance fee revenue by approximately $2.9 and$1.2 million, respectively. Because we typically generate managerialassistance fee revenue only when we make new loans, our relatively slow pace ofloans during the 2003 and 2002 fiscal years led to this shortfall. In thefuture, we will need to make loans at a faster pace in order to meet thisobjective. However, we believe that, as the economic environment improves, wewill be able to make sufficient new investments so that over time our managerialassistance fee revenue will equal or exceed our operating expenses (excludinginterest expense), although there can be no guarantee that we will be able todo so.

 

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

 

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 proposed borrowerfor our reasonable expenses incurred in connection with the proposedtransaction. Any amounts collected are recognized as “other income” in thequarter in which such reimbursement is received. Also, in the event that wehave incurred significant legal fees in connection with the transaction, wewill typically also seek reimbursement for these expenses from the proposedborrower. However, there can be no guarantee that we will be successful incollecting 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). While in some instances we may alsoreceive on-going managerial assistance fee revenue in connection with aconsummated investment, any such amounts are insignificant.

 

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The general economic climate during bothfiscal years ended September 30, 2003 and 2002 was unfavorable. Manybusinesses saw their sales and business prospects decline during the year.Consequently, many of these companies were forced to lay off employees andengage in other cost cutting measures. As a result of the difficult businessclimate, we determined it prudent to proceed cautiously in making loans duringeach of these fiscal years. Since our initial public offering inAugust 2001, we have made eighteen different loans to, or investments in,twelve companies for a total of approximately $131 million (including themaximum aggregate amount outstanding under an $8 million line of credit infavor of one of our portfolio companies, that has subsequently been retired).

 

In spite of the economic environment, we areearnestly working toward the consummation of more investments. Theseprospective loans are subject to, among other things, the satisfactorycompletion of our due diligence investigation of each borrower, acceptance ofterms and structure and necessary consents. With respect to each prospectiveloan, we will only agree to provide the loan if, among other things, theresults of our due diligence investigations are satisfactory, the terms andconditions of the loan are acceptable and all necessary consents are received.Our management has initiated its due diligence investigations of the potentialborrowers, however we can not assure you that we will not discover facts in thecourse of completing our due diligence that would render a particularinvestment imprudent or that any of these loans will actually be made.

 

**CriticalAccounting 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. We have identified our investmentvaluation process as our most critical accounting policy.

 

**InvestmentValuation**

 

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.

 

We value our investment portfolio eachquarter. Members of our portfolio management team prepare the portfolio companyvaluations using the most recent portfolio company financial statements andforecasts.  These individuals alsoconsult with the respective principal who originated the portfolio investmentto obtain further updates on the portfolio company’s performance, including informationsuch as industry trends, new product development, and other operationalissues.  As of March 31, 2003, weengaged Standard & Poor’s Loan Evaluation Service (S&P) to helpevaluate the value of the majority of our loan securities.  Since June 30, 2003, our S&Pengagement includes evaluations on exit fees (conditional interest included insome loan securities).  We and S&Ponly evaluate the value of an exit fee if the probability of receiving the exitfee on a given loan is above 6-8%, a threshold of significance, in which case avalue is assigned.  Upon completing thedata collection, the valuation data is presented to S&P.  S&P makes its independent assessment ofthe data and assesses its own data to determine market values for thesecurities.  With regard to its work,S&P has issued the following paragraph:

 

S&Pprovides evaluated price opinions which are reflective of what S&P believesthe bid side of the market would be for each loan after careful review andanalysis of descriptive, market and credit information.  Each price reflects S&P’s best judgmentbased upon careful examination of a variety of market factors.  Because of fluctuation in the market and inother factors beyond its control, S&P cannot guarantee theseevaluations.  The evaluations reflectthe market prices, or estimate 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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Withour assessment and S&P value estimates as a backdrop, our Board votes toaccept or not accept the analyses and values recommended by management andS&P.  At September 30, 2003,the Board elected to accept the valuations recommended by S&P on thoseloans as denoted on the Schedule of Investments in the ConsolidatedFinancial Statements.  Because there isa lag 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 Boardmakes its own determination about the value of the loan in accordance with ourvaluation policy.  Because S&P doesnot provide values for mortgage loans or equity securities, the directors alsodetermine fair value of these using the valuation policy:

 

GeneralValuation Policy: We carry our investments at fair value, as determined by ourBoard of Directors.  Securities that arepublicly traded, if any, are valued at the closing price on the valuation date.Debt and equity securities that are not publicly traded or for which we havevarious degrees of trading restrictions, are valued at fair value as determinedin good faith by our Board of Directors. In making the good faith determination of the securities, we start withthe cost basis of the security, which includes the amortized original issuediscount, exit fee (defined interest) and PIK interest, if any.  We then apply the methods set out below inValuation Methods.  Due to theuncertainty inherent in the valuation process, such estimates of fair value maydiffer significantly from the values that would have been obtained had a readymarket for the securities 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.  No single standard for determining fair value in good faithexists since fair value depends upon circumstances of each individualcase.  In general, fair value is theamount that we might reasonably expect to receive upon the current sale of thesecurity.

 

CreditInformation: We monitor a widevariety of key credit statistics that provide information regarding ourportfolio companies to help us assess credit quality and portfolioperformance.  We require our portfoliocompanies to provide annual audited and monthly, unaudited financialstatements.  Using these statements, wecalculate and evaluate the credit statistics. For purposes of analyzing the financial performance of our portfoliocompanies, we may make certain adjustments to their cash flow statements toreflect the pro forma results of a company consistent with a change of controltransaction, to reflect anticipated cost savings resulting from a merger orrestructuring, costs related to new product development, compensation toprevious owners, and other acquisition or restructuring related items.

 

LoanGrading and Risk Rating: As ofDecember 31, 2002 we expanded the scale of our loan grading system fromone that had a scale of 1 to 4, to a scale that uses 0 to 10.  This system is used to estimate theprobability of default on our debt securities and the probability of loss ifthere is a default.  These types ofsystems are referred to as risk rating systems and are used by banks and ratingagencies.  We risk rate each of our debtsecurities.  The risk rating system coversboth qualitative and quantitative aspects of the business and the securities wehold.

 

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Weseek to have our risk rating system mirror the risk rating systems of majorrisk rating organizations such as those provided by nationally recognizedstatistical rating organizations (“NRSRO”) as defined in Rule 2a-7 under the1940 Act.  While we seek to mirror theNRSRO systems, we cannot provide any assurance that our risk rating systemprovides the same risk rating as a NRSRO. The following chart is an estimate of the relationship of our riskrating system to the designations used by two NRSROs as they risk rate debtsecurities of major companies.  Becausewe have established our system to rate debt securities of companies that areunrated by any NRSRO there can be no assurance that the correlation to theNRSRO 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.

 
| **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 ratesset here are for a ten year term debt, if the company’s debt security is lessthan ten years then the probability of default is adjusted to a lowerpercentage for the shorter period which may move the security higher on thecompany’s risk rating scale.*

 

AtSeptember 30, 2002, all debt investments were grade 3 under the 1-to-4loan grading system. The rating of 3 on the 1-4 system means that the portfoliocompanies were performing as agreed and they had paid on time.  Using the expanded scale, at December 31,2002, March 31, 2003, June 30, 2003, and September 30, 2003 theaverage, weighted average and highest rated loan and lowest rated loan were asfollows:

 

| **Rating**       |   | **December 31,  2002** |   | **March 31,  2003** |   | **June 30,  2003** |   | **September 30,  2003** |   |
|------------------|--------|-----------------------------|--------|--------------------------|--------|-------------------------|--------|------------------------------|--------|
| Average          |   | 7.5                         |   | 7.7                      |   | 7.7                     |   | 7.8                          |   |
| Weighted Average |   | 7.5                         |   | 7.7                      |   | 7.6                     |   | 7.6                          |   |
| Highest          |   | 9.0                         |   | 9.0                      |   | 9.0                     |   | 9.0                          |   |
| Lowest           |   | 6.0                         |   | 6.0                      |   | 6.0                     |   | 6.0                          |   |

 

Theabove scale gives an indication of the probability of default and the magnitudeof the loss if there is a default using the expanded risk rating scale.

 

Ourpolicy is to stop accruing interest on an investment if we determine thatinterest is no longer collectible. To date we have not placed any investmentson non-accrual.  At September 30,2003 and September 30, 2002, no payments were past due on any of our debtsecurities.  We do not risk rate ourequity securities.

 

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ValuationMethods:  For debt securities, we firstdetermine if there is a market for the debt security.  If there is a market, then we will determine the value based onthe market prices for the security, even if that market is not robust.  At September 30, 2003 andSeptember 30, 2002 there was no market for any of the debt securities inour portfolio.  If there is no marketfor the debt securities, then we begin with the risk rating designation of thesecurity described above.  Using therisk rating designation above, we seek to determine the value of the securityas if we intended to sell the security in a current sale.  To determine the current sale price of thesecurity, we may use some or all of the following items: financial standing ofthe issuer of the security, comparison of the business and financial plan ofthe issuer with actual results, the cost of the security, the size of thesecurity held as it relates to the liquidity of the market for such securities,contractual restrictions on the disposition of the security, pending publicoffering of the issuer of the security, pending reorganization activity affectingthe issuer such as mergers or debt restructuring, reported prices of similarsecurities of the issuer or comparable issuers, ability of the issuer to obtainneeded financing, changes in the economy affecting the issuer, recent purchasesor sale of a security of the issuer, pricing by other buyers or sellers ofsimilar securities, financial statements of the borrower, the type of security,cost at date of purchase, size of holding, discount from market value ofunrestricted securities of the same class at the time of purchase, specialreports prepared by analysts, information as to any transactions or offers withrespect to the security, existence of merger proposals or tender offersaffecting the securities, the collateral, the issuer’s ability to makepayments, the current and forecasted earnings of the issuer, sales to thirdparties of similar securities, statistical ratios compared to lendingstandards, statistical ratios compared to other similar securities and otherpertinent factors.

 

Forequity securities, we first determine if there is any market for the equitysecurity.  If there is a market, then wedetermine the value based on the market prices for the security, even if thatmarket is not robust.  AtSeptember 30, 2003 and September 30, 2002 there was no market for anyof the equity securities we owned.  Ifthere is no market for the equity securities, then we use the same informationwe would use for a debt security valuation described above, except risk-rating,as well as standard valuation techniques used by major valuation firms to valuethe equity securities of private companies. These valuation techniques consist of: discounted cash flow of theexpected sales price in the future, the value of the securities based on therecent sale of comparable transactions and a review of similar companies thatare publicly traded and the market multiple of their equity securities.  At September 30, 2003 we had $37,000invested, at cost, in equity securities compared to our debt portfolio with acost basis of $109,529,893.

 

AtSeptember 30, 2003, The Home Care Supply, Inc. senior loan has anappreciation of $473,400 in its value as a result of the value applied to theexit fee.  Further, the value of ourwarrants in Finn Corporation has an appreciation of $394,111 atSeptember 30, 2003.  Thisappreciation plus an increase of $9,000 on the Kozy Shack Enterprisesinvestment totals $876,511 and partially offsets depreciation of $1,098,851.

 

Ournew risk rating system is more detailed than our prior system. Due to the moredetailed nature of the risk rating system there is the likelihood that futurevaluations will change more frequently. S&P determines what a loan might trade at if it was publicly traded,which also adds volatility to our valuations.

 

**ManagerialAssistance Fees**

 

The 1940 Act requires that a businessdevelopment company make available managerial assistance to its portfoliocompanies. We provide managerial assistance to our portfolio companies inconnection with our investments through our wholly-owned subsidiary, GladstoneAdvisers, Inc. and receive fees for our managerial assistance services.These fees are normally paid at the closing of our investments in our portfoliocompanies, are generally non-recurring and are recognized as revenue whenearned. The managerial assistance services we provide vary by investment, butgenerally consist of reviewing existing credit facilities, arranging bankfinancing, arranging equity financing, structuring financing from multiplelenders, structuring financing from equity investors, restructuring existingloans, raising equity and debt capital, and providing general financial advice.From time to time, we are invited to participate as a co-lender in atransaction. In the event that we do not provide significant managerialassistance services in connection with our investment, loan fees paid to us insuch situations are deferred and amortized over the life of the loan.

 

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**RESULTSOF OPERATIONS**

*COMPARISON OF THE FISCAL YEARS ENDED SEPTEMBER 30, 2003AND SEPTEMBER 30, 2002*

 

**OperatingIncome**

 

Operating income for the fiscal year endedSeptember 30, 2003 was $15.2 million as compared to $10.5 million for thefiscal year ended September 30, 2002. This increase is primarily a result of increased interest income from anincrease in the amount of investments. These debt securities provide a higheryield than the short-term investment grade securities.

 

Interest income from our investments in debtsecurities of private companies was approximately $13.2 million, including$781,000 of PIK interest, for the fiscal year ended September 30, 2003 ascompared to $6.6 million for the fiscal year ended September 30,2002, including $462,000 of PIK interest.     This increase was primarily the result ofapproximately $47.0 million of new investments for the fiscal year endedSeptember 30, 2003.

 

The weighted average yield on our portfoliofor the fiscal year ended September 30, 2003 was 13.14% (without givingeffect to PIK interest) and 13.86% (after giving effect to PIK interest). Theweighted average yield on our portfolio for the fiscal year endedSeptember 30, 2002 was 13.82% (without giving effect to PIK interest) and14.79% (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, 2003 was approximately$466,000, as compared to approximately $1.6 million for the fiscal year endedSeptember 30, 2002. This decrease was primarily a result of $47.0 millionof new investments.

 

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

 

Managerial assistance fees were approximately$886,000 for the fiscal year ended September 30, 2003 and$1.7 million for the fiscal year ended September 30, 2002.  Fee income for each of the fiscal yearsended September 30 consists primarily of managerial assistance feesreceived in connection with investments we closed during the respective fiscalyear. During the fiscal year ended September 30, 2003, we closed five newloans compared to eight from the prior fiscal year.

 

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

 

**OperatingExpenses**

 

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

 

Salaries and benefits for the fiscal yearended September 30, 2003 were approximately $2.0 million, as comparedto approximately $1.4 million for the fiscal year ended September 30,2002. The primary reason for the increase was the hiring additional employeesduring the year. We expect salaries and benefits to continue to increase as wehire additional personnel as operations expand.

 

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

 

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

 

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

 

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

 

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

 

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

 

General and administrative expenses, consisting primarily of office operations,travel and data communications, for the fiscal year ended September 30,2003 were approximately $507,000, as compared to approximately $464,000 for thefiscal year ended September 30, 2002. These increases were largely relatedto new employees and the expansion of operations.

 

**Net Increase in Stockholders’ Equity fromOperations**

 

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

 

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

 

27

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*COMPARISON OF THE FISCAL YEARENDED SEPTEMBER 30, 2002 TO THE PERIOD FROM INCEPTION (MAY 30, 2001)THROUGH SEPTEMBER 30, 2001*

 

**Operating Income**

 

Operating income for the fiscal year ended September 30, 2002 wasapproximately $10.5 million as compared to $395,000 for the period frominception (May 30, 2001) through September 30, 2001. This increasewas primarily a result of the inclusion of a full year of operations in theresults for the 2002 fiscal year as contrasted to our limited operations duringthe prior period. In addition, during the 2002 fiscal year, we began investingthe proceeds of our initial public offering in debt securities of privatecompanies. These debt securities provide a higher yield than the short-terminvestment grade securities that represented substantially all of our assets asof September 30, 2001.

 

Interest income from our investments in debt securities of privatecompanies was approximately $6.6 million for the fiscal year endedSeptember 30, 2002, including $462,000 of PIK interest. Because we did notmake any such investments prior to November 2001, we did not recordinterest income from debt securities of private companies for the period frominception through September 30, 2001.

 

The weighted average yield on our portfolio for the fiscal year endedSeptember 30, 2002 was 13.82% (without giving effect to PIK interest) and14.79% (after giving effect to PIK interest).

 

Interest income from invested cash and cash equivalents for the fiscalyear ended September 30, 2002 was approximately $1.6 million, ascompared to approximately $350,000 for the period from inception throughSeptember 30, 2001. This increase was primarily a result of our investmentof the net proceeds of our initial public offering for the full year. Bycomparison, the results for the period from inception throughSeptember 30, 2001 include interest income earned on the investment of thenet proceeds of our initial public offering from August 29, 2001 (the dateof the closing of our initial public offering) through September 30, 2001.As we continue to acquire debt securities of private companies, which weanticipate will be at interest rates significantly greater than the rates thatwe are currently receiving on our deposited cash and cash equivalents, weexpect that income from invested cash and cash equivalents will decline as apercentage of total revenue and that interest income from debt securities willincrease and become our predominant source of revenue.

 

For the fiscal year ended September 30, 2002, we recordedapproximately $433,000 in interest income from loans to our employees inconnection with the exercise of employee stock options, as compared toapproximately $45,000 in interest income from such loans for the period frominception through September 30, 2001. The increase is primarily the resultof the inclusion in the results of operations for the year endedSeptember 30, 2002 of a full year of interest income on the majority ofsuch employee loans (which were made at the time of our initial publicoffering) and, to a lesser extent, the inclusion of interest income on employeeloans entered into during the 2002 fiscal year. By comparison, the results forthe period from inception through September 30, 2001 include interestearned on such employee loans from the time of exercise of such options (August 23,2001) through September 30, 2001.

 

Managerial assistance fees were approximately $1.7 million for thefiscal year ended September 30, 2002. Fee income for the fiscal year endedSeptember 30, 2002 consists primarily of managerial assistance feesreceived in connection with investments we closed during the fiscal year. Italso includes approximately $47,000 in fees associated with a line of credit weextended to one of our portfolio companies that is no longer outstanding.Because we did not make any investments in debt securities of private companiesprior to November 2001, we did not record any managerial assistance feeincome for the period from inception through September 30, 2001.

 

Other income was approximately $131,000 for the fiscal year ended September 30,2002. This amount was comprised of approximately $81,000 in up-front feesreceived in connection with five proposed investments that ultimately were notconsummated and approximately $50,000 in other fees. Because we did notexperience the termination of any such negotiations during the period frominception through September 30, 2001, we did not record any other incomefor such period.

 

**Operating Expenses**

 

Operating expenses for the fiscal year ended September 30, 2002were approximately $2.8 million, compared to approximately $487,000 forthe period from inception through September 30, 2001. This increase wasprimarily a result of the inclusion of a full year of operations in the resultsfor the 2002 fiscal year, as contrasted to our limited operations during theperiod from inception through September 30, 2001. However, this increasewas partially offset by substantial nonrecurring costs associated with ourorganization and our commencement of operations incurred during the period frominception through September 30, 2001.

 

Salaries and benefits for the fiscal year ended September 30, 2002were approximately $1.4 million, as compared to

 

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approximately $229,000 for the period from inception throughSeptember 30, 2001. This increase was primarily a result of the inclusionof a full year of operations in the results for the 2002 fiscal year, ascontrasted to our limited operations during the period from inception throughSeptember 30, 2001. Salaries and benefits also increased as a result ofour hiring additional employees during the year.

 

General and administrative expenses, consisting primarily of insurance,office operations, travel and stockholder related expenses, for the fiscal yearended September 30, 2002 were approximately $775,000, as compared toapproximately $145,000 during the period from inception throughSeptember 30, 2001. This increase was primarily a result of the inclusionof a full year of operations in the results for the 2002 fiscal year, ascontrasted to our limited operations during the period from inception throughSeptember 30, 2001. General and administrative expense also increased as aresult of the general expansion of our operations during the year.

 

Professional fees, consisting primarily of legal and audit fees, forthe fiscal year ended September 30, 2002 were approximately $550,000, ascompared to approximately $72,000 during the period from inception throughSeptember 30, 2001. This increase was primarily a result of the inclusionof a full year of operations in the results for the 2002 fiscal year, ascontrasted to our limited operations during the period from inception throughSeptember 30, 2001.

 

Rent expense for the fiscal year ended September 30, 2002 wasapproximately $125,000, as compared to approximately $3,000 during the periodfrom inception through September 30, 2001. This increase was primarily aresult of the inclusion of a full year of operations in the results for the2002 fiscal year, as contrasted to our limited operations during the periodfrom inception through September 30, 2001. This amount also increased as aresult of our relocation of our principal executive offices following thecompletion of our initial public offering.

 

Directors fees for the fiscal year ended September 30, 2002 wereapproximately $22,000, as compared to approximately $38,000 during the periodfrom inception through September 30, 2001. We anticipate that annualdirectors fees will approximate $18,000 per non-employee director over time.

 

**Net Increase in Stockholders’ EquityResulting from Operations**

 

As a result of the operating income and operating expenses describedabove, we had net increase to stockholders’ equity resulting from operations ofapproximately $7.6 million for the fiscal year ended September 30,2002. Based on a weighted-average of 10,064,900 (basic) and 10,166,752(diluted) shares outstanding, our net increase in stockholders’ equityresulting from operations per common share for the fiscal year ended September 30,2002 was $0.76 (basic) and $0.75 (diluted).

 

For the period from inception through September 30, 2001, weincurred a net decrease in stockholders’ equity resulting from operations ofapproximately $93,000. Based on a weighted-average of 3,219,525 sharesoutstanding, our net decrease to stockholders’ equity resulting from operationsper common share for the period from inception through September 30, 2001was $(0.03), basic and diluted.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

At September 30, 2003, we had investments in debt securities of,or loans to, eleven private companies totaling approximately $109.5 million,including approximately $807,000 in accrued PIK interest.  At September 30, 2002, we had investmentsin debt securities of, or loans to, seven private companies, totalingapproximately $79.7 million of total investment assets, includingapproximately $400,000 in accrued PIK interest.  PIK interest is described in “Overview,” and is added to ourcarrying value of our investments.

 

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

 
| **Year**   |   | **Amount** |        |
|------------|--------|------------|-------------|
|       |   |       |        |
| 2004       |   | $          | 3,622,918   |   |
| 2005       |   | $          | 12,924,071  |   |
| 2006       |   | $          | 14,205,747  |   |
| 2007       |   | $          | 29,427,990  |   |
| 2008       |   | $          | 15,837,500  |   |
| Thereafter |   | $          | 33,511,667  |   |
| Total      |   | $          | 109,529,893 |   |

 

Cash provided by operating activities for the fiscal year endedSeptember 30, 2003, consisting primarily of the items described in“Results of Operations,” was approximately $9.9 million as compared toapproximately $7.0 million for the fiscal year ended September 30, 2002.Net cash provided by investing activities was approximately $10.3 million ascompared to net cash used in investing activities of approximately $40.2 millionfor the fiscal year ended September 30, 2002. The net cash provided wasdue largely in part to $39.2 million provided in connection with the repurchaseagreements and the repayments of the repurchase agreements, and principalrepayments of $18.0 million, partially offset by $47.0 million of investedcash. At September 30, 2002, the net cash used consisted of investments inour portfolio companies, partially offset by a net increase in cash ofapproximately $39.2 million in connection with repurchase agreements andthe repayment, by our portfolio companies, of principal of approximately$18.4 million. Net cash used in financing activities was approximately$10.9 million for the fiscal year ended September 30, 2003 and consistedof the payment of dividends of $9.8 million and the payment of prepaidfinancing fees associated with the establishment of our warehouse line ofcredit of $1.1 million. Net cash used in financing activities was approximately$6.7 million for the fiscal year ended September 30, 2002 andconsisted primarily of the payment of dividends of approximately$6.0 million and the repayment of accrued costs of approximately $641,000associated with our initial public offering.

 

During the fiscal year ended September 30, 2003, cash and cash equivalentsincreased from approximately $91.9 million at the beginning of the year toapproximately $101.1 million at the end of the year.  This increase was largely the result of the repurchase agreementdescribed below.

 

During the fiscal year ended September 30, 2002, cash and cashequivalents decreased from approximately $131.8 million at the beginningof the year to approximately $91.9 million at the end of the year. Thisdecrease of approximately $39.9 million was largely the result of ourinvesting activities, partially offset by an increase in cash and cashequivalents in connection with the repurchase agreement described below.

 

On September 30, 2003, we entered into a repurchase agreement (theRepurchase Agreement) with UBS for $78,449,000, which agreement was settled onOctober 1, 2003.  The RepurchaseAgreement was recorded at cost and was fully collateralized by a United StatesTreasury Bill with a fair value of $80,050,000 and a carrying value of $80,022,249that matured on October 16, 2003. The interest rate on the RepurchaseAgreement was 0.80%. The repurchase agreement was reflected on the consolidatedbalance sheet at September 30, 2003 as cash and cash equivalents pledgedto creditors of $80.0 million and a liability of $78.4 million. In the future,we plan to use a similar form of repurchase agreement as an investment optionor in order to satisfy certain asset diversification requirements and maintainour status as a RIC under Subchapter M of the Internal Revenue Code.

 

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On September 30, 2002, we entered into a repurchase agreement withUBS Paine Webber for approximately $39.2 million. The repurchase agreementwas fully collateralized by a United States treasury bill with a fair value ofapproximately $40.0 million that matured on October 3, 2002. Theinterest rate on the repurchase agreement was 1.85%. This repurchase agreementwas reflected on our balance sheet as of September 30, 2002 as an increasein cash and cash equivalents pledged to creditors of $39.2 million, alongwith a corresponding liability for the same amount. The repurchase agreementwas settled on October 1, 2002.

 

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, we declaredand paid quarterly cash dividends of $0.23, $0.25, $0.29 and $0.33 per share onour common stock for the first, second, third and fourth quarters,respectively, of the fiscal year ended September 30, 2003 and $0.18,$0.21, $0.21 and $0.21 per share on our common stock for the first, second,third and fourth quarters, respectively, of the fiscal year endedSeptember 30, 2002.

 

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.

 

Aggregate dividends declared and paid for the 2002 fiscal year wereapproximately $8.2 million. We declared these dividends based upon ourestimate of net operating income for the year. Because of the difficulteconomic climate during the 2002 fiscal year, our investment pace was slowerthan we had originally anticipated, and consequently, our net operating incomewas lower than we had originally projected. This resulted in our dividendsrelated to our 2002 fiscal year exceeding our net operating income for the yearby approximately $0.5 million. Additionally, dividends related to our 2002fiscal year exceeded our current and accumulated earnings and profits and, as aresult, a portion of these dividends were treated as a return of capital to ourstockholders.

 

In November 2003, Kozy Shack Enterprises Inc, repaid its entireoutstanding loan balance.

 

We anticipate borrowing funds and issuing additional equity securitiesto obtain additional capital once the proceeds of our initial public offeringhave been fully invested. 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 March 19, 2003, the SEC declared theregistration statement effective, and we currently have no immediate plans toissue any securities under the registration statement.

 

**Revolving CreditFacility**

 

Through our wholly-owned subsidiary, Business Loan, we have obtained a$100 million revolving credit facility. On May 19, 2003, we executed a Purchase and Sale Agreement pursuantto which we agreed to sell certain loans to Business Loan in consideration of amembership interest therein. Simultaneously, Business Loan executed a Credit Agreement with CIBCWorld Markets Inc., as administrative agent, and others, pursuant to which BusinessLoan pledged the loans purchased from us to secure future advances by certaininstitutional lenders.  Interest ratescharged on the advances under the facility will be based on LIBOR, the PrimeRate or the Federal Funds Rate, depending on market conditions, and will adjustperiodically.

 

The facility contains covenants that, among other things, requireBusiness Loan to maintain its status as a separate entity; prohibit certainsignificant corporate transactions (such as mergers, consolidations,liquidations or dissolutions); and restrict material changes to our credit andcollection policies.  The facility alsorestricts some of the terms and provisions (including interest rates, terms tomaturity and payments schedules) and limits the borrower and industryconcentrations of loans that are eligible to secure advances.  As of November 20, 2003, Business Loanwas in compliance with all of the facility covenants.  We currently intend to securitize all of the loans held byBusiness Loan and will use the proceeds from the securitization to pay down anyamounts then outstanding under the revolving credit facility.  There are currently no advances outstandingunder this facility.

 

Gladstone Advisers, Inc. (“Advisers”), our servicing subsidiary, willservice the loans pledged under the facility. As a condition to this servicing arrangement, we executed a PerformanceGuaranty pursuant to which we guaranteed that Advisers would comply fully withall of its obligations under the facility.   The Performance Guaranty requires us to maintain a minimum net worth of$100 million and to maintain “asset coverage” with respect to “seniorsecurities representing indebtedness” of at least 200%, in accordance withSection 18 of the 1940 Act.  As ofNovember 20, 2003, we were in compliance with our covenants under thePerformance Guaranty.

 

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

 

We are subject to financial market risks, including changes in interestrates. We expect that ultimately approximately 50% of the loans in ourportfolio will be made at fixed rates, with approximately 50% made at variablerates.  Currently our portfolio hasapproximately 44% of the loans at fixed rates and the remaining 56% at variablerates with a minimum rate provision. Currently these variable loans record income based on the minimum rateprovision.

 

Pursuant to our line of credit, we have agreed to enter into hedgingtransactions, such as interest rate swaps, in connection with the borrowingsthat we make under the line of credit, which we currently expect to beginmaking in the near future.  Suchtransactions will effectively convert our fixed rate portfolio loans intovariable rate loans in an effort to mitigate our exposure to increases ininterest rates on our borrowings on the line of credit, which will be atvariable rates.  Furthermore, in theevent that we securitize a portion of our loan portfolio in the future, webelieve that we will likely be required to enter into similar arrangements withrespect to securitized loans.

 

While hedging activities may insulate us against adverse fluctuationsin interest rates, they may also limit our ability to participate in thebenefits of lower interest rates with respect to our portfolio of investments.

 

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

 

**Index to Consolidated Financial Statements**

 
| Report of Independent Auditors                                                                                                                                                                     |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Report of Independent Auditors                                                                                                                                                                     |   |
| Consolidated Balance Sheets as of September 30, 2003 and  September 30, 2002                                                                                                             |   |
| Consolidated Schedules of Investments as of  September 30, 2003 and September 30, 2002                                                                                                   |   |
| Consolidated Statements of Operations for  the years ended September 30, 2003, September 30, 2002 and the  period May 30, 2001 (inception) through September 30, 2001          |   |
| Consolidated Statements of Stockholders  Equity for the years ended September 30, 2003, September 30, 2002  and the period May 30, 2001 (inception) through September 30, 2001 |   |
| Consolidated Statements of Cash Flows for  the years ended September 30, 2003, September 30, 2002 and the  period May 30, 2001 (inception) through September 30, 2001          |   |
| Notes to Financial Statements                                                                                                                                                                      |   |

 

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**Reportof Independent Auditors**

 

Tothe Board of Directors and Stockholders

ofGladstone Capital Corporation:

 

Inour opinion, the accompanying consolidated balance sheet, including theschedule of investments, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows present fairly, in allmaterial respects, the financial position of Gladstone Capital Corporation andits subsidiaries (the “Company”) at September 30, 2003, and the results oftheir operations and their cash flows for the year then ended****inconformity with accounting principles generally accepted in the United Statesof America.  These financial statementsare the responsibility of the Company’s management; our responsibility is toexpress an opinion on these financial statements based on our audit.  We conducted our audit of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audit provides a reasonable basis for our opinion.  The financial statements of the Company forthe year ended September 30, 2002 and for the period from May 30,2001 (inception) through September 30, 2001 were audited by other auditorswhose report dated November 1, 2002 expressed an unqualified opinion onthose statements.

 

 
| /s/ PricewaterhouseCoopers LLP |   |
|--------------------------------|--------|
| Baltimore, Maryland            |
| October 28, 2003          |

 

34

----

 

**Report of****Independent Auditors**

 

To the Board of Directors and Stockholders ofGladstone Capital Corporation

 

We have audited the accompanying consolidated balance sheets ofGladstone Capital Corporation (the Company) as of September 30, 2002 and2001, including the consolidated schedule of investments as ofSeptember 30, 2002, and the related consolidated statements of operations,stockholders’ equity, and cash flows for the year ended September 30, 2002and the period from May 30, 2001 (inception) through September 30,2001. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofGladstone Capital Corporation at September 30, 2002 and 2001, and theconsolidated results of its operations and its cash flows for the year endedSeptember 30, 2002 and the period from May 30, 2001 (inception)through September 30, 2001, in conformity with accounting principlesgenerally accepted in the United States.

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

 

35

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                              |   | **September 30,****2003** |        | **September 30,****2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|-------------|--------------------------------|------------|
|                                                                                                                              |   |                           |        |                           |       |
| **ASSETS**                                                                                                                        |   |                           |        |                           |       |
| Investments at fair value (Cost  9/30/2003:$109,529,893; 9/30/2002:$79,718,354)                                                   |   | $                              | 109,307,553 |                           | $          | 79,718,354 |   |
| Cash and cash equivalents                                                                                                         |   | 21,143,972                     |        | 51,930,529                     |       |
| Cash and cash equivalents pledged to  creditors                                                                                   |   | 80,022,249                     |        | 39,998,799                     |       |
| Interest receivable—investments in debt securities                                                                           |   | 1,041,943                      |        | 685,274                        |       |
| Interest receivable—cash and cash  equivalents                                                                               |   | 955                            |        | 4,389                          |       |
| Interest receivable—officers                                                                                                 |   | 108,657                        |        | 109,874                        |       |
| Due from custodian                                                                                                                |   | 1,207,000                      |        |                           |       |
| Prepaid assets                                                                                                                    |   | 1,479,815                      |        | 357,955                        |       |
| Other assets                                                                                                                      |   | 254,519                        |        | 116,865                        |       |
| **TOTAL ASSETS**                                                                                                                  |   | $                              | 214,566,663 |                           | $          | 172,922,039 |   |
|                                                                                                                              |   |                           |        |                           |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                    |   |                           |        |                           |       |
| **Liabilities**                                                                                                                   |   |                           |        |                           |       |
| Accounts payable                                                                                                                  |   | $                              | 23,247      |                           | $          | — |   |
| Dividends payable                                                                                                                 |   | 3,327,009                      |        | 2,115,087                      |       |
| Accrued expenses and deferred liabilities                                                                                         |   | 1,965,025                      |        | 944,960                        |       |
| Repurchase agreement                                                                                                              |   | 78,449,000                     |        | 39,198,719                     |       |
| Total Liabilities                                                                                                                 |   | $                              | 83,764,281  |                           | 42,258,766 |   |
|                                                                                                                              |   |                           |        |                           |       |
| **Stockholders’  Equity**                                                                                                    |   |                           |        |                           |       |
| Common stock, $0.001 par value, 50,000,000  shares authorized and 10,081,844 and 10,071,844 issued and outstanding,  respectively |   | 10,082                         |        | 10,072                         |       |
| Capital in excess of par value                                                                                                    |   | 140,416,674                    |        | 140,266,684                    |       |
| Notes receivable—officers                                                                                                    |   | (8,985,940                     | )           | (8,983,796                     | )          |
| Net unrealized depreciation on investments                                                                                        |   | (222,340                       | )           | —                         |       |
| Undistributed/(overdistributed) net investment  income                                                                            |   | (416,094                       | )           | (629,687                       | )          |
| Total Stockholders’ Equity                                                                                                   |   | 130,802,382                    |        | 130,663,273                    |       |
| **TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                              |   | $                              | 214,566,663 |                           | $          | 172,922,039 |   |

 

*See accompanying notes.*

 

36

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OF INVESTMENTS**

**SEPTEMBER 30, 2003**

 
| **Company (1)**                                                                |   | **Industry**                                             |   | **Investment**                             |   | **Cost**              |        | **Fair Value**        |   |
|--------------------------------------------------------------------------------|--------|----------------------------------------------------------|--------|--------------------------------------------|--------|-----------------------|-------------|-----------------------|--------|
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| America’s Water Heater Rentals, LLC                                       |   | Water heater rentals and servicing                       |   | Senior Term Debt (2)(4)                    |   | $                     | 12,000,000  |                  | $      | 12,000,000 |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| ARI Holdings, Inc.                                                             |   | Manufacturing-auto parts                                 |   | Senior Term Debt (2)(3)                    |   | 3,511,667             |        | 3,511,667             |   |
|                                                                           |   |                                                     |   | Senior Term Debt (2)                       |   | 1,500,000             |        | 1,500,000             |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Coyne International Enterprises                                                |   | Industrial services                                      |   | Senior Term Debt (2)(3)(4)                 |   | 15,421,740            |        | 15,306,077            |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Finn Corporation                                                               |   | Manufacturing-landscape equipment                        |   | Senior Subordinated Term Debt(4)           |   | 10,500,000            |        | 10,421,250            |   |
|                                                                           |   |                                                     |   | Common Stock Warrants for 2% ownership     |   | 37,000                |        | 431,111               |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Fugate & Associates, Inc.                                                  |   | Imaging supplies                                         |   | Senior Term Debt (4)                       |   | 3,412,500             |        | 3,412,500             |   |
|                                                                           |   |                                                     |   | Senior Term Debt (4)                       |   | 1,833,333             |        | 1,833,333             |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Home Care Supply, Inc.                                                         |   | Medical equipment rental                                 |   | Senior Term Debt (2)(4)(5)                 |   | 18,000,000            |        | 18,428,400            |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Inca Metal Products Corp.  Kingway Acquisition, Inc.  Clymer Acquisition, Inc. |   | Material handling and storage products                   |   | Senior Term Debt (2)(4)                    |   | 5,775,000             |        | 4,995,375             |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Kozy Shack Enterprises, Inc.                                                   |   | Food production and sales                                |   | Senior Term Debt (2)(4)                    |   | 900,000               |        | 909,000               |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
|                                                                           |   |                                                     |   | Senior Term Debt (2)(4)                    |   | 6,975,000             |        | 6,922,687             |   |
| Marcal Paper Mills, Inc.                                                       |   | Manufacturing-paper products                             |   | First Mortgage Debt (3)                    |   | 9,163,653             |        | 9,163,653             |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Mistras Holdings, Inc.                                                         |   | Nondestructive testing instruments, systems and services |   | Senior Term Debt (2)  Senior Term Debt (2) |   | 10,000,000  5,000,000 |        | 10,000,000  5,000,000 |   |
|                                                                           |   |                                                     |   |                                       |   |                  |        |                  |   |
| Wingstop Restaurants                                                           |   |                                                     |   | Senior Term Debt (4)                       |   | 3,500,000             |        | 3,482,500             |   |
| International, Inc.                                                            |   | Restaurant – fast food                              |   | Senior Debt (4)                            |   | 2,000,000             |        | 1,990,000             |   |
| Totals                                                                         |   |                                                     |   |                                       |   | $                     | 109,529,893 |                  | $      | 109,307,553 |   |

 

----

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

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

(3) Has some paid in kind(PIK) interest.  Refer to Note 2“Summary of Significant Accounting Policies” of Form 10-K for the fiscal yearended September 30, 2003.

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

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

 

*See accompanying notes.*

 

37

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**GLADSTONE CAPITAL CORPORATION**

**SCHEDULE OFINVESTMENTS**

**SEPTEMBER 30, 2002**

 
| **Company (1)**                 |   | **Industry**                           |   | **Investment**                         |   | **Cost**   |       | **Fair Value** |
|---------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|------------|------------|----------------|
|                            |   |                                   |   |                                   |   |       |       |           |
| ARI Holdings, Inc.              |   | Manufacturing-auto parts               |   | Junior Subordinated Term Debt (3)      |   | $          | 8,250,803  |           | $ | 8,250,803 |
| Coyne International Enterprises |   | Industrial services                    |   | Senior Term Debt (2)(3)                |   | 16,054,268 |       | 16,054,268     |
| Finn Corporation                |   |                                   |   | Senior Subordinated Term Debt          |   | 10,500,000 |       | 10,500,000     |
|                            |   | Manufacturing-landscape equipment      |   | Common Stock Warrants for 2% ownership |   | 37,000     |       | 37,000         |
| Home Care Supply, Inc.          |   | Medical equipment rental               |   | Senior Term Debt (2)                   |   | 18,000,000 |       | 18,000,000     |
| Inca Metal Products Corporation |   | Material handling and storage products |   | Senior Term Debt (2)                   |   | 6,000,000  |       | 6,000,000      |
| Kozy Shack Enterprises,Inc.     |   | Food preparations                      |   | Senior Term Debt (2)                   |   | 4,300,000  |       | 4,300,000      |
|                            |   |                                   |   | Senior Term Debt (2)                   |   | 7,500,000  |       | 7,500,000      |
| Marcal Paper Mills, Inc.        |   | Manufacturing-paper products           |   | First Mortgage Debt (3)                |   | 9,076,283  |       | 9,076,283      |
| Totals                          |   |                                   |   |                                   |   | $          | 79,718,354 |           | $ | 79,718,354 |

 

----

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

(3) Has some paid in kind(PIK) interest. Refer to Note 2 “Summary of Significant Accounting Policies” ofForm 10-K for the fiscal year ended September 30, 2002.

 

*See accompanying notes.*

 

38

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
|                                                                                                   |   | **Year Ended  September 30,  2003** |       | **Year Ended  September 30,  2002** |   | **Period  May 30, 2001  (Inception)  Through  September 30,  2001** |    |
|--------------------------------------------------------------------------------------------------------|--------|------------------------------------------|------------|------------------------------------------|--------|-------------------------------------------------------------------------------|---------|
|                                                                                                   |   |                                     |       |                                     |   |                                                                          |    |
| **INVESTMENT INCOME**                                                                                  |   |                                     |       |                                     |   |                                                                          |    |
| Interest income-investments                                                                            |   | $                                        | 13,248,415 |                                     | $      | 6,641,144                                                                     |    | — |   |
| Interest income-cash and cash equivalents                                                              |   | 466,316                                  |       | 1,576,304                                |   | $                                                                             | 349,500 |   |
| Interest income-notes receivable from  officers                                                        |   | 437,737                                  |       | 433,391                                  |   | 45,355                                                                        |    |
| Managerial assistance fees                                                                             |   | 885,500                                  |       | 1,673,614                                |   | —                                                                        |    |
| Other income                                                                                           |   | 116,906                                  |       | 131,250                                  |   | —                                                                        |    |
| Total Investment Income                                                                                |   | $                                        | 15,154,874 |                                     | $      | 10,455,703                                                                    |    | $ | 394,855 |   |
| **EXPENSES**                                                                                           |   |                                     |       |                                     |   |                                                                          |    |
| Salaries and benefits                                                                                  |   | $                                        | 2,018,004  |                                     | $      | 1,367,180                                                                     |    | $ | 229,379 |   |
| Rent                                                                                                   |   | 209,864                                  |       | 125,128                                  |   | 3,306                                                                         |    |
| Professional fees                                                                                      |   | 409,826                                  |       | 549,781                                  |   | 72,088                                                                        |    |
| Directors fees                                                                                         |   | 73,647                                   |       | 22,000                                   |   | 38,000                                                                        |    |
| Insurance                                                                                              |   | 275,511                                  |       | 206,385                                  |   | 20,586                                                                        |    |
| Stockholder related costs                                                                              |   | 143,273                                  |       | 104,167                                  |   | —                                                                        |    |
| Financing fees                                                                                         |   | 222,038                                  |       | —                                   |   | —                                                                        |    |
| General and administrative                                                                             |   | 506,790                                  |       | 464,461                                  |   | 124,140                                                                       |    |
| Total Expenses                                                                                         |   | $                                        | 3,858,953  |                                     | $      | 2,839,102                                                                     |    | $ | 487,499 |   |
| **NET INVESTMENT  INCOME (LOSS)**                                                                      |   | $                                        | 11,295,921 |                                     | $      | 7,616,601                                                                     |    | $ | (92,644 | ) |
|                                                                                                   |   |                                     |       |                                     |   |                                                                          |    |
| Net unrealized depreciation on investments                                                             |   | 222,340                                  |       | —                                   |   | —                                                                        |    |
| **NET INCREASE  (DECREASE) IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS**                    |   | $                                        | 11,073,581 |                                     | $      | 7,616,601                                                                     |    | $ | (92,644 | ) |
|                                                                                                   |   |                                     |       |                                     |   |                                                                          |    |
| **NET INCREASE  (DECREASE) IN STOCKHOLDERS’ EQUITY RESULTING FROM OPERATIONS PER COMMON  SHARE:** |   |                                     |       |                                     |   |                                                                          |    |
| Basic                                                                                                  |   | $                                        | 1.10       |                                     | $      | 0.76                                                                          |    | $ | (0.03 | ) |
| Diluted                                                                                                |   | $                                        | 1.09       |                                     | $      | 0.75                                                                          |    | $ | (0.03 | ) |
| **WEIGHTED AVERAGE  SHARES OF COMMON STOCK OUTSTANDING:**                                              |   |                                     |       |                                     |   |                                                                          |    |
| Basic                                                                                                  |   | 10,072,677                               |       | 10,064,900                               |   | 3,219,525                                                                     |    |
| Diluted                                                                                                |   | 10,188,488                               |       | 10,166,752                               |   | 3,219,525                                                                     |    |

 

*See accompanying notes.*

 

39

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

 
|                                                                                                          |   | **Common  Stock** |       | **Capital in  Excess of** |       | **Notes  Receivable  from Sale of  Common** |       | **Under/(Over)  Distributed Net  Investment** |       | **Unrealized  Appreciation/  (Depreciation) of** |       | **Total  Stockholders’** |       |
|---------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|---------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------|------------|
|                                                                                                          |   | **Shares**        | ** ** | **Amount**                | ** ** | **Par Value**                               | ** ** | **Stock**                                     | ** ** | **Income**                                       | ** ** | **Investments**               | ** ** | **Equity** | ** ** |
|                                                                                                          |   |              |       |                      |       |                                        |       |                                          |       |                                             |       |                          |       |   |   |
| Balance at May 30, 2001 (Inception)                                                                      |   | 43,508            |       | $                         | 44         |                                        | $          | 652,587                                       |       | $                                                | —     |                          | $          | — |   |   |   | $ | 652,631 |   |
| Issuance of Common Stock In Public Offering (net  of underwriting discount and offering costs of $10,760,843) |   | 9,430,000         |       | 9,430                     |       | 130,679,727                                 |       | —                                        |       | —                                           |       |                          |       | 130,689,157 |   |
| Issuance of Common Stock                                                                                      |   |              |       |                      |       |                                        |       |                                          |       |                                             |       |                          |       |   |   |
| Under Stock Option Plan                                                                                       |   | 586,670           |       | 586                       |       | 8,799,464                                   |       | (8,800,050                                    | )          | —                                           |       |                          |       | — |   |
| Net Decrease in Stockholders’ Equity Resulting  from Operations                                          |   | —            |       | —                    |       | —                                      |       | —                                        |       | (92,644                                          | )          |                          |       | (92,644 | ) |
| Balance at September 30, 2001                                                                            |   | 10,060,178        |       | $                         | 10,060     |                                        | $          | 140,131,778                                   |       | $                                                | (8,800,050 | )                             | $          | (92,644 | ) |   |   | $ | 131,249,144 |   |
| Issuance of Common Stock                                                                                      |   |              |       |                      |       |                                        |       |                                          |       |                                             |       |                          |       |   |   |
| Under Stock Option Plan                                                                                       |   | 11,666            |       | 12                        |       | 185,878                                     |       | (185,890                                      | )          |                                             |       |                          |       | — |   |
| Offering Costs                                                                                                |   |              |       |                      |       | (50,972                                     | )          |                                          |       |                                             |       |                          |       | (50,972 | ) |
| Repayment of Principal on Notes Receivable                                                                    |   |              |       |                      |       |                                        |       | 2,144                                         |       |                                             |       |                          |       | 2,144 |   |
| Net Increase in Stockholders’ Equity Resulting  from Operations                                          |   |              |       |                      |       |                                        |       |                                          |       | 7,616,601                                        |       |                          |       | 7,616,601 |   |
| Distributions Declared ($0.81 per common share)                                                               |   | —            |       | —                    |       | —                                      |       | —                                        |       | (8,153,644                                       | )          |                          |       | (8,153,644 | ) |
| Balance at September 30, 2002                                                                            |   | 10,071,844        |       | $                         | 10,072     |                                        | $          | 140,266,684                                   |       | $                                                | (8,983,796 | )                             | $          | (629,687 | ) |   |   | $ | 130,663,273 |   |
|                                                                                                          |   |              |       |                      |       |                                        |       |                                          |       |                                             |       |                          |       |   |   |
| Issuance of Common Stock                                                                                      |   |              |       |                      |       |                                        |       |                                          |       |                                             |       |                          |       |   |   |
| Under Stock Option Plan                                                                                       |   | 10,000            |       | 10                        |       | 149,990                                     |       | (150,000                                      | )          |                                             |       |                          |       | — |   |
| Repayment of Principal on Notes Receivable                                                                    |   |              |       |                      |       |                                        |       | 147,856                                       |       |                                             |       |                          |       | 147,856 |   |
| Net Increase in Stockholders’ Equity Resulting  from Operations                                          |   |              |       |                      |       |                                        |       |                                          |       | 11,295,921                                       |       | (222,340                      | )          | 11,073,581 |   |
| Distributions Declared ($1.10 per common share)                                                               |   | —            |       | —                    |       | —                                      |       | —                                        |       | (11,082,328                                      | )          |                          |       | (11,082,328 | ) |
| Balance at September 30, 2003                                                                            |   | 10,081,844        |       | $                         | 10,082     |                                        | $          | 140,416,674                                   |       | $                                                | (8,985,940 | )                             | $          | (416,094 | ) | $ | (222,340 | ) | $ | 130,802,382 |   |
|                                                                                                               |        |                   |            |                           |            |                                             |            |                                               |            |                                                  |            |                               |            |  |  |  |  |  |  |  |  |

 

*See accompanying notes.*

 

40

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**GLADSTONE CAPITAL CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
|                                                                                                                                                              |   | **Year Ended  September 30,  2003** |        | **Year Ended  September 30,  2002** |   | **Period  May 30, 2001  (Inception)  Through  September 30,  2001** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------|-------------|------------------------------------------|--------|-------------------------------------------------------------------------------|--------|
|                                                                                                                                                              |   |                                     |        |                                     |   |                                                                          |   |
| **CASH FLOWS FROM  OPERATING ACTIVITIES**                                                                                                                         |   |                                     |        |                                     |   |                                                                          |   |
| Net increase (decrease) in stockholders’  equity resulting from operations                                                                                   |   | $                                        | 11,073,581  |                                     | $      | 7,616,601                                                                     |   | $ | (92,644 | ) |
| Adjustments to reconcile net increase  (decrease) in stockholders’ equity resulting from operations to net cash  provided by (used in) operating activities: |   |                                     |        |                                     |   |                                                                          |   |
| Depreciation                                                                                                                                                      |   | 29,310                                   |        | 13,822                                   |   | 265                                                                           |   |
| Net unrealized depreciation                                                                                                                                       |   | 222,340                                  |        | —                                   |   | —                                                                        |   |
| Increase in interest receivable                                                                                                                                   |   | (352,018                                 | )           | (719,638                                 | )      | (79,899                                                                       | )      |
| Increase in funds due from custodian                                                                                                                              |   | (1,207,000                               | )           | —                                   |   | —                                                                        |   |
| (Increase) decrease in other assets                                                                                                                               |   | (84,616                                  | )           | 75,546                                   |   | (103,728                                                                      | )      |
| Increase in prepaid assets                                                                                                                                        |   | (34,996                                  | )           | (191,705                                 | )      | (166,250                                                                      | )      |
| Increase in accounts payable                                                                                                                                      |   | 23,247                                   |        | —                                   |   | —                                                                        |   |
| Increase in accrued expenses and deferred  liabilities                                                                                                            |   | 1,020,065                                |        | 579,000                                  |   | 365,960                                                                       |   |
| Increase in investment balance due to  payment in kind interest                                                                                                   |   | (806,088                                 | )           | (400,491                                 | )      | —                                                                        |   |
| Net Cash Provided by (Used in) Operating  Activities                                                                                                              |   | 9,883,825                                |        | 6,973,135                                |   | (76,296                                                                       | )      |
| **CASH FLOWS FROM  INVESTING ACTIVITIES**                                                                                                                         |   |                                     |        |                                     |   |                                                                          |   |
| Net purchase of furniture and equipment                                                                                                                           |   | (82,344                                  | )           | (70,976                                  | )      | (31,794                                                                       | )      |
| Purchase of investments                                                                                                                                           |   | (47,011,278                              | )           | (97,705,054                              | )      | —                                                                        |   |
| Principal repayments on investments                                                                                                                               |   | 18,005,827                               |        | 18,387,191                               |   | —                                                                        |   |
| Proceeds from repurchase agreements                                                                                                                               |   | 245,070,973                              |        | 44,098,719                               |   | —                                                                        |   |
| Repayment of repurchase agreements                                                                                                                                |   | (205,820,693                             | )           | (4,900,00                                | )      | —                                                                        |   |
| Receipt of principal on notes receivable  officers                                                                                                                |   | 147,856                                  |        | 2,144                                    |   |                                                                          |   |
| Net Cash Provided by (Used in) Investing  Activities                                                                                                              |   | 10,310,341                               |        | (40,187,976                              | )      | (31,794                                                                       | )      |
| **CASH FLOWS FROM  FINANCING ACTIVITIES**                                                                                                                         |   |                                     |        |                                     |   |                                                                          |   |
| Net proceeds from the issuance of common  stock                                                                                                                   |   | —                                   |        | —                                   |   | 131,341,788                                                                   |   |
| Offering costs                                                                                                                                                    |   | —                                   |        | (50,972                                  | )      |                                                                          |   |
| (Decrease) increase in accrued offering  costs                                                                                                                    |   | —                                   |        | (590,382                                 | )      | 590,382                                                                       |   |
| Prepaid financing fees                                                                                                                                            |   | (1,086,864                               | )           | —                                   |   | —                                                                        |   |
| Distributions paid                                                                                                                                                |   | (9,870,409                               | )           | (6,038,557                               | )      | —                                                                        |   |
| Net Cash (Used in) Provided by Financing  Activities                                                                                                              |   | (10,957,273                              | )           | (6,679,911                               | )      | 131,932,170                                                                   |   |
| **NET INCREASE (DECREASE)  IN CASH AND CASH EQUIVALENTS (1)**                                                                                                     |   | 9,236,893                                |        | (39,894,752                              | )      | 131,824,080                                                                   |   |
| **CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD**                                                                                                               |   | 91,929,328                               |        | 131,824,080                              |   | —                                                                        |   |
| **CASH AND CASH  EQUIVALENTS, END OF PERIOD**                                                                                                                     |   | $                                        | 101,166,221 |                                     | $      | 91,929,328                                                                    |   | $ | 131,824,080 |   |
| **NON-CASH FINANCING ACTIVITIES**                                                                                                                                 |   |                                     |        |                                     |   |                                                                          |   |
| Notes receivable issued in exchange for  common stock associated with the exercise of employee stock options                                                      |   | $                                        | 150,000     |                                     | $      | 185,890                                                                       |   | $ | 8,800,050 |   |

 

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

 

*See accompanying notes.*

 

41

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**GLADSTONE CAPITAL CORPORATION**

**NOTESTO****FINANCIALSTATEMENTS**

**SEPTEMBER 30, 2003**

 

**Note 1. Organization**

 

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

 

Gladstone Advisers, Inc. (Advisers), a wholly-owned subsidiary,conducts the daily administrative operations of the Company and provides managerialassistance to the Company’s portfolio companies.

 

Gladstone Business Loan LLC, a wholly-owned subsidiary of the Company,was established on February 3, 2003 for the purpose of owning theCompany’s portfolio of loan investments. The financial statements of the subsidiary are consolidated with thoseof 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.

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents consist of demand deposits and highly liquidinvestments with original maturities of three months or less. Cash and cash equivalentsare carried at cost which approximates fair value as of September 30,2003. Cash and cash equivalents pledged to creditors as of September 30,2003 consists of the United States Treasury Bill that collateralizes theCompany’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.

 

42

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*Investment Valuation*

 

The Company carries its investments at fair value, based on valuationsvoted on by its Board of Directors. Standard & Poor’s Loan EvaluationService provides an independent assessment of the loan portfolio, excludingmortgage loans and equity securities, data and assesses its own data todetermine market values for a majority of the Company’s portfoliosecurities.  The Board of Directorsvotes to accept the valuation recommendations presented by S&P.  Securities that are publicly traded, if any,are valued at the closing price on the valuation date (to date there are nopublicly traded securities in our portfolio). 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 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.

 

*Property and Equipment*

 

Property and equipment are carried at cost and are depreciated usingthe straight-line method over the estimated useful lives of the related assetsranging from three to five years.

 

*Interest Income Recognition*

 

Interest income is recorded on the accrual basis to the extent thatsuch amounts are expected to be collected. The Company stops accruing intereston its investments when it is determined that interest is no longercollectible.

 

*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, 2003 and September 30, 2002, the Company recorded PIKincome of $781,407 and $461,627, respectively. The Company did not record anyPIK income for the period from inception (May 30, 2001) throughSeptember 30, 2001.

 

*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. In December 2002,the Company adopted Statement of Financial Accounting Standards (SFAS)Statement No. 148, “Accounting for Stock-Based Compensation – Transition andDisclosure” which amended SFAS 123, “Accounting for Stock-BasedCompensation” (SFAS 123). The Company adopted SFAS 148 on January 1,2003 and elects to continue to account for its stock-based compensation planunder the provisions of APB 25. The Company continues to provide pro formadisclosure (see Note 3) of the Company’s net increase (decrease) to stockholders’equity resulting from operations calculated as if the grants of stock optionshad been recorded as compensation costs in accordance with SFAS 148 and123.

 

*Management Fees*

 

The Company is self-managed and therefore does not incur management feespayable to third parties.

 

*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.

 

43

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*Dividends*

 

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

 

*New Accounting Standards*

 

SFAS 148

 

In December 2002, the Financial Accounting Standards Board issuedSFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure.” SFAS No. 148 provides alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. SFAS No. 148 also amends the disclosure requirements ofSFAS No.123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results. The Companyis required to follow the prescribed format and provide the additionaldisclosures required by SFAS No. 148 in its annual financial statements for theyear ending September 30, 2003 and is also required to provide thedisclosures in its quarterly reports containing financial statements forinterim periods. The Company adopted SFAS 148 on January 1, 2003 andelected to continue to account for its stock based compensation plans under theprovisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees” asare described in Note 3 of these audited consolidated financial statements. Theadoption did not have an impact on the Company’s consolidated financialstatements.

 

SFAS 149

 

In April 2003, the Financial Accounting Standards Board issuedSFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and HedgingActivities.” SFAS No. 149 amends and clarifies financial accounting andreporting for derivative instruments, including certain derivative instrumentsembedded in other contracts and for hedging activities under SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003, andhedging relationships designated after June 30, 2003, except for thoseprovisions of SFAS No. 149 which relate to SFAS No. 133 Implementation Issuesthat have been effective for fiscal quarters that began prior to June 15,2003.  The Company does not expect theadoption of SFAS 149 to have a material impact on the Company’s consolidatedfinancial statements.

 

SFAS 150

 

In May 2003, the Financial Accounting Standards Board issued SFASNo. 150, “Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity.” SFAS No. 150 establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. SFAS No. 150 requires that anissuer classify a financial instrument that is within its scope as a liability(or as an asset in some circumstances). SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003 and otherwiseeffective on July 1, 2003 for financial instruments created beforeMay 31, 2003. The Company does not expect the adoption of SFAS No. 150 tohave a material impact on the Company’s consolidated financial statements.

 

44

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FIN 45

 

In November 2002, the FASB published Interpretation No. 45,“Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others.” FIN 45 requires that aguarantor recognize a liability for the fair value of an obligation assumedunder a guarantee and also discusses additional disclosures to be made in theinterim and annual financial statements of the guarantor regarding obligationsunder certain guarantees. The initial measurement and recognition requirementsof FIN 45 are effective prospectively for guarantees issued or modified afterDecember 31, 2002.  The adoptiondid not have an impact on the Company’s consolidated financial statements atSeptember 30, 2003.  In the normalcourse of business the Company enters into contracts that contain a variety ofrepresentations, which provide general indemnifications.  The Company’smaximum exposure under these arrangements is unknown as this would involvefuture claims that may be made against the Company that have not yet occurred. However, based on experience, the Company expects the risk of loss to beremote.

 

FIN 46

 

In January 2003, the FASB issued Interpretation No. 46,“Consolidation of Variable Interest Entities.” This standard clarifies theapplication of Accounting Research Bulletin No. 51, “Consolidated FinancialStatements,” and addresses consolidation by business enterprises of variableinterest entities (more commonly known as Special Purpose Entities or SPE’s).FIN 46 requires existing unconsolidated variable interest entities to beconsolidated by their primary beneficiaries if the entities do not effectivelydisperse risk among the parties involved. FIN 46 also enhances the disclosurerequirements related to variable interest entities. This statement is effectivefor variable interest entities created or in which an enterprise obtains aninterest after January 31, 2003. In October 2003, the FASB voted to defer the implementation untilafter the fourth quarter of 2003.  TheCompany does not expect the adoption of FIN 46 to have a material impact on theconsolidated financial statements.

 

 

**Note 3. Stock Option Plan**

 

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

 

Options granted under the 2001 Plan may be either incentive stockoptions or nonstatutory stock options.  The option exercise price is equal to the market price on the date ofthe grant. 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 grantdate.  Some of the options grantedduring the fiscal year ended September 30, 2003 vest at 25%, 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 accounts for its stock-based compensation plans inaccordance with APB 25, “Accounting for Stock Issued to Employees”.  The pro forma information below illustratesthe effect on net increase (decrease) in stockholders’ equity resulting fromoperations per share based on provisions of SFAS No. 123, “Accounting forStock-Based Compensation”, as amended by SFAS 148, “Accounting for Stock-BasedCompensation – Transition and Disclosure”, issued in December 2002.

 

45

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|                                                                                                             |   | **Year Ended  September 30,  2003** |       | **Year Ended  September 30,  2002** |   | **Period  May 30, 2001  (Inception)  Through  September 30,  2001** |   |
|------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------|------------|------------------------------------------|--------|-------------------------------------------------------------------------------|--------|
|                                                                                                             |   |                                     |       |                                     |   |                                                                          |   |
| Net increase (decrease) in stockholders’  equity resulting from operations                                  |   |                                     |       |                                     |   |                                                                          |   |
| As reported                                                                                                      |   | $                                        | 11,073,581 |                                     | $      | 7,616,601                                                                     |   | $ | (92,644 | ) |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards |   | $                                        | (1,576,555 | )                                        | $      | (1,555,099                                                                    | )      | $ | (1,734,340 | ) |
| Pro forma net increase (decrease) in  stockholders’ equity resulting from operations                        |   | $                                        | 9,497,026  |                                     | $      | 6,061,502                                                                     |   | $ | (1,826,984 | ) |
| Net increase (decrease) in stockholders’  equity resulting from operations per share                        |   |                                     |       |                                     |   |                                                                          |   |
| As reported-basic                                                                                                |   | $                                        | 1.10       |                                     | $      | 0.76                                                                          |   | $ | (0.03 | ) |
| As reported-diluted                                                                                              |   | $                                        | 1.09       |                                     | $      | 0.75                                                                          |   | $ | (0.03 | ) |
| Pro forma-basic                                                                                                  |   | $                                        | 0.94       |                                     | $      | 0.60                                                                          |   | $ | (0.57 | ) |
| Pro forma-diluted                                                                                                |   | $                                        | 0.93       |                                     | $      | 0.60                                                                          |   | $ | (0.57 | ) |

 

For options granted during the fiscal year ended September 30,2003, the Company estimated a weighted-average fair value of $2.29 using aBlack-Scholes option pricing model and the following assumptions:  dividend yield of 6.79%, risk-free interestrate of 0.95%, expected volatility factor of 0.1771, and expected lives of theoptions of three years.  For optionsgranted during the fiscal year ended September 30, 2002, the Companyestimated a fair value per option on the date of grant of $1.40 using aBlack-Scholes option-pricing model and the following assumptions: dividendyield of 8.17%, risk-free interest rate of 2.02%, expected volatility factor of0.258, and expected lives of the options of three years. For options grantedduring the period from inception through September 30, 2001, the Companyestimated a fair value per option on the date of grant of $2.51 using aBlack-Scholes option-pricing model and the following assumptions: dividendyield of 6.00%, risk-free interest rate of 4.60%, expected volatility factor of0.324, and expected lives of the options of three years.

 

A summary of the status of the Company’s 2001 Plan for the period frominception through September 30, 2003 is as follows:

 
|                                                                                     |   | **Shares** |   | **Weighted Average  Exercise Price** |   |
|------------------------------------------------------------------------------------------|--------|------------|--------|--------------------------------------|--------|
|                                                                                     |   |       |   |                                 |   |
| Options outstanding at May 30, 2001                                                 |   | —     |   |                                 |   |
| Granted                                                                                  |   | 1,250,000  |   | $                                    | 15.00  |   |
| Exercised                                                                                |   | (586,670   | )      | $                                    | 15.00  |   |
| Options outstanding at September 30,  2001, of which 63,330 shares were exercisable |   | 663,330    |   | $                                    | 15.00  |   |
| Granted                                                                                  |   | 160,000    |   | $                                    | 17.14  |   |
| Exercised                                                                                |   | (11,666    | )      | $                                    | 15.93  |   |
| Options outstanding at September 30,  2002, of which 741,664 shares are exercisable |   | 811,664    |   | $                                    | 15.40  |   |
|                                                                                     |   |       |   |                                 |   |
| Granted                                                                                  |   | 170,000    |   | $                                    | 17.10  |   |
|                                                                                     |   |       |   |                                 |   |   |
| Exercised                                                                                |   | (10,000    | )      | $                                    | 15.00  |   |
| Options outstanding at September 30,  2003, of which 841,664 shares are exercisable |   | 971,664    |   | $                                    | 15.71  |   |

 

46

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

 
| **Fiscal Year Ended**   |   | **Range of Exercise Prices** |   | **Stock Options  Outstanding** |   | **Weighted Average  Remaining Contractual  Life (Years)** |   |
|-------------------------|--------|------------------------------|--------|--------------------------------|--------|-----------------------------------------------------------|--------|
|                    |   |                         |   |                           |   |                                                      |   |
| September 30, 2003 |   | $15.00—$19.56           |   | 971,664                        |   | 8.33                                                      |   |
| September 30, 2002 |   | $15.00—$17.18           |   | 811,664                        |   | 9.08                                                      |   |

 

During the fiscal year ended September 30, 2003, the Companyissued 10,000 shares of common stock to an employee pursuant to a stock optionexercise, in exchange for a full recourse note receivable of $150,000.  During the fiscal year ended September 30,2002, the Company issued 11,666 shares of common stock to employees of theCompany pursuant to stock option exercises, in exchange for full recourse notesreceivable totaling $185,890. During the period from inception throughSeptember 30, 2001, the Company issued 586,670 shares of common stock toemployees of the Company pursuant to stock option exercises, in exchange forfull recourse notes receivable totaling $8,800,050. These transactions wereeffected pursuant to the 2001 Plan, which allows the Company to lend itsemployees funds to pay for the exercise of stock options. All loans made underthis arrangement are fully secured by the value of the common stock purchased.Interest is charged and paid on such loans at the market rate as determinedbased on individual financial positions.

 

**Note 4. Commitments and Contingencies**

 

The Company occupies its McLean, Virginia office space pursuant to alicense agreement scheduled to expire October 31, 2003 and has renewed thelicense agreement for an additional year. The Company’s New York City office facilityhas a service agreement scheduled to expire August 31, 2004. The futurescheduled payments are as follows:

 
|                        |   |      |    | **Payment  Due by Period** |   |
|-----------------------------|--------|-----------|---------|----------------------------|--------|
| **Contractual Obligations** |   | **Total** |    | **Less than  1 Year**      |   | **1-3 Years** |   | **3-5  Years** |   | **More than  5 Years** |   |
| Office Lease Obligations    |   | $         | 211,890 |                       | $      | 198,375 |   | $ | 13,515 |   | — |   | — |   |
| Total                       |   | $         | 211,890 |                       | $      | 198,375 |   | $ | 13,515 |   | — |   | — |   |

 

47

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**Note 5. Net Increase (Decrease) inStockholders’ Equity Resulting from Operations per Share**

 

The following table sets forth the computation of basic and diluted netincrease (decrease) in stockholders’ equity resulting from operations per sharefor the fiscal year ended September 30, 2003, September 30, 2003 andthe period from inception through September 30, 2001:

 
|                                                                                                                       |   | **September 30,  2003** |       | **September 30,  2002** |   | **Period  May 30, 2001  (Inception) Through  September 30,  2001** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|------------|------------------------------|--------|-----------------------------------------------------------------------------------|--------|
|                                                                                                                       |   |                         |       |                         |   |                                                                              |   |
| Numerator for basic and diluted net  increase (decrease) in stockholders’ equity resulting from operations per  share |   | $                            | 11,073,581 |                         | $      | 7,616,601                                                                         |   | $ | (92,644 | ) |
|                                                                                                                       |   |                         |       |                         |   |                                                                              |   |
| Denominator for basic weighted average  shares                                                                             |   | 10,072,677                   |       | 10,064,900                   |   | 3,219,525                                                                         |   |
| Dilutive effect of stock options                                                                                           |   | 115,811                      |       | 101,852                      |   | 0                                                                                 |   |
| Denominator for diluted weighted average  shares                                                                           |   | 10,188,488                   |       | 10,166,752                   |   | 3,219,525                                                                         |   |
| Basic net increase (decrease) in  stockholders’ equity resulting from operations per share                            |   | $                            | 1.10       |                         | $      | 0.76                                                                              |   | $ | (0.03 | ) |
| Diluted net increase (decrease) in  stockholders’ equity resulting from operations per share                          |   | $                            | 1.09       |                         | $      | 0.75                                                                              |   | $ | (0.03 | ) |

 

**Note 6. 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.During the fiscal year ended September 30, 2003, the Company issued a$150,000 loan to an employee for the exercise of options and received the finalpayment for a loan issued during fiscal year 2001. During the fiscal year endedSeptember 30, 2002, the Company issued $185,890 in loans to two employeesfor the exercise of options. During the period from inception throughSeptember 30, 2001, the Company issued $8,800,050 in loans to seven employeesfor the exercise of options. The Company recognized interest income from allemployee stock option loans of $437,737, $433,391 and $45,355 during the fiscalyears ended September 30, 2003, September 30, 2002 and the periodfrom inception through September 30, 2001, respectively. The outstandingprincipal balances due on all employee stock option loans at September 30,2003, September 30, 2002 and September 30, 2001 were $8,985,940,$8,983,796 and $8,800,050, 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. During the fiscal year ended September 30, 2002, theCompany paid personnel recruiting fees totaling $31,750 to Medical FundingCorporation.

 

**Note 7. Repurchase Agreement**

 

On September 30, 2003, the Company entered into a repurchaseagreement (the Repurchase Agreement) with UBS for $78,449,000, which agreementwas settled on October 1, 2003. The Repurchase Agreement was recorded at cost and was fully collateralizedby a United States Treasury Bill with a fair value of $80,050,000 and acarrying value of $80,022,249 that matured on October 16, 2003.  The interest rate on the RepurchaseAgreement was 0.80%.

 

48

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On September 30, 2002, the Company entered into a repurchaseagreement with UBS PaineWebber for $39,198,719, which agreement was settled onOctober 1, 2002. The Repurchase Agreement was recorded at cost and wasfully collateralized by a United States Treasury Bill with a fair value of$40,004,000 and a carrying value of $39,998,799 that matured on October 3,2002. The interest rate on the Repurchase Agreement was 1.85%.

 

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

 

**Note 8. Deferred Compensation Plan**

 

The Company has adopted a deferred compensation plan (the 401(k) Plan)effective January 1, 2002. The 401(k) Plan permits an employee to 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 30,2003, the Company funded $23,987 in contributions to the 401(k) Plan. The Companyhas received a determination letter from the IRS concurring that the deferredcompensation plan satisfies the qualification requirements of the Code. For thefiscal years ended September 30, 2003 and September 30, 2002, theCompany recorded $42,607 and $23,569, respectively, in expenses related to the401(k) Plan. There were no expenses related to the 401(k) Plan incurred duringthe period from inception through September 30, 2001.

 

**Note 9. Dividends**

 

On October 7, 2003, the Company paid adividend of $0.33 per share on its common stock to stockholders of record as ofSeptember 30, 2003. On July 7, 2003, The Company paid a dividend of $0.29 per share onits common stock to stockholders of record as of June 30, 2003.  On April 7, 2003, the Company paid adividend of $0.25 per share on its common stock to stockholders of record as ofMarch 31, 2003 and on January 7, 2003, the Company paid a dividend of$0.23 per share on its common stock to its stockholders of record as ofDecember 31, 2002.

 

On October 7, 2002, the Company paid a dividend of $0.21 per shareon its common stock to its stockholders of record as of September 30,2002.  On July 8, 2002, the Companypaid a dividend of $0.21 per share on its common stock to its stockholders ofrecord as of June 28, 2002. On April 8, 2002, the Company paid adividend of $0.21 per share on its common stock to its stockholders of recordas of March 28, 2002. On January 15, 2002, the Company paid adividend of $0.18 per share on its common stock to its stockholders of recordas of December 31, 2001.

 

Aggregate dividends declared and paid for the 2002 fiscal year wereapproximately $8.2 million. The Company declared these dividends basedupon an estimate of net operating income for the year. Because of the difficulteconomic climate during the year, the Company’s investment pace was slower thanoriginally anticipated, and consequently, net operating income was lower thanoriginally projected. This resulted in dividends related to the 2002 fiscalyear exceeding net operating income for the year by approximately$0.5 million. Additionally, dividends related to the 2002 fiscal yearexceeded current and accumulated earnings and profits and, as a result, aportion of the Company’s dividends will be treated as a return of capital to theCompany’s stockholders.

 

49

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**Note 10. Managerial Assistance Fees**

 

The 1940 Act requires that a business development company makeavailable managerial assistance to its portfolio companies. The companyprovides managerial assistance to its portfolio companies in connection withits investments through its wholly-owned subsidiary, Advisers, and receivesfees for its managerial assistance services. Such fees are normally paid at theclosing of the Company’s investments in its portfolio companies, are generallynon-recurring and are recognized as revenue when earned. The managerialassistance services provided by the Company vary by investment, but generallyconsist of 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, and providing general financial advice. Forthe fiscal years ended September 30, 2003 and September 30, 2002,these fees totaled $885,500 and $1,673,614, respectively. For the period frominception through September 30, 2001, the Company did not receive anymanagerial assistance fees.

 

From time to time, the Company is invited to participate as a co-lenderin a transaction. In the event that the Company does not provide significantmanagerial assistance services in connection with its investment, loan feespaid to the Company in such situations are deferred and amortized over the lifeof the loan. The Company did not receive any such loan fees during the fiscalyears ended September 30, 2003, September 30, 2002 or for the periodfrom inception through September 30, 2001.

 

**Note 11. Gladstone Business Loan LLC**

 

On May 19, 2003, Gladstone Business Loan LLC entered into a creditagreement with CIBC World Markets Corp. to provide the Company with a $100million revolving credit facility.  Thiswill enable the Company to securitize existing loans in order to be able to obtainadditional lending funds.  AtSeptember 30, 2003, there were no outstanding borrowings from therevolving credit facility.

 

**Note 12.  Subsequent Events**

 

In November 2003, Kozy Shack Enterprises, Inc. repaid its entireoutstanding loan balance for full settlement of any further obligations.

 

On December 5, 2003 the Company sold a $3.2 million portion of its $5.7million Inca Metal Products Corp., Kingway Acquisition Inc., ClymerAcquisitions, Inc. note to American Capital Strategies for $3.2 million.  This leaves the principal balance of theinvestment at $2.5 million.

 

50

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**Note 13. Financial Highlights**

 
|                                                        |   | **Year Ended  September 30,  2003** |        | **Year Ended  September 30,  2002** |   | **Period  May 30, 2001  (Inception) Through  September 30, 2001** |   |
|-------------------------------------------------------------|--------|------------------------------------------|-------------|------------------------------------------|--------|-----------------------------------------------------------------------------|--------|
|                                                        |   |                                     |        |                                     |   |                                                                        |   |
| **Per Share Data (1)**                                      |   |                                     |        |                                     |   |                                                                        |   |
| Net asset value at beginning of period                      |   | $                                        | 12.97       |                                     | $      | 13.05                                                                       |   | $ | 15.00 |   |
| Net investment income (loss)                                |   | 1.12                                     |        | 0.76                                     |   | (0.03                                                                       | )      |
| Net unrealized loss on investments                          |   | (0.02                                    | )           | —                                   |   | —                                                                      |   |
| Issuance of common stock                                    |   | —                                   |        | (0.02                                    | )      | (0.80                                                                       | )      |
| Offering costs and underwriting discount                    |   | —                                   |        | (0.01                                    | )      | (1.12                                                                       | )      |
| Distributions from net investment income                    |   | (1.10                                    | )           | (0.76                                    | )      | —                                                                      |   |
| Distributions in excess of net investment  income           |   | —                                   |        | (0.05                                    | )      | —                                                                      |   |
| Net asset value at end of period                            |   | $                                        | 12.97       |                                     | $      | 12.97                                                                       |   | $ | 13.05 |   |
| Per share market value at beginning of  period              |   | $                                        | 16.88       |                                     | $      | 16.14                                                                       |   | $ | 15.00 | (4) |
| Per share market value at end of period                     |   |                                     | 19.45       |                                     | 16.88  |                                                                        | 16.14  |   |
| Total Return (2)                                            |   | 21.74                                    | %           | 9.60                                     | %      | 7.60                                                                        | %(3)   |
| Shares outstanding at end of period                         |   | 10,081,844                               |        | 10,071,844                               |   | 10,060,178                                                                  |   |
| **Ratios/Supplemental  Data**                               |   |                                     |        |                                     |   |                                                                        |   |
| Net assets at end of period                                 |   | $                                        | 130,802,382 |                                     | $      | 130,663,273                                                                 |   | $ | 131,249,144 |   |
| Average net assets                                          |   | 132,196,505                              |        | 130,984,674                              |   | 52,937,390                                                                  |   |
| Ratio of operating expenses to average net  assets          |   | 2.92                                     | %           | 2.17                                     | %      | 0.92                                                                        | %(3)   |
| Ratio of net operating income (loss) to  average net assets |   | 8.38                                     | %           | 5.81                                     | %      | (0.18                                                                       | )%(3)  |

 

----

(1)           Basic per share data.

 

(2)           Total return equals the increase of theending market value over the beginning market value, plus distributions,divided by the beginning market value.

 

(3)           Amounts were not annualized.

 

(4)           Represents the initial public offeringprice.

 

51

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**Note 14.Selected Quarterly Data (Unaudited)**

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

 

 
|                                                                 |   | **Year Ended September 30, 2002**      |      |
|----------------------------------------------------------------------|--------|---------------------------------------------|-----------|
|                                                                 |   | **Quarter  Ended  December 31,  2001** |      | **Quarter  Ended  March 31,  2002** |   | **Quarter  Ended  June 30,  2002** |   | **Quarter  Ended  September 30,  2002** |   |
|                                                                 |   |                                        |      |   |   |   |   |   |   |
| Total Investment Income                                              |   | $                                           | 1,689,399 |   | $ | 2,149,551 |   | $ | 2,915,149 |   | $ | 3,701,604 |   |
| Net Investment Income                                                |   | 1,196,980                                   |      | 1,408,482 |   | 2,224,574 |   | 2,786,565 |   |
| Net Increase in Stockholders’ Equity  Resulting From Operations |   | 1,196,980                                   |      | 1,408,482 |   | 2,224,574 |   | 2,786,565 |   |
| Basic Earnings per Common Share                                      |   | $                                           | 0.12      |   | $ | 0.14 |   | $ | 0.22 |   | $ | 0.28 |   |
| Diluted Earnings per Common Share                                    |   | $                                           | 0.12      |   | $ | 0.14 |   | $ | 0.22 |   | $ | 0.27 |   |

 

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

 

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

 

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

 

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

 

We have requested Ernst & Young to furnish it a letteraddressed to the SEC stating whether it agrees with the above statements. Acopy of that letter, dated December 20, 2002, is filed asExhibit 16.1 to our Current Report on Form 8-K filed onDecember 20, 2002.

 

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

 

 

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

 

As of September 30, 2003 (the end of the period covered by thisreport), we, including our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures.  Based on thatevaluation, our management, including the Chief Executive Officer and ChiefFinancial Officer, concluded that our disclosure controls and procedures wereeffective in timely alerting management, including the Chief Executive Officerand Chief Financial Officer, of material information about us required to beincluded in periodic SEC filings. However, in evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

There have been no changes in our internal control over financialreporting that occurred during the fiscal year ended September 30, 2003,that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

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**PARTIII**

 

We will file a definitive Proxy Statement for our 2004 AnnualMeeting of Stockholders (the “2004 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 2004 Proxy Statement that specifically address the items set forthherein are incorporated by reference.

 

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

 

The information required by Item 10 is hereby incorporated by referencefrom our 2004 Proxy Statement under the captions “Election of Directors” and“Section 16(a) Beneficial Ownership Reporting Compliance.”  All members of the Audit Committee have beendesignated by the Board of Directors as financial experts.

 

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

 

The information required by Item 11 is hereby incorporated by referencefrom our 2004 Proxy Statement under the caption “Compensation of Directors andExecutive Officers.”

 

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

 

The information required by Item 12 is hereby incorporated by referencefrom our 2004 Proxy Statement under the caption “Security Ownership of CertainBeneficial Owners and Management.”

 

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

 

The information required by Item 13 is hereby incorporated by referencefrom our 2004 Proxy Statement under the caption “Certain Transactions.”

 

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

 

The information required by Item 14 is hereby incorporated by referencefrom our 2004 Proxy Statement under the caption “Audit Fees.”

 

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**PARTIV**

 

**Item 15. Exhibits, Financial StatementSchedules, and Reports on Form 8-K**

 

**a.****             DOCUMENTS FILED ASPART OF THIS REPORT**

 

1.             The following financial statements arefiled herewith:

 
| Reports of Independent Auditors                                                                                                                                                                                                   |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets as of September 30, 2003 and  September 30, 2002                                                                                                                                            |   |
| Consolidated Schedule of Investments  as of September 30, 2003                                                                                                                                                          |   |
| Consolidated Schedule of Investments  as of September 30, 2002                                                                                                                                                          |   |
| Consolidated Statements of Operations for  the years ended September 30, 2003 and September 30, 2002 and the  period May 30, 2001 (inception) through September 30, 2001                                      |   |
| Consolidated Statement of Stockholders  Equity for the years ended September 30, 2003 and September 30,  2002 and September 30, 2002 and the period May 30, 2001 (inception)  through September 30, 2001 |   |
| Consolidated Statements of Cash Flows for  the years ended September 30, 2003 and September 30, 2002 and the  period May 30, 2001 (inception) through September 30, 2001                                      |   |
| Notes to Financial Statements                                                                                                                                                                                                     |   |

 

2.             Financial statement 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.                                                                                                                                                                              |
| 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.                                                                                                                         |

 

55

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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   |   | Facility Service License, dated November 1, 2001**,** between the Company and Teqcorner, LLC,  incorporated by reference to Exhibit 10.8 to the Company’s Annual Report  on Form 10-K for the fiscal year ended September 30, 2001 (File  No. 814-00237), filed December 21, 2001. |
| 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.                                                                                                                                                                                                                                             |
| 10.18  |   | Facility License Agreement, dated November 1, 2003, between the  Company and Teqcorner LLC.                                                                                                                                                                                                                      |
| 11     |   | Computation of Per Share Earnings (included in the notes to the  audited financial statements contained in this report).                                                                                                                                                                                              |
| 21     |   | Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                       |
| 23.1   |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                                |
| 23.2   |   | Consent of Ernst & Young LLP.                                                                                                                                                                                                                                                                                     |
| 31.1   |   | Certification of Chief Executive Officer pursuant to section 302  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                             |
| 31.2   |   | Certification of Chief Financial Officer pursuant to section 302  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                             |
| 32.1   |   | Certification of Chief Executive Officer pursuant to section 906  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                             |
| 32.2   |   | Certification of Chief Financial Officer pursuant to section 906  of The Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                             |

 

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*              Denotes management contract orcompensatory plan or arrangement.

 

**b.****             REPORTS ONFORM 8-K**

 

On August 14, 2003, the Company filed a Current Report on Form 8-Kto indicate it had issued a press release announcing the financial result forthe quarter ended June 30, 2003.

 

On September 11, 2002, the Company filed a Current Report on Form8-K to indicate it had issued a press release announcing the declaration of thefiscal year 2003 fourth quarter dividend.

 

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**SIGNATURES**

 

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

 
|                        | **GLADSTONE CAPITAL CORPORATION** |
|-----------------------------|-----------------------------------|
|                        |                              |   |
| Date: December 9, 2003 | 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 9, 2003 | By:    | /s/ DAVID GLADSTONE                                                                           |
|-----------------------------|--------|-----------------------------------------------------------------------------------------------|
|                        |   | David Gladstone                                                                               |
|                        |   | Chief Executive Officer and Chairman of the Board of Directors  (principal executive officer) |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ TERRY LEE BRUBAKER                                                                        |
|                        |   | Terry Lee Brubaker                                                                            |
|                        |   | President, Chief Operating Officer and Director                                          |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ HARRY BRILL                                                                               |
|                        |   | Harry Brill                                                                                   |
|                        |   | Chief Financial Officer  (principal financial and accounting officer)                         |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ GEORGE STELLJES, III                                                                      |
|                        |   | George Stelljes, III                                                                          |
|                        |   | Chief Investment Officer and Director                                                         |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ DAVID A.R. DULLUM                                                                         |
|                        |   | David A.R. Dullum                                                                             |
|                        |   | Director                                                                                      |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ ANTHONY W. PARKER                                                                         |
|                        |   | Anthony W. Parker                                                                             |
|                        |   | Director                                                                                      |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ MICHELA A. ENGLISH                                                                        |
|                        |   | Michela A. English                                                                            |
|                        |   | Director                                                                                      |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ PAUL ADELGREN                                                                             |
|                        |   | Paul Adelgren                                                                                 |
|                        |   | Director                                                                                      |
|                        |   |                                                                                          |
| Date: December 9, 2003 | By:    | /s/ MAURICE COULON                                                                            |
|                        |   | Maurice Coulon                                                                                |
|                        |   | Director                                                                                      |

 

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