**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTOND.C. 20549**

 

**Form 10-KSB**

 

**(MARK ONE)**
| **ý**                                                                                                                                                                | **ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES  EXCHANGE ACT OF 1934**     |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------|
|                                                                                                                                                                      |                                                                                         |
| **For the  fiscal year ended December 31, 2004**                                                                                                                     |
|                                                                                                                                                                      |                                                                                         |
| **o**                                                                                                                                                                     | **TRANSITION REPORT UNDER SECTION 13 OR 15(B) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|                                                                                                                                                                      |                                                                                         |
| **For the  transition period from           to           ** |

 

**Commissionfile number: 0-18188**

 

**PAULSONCAPITAL CORP.**

(Name of small business issuer as specified inits charter)

 
| **Oregon**                                                           | ** ** | **93-0589534**                     |
|----------------------------------------------------------------------|------------|------------------------------------|
| (State or Other  Jurisdiction of  incorporation or organization)     |       | (IRS Employer  Identification No.) |
|                                                                 |       |                               |
| **811 S.W. Naito Parkway, Suite  200, Portland, OR 97204**           |
| (Address of Principal  Executive Office)                             |
|                                                                 |       |                               |
| **(503) 243-6000**                                                   |
| (Issuer’s telephone number,  including area code)               |
|                                                                 |       |                               |
| Securities registered under  Section 12(b) of the Exchange Act: |
|                                                                 |
| **NONE**                                                             |
|                                                                 |
| Securities registered under  Section 12(g) of the Exchange Act: |
|                                                                 |       |                               |
| **COMMON STOCK, NO PAR VALUE**                                       |
| (Title of Class)                                                     |

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.   Yes   ý     No   o

 

Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-B contained in this form, and no disclosure will be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part II of this Form 10-KSB or anyamendment to this Form 10-KSB.  o

 

Stateissuer’s revenues for its most recent fiscal year:

 

$32,915,275

 

As of March 15, 2005, 3,174,590 shares of theregistrant’s common stock, no par value, were outstanding and the aggregatemarket value of the shares of common stock of the Registrant held bynon-affiliates (based upon the average of the closing bid and asked prices ofRegistrant’s shares in the over-the-counter market as of such date) was $10,050,459.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive proxystatement for the 2005 annual meeting of shareholders to be filed with theSecurities and Exchange Commission are incorporated by reference into Part III.

 

 

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**PART I**

 

**FORWARD-LOOKING STATEMENTS**

 

**This report, including, without limitation, “Item6. Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains or incorporates both historical and “forward-looking” statementswithin the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended. Words such as “anticipates”, “believes”, “expects”, “intends”, “future”and similar expressions identify forward-looking statements.  Any such forward-looking statements in thisreport reflect our current views with respect to future events and financialperformance and are subject to a variety of factors that could cause our actualresults to differ materially from historical results or from anticipatedresults expressed or implied by such forward-looking statements.  Because of such factors, we cannot assure youthat the results anticipated in this report will be realized.  As noted elsewhere in this report, variousaspects of our business are subject to extreme volatility often as a result offactors beyond our ability to anticipate or control.  In particular, factors, such as the conditionof the securities markets, which are in turn based on popular perceptions ofthe health of the economy generally, can be expected to affect the volume ofour business as well as the value of the securities maintained in our tradingand investment accounts.  Other factorsthat may affect our future financial condition or results of operations includethe following:**

 

•      **The performance of companies whose securities we have underwritten orotherwise sold to our customers may affect our reputation with other potentialsyndicate and selling group members and institutional and other retail accountsand may also affect the amount of money in our customers’ portfolios availablefor the kinds of investments that we offer.**

 

•      **The value of our investment portfolio, including the value ofsecurities without a readily ascertainable market value, that we have estimatedfor the purpose of reporting on our financial condition and results ofoperations, may be significantly and adversely affected by changes in the valueof the companies themselves or of comparable companies whose stock values weuse in estimating the value of our portfolio securities.**

 

•      **We are subject to a very high degree of regulation and are responsiblefor compliance with applicable regulations by all of our personnel.  A significant regulatory infraction by us orany of our registered representatives could result in significant penalties,including the loss of our license to conduct securities business in one or morejurisdictions.**

 

•      **Alternatives available to our customers to transact securities tradescould affect our ability to continue to execute our brokerage customers’transactions.**

 

•      **The loss of our Chairman, Chester Paulson, could have a materialadverse impact on our business.**

 

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**ITEM 1.****          DESCRIPTIONOF BUSINESS**

 

**General**

 

Paulson Capital Corp. (“Paulson Capital” orthe “Company”), established in 1970, is a holding company whose only operatingsubsidiary is Paulson Investment Company, Inc. (“PIC”), a full servicebrokerage firm engaged in the purchase and sale of securities from and to thepublic and for its own account and in investment banking activities.  The Company operates in one industry segment,the financial services industry.  At March 15,2005, PIC employed 42 brokers and had independent contractor arrangements with 53brokers registered with the National Association of Securities Dealers, Inc. (“NASD”).  PIC also employed executive and support staffof 53 persons in its headquarters in Portland, Oregon and in certain of its employeebranch offices.  At March 15, 2005, PIChad 25 branch offices throughout the United States.

 

Paulson Capital is located at 811 S.W. NaitoParkway, Suite 200, Portland, Oregon 97204. Its telephone number is (503) 243-6000.

 

**Principal Products, Services and Markets**

 

Virtually all of Paulson Capital’s businessis carried on through PIC.  PIC isinvolved in the purchase and sale of most investment securities but is notinvolved in commodities or futures.  Fourbroad categories of securities activities contribute to revenues of PIC: retailbrokerage, corporate finance/investment banking, trading and market making (orwholesale).  PIC also receives revenuesfrom gains and losses in investment accounts, from underwriter warrantsreceived in connection with its corporate finance activities, and from othersources. The securities in the investment account are held for investment, notactively traded, and not deemed part of operations in accordance withmanagement intentions.

 

The following table shows the portion of ourrevenues that was attributable to each category for the last two fiscal years:

 
| ** **                | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|---------------------------|------------|------------|------------|-----------|------------|
| **Securities  Brokerage** |       | $          | 18,304,103 |      | $          | 16,597,119 |   |
| **Corporate  Finance**    |       | 11,213,195 |       | 6,801,330 |       |
| **Investment  Income**    |       | 2,017,840  |       | 3,359,973 |       |
| **Trading  Income**       |       | 1,350,816  |       | 1,245,018 |       |
| **Other**                 |       | 29,321     |       | 55,719    |       |
|                           |            |            |            |           |            |  |  |

 

The table listed above reflects revenue categories and does not takeinto account any associated expenses. Because trading and investment income aredetermined by changes in the market value of PIC’s associated accounts, revenuein these categories can be either positive or negative.

 

**Securities Brokerage**

 

As a securities broker, PIC acts as agent forits customers in the purchase and sale of common and preferred stocks, options,warrants and debt securities traded on securities exchanges or in theover-the-counter (“OTC”) market.  Aportion of its revenue is derived from commissions from customers on thesetransactions. In the OTC market, transactions with customers in securities notlisted on an exchange may be effected as principal, rather than agent,primarily in securities for which PIC is a market maker.  Customer transactions in securities areeffected either on a cash or margin basis.

 

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PIC also enters into dealer agreements withmutual fund management companies and publicly registered limitedpartnerships.  Commissions on the sale ofthese securities are derived from the standard dealer discounts, which rangefrom approximately 1 percent to 8.5 percent of the purchase price of thesecurities, depending on the terms of the dealer agreement and the amount ofthe purchase.  PIC does not generallysell interests in limited partnerships that are not publicly registered.

 

In the case of corporate financetransactions, described below, a portion of the discount applicable tosecurities placed by PIC’s retail brokerage group is credited to securitiesbrokerage and the commission payable to the broker is recorded as securitiesbrokerage expense.

 

Pursuant to an agreement between PIC and NationalFinancial Services LLC, a Fidelity Investment Company (“NFS”), NFS carries allof PIC’s customer securities accounts and performs the following services:(1) preparation and mailing of monthly statements to PIC customers;(2) settlement of contracts and transactions in securities between PIC andother broker-dealers and between PIC and its customers; (3) custody andsafe-keeping of securities and cash, the handling of margin accounts,dividends, exchanges, rights offerings and tender offers; and (4) theexecution of customer orders placed on an exchange.  PIC determines the amount of commission to becharged to its customers on agency transactions and the price of securitiespurchased or sold in principal transactions. NFS receives compensation based on the size of the transaction, subjectto certain minimum and maximum amounts. The agreement between PIC and NFS maybe canceled by either party upon 60 days written notice, which period may bereduced in certain events.  In the eventof a liability arising from a bad debt from a customer, PIC is required toindemnify NFS against any loss.  Thispotential liability is uninsured.

 

In addition to providing clearing servicesfor PIC, NFS loans money to PIC in the ordinary course of PIC’s business,pursuant to an arrangement under which NFS agrees to finance PIC’s tradingaccounts.  At December 31, 2004, nonet loans were outstanding pursuant to this arrangement.

 

**Corporate Finance**

 

PIC raises capital for its corporate financeclients through public offerings and, to a lesser extent, private offerings ofsecurities of corporations that are engaged in a variety of businesses.  PIC participates in underwritings ofcorporate securities as managing underwriter and as a syndicate member.  Management of an underwriting generates morerevenue than participation as a member of an underwriting syndicate.  Revenues generated by syndicateparticipations have not been material.

 

PIC acts as the managing underwriter ofpublic offerings of securities that typically range in size from $5 million to $45million.  PIC underwrites these offeringson a “firm commitment” basis, which means that it agrees to purchase a specificamount of securities from the issuer at a discount and resells the securitiesto the public at a specified price after the registration statement for theoffering is declared effective by the Securities and Exchange Commission (the “SEC”).Managing these public offerings involves the risk of loss if PIC is unable toresell at a profit the securities it is committed to purchase.  This risk is usually reduced by acceptingother stock brokerage firms as a part of an underwriting syndicate in whicheach member commits to purchase a specified amount of the offering.  PIC and the other underwriters may also sella portion of their commitment through a “selling group” of other stockbrokerage firms that participate in selling the offering but are not subject toan underwriter’s commitment.  As anunderwriter, PIC is also subject to potential liability under federal and statesecurities laws if the registration statement or prospectus contains a materialmisstatement or omission.  PIC has noinsurance to cover its potential liabilities as an underwriter.

 

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The commitment of capital by PIC between thetime a firm commitment underwriting agreement becomes effective and the timePIC resells the securities constitutes a charge against its net capital.  Accordingly, PIC’s participation in orinitiation of underwritings may be limited by the financial requirements of theSEC and NASD.  See “Net CapitalRequirements.”

 

Between June 1, 1978 and December 31,2004, PIC acted as the managing underwriter or co-managing underwriter for 152securities offerings, raising approximately $1.1 billion for corporate financeclients.  Of these, 94 were initialpublic offerings.  PIC typically receives2 to 3 percent of the aggregate amount of money raised in an offering to covernonaccountable expenses and between 7 and 9 percent as compensation tounderwriters, selling group members and registered representatives, althoughthese percentages may be lower for larger transactions. PIC also typicallyreceives warrants to purchase securities, equal to 10 percent of the securitiessold in the offering, exercisable for a period of five years from the effectivedate of the public offering at a price equal to 120 percent of the publicoffering price.  A portion of theseunderwriter warrants is typically transferred as compensation to persons associatedwith PIC and, in certain cases, to other major underwriters in the publicoffering.

 

**Investment Income**

 

For a variety of reasons, PIC holdssecurities for investment.  Securitiesheld for investment are maintained in investment accounts that are segregatedfrom the trading accounts.  PIC’sinvestment portfolio principally consists of securities purchased forinvestment and underwriter warrants.

 

From time to time, PIC makes investments as aprincipal in companies that are, or are expected to be, corporate financeclients.  The investment may be asconvertible debt in anticipation of a public offering, in which case, if theoffering is successful, the principal and interest are either converted toequity or repayable from the offering proceeds. If the offering is not successful, the debt is typically converted toequity.  PIC also makes investments incompanies that are not anticipating an immediate public offering.  In such cases, the investment is typicallymade in the form of the purchase of restricted equity securities.  Typical investments described in thisparagraph have ranged from $100,000 to $600,000.

 

**Trading and Market Making**

 

In addition to executing trades as an agent,PIC regularly acts as a principal in executing trades in equity securities,corporate debt securities and municipal bonds. At December 31, 2004, PIC made a market in 50 securities of 44issuers.  Of these, 21 were corporationsfor which PIC has acted as managing or co-managing underwriter of publicfinancings.  In addition, at December 31,2004, PIC held securities of 22 companies in its investment account.  In 2004, the value of securities held in thetrading accounts and investment account ranged between $16,937,466 and $23,803,971.The level of positions carried in PIC’s trading and investment accountsfluctuates significantly.  The size ofthe securities positions at any date may not be representative of PIC’sexposure on any other date, because the securities positions vary substantiallydepending upon economic and market conditions, the allocation of capital amongtypes of inventories, underwriting commitments, customer demands and tradingvolume.  The aggregate value ofinventories that PIC may carry is limited by certain requirements under the SEC’snet capital rules.  See “Net CapitalRequirements.”

 

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PIC’s market making activities are conductedboth with other dealers in the “wholesale market” and with PIC’scustomers.  Transactions with customersare effected as principal at a net price equal to the current interdealer priceplus or minus the approximate equivalent of a brokerage commission.  In such transactions, the commission isrecorded as securities brokerage revenue while any profit or loss attributableto a change in value of the security in PIC’s trading account is recorded astrading profit or loss. PIC’s transactions as principal expose PIC to riskbecause securities positions are subject to fluctuations in market value andliquidity.  Profits or losses on tradingand investment positions depend upon the skills of the employees in PIC’strading department and employees responsible for taking investmentpositions.  The trading department isheadquartered in PIC’s Portland, Oregon office.

 

**Branch Offices**

 

PIC branch offices are generally run byindependent contractors who assume liability for all the operating expenses ofthe branch.  PIC typically receivesbetween 10 and 20 percent of the gross commission earned by the branch, withthe balance retained by the branch to pay its expenses and staff.  Persons in these branches are registered withPIC, and PIC assumes the same compliance and regulatory obligations as would bethe case if PIC were fully responsible for the branch’s expenses.  As of March 15, 2005, PIC had 25 branchoffices in California, Connecticut, Georgia, New Jersey, New York, NorthCarolina, Oregon, Utah, Vermont, and Washington.  All of these branches, except our offices inSalem, Oregon and Manhattan, New York, operate as independent contractor offices.  PIC continues to be responsible for allexpenses of the Salem and Manhattan offices.

 

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**Regulation**

 

PIC is registered with the SEC as abroker-dealer under the Securities Exchange Act of 1934 and is a member of theNASD. It is also registered as a broker-dealer under the laws of all 50 statesand Washington, D.C.

 

The securities business is subject toextensive regulation under federal and state laws.  The principal purpose of regulation anddiscipline of broker-dealers is the protection of customers and the securitiesmarkets rather than protection of creditors and stockholders ofbroker-dealers.  The SEC is the federalagency charged with administration of the federal securities laws.  Much of the regulation of broker-dealers,however, has been delegated to self-regulatory organizations, principally theNASD.  These self-regulatoryorganizations adopt rules (subject to approval by the SEC) that govern theindustry and conduct periodic examinations of member broker-dealers.  Securities firms are also subject toregulation and examination by state securities commissions in the states inwhich they are registered.

 

The regulations to which broker-dealers aresubject cover all aspects of the securities business, including sales methods,trading practices among broker-dealers, capital structure of securities firms,record keeping and the conduct of directors, officers and employees.  Additional legislation, changes in rulespromulgated by the SEC and by self-regulatory bodies or changes in theinterpretation or enforcement of existing laws and rules often directly affectthe method of operation and profitability of broker-dealers.  The SEC, NASD and state regulatoryauthorities may conduct administrative proceedings that can result in censure,fine, suspension or expulsion of a broker-dealer, its officers or employees.

 

**Net Capital Requirements**

 

PIC is required to maintain minimum “netcapital” under the SEC’s net capital rule of not less than 6.67 percent of its “aggregateindebtedness”.  In general, net capitalconsists of the broker-dealer’s net worth, adjusted by numerous factorsspecified in the applicable regulations. In particular, the value of securities that can be included in netcapital is subject to reduction in market value or principal amount. The amountof the required reduction or “haircut” depends on the nature of thesecurity.  As of December 31, 2004,PIC had net capital of $14,104,972, which exceeded its minimum requirement of $213,214by $13,891,758.  The ratio of aggregateindebtedness of $3,198,212 to net capital of $14,104,972 on December 31,2004, was approximately 0.23 to 1.  TheCompany recorded a subsequent event related to a legal settlement.  If this amount would have been reflected inthe net capital computation at year end, the Company's net capital would havetotaled $13,486,973, and the ratio of aggregate indebtedness to net capitalwould have been 0.31 to 1.  In a publicoffering in which PIC acts as an underwriter, PIC must have sufficient netcapital to cover the amount of securities underwritten, applying applicableformula mandated by the SEC, during the period between effectiveness and theclosing of the transaction, usually 3 business days. This results in asignificant temporary increase in PIC’s required net capital.  In some cases, the amount of securitiesunderwritten by PIC could be limited by its net capital.  Any significant reduction in PIC’s netcapital, even if PIC were still in compliance with the SEC’s net capital rulefor its retail and trading activities, could have a material adverse impact onPIC’s ability to continue its investment banking activities.

 

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**Competition**

 

All aspects of PIC’s business are highly competitive.  In its general brokerage activities, PICcompetes directly with numerous other broker-dealers, many of which are largewell-known firms with substantially greater financial and personnel resourcesthan PIC.  Many of PIC’s competitorsemploy extensive advertising and actively solicit potential clients in order toincrease business.  In addition,brokerage firms compete by furnishing investment research publications toexisting clients, the quality and breadth of which are considered important inthe development of new business and the retention of existing clients.  PIC also competes with a number of smallerregional brokerage firms.

 

Some commercial banks and thrift institutionsoffer securities brokerage services. Many commercial banks offer a variety of investment bankingservices.  Competition among financialservices firms also exists for investment representatives and other personnel.

 

The securities industry has becomeconsiderably more concentrated and more competitive since the Company was founded,as numerous securities firms have either ceased operations or have beenacquired by or merged into other firms. This trend has been particularly pronounced among firms similar in sizeand business mix to PIC.  In addition,companies not engaged primarily in the securities business, but withsubstantial financial resources, have acquired leading securities firms.  These developments have increased competitionfrom firms with greater capital resources than those of the Company.  In particular, various recent legislative andregulatory developments have tended to increase competition within the industryor reduce profits for the industry.

 

The securities industry has experiencedsubstantial commission discounting by broker-dealers competing for brokeragebusiness.  In addition, an increasingnumber of specialized firms offer “discount” services to individualcustomers.  These firms generally effecttransactions for their customers on an “execution only” basis without offeringother services such as portfolio valuation, investment recommendations andresearch.  A growing number of discountbrokerage firms offer their services over the Internet, further decreasingoffered commission rates and increasing ease of use for customers.  The continuation of such discounting and anincrease in the number of new and existing firms offering discounts couldadversely affect the Company.  Inaddition, rapid growth in the mutual fund industry is presenting potentialcustomers of PIC with an increasing number of alternatives to traditional stockbrokerage accounts.

 

In its investment banking activities, PICcompetes with other brokerage firms, venture capital firms, banks and all othersources of capital for small, growing companies.  Since PIC generally manages offerings smallerthan $45 million, it does not typically compete with the investment bankingdepartments of large, well-known national brokerage firms.  Nevertheless, PIC occasionally manages largerofferings.  In addition, large nationaland regional investment banking firms occasionally manage offerings of a sizethat is competitive with PIC, typically for fees and compensation less thanthat charged by PIC.  When the market forinitial public offerings is active, many small regional firms that do nottypically engage in investment banking activities also begin to compete withPIC.

 

**Employees**

 

At March 15, 2005, PIC had 95 employees(of which 93 are full-time), of whom 53 were executives and support staff and42 were involved in brokerage activities and compensated primarily on acommission basis.  PIC also hadindependent contractor arrangements with 53 independent contractors, all ofwhom are compensated solely on a commission basis.  Paulson Capital had no employees separatefrom PIC.

 

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**ITEM 2.****          DESCRIPTIONOF PROPERTY**

 

PIC leases approximately 17,100 square feetof space for its office in Portland, Oregon under a lease expiring May 31,2009.  The base monthly rental rate onthis lease is currently $25,704.  The rentalrate increases every 2-3 years, from $25,704 beginning in June 2002 to$29,988 through the expiration of the lease in June 2009.  PIC’s Salem office leases space under a leasethat expires on October 31, 2005 at a monthly rent of $3,055, with rent subjectto increases based upon inflation.  PIC’sManhattan office leases space on a month-to-month basis at $5,400 permonth.  The Company believes the existingleased space in Portland and Salem is adequate for its business for theforeseeable future.  The Company is negotiatingfor leased space in Manhattan that is more suitable for PIC’s Manhattanoperations. The other branch offices lease space but, under the terms of therelationship between PIC and these offices, PIC is not responsible for theselease costs. The Company has no additional leases other than through PIC.

 

**ITEM 3.****          LEGALPROCEEDINGS**

 

In March 2002, the Company’s whollyowned subsidiary, Paulson Investment Company (“PIC”), and one of its registeredrepresentatives, Marvin Cox, were named as defendants in lawsuits filed byLouis Barinaga and Stuart Mackenzie, former PIC customers.  The claims of Barinaga and Mackenzie relateto purchases of convertible notes of E.com, which were purchased directly fromE.com. Plaintiffs abated their lawsuit and refiled their claims before theNASD.  Claimant Barinaga amended hisarbitration statement of claim to include claims for breach of fiduciary duty,violations of federal and state securities laws, fraud and negligence relatingto transactions in stock of e.Digital. Barinaga’s amended statement of claim also names UBS PaineWebber, Inc.as a respondent.  Barinaga claims thatCox, PIC and UBS PaineWebber, Inc.’s actions prevented him from realizing inexcess of $12 million on sales of e.Digital stock.  Barinaga sought over $18 million plusinterest and fees on the e.Digital claims. The e.Digital stock in question was subject to an agreement entered intobetween Barinaga and UBS PaineWebber, Inc. An arbitration hearing was set to begin on January 24, 2005.  The claims of Barinaga and Mackenzie relatingto E.com notes were settled prior to the start of the arbitration.  The remaining claim of Barinaga relating toe.Digital stock also was settled between PIC and Barinaga prior to the start ofthe arbitration.  The settlement has beenconsummated with Barinaga.  However, PIC’sinsurance carrier, after previously providing settlement authorization to PIC,has now withdrawn that authorization because of a dispute between Cox andBarinaga.  PIC believes that the insurancecarrier is obligated to provide the settlement authorization to which itpreviously agreed.  PIC has filed suitagainst the insurance carrier and intends to pursue the insurance proceedsvigorously. As of December 31, 2004, the Company has recorded the totalamount of the settlement expense in its financial statements.

 

In October 2002, PIC was named as adefendant in a lawsuit filed by Special Situations Fund III, LP and SpecialSituations Cayman Fund, LP.  The lawsuitwas filed in U.S. District Court for the District of New Jersey.  It asserts various federal securities lawclaims and common law fraud and negligence against numerous defendants,including PIC, arising out of two follow-on offerings of Suprema Specialties,Inc.  PIC participated in one of the twoofferings, the August 25, 2000 follow-on offering of Suprema Specialties,Inc., as a member of the underwriting syndicate, underwriting 75,000 shares intotal.  The plaintiffs seek damages forthe purchase of 399,151 shares of Suprema Specialties, Inc. stock between August 25,2000 and November 14, 2001.  Thefederal district court has dismissed the claims against PIC.  Plaintiffs have filed a notice ofappeal.  PIC believes it has meritoriousdefenses and intends to defend this matter vigorously.

 

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An adverse outcome in certain of the mattersdescribed above could have a material adverse effect on PIC or the Company. PICalso has been named in certain other legal proceedings and has received noticethat certain customers may commence legal proceedings against PIC. The Companyhas no additional legal proceedings other than through PIC. The Companybelieves, based upon information received to date and, where the Companybelieves it appropriate, discussions with legal counsel, that resolution ofthis additional pending or threatened litigation will have no material adverseeffect on the consolidated financial condition, results of operations, orbusiness of the Company.

 

**ITEM 4.****          SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None

 

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**PART II**

 

**ITEM 5.****          MARKETFOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND SMALL BUSINESS ISSUERPURCHASES OF EQUITY SECURITIES**

 

The Company’s common stock trades in theover-the-counter market.  The Company’sstock is quoted on the Nasdaq SmallCap Market under the symbol “PLCC,” but itis not actively traded.  The followingare high and low sales prices for the common stock for the periods shown.

 
| ** **   | ** ** | **2004 Prices** | ** ** | **2003 Prices** | ** ** |
|--------------|------------|-----------------|------------|-----------------|------------|
| ** **   | ** ** | **High**        | ** ** | **Low**         | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st  Quarter |       | $               | 15.30      |            | $          | 7.83 |   | $ | 5.21 |   | $ | 4.22 |   |
| 2nd  Quarter |       | 9.07            |       | 6.61            |       | 5.04 |   | 4.02 |   |
| 3rd  Quarter |       | 7.41            |       | 5.22            |       | 6.61 |   | 4.15 |   |
| 4th  Quarter |       | 8.70            |       | 5.83            |       | 10.47 |   | 5.83 |   |
|              |            |                 |            |                 |            |  |  |  |  |  |  |  |  |

 

The closing high and low prices for the first quarter of 2005, through March 15,2005, were $8.57 and $7.92, respectively.

 

As of March 15, 2004, there were 3,174,590shares of the Company’s common stock outstanding and held of record by 92holders.  The number of record holdersincludes as single holders various institutions (such as brokerage firms) thathold shares in “street name” for multiple shareholders.  Based on the number of requests for theCompany’s proxy materials for its 2004 annual meeting, the Company believesthere are approximately 345 beneficial holders of its common stock.  The Company repurchased 13,011 shares ofcommon stock during 2004. Additional shares of common stock may be repurchasedfrom time to time in the future.

 

No dividend was declared during fiscal year2004. The Company declared a $0.10 per share dividend on its common stock in December 2003,paid in January 2004. Further, the Company declared a $0.15 per sharedividend in January 2005, payable in March 2005. Net capitalrequirements may limit the ability of PIC to pay future dividends to theCompany, which would affect the Company’s ability to pay dividends to itsshareholders.

 

The following table provides certain information about the Company’sequity compensation plans in effect as of the end of fiscal year 2004.

 
| **Plan Category**                                       | ** ** | **Number of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-Average Exercise  Price of Outstanding  Options,  Warrants and Rights** | ** ** | **Number of Securities  Remaining  Available for Future  Issuance under  Equity Compensation Plans  (excluding securities  reflected in  column(a))** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **(a)**                                                                                            | ** ** | **(b)**                                                                            | ** ** | **(c)**                                                                                                                                               | ** ** |
|                                                    |       |                                                                                               |       |                                                                               |       |                                                                                                                                                  |       |
| Equity  Compensation Plans Approved by Shareholders(1)  |       | 110,000                                                                                            |       | $                                                                                  | 7.80       |                                                                                                                                                  | 260,500    |   |
| Equity  Compensation Plans Not Approved by Shareholders |       | —                                                                                             |       | —                                                                             |       | —                                                                                                                                                |       |
| Total                                                   |       | 110,000                                                                                            |       | $                                                                                  | 7.80       |                                                                                                                                                  | 260,500    |   |

 

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(1)           Consistsof the Company’s 1999 Stock Option Plan.

 

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Thefollowing table provides certain information about the Company’s unregisteredsales of equity securities and use of proceeds during the fourth quarter of2004.

 

**Small Business Issuer Purchasesof Equity Securities**

 
| **Period**            | ** ** | **Paulson Capital  Corp. Total  Number of Shares  Purchased** | ** ** | **Paulson Capital Corp.  Average Price Paid  per Share** | ** ** | **Total Number of  Shares  Purchased as Part of  Publicly Announced  Plans  or Programs** | ** ** | **Maximum Number of  Shares that May Yet  Be Purchased Under  the Plans or Programs** | ** ** |
|-----------------------|------------|---------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| 10/01/04 to  10/31/04 |       | None                                                          |       | N/A                                                      |       | None                                                                                      |       | 227,644                                                                               |       |
| 11/01/04 to  11/30/04 |       | None                                                          |       | N/A                                                      |       | None                                                                                      |       | 227,644                                                                               |       |
| 12/01/04 to  12/31/04 |       | 5,410                                                         |       | $                                                        | 8.34       |                                                                                      | 5,410      |                                                                                  | 222,234    |   |
| Total                 |       | 5,410                                                         |       | $                                                        | 8.34       |                                                                                      | 5,410      |                                                                                  | 222,234    |   |

 

All of the shares purchased were open-markettransactions as part of a corporate plan for stock repurchase. The stockrepurchase plan, approved by the board of directors on September 17, 2001,authorizes the repurchase of up to 300,000 shares. There is no expiration dateon the stock repurchase plan.

 

12

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**ITEM 6.****          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**SELECTEDFINANCIAL DATA**

 

**IncomeStatement Information**

 
| ** **                                             | ** ** | **Years Ended December 31,**             | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | **2004**                                      | ** ** | **2003** | ** ** |
| ** **                                             | ** ** | **(in thousands, except per share  amounts)** | ** ** |
| Revenues                                               |       | $                                             | 32,915     |   | $ | 28,059 |   |
| Commissions  and Salaries                              |       | 19,263                                        |       | 16,959 |   |
| Other  Expenses                                        |       | 7,756                                         |       | 4,956 |   |
| Total  Expenses                                        |       | 27,019                                        |       | 21,915 |   |
| Pretax  Income                                         |       | 5,896                                         |       | 6,144 |   |
| Net Income                                             |       | 3,489                                         |       | 4,040 |   |
| Diluted  Earnings per share                            |       | $                                             | 1.09       |   | $ | 1.29 |   |
| Average  Number of Common Shares Outstanding (Diluted) |       | 3,187                                         |       | 3,132 |   |

 

**BalanceSheet Information**

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**    | ** ** |
| Total Assets               |       | $                     | 44,325     |   | $ | 36,070 |   |
| Long-Term  Debt            |       | —                |       | — |   |
| Shareholders’  Equity |       | 33,570                |       | 29,595 |   |
|                            |            |                       |            |  |  |  |  |

 

**Overview**

 

Substantially all of our business consists ofthe securities brokerage and investment banking activities of our wholly ownedsubsidiary, Paulson Investment Company, Inc., or PIC.  PIC has operations in four principalcategories, all of them in the financial services industry.  These categories are:

 

•      securitiesbrokerage activities for which PIC earns commission revenues;

•      corporatefinance revenues consisting principally of underwriting discounts andunderwriter warrants;

•      securitiestrading from which PIC records profit or loss, depending on trading results;and

•      investmentincome resulting from earnings on, and increases or decreases in the value of,PIC’s investment portfolio.

 

Because we operate in the financial servicesindustry, our revenues and earnings are substantially affected by generalconditions in financial markets. In our securities brokerage and corporatefinance business, the amount of our revenues depends on levels of marketactivity requiring the services we provide. Our investment banking activity, which consists primarily of acting asthe managing underwriter of initial and follow-on public offerings for smallercompanies, is similarly affected by the strength of the market for new equityofferings, which has historically experienced substantial cyclicalfluctuation.  Although we attempt tomatch operating costs with activity levels, many of our expenses are eitherfixed or difficult to change on short notice. Accordingly, fluctuations in brokerage and investment banking revenuestend to result in sharper fluctuations, on a percentage basis, in net income orloss.

 

13

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Our investment income or loss and, to alesser extent, our trading income or loss is affected by changes in marketvaluation of securities generally and, in particular, by changes in valuationof the equity securities of microcap companies in which our investments andtrading activities tend to be concentrated. Equity markets in general, and microcap equity markets in particular,have always experienced significant volatility and this volatility has, in recentyears, been extreme.  The results of thisvolatility on the value of our investment portfolio and securities held inconnection with our trading and investment activities include large quarterlyfluctuations in income or loss from these operations and substantial increasesor decreases in our net worth as our securities holdings are marked to market.The securities in the investment account are held for investment, not activelytraded, and not deemed part of operations in accordance with management intentions.

 

A substantial portion of our investmentbanking business consists of acting as managing underwriter of initial andfollow-on public offerings for microcap companies.  As a part of our compensation for thisactivity, we typically receive warrants exercisable to purchase securitiesidentical to those that we offer and sell to the public.  The warrants are not exercisable for thefirst year after the offering in which they are earned and are thereafterexercisable for four years, after which they expire.  The exercise price is typically 120% of theprice at which the securities are initially sold to the public. Accordingly,unless there is at least a 20% increase in the price of these securities atsome time more than one and less than five years after the offering, thewarrants will remain “under water” and will ultimately expire unexercised.

 

### **CriticalAccounting Policies**

### ** **

The following discussion and analysis of ourfinancial condition and results of operations is based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  In preparing our consolidated financialstatements, we must make estimates and judgments that affect the reportedamounts of assets and liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities at the date of our financialstatements.  Actual results are likely todiffer from these estimates under different assumptions and conditions.

 

The critical accounting policies describedbelow include those that reflect significant judgments and uncertainties, whichpotentially could produce materially different results under differentassumptions and conditions.  We believeour critical accounting policies are limited to those described below.

 

*Revenue Recognition.*Securitiestransactions and related revenue are recorded on a trade date basis.  Underwriting revenues are recognized at thetime the underwriting is completed. Revenue from the receipt of underwriter warrants received in corporatefinance transactions is recognized based on the estimated fair value of thesecurities received. Underwriter warrants are valued at estimated fair valueusing the Black-Scholes option-pricing model, taking into account the exerciseprice, remaining life of the warrant, the current price of the underlying stockand its expected volatility, expected dividends on the stock and the risk-freeinterest rate for the remaining term of the warrant.

 

*Use of Estimates.*We are required to estimate the value of all derivativesecurities that we hold at the date of any financial statements and to includethat value, and changes in such value, in those financial statements.  Accordingly, the aggregate estimated value ofour warrants as of the date of any balance sheet is recorded as an asset onthat balance sheet.  When a new warrantis received as a result of our investment banking activity, its estimated valueis included in corporate finance revenue on the date on which it isearned.  Subsequently, any change inestimated value is recorded as investment income or loss.  When a warrant is exercised, the book valueis adjusted to reflect the value of the securities purchased, net of theexercise price, and the adjustment amount is recorded as income or loss for therelevant period. If a warrant expires unexercised, the book value is adjustedto zero and the decrease is recorded as a loss in the relevant period.

 

14

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We estimate the value of our underwriterwarrants using the Black-Scholes Option Pricing Model. The Black-Scholes modelrequires us to use historical price data combined with various assumptions andjudgments as inputs for the model.  Themost influential factor in this model is price volatility, which we calculatefor each company’s warrants based on each company’s own historical stock pricemovements as well as an index of historical prices for comparablecompanies.  When we initially receive anew underwriter warrant from an initial public offering, its calculatedvolatility factor is entirely based on the volatility of an index of comparablecompanies, since there is no price history for a new publicly tradedcompany.  As each underwriter warrantapproaches its expiration date, its volatility factor is derived primarily fromthe historical prices of its underlying common stock.  We cannot assure you that we will ultimatelybe able to exercise any of our warrants in a way that will realize the valuethat we attribute to them in our financial statements based on this model.

 

In addition to our underwriter warrants, wehold other securities, some of which have very limited liquidity and some ofwhich do not have a readily ascertainable market value.  According to accounting principles generallyaccepted in the United States of America (US GAAP), we are required to carrythese securities at estimated fair value.

 

As a result of the factors described above,our revenues and earnings are subject to substantial fluctuation from period toperiod based on circumstances, many of which are beyond our control.  An increase in financial market activitygenerally, and/or an increase in equity valuations generally, will normallyresult in increases in our revenues, earnings and net worth as our activitylevels and the value of our investment portfolio increase.  Conversely, a general market retrenchmentwill typically lead to decreased revenues, earnings and net worth as a resultboth of decreased activity and the need to adjust high investment portfoliovalues to lower levels.  Accordingly,results for any historical period are not necessarily indicative of similarresults for any future period.

 

**Recently Issued Accounting Pronouncements**

 

In March 2005, the Securities ExchangeCommission announced that the compliance date for non-accelerated filers andforeign private issuers pursuant to Section 404 of the Sarbanes-Oxley Acthas been extended.  Under the latestextension, a company that is not required to file its annual and quarterlyreports on an accelerated basis and a foreign private issuer filing its annualreport on Form 20-F or 40-F, must begin to comply with the internal controlover financial reporting requirements for its first fiscal year ending on orafter July 15, 2006.  This is aone-year extension from the previously established July 15, 2005compliance date.  The Commissionsimilarly has extended the compliance date for these companies relating torequirements regarding evaluation of internal control over financial reportingand management certification requirements. The Company will, therefore, be required to comply with Section 404of the Sarbanes-Oxley Act as of December 31, 2006.

 

In December 2004, the FASB issued FAS 123R, which requires thatcompensation costs relating to share-based payments be recognized in the Company’sfinancial statements. The Company currently accounts for those payments underthe recognition and measurement principles of Accounting Principles Board(APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” andrelated interpretations. The Company is preparing to implement this standardeffective January 1, 2006.  Althoughwe have not yet determined whether the adoption of 123(R) will result inamounts that are similar to the current pro form data (see Note A10), we expectthe adoption may have a material impact on future financial statements.  This estimate is based on preliminaryinformation and could materially change based on the actual facts andcircumstances and the terms of future option grants.

 

15

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**Results of Operations**

 

PIC’s revenues and operating results areinfluenced by fluctuations in the equity underwriting markets as well asgeneral economic and market conditions, particularly conditions in theover-the-counter market, where PIC’s investment account, trading inventorypositions and underwriter warrants are heavily concentrated.  Significant fluctuations can occur in PIC’srevenues and operating results from one period to another.  PIC’s results of operations depend upon manyfactors, such as the number of companies that are seeking public financing, thequality and financial condition of those companies, market conditions ingeneral, the performance of previous PIC underwritings and interest in certainindustries by investors.  As a result,revenues and income derived from these activities may vary significantly fromyear to year.  In the tables below, “CorporateFinance” revenues are a function of total proceeds from offerings done duringthe period, compensation per offering, and the fair value of underwriterwarrants received.  “Investment Income”includes realized gains from the exercise of underwriter warrants, gains andlosses from the sales of investment securities, and unrealized gains and lossesfrom underwriter warrants and other investment securities.  “Trading Income” is the net gain or loss fromtrading positions before commissions paid to the representatives in the tradingdepartment.

 

**Summary ofChanges in Major Categoriesof Revenues and Expense**

 
| ** **                    | ** ** | ** **              | ** ** | ** **         | ** ** | **Vs.**    | ** ** |
|-------------------------------|------------|-------------------------|------------|--------------------|------------|------------|------------|
| ** **                    | ** ** | **Increase/(Decrease)** | ** ** | **Percent Change** | ** ** | **2004**   | ** ** | **2003** | ** ** |
| Revenues:                     |       |                    |       |               |       |       |       |   |   |
| Sales  Commissions            |       | $                       | 1,706,984  |               | 10.3       |       | $          | 18,304,103 |   | $ | 16,597,119 |   |
| Corporate  Finance            |       | 4,411,865               |       | 64.9               |       | 11,213,195 |       | 6,801,330 |   |
| Investment  Income            |       | (1,342,133              | )          | (39.9              | )          | 2,017,840  |       | 3,359,973 |   |
| Trading  Income               |       | 105,798                 |       | 8.5                |       | 1,350,816  |       | 1,245,018 |   |
| Other                         |       | (26,398                 | )          | (47.4              | )          | 29,321     |       | 55,719 |   |
|                          |       |                    |       |               |       |       |       |   |   |
| Total                         |       | $                       | 4,856,116  |               | 17.3       |       | $          | 32,915,275 |   | $ | 28,059,159 |   |
|                          |       |                    |       |               |       |       |       |   |   |
| Expenses:                     |       |                    |       |               |       |       |       |   |   |
| Commissions  and Salaries     |       | 2,304,029               |       | 13.6               |       | 19,263,085 |       | 16,959,056 |   |
| Underwriting  Expenses        |       | 348,584                 |       | 66.0               |       | 876,981    |       | 528,397 |   |
| Rent,  Telephone & Quotes |       | 54,981                  |       | 4.8                |       | 1,211,383  |       | 1,156,402 |   |
| Other                         |       | 2,396,069               |       | 73.3               |       | 5,667,360  |       | 3,271,291 |   |
|                          |       |                    |       |               |       |       |       |   |   |
| Total                         |       | $                       | 5,103,663  |               | 23.3       |       | $          | 27,018,809 |   | $ | 21,915,146 |   |
|                          |       |                    |       |               |       |       |       |   |   |
| Earnings  before income taxes |       | $                       | (247,547   | )                  | (4.0       | )          | $          | 5,896,466 |   | $ | 6,144,013 |   |

 

**2004 Compared to 2003**

 

**Revenues**

 

Total revenues for 2004 increased approximately$4.8 million. As shown in the table above, sales commissions increased approximately$1.7 million, or 10.3 percent for 2004 as compared to 2003. This increase wasprimarily the result of increased trading activity and increased retailcommissions related to the Company’s corporate finance transactions. A largetransaction of a nanotechnology company (The Lumera Corporation), completed in July 2004,resulted in additional retail commissions of approximately $700,000.

 

Corporate finance revenuesincreased approximately $4.4 million, or 64.9 percent, for 2004 as compared to2003. Six corporate finance transactions, totaling $83.9 million, werecompleted during 2004 compared with three corporate finance transactions, totaling$66.0 million, completed during 2003.  Thesize of corporate finance transactions completed during 2004 ranged from $5million to $41.7 million. Corporate finance revenues are directlyrelated to the amount of money raised in corporate finance transactions. Thetransaction completed in the third quarter of 2004 for the Lumera Corporationraised $41.7 million and was one of the largest transactions ever completed bythe Company.

 

16

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Corporate finance revenues also include thereceipt of underwriter warrants as compensation for the Company’s underwritingefforts. During 2004, the Company received underwriter warrants, valued usingthe Black-Scholes option-pricing model, resulting in unrealized revenue of$7,288,588, as compared to underwriter warrants received during 2003 valued at$4,249,407.

 

Investment income decreasedapproximately $1.3 million for 2004 compared to 2003, primarily as a result oflower market values of certain stocks in which the Company has a concentration.During 2004, underwriter warrant expiration and depreciation totaled $3,294 and$2,124,342, respectively, compared to underwriter warrant expiration and appreciationof $532,533 and $1,160,968, respectively during 2003. Realized loss in 2004totaled $410,233, compared to realized loss of $2,317,543 in 2003. Theremainder of total investment income is unrealized gain and losses insecurities with quoted market prices and securities not readily marketable.

 

Trading income increased a modest $105,798 in 2004, compared to 2003 asa result of the combination of increases in prices of securities in which thecompany makes a market and the relative volume of transactions.

 

**Expenses**

 

Total expenses for 2004increased approximately $5.1 million, or 23.3 percent as compared to 2003. Thelargest increase was in commissions and salaries. Commission and salaryexpenses combined increased 13.6 percent, or approximately $2.3 million. Commissionsincreased year-over-year a total of $1.9 million (from $15 million to $16.9million) due to larger retail and corporate finance commissions paid on highercommission revenues during 2004. Administrative and salary expense expensesincreased year-over-year approximately $414,000 (from $2 million to $2.4million) as a result of adding additional staff to handle the increasingburdens of operating in a regulated industry and as a publicly traded company.  Underwriting expenses increased a total of $348,584in the comparative one year period as a result of completing six corporatefinance transactions in 2004 compared to completing three corporate financetransactions in 2003. The aggregate of all other expenses increasedapproximately $2.4 million, or 73.3 percent, for 2004. The increases in otherexpense included: travel and entertainment increase of approximately $117,000as a result of the investor conference held in June 2004 with nocomparable conference held in 2003; professional fee increase of approximately $379,000as a result of increased legal activity related to settlements; and advertisingexpense increase of approximately $90,000 as a result of PIC’s retention of apublic relations firm during 2004. The Company incurred bad debt expense of approximately$684,000 during 2004, as compared to approximately $368,000 during 2003, anincrease in of $316,000. The significant increase in bad debt expense isprimarily the result of an approximate $600,000 in settlement expense that wascharged to the responsible broker. The broker accounts receivable was subsequentlydeemed uncollectible based on the brokers’ inability to pay.  Increases in other expenses year-over-yearinclude an approximate $1.2 million in lawsuit settlement expense (see ITEM 3)and an increase in insurance expense of approximately $91,000 as the cost ofthe errors and omissions insurance and other coverage has increased. Theremainder of the net increase in other expenses consists of increases anddecreases in various expense categories.

 

**Income**

 

The Company had a decrease in earnings beforeincome taxes of $247,547 for 2004 as compared to 2003. Earnings before incometaxes as a percentage of revenues totaled 17.9 percent for 2004 as compared to22 percent for 2003, as a result of the increase in expenses exceeding theincrease in revenues. Independent of the change in the Black-Scholes value ofthe underwriter warrants and the income and expense associated with the receiptof the underwriter warrants, the Company would have had pretax income totaling$2,791,466 for 2004, as compared to pretax income of $2,547,013 for 2003.Because of the Black-Scholes value of underwriter warrants and other factors,significant fluctuations often occur in PIC’s revenues and operating resultsfrom one period to another.

 

17

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**Liquidity and Capital Resources**

 

Conducting business as a dealer in securitiesrequires that a substantial inventory of securities be maintained and that alarge amount of liquid assets be readily available.  The Company’s equity at December 31, 2004was $33,570,462. Of Paulson Capital’s total assets (net of intercompanyaccounts) at December 31, 2004 of $44,325,378, approximately 74.9 percentconsisted of securities in the Company’s investment account, trading inventoryand underwriter warrant securities, at fair value, and approximately 18 percentconsisted of cash and cash equivalents and receivables from its correspondentbroker.

 

PIC’s securities inventory is stated at fairvalue.  The liquidity of the market formany of PIC’s securities holdings, however, varies with trends in the stockmarket.  Since many of the securitiesheld by PIC are thinly traded, and PIC is in many cases a primary market makerin the issues held, any significant sales of PIC’s positions could adverselyaffect the liquidity and prices of the issues held.  In general, falling prices in OTC securities(which make up most of PIC’s trading positions) lead to decreased liquidity inthe market for these issues, while rising prices in OTC issues tend to increasethe liquidity of the market for these securities.  The overall decline in prices for the verysmall capitalization OTC securities traded by PIC in 2002, 2001, and 2000 werecombined with a general reduction in the liquidity of the markets for thesesecurities.  This situation was thereverse of 2004 and 2003, when increases in prices of OTC securities increasedthe liquidity of the markets for these securities.  PIC’s investment account and tradinginventory accounts are stated at fair value. They include shares of restrictedstock held by PIC, with an original cost of $1,495,974, currently valued at $1,739,985,which the Company believes, based upon available evidence, approximates marketvalue.

 

PIC borrows money from NFS in the ordinarycourse of its business, pursuant to an arrangement under which NFS agrees tofinance PIC’s trading accounts in an amount determined by the size of thoseaccounts and the type of securities held, with interest charged at prevailingmargin rates. As of December 31, 2004, no net loans were owed by PIC to NFSpursuant to this arrangement.  PIC andthe Company are generally able to meet their compensation and other obligationsout of current liquid assets.

 

18

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Another source of capital to PIC and theCompany has been the underwriter warrants issued to PIC in connection with itscorporate finance activities.  Therecorded value of our underwriter warrants is typically not readily realizable,either because the warrants are not currently exercisable or because theirexercise price is more than the price that we could realize if we exercised thewarrants and sold the underlying securities. There is no public market for our underwriter warrants and the warrantsthemselves are transferable only under very limited circumstances.  Accordingly, their value cannot be realizedby selling the warrants themselves. Underwriter warrants exercisable to purchase securities having a valuein excess of the exercise price are liquid, subject to restrictions onliquidity applicable to OTC securities generally.  The securities issuable on exercise of ourunderwriter warrants are registered under the Securities Act of 1933, asamended, and, in some cases, may also be resold under an exemption fromregistration.  Accordingly, there is nolegal impediment to liquidity with respect to these securities, except duringthe first year (the first six months for new issues) following a company’spublic offering.  At December 31,2004, PIC owned 21 underwriter warrants (from 17 different issuers), of which16 were currently exercisable; five had an exercise price below the currentmarket price of the securities receivable on exercise.  If we had exercised the “in-the-money”warrants and sold the underlying securities on December 31, 2004, we wouldhave received approximately $2.3 million in net proceeds.  As of December 31, 2004, the computedvalue of our underwriter warrants, based on the Black-Scholes Option PricingModel, was $9,416,000, a significant increase from the computed value of $6,311,000million at year-end 2003. The collective value of the underwriter warrantsincreases significantly during the years in which the Company completescorporate finance transactions as the Company receives underwriter warrants aspart of each transaction. There is little or no direct relationship between theintrinsic value of PIC’s underwriter warrants at the end of any given periodand the fair value calculated using the Black-Scholes Option Pricing Model, asdescribed more fully in “Critical Accounting Policies” above.

 

In 2004, $143,973 of net cash was provided byoperating activities.  The majoradjustments to reconcile this result to the Company’s net income include thefollowing items that are positive adjustments to or provided cash to operatingactivities: noncash compensation associated with underwriter warrants of$2,055,952; unrealized depreciation and expiration of underwriter warrantstotaling $2,127,636; and deferred income taxes of $2,522,600. The followingitems are negative adjustments to or a use of cash for operating activities: anincrease in trading and investment securities of $4,740,868; and the receipt ofunderwriter warrants of $7,288,588. Net cash used in investing activities in2004 was for additions to furniture and equipment of $127,615. Net cash used infinancing activities in 2004 totaled $38,827, resulting from proceeds from theexercise of employee stock options, dividends paid to common shareholders, andpayments to retire common stock.

 

As a securitiesbroker-dealer, the Company’s wholly owned subsidiary, PIC, is required by SECregulations to meet certain liquidity and capital standards.  In the unlikely event that PIC was unable tomeet these regulatory standards, it would be unable to pay dividends to theCompany.  Since PIC is the Company’s onlyoperating business, such a failure could have a material adverse effect on theCompany.

 

At December 31, 2004, the Company had nomaterial commitments for capital expenditures.

 

In general, the primary sources of PIC’s, andtherefore the Company’s, liquidity, includes PIC’s trading positions,borrowings on those positions and profits realized upon the exercise ofunderwriter warrants. All of these sources depend in large part on the trend inthe general markets for OTC securities. Rising OTC price levels will tend to increase the value and liquidity ofPIC’s trading positions, the amount that can be borrowed from NFS based uponthose positions, and the value of PIC’s underwriter warrants.  The Company believes its liquidity issufficient to meet its needs for both the short and long term horizon. TheCompany’s liquidity could be affected by protracted unfavorable marketconditions.

 

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**ITEM 7.****           FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA.**

 
| **(a) Financial Statements**                                                                             | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                               | ** ** |
| Reference is made to the report and  financial statements beginning on page F-1                          | ** ** |
| ** **                                                                                               | ** ** |
| Report of Independent Certified Public  Accountants                                                      |       |
|                                                                                                     |       |
| Consolidated Balance Sheet as of December 31, 2004                                                  |       |
|                                                                                                     |       |
| Consolidated Statements of Income for the  years ended December 31, 2004 and 2003                   |       |
|                                                                                                     |       |
| Consolidated Statement of Shareholders’  Equity for the years ended December 31, 2004 and 2003 |       |
|                                                                                                     |       |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2004 and 2003               |       |
|                                                                                                     |       |
| Notes to Consolidated Financial Statements                                                               |       |
|                                                                                                     |       |
| Supplementary Schedule of Warrants  Owned                                                           |       |
|                                                                                                     |       |
| Schedule II - Valuation and Qualifying  Accounts                                                    |       |

 

**ITEM 8.****            CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

**ITEM 8-A.****        CONTROLSAND PROCEDURES**

 

(a)           Underthe supervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, we conducted an evaluationof our disclosure controls and procedures, as such term is defined under Rules13a-15(e) and 15.1-15(e) promulgated under the Securities Exchange Act of 1934,as amended. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures wereeffective as of December 31, 2004, the end of the period covered by thisreport.

 

(b)           Forthe quarter ended December 31, 2004, there were no changes in our internalcontrol over financial reporting that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**ITEM 8-B.****        OTHERINFORMATION**

 

None

 

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**PART III**

 

**ITEM 9.****            DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Theinformation required by this item is incorporated by reference to theinformation under the captions “Directors and Executive Officers,” “AdditionalInformation Concerning the Board of Directors” and “Section 16(a)Beneficial Ownership Reporting Compliance” in our Proxy Statement for theAnnual Meeting of Shareholders scheduled to be held in June 2005.

 

We haveadopted a code of ethics that applies to our officers (including our principalexecutive, financial and accounting officers), directors, employees andconsultants.  The text of our code ofethics is posted at our Internet website, located atwww.paulsoninvestment.com.  Furthermore,if disclosure of an amendment or waiver to our code of ethics is required byItem 5.05 of Form 8-K, we intend to satisfy such disclosure either by timelyfiling a Form 8-K or by posting such information at the same Internet website.

 

**ITEM 10.****          EXECUTIVECOMPENSATION**

 

Theinformation required by this item is incorporated by reference to theinformation under the captions “Executive Compensation,” “Summary CompensationTable,” “Option/SAR Grants in Last Fiscal Year,” “Equity Compensation PlanInformation” and “Aggregated Option Exercises in Last Fiscal Year and FiscalYear-End Option Values” in our Proxy Statement for the Annual Meeting ofShareholders scheduled to be held in June 2005.

 

**ITEM 11.****          SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

 

Theinformation required by this item is incorporated by reference to theinformation under the caption “Stock Ownership of Principal Owners andManagement” in our Proxy Statement for the Annual Meeting of Shareholdersscheduled to be held in June 2005. For information required by Item 201(d)of Regulation S-B, reference is made to Item 5 of this report.

 

**ITEM 12****.****          CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

To theextent there is information to report, the information required by this item isincorporated by reference to the information in our Proxy Statement for theAnnual Meeting of Shareholders scheduled to be held in June 2005.

 

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**ITEM 13.****          EXHIBITS**

 

**(a) Exhibits**

 
| **Number** | ** ** | **Description**                                                                                                                                                                                                                                  |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1        |       | Articles of Incorporation (incorporated by  reference to Exhibit 3.1 to the Company’s Registration Statement on Form 10  filed with the Commission on December 18, 1989 (the “Form 10”)                                      |
|       |       |                                                                                                                                                                                                                                             |
| 3.2        |       | Bylaws (incorporated by reference to  Exhibit 3.2 to the Form 10)                                                                                                                                                                                |
|       |       |                                                                                                                                                                                                                                             |
| 10.1       |       | Office lease dated June 28, 1988  (incorporated by reference to Exhibit 10.2 to the Form 10)                                                                                                                                                |
|       |       |                                                                                                                                                                                                                                             |
| 10.2       |       | Office Lease renewal for the period from  6/1/97 to 5/31/02, dated as of May 6, 1997 (incorporated by reference to  Exhibit 10.4 to the Form 10-QSB for the quarter ended June 30, 1997  filed with the Commission on August 13, 1997) |
|       |       |                                                                                                                                                                                                                                             |
| 10.3       |       | Amendment 1 to Office Lease dated as of May  6, 1997 (incorporated by reference to Exhibit 10.5 to Form 10-KSB for the  year ended December 31, 2001)                                                                                       |
|       |       |                                                                                                                                                                                                                                             |
| 10.4       |       | 1999 Stock Option Plan (incorporated by  reference to Exhibit 10.5 to the Form 10-KSB for the year ended December 31,  1999)                                                                                                                |
|       |       |                                                                                                                                                                                                                                             |
| 10.5       |       | Contract with Correspondent Services  Corporation, dated July 24, 1992 (incorporated by reference to Exhibit  10.3 to the Form 10-Q for the quarter ended September 30, 1992 filed  with the Commission on November 13, 1992)     |
|       |       |                                                                                                                                                                                                                                             |
| 21.1       |       | Subsidiaries of Paulson Capital Corp. Filed  herewith electronically.                                                                                                                                                                            |
|       |       |                                                                                                                                                                                                                                             |
| 23.1       |       | Consent of Grant Thornton LLP                                                                                                                                                                                                                    |
|       |       |                                                                                                                                                                                                                                             |
| 31.1       |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                  |
|       |       |                                                                                                                                                                                                                                             |
| 31.2       |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                  |
|       |       |                                                                                                                                                                                                                                             |
| 32.1       |       | Certification of Principal  Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith  electronically.                                                |
|       |       |                                                                                                                                                                                                                                             |
| 32.2       |       | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith  electronically.                                                    |

 

**ITEM 14.****          PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

Theinformation required by this item is incorporated by reference to theinformation under the captions “Independent Public Accountants” and “AuditCommittee Report” in our Proxy Statement for the Annual Meeting of Shareholdersscheduled to be held in June 2005.

 

22

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|           |   |    PAULSON CAPITAL CORP. |
|----------------|--------|-----------------------------------------|
|           |   |                                    |
| Date: 03/30/05 | By:    | /s/ Chester L.F. Paulson                |   |
|           |   | Chester L.F. Paulson                    |
|           |   | President                               |

 

23

----

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the Registrant in the capacities and on thedates indicated.

 
| **Signature**                   | ** ** | **Title**                                     | ** ** | **Date** |
|---------------------------------|------------|-----------------------------------------------|------------|----------|
| **(1) Chief Executive Officer** |       | (Principal Executive Officer)                 |       |     |
|                            |       |                                          |       |     |
| /s/ Chester L.F. Paulson        |       |                                          |       |     |
| Chester L.F. Paulson            |       | Chairman of  the Board and  President         |       | 3/30/05  |
|                            |       |                                          |       |     |
| **(2) Chief Financial Officer** |       | (Principal  Financial and Accounting Officer) |       |     |
|                            |       |                                          |       |     |
| /s/ Carol Rice                  |       |                                          |       |     |
| Carol Rice                      |       | Chief  Financial Officer                      |       | 3/30/05  |
|                            |       |                                          |       |     |
| **(3) Directors**               |       |                                          |       |     |
|                            |       |                                          |       |     |
| /s/ Jacqueline M. Paulson       |       |                                          |       |     |
| Jacqueline M. Paulson           |       | Secretary,  Treasurer and  Director           |       | 3/30/05  |
|                            |       |                                          |       |     |
| /s/ Glen Davis                  |       |                                          |       |     |
| Glen Davis                      |       | Director                                      |       | 3/30/05  |
|                            |       |                                          |       |     |
| /s/ Steve Kleemann              |       |                                          |       |     |
| Steve Kleemann                  |       | Director                                      |       | 3/30/05  |
|                            |       |                                          |       |     |
| /s/ Shannon Pratt               |       |                                          |       |     |
| Shannon Pratt                   |       | Director                                      |       | 3/30/05  |
|                            |       |                                          |       |     |
| /s/ Paul Shoen                  |       |                                          |       |     |
| Paul Shoen                      |       | Director                                      |       | 3/30/05  |

 

24

----

 

**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                  |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Articles of Incorporation (incorporated by  reference to Exhibit 3.1 to the Company’s Registration Statement on Form 10  filed with the Commission on December 18, 1989 (the “Form 10”))                                     |
|                |       |                                                                                                                                                                                                                                             |
| 3.2                 |       | Bylaws (incorporated by reference to  Exhibit 3.2 to the Form 10)                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                             |
| 10.1                |       | Office lease dated June 28, 1988  (incorporated by reference to Exhibit 10.2 to the Form 10)                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                             |
| 10.2                |       | Office Lease renewal for the period from  6/1/97 to 5/31/02, dated as of May 6, 1997 (incorporated by reference to  Exhibit 10.4 to the Form 10-QSB for the quarter ended June 30, 1997  filed with the Commission on August 13, 1997) |
|                |       |                                                                                                                                                                                                                                             |
| 10.3                |       | Amendment 1 to the Office Lease dated as of  May 6, 1997 (incorporated by reference to Exhibit 10.5 to Form 10-KSB for the  year ended December 31, 2001)                                                                                   |
|                |       |                                                                                                                                                                                                                                             |
| 10.4                |       | 1999 Stock Option Plan (incorporated by  reference to Exhibit 10.5 to the Form 10-KSB for the year ended December 31,  1999)                                                                                                                |
|                |       |                                                                                                                                                                                                                                             |
| 10.5                |       | Contract with Correspondent Services  Corporation, dated July 24, 1992 (incorporated by reference to Exhibit  10.3 to the Form 10-Q for the quarter ended September 30, 1992 filed  with the Commission on November 13, 1992)     |
|                |       |                                                                                                                                                                                                                                             |
| 21.1                |       | Subsidiaries of Paulson Capital Corp. filed  herewith electronically.                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                             |
| 23.1                |       | Consent of Grant Thornton LLP                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                             |
| 31.1                |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                             |
| 31.2                |       | Section 302 Certification.  Filed herewith electronically.                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                             |
| 32.1                |       | Certification of Principal Executive  Officer pursuant to 18 U.S.C. Section 1350  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  Filed herewith electronically.                                                |
|                |       |                                                                                                                                                                                                                                             |
| 32.2                |       | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed  herewith electronically.                                                     |

 

25

----

 

Financial Statements and Report of

Independent Certified Public Accountants

 

**Paulson Capital Corp. and Subsidiary**

 

December 31, 2004 and 2003

 

----

 

Report of Independent Registered Public Accounting Firm

 

Board of Directors and Shareholders

Paulson Capital Corp.

 

We have audited the accompanying consolidated balance sheet of PaulsonCapital Corp. (an Oregon corporation) and Subsidiary as of December 31,2004, and the related consolidated statements of income, shareholders’ equityand cash flows for each of the two years in the period then ended.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform an audit of its internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statement, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofPaulson Capital Corp. and Subsidiary as of December 31, 2004, and theconsolidated results of its operations and its consolidated cash flows for eachof the two years in the period then ended, in conformity with accountingprinciples generally accepted in the United States of America.

 

Our audits were made for the purpose of forming an opinion on the basicconsolidated financial statements taken as a whole.  The accompanying Supplementary Schedule ofWarrants Owned as of December 31, 2004 is presented for purposes ofadditional analysis and is not a required part of the basic consolidatedfinancial statements.  Such informationhas been subjected to the auditing procedures applied in the audits of thebasic consolidated financial statements and, in our opinion, is fairly stated,in all material respects, in relation to the basic consolidated financialstatements taken as a whole.

 

We have also audited Schedule II for each of the two years in theperiod ended December 31, 2004. In our opinion, this schedule presentsfairly, in all material respects, the information required to be set forththerein.

 
| Portland, Oregon                                                                                            | /s/ GRANT THORNTON LLP |   |
|-------------------------------------------------------------------------------------------------------------|------------------------|--------|
| February 24, 2005, except for the  second  paragraph of Note P as to which the date is  March 7, 2005. |                   |
|                                                                                                        |                   |

 

F-1

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATEDBALANCE SHEET

 

December 31, 2004

 
| ASSETS                                                                                                | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|------------|
| ** **                                                                                            | ** ** | ** ** | ** ** |
| Cash and  cash equivalents                                                                            |       | $          | 132,845    |   |
| Receivable  from clearing organization                                                                |       | 7,856,254  |       |
| Notes and  other receivables                                                                          |       | 442,934    |       |
| Income taxes  receivable                                                                              |       | 851,000    |       |
| Trading  securities, at market value                                                                  |       | 3,029,326  |       |
| Investment  securities, at market value                                                               |       | 20,774,645 |       |
| Underwriter  warrants, at estimated fair value                                                        |       | 9,416,000  |       |
| Prepaid and  deferred expenses                                                                        |       | 1,583,346  |       |
| Furniture  and equipment, net                                                                         |       | 239,028    |       |
|                                                                                                  |       |       |       |
| Total assets                                                                                          |       | $          | 44,325,378 |   |
|                                                                                                  |       |       |       |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                            |       |       |       |
|                                                                                                  |       |       |       |
| LIABILITIES                                                                                           |       |       |       |
| Accounts  payable and accrued liabilities                                                             |       | $          | 2,138,856  |   |
| Payable to  clearing organization                                                                     |       | 1,021,860  |       |
| Compensation,  employee benefits and payroll taxes                                                    |       | 2,108,056  |       |
| Securities  sold, not yet purchased, at market value                                                  |       | 50,144     |       |
| Deferred  income taxes payable                                                                        |       | 5,436,000  |       |
|                                                                                                  |       |       |       |
| Total  liabilities                                                                                    |       | 10,754,916 |       |
|                                                                                                  |       |       |       |
| COMMITMENTS  AND CONTINGENCIES                                                                        |       | —     |       |
|                                                                                                  |       |       |       |
| SHAREHOLDERS’  EQUITY                                                                            |       |       |       |
| Preferred  stock, no par value; authorized, 500,000 shares; issued and outstanding, no  shares        |       | —     |       |
| Common  stock, no par value; authorized, 10,000,000 shares; issued and outstanding,  3,190,300 shares |       | 1,745,824  |       |
| Retained  earnings                                                                                    |       | 31,824,638 |       |
|                                                                                                  |       |       |       |
| Total  shareholders’ equity                                                                      |       | 33,570,462 |       |
|                                                                                                  |       |       |       |
| Total  liabilities and shareholders’ equity                                                      |       | $          | 44,325,378 |   |

 

The accompanying notes are an integral part of this statement.

 

F-2

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATEDSTATEMENTS OF INCOME

 

Years ended December 31,

 
| ** **                                   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
|                                         |       |       |       |       |       |
| Revenues                                     |       |       |       |       |       |
| Commissions                                  |       | $          | 18,304,103 |       | $          | 16,597,119 |   |
| Corporate  finance                           |       | 11,213,195 |       | 6,801,330  |       |
| Investment  income                           |       | 2,017,840  |       | 3,359,973  |       |
| Trading  income                              |       | 1,350,816  |       | 1,245,018  |       |
| Interest and  dividends                      |       | 27,686     |       | 52,764     |       |
| Other                                        |       | 1,635      |       | 2,955      |       |
|                                         |       |       |       |       |       |
|                                         |       | 32,915,275 |       | 28,059,159 |       |
|                                         |       |       |       |       |       |
| Expenses                                     |       |       |       |       |       |
| Commissions  and salaries                    |       | 19,263,085 |       | 16,959,056 |       |
| Underwriting  expenses                       |       | 876,981    |       | 528,397    |       |
| Rent,  telephone and quotation services      |       | 1,211,383  |       | 1,156,402  |       |
| Interest  expense                            |       | 10,093     |       | 16,813     |       |
| Professional  fees                           |       | 1,029,800  |       | 650,831    |       |
| Bad debt  expense                            |       | 684,429    |       | 367,796    |       |
| Travel and  entertainment                    |       | 368,044    |       | 250,973    |       |
| Depreciation  and amortization               |       | 96,914     |       | 136,876    |       |
| Settlement  expense                          |       | 1,274,540  |       | 96,849     |       |
| Other                                        |       | 2,203,540  |       | 1,751,153  |       |
|                                         |       |       |       |       |       |
|                                         |       | 27,018,809 |       | 21,915,146 |       |
|                                         |       |       |       |       |       |
| Earnings  before income taxes                |       | 5,896,466  |       | 6,144,013  |       |
|                                         |       |       |       |       |       |
| Income tax  expense                          |       | 2,406,866  |       | 2,103,736  |       |
|                                         |       |       |       |       |       |
| NET EARNINGS                                 |       | $          | 3,489,600  |       | $          | 4,040,277 |   |
|                                         |       |       |       |       |       |
| Basic  earnings per share                    |       | $          | 1.10       |       | $          | 1.30 |   |
|                                         |       |       |       |       |       |
| Diluted  earnings per share                  |       | $          | 1.09       |       | $          | 1.29 |   |
|                                         |       |       |       |       |       |
| Weighted  average common shares outstanding: |       |       |       |       |       |
| Basic                                        |       | 3,183,194  |       | 3,116,786  |       |
| Diluted                                      |       | 3,186,889  |       | 3,131,605  |       |

 

The accompanying notes are an integral part of these statements.

 

F-3

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

 

Two year period ended December 31,2004

 
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Retained  Earnings** | ** ** |
|----------------------------------------------------------------------------|------------|------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **Shares**       | ** ** | **Amount**             | ** ** | ** ** |
|                                                                       |       |             |       |                   |       |   |   |
| Balance at December 31,  2002                                         |       | 3,125,811        |       | $                      | 1,086,740  |   | $ | 24,756,219 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Stock  options exercised and income tax benefit from stock option exercise |       | 14,000           |       | 90,055                 |       | — |   |
|                                                                       |       |             |       |                   |       |   |   |
| Redemption  of common stock                                                |       | (15,000          | )          | (3,750                 | )          | (62,152 | ) |
|                                                                       |       |             |       |                   |       |   |   |
| Dividends to  common shareholders                                          |       | —           |       | —                 |       | (312,481 | ) |
|                                                                       |       |             |       |                   |       |   |   |
| Net earnings  for the year                                                 |       | —           |       | —                 |       | 4,040,277 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Balance at December 31,  2003                                         |       | 3,124,811        |       | 1,173,045              |       | 28,421,863 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Stock  options exercised and income tax benefit from stock option exercise |       | 78,500           |       | 577,518                |       | — |   |
|                                                                       |       |             |       |                   |       |   |   |
| Redemption  of common stock                                                |       | (13,011          | )          | (4,739                 | )          | (86,825 | ) |
|                                                                       |       |             |       |                   |       |   |   |
| Net earnings  for the year                                                 |       | —           |       | —                 |       | 3,489,600 |   |
|                                                                       |       |             |       |                   |       |   |   |
| Balance at December 31,  2004                                         |       | 3,190,300        |       | $                      | 1,745,824  |   | $ | 31,824,638 |   |

 

The accompanying notes are an integral part of this statement.

 

F-4

----

 

PaulsonCapital Corp. and Subsidiary

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years ended December 31,

 
| ** **                                                                          | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
|                                                                                |       |       |       |       |       |
| Cash flows  from operating activities                                               |       |       |       |       |       |
| Net earnings                                                                        |       | $          | 3,489,600  |       | $          | 4,040,277 |   |
| Adjustments  to reconcile net earnings to net cash provided by operating activities |       |       |       |       |       |
| Receipt of  underwriter warrants                                                    |       | (7,288,588 | )          | (4,249,407 | )          |
| Unrealized  (appreciation) depreciation/expiration of underwriter warrants          |       | 2,127,636  |       | (628,435   | )          |
| Noncash  compensation associated with underwriter warrants                          |       | 2,055,952  |       | 1,280,842  |       |
| Deferred  income taxes                                                              |       | 2,522,600  |       | 3,125,700  |       |
| Depreciation  and amortization                                                      |       | 96,914     |       | 136,876    |       |
| Changes in  assets and liabilities                                                  |       |       |       |       |       |
| Receivables                                                                         |       | 223,540    |       | 15,181     |       |
| Receivable  from/payable to clearing organization                                   |       | (168,098   | )          | (4,827,452 | )          |
| Trading and  investment securities, net                                             |       | (4,740,868 | )          | (681,787   | )          |
| Income taxes  receivable/payable                                                    |       | 233,900    |       | 809,100    |       |
| Prepaid and  deferred expenses                                                      |       | (164,809   | )          | (259,799   | )          |
| Accounts  payable and accrued liabilities                                           |       | 1,725,101  |       | 1,401,872  |       |
| Securities  sold, not yet purchased                                                 |       | 31,093     |       | (41,792    | )          |
|                                                                                |       |       |       |       |       |
| Net cash  provided by operating activities                                          |       | 143,973    |       | 121,176    |       |
|                                                                                |       |       |       |       |       |
| Cash flows  from investing activities                                               |       |       |       |       |       |
| Additions to  furniture and equipment                                               |       | (127,615   | )          | (87,645    | )          |
|                                                                                |       |       |       |       |       |
| Cash flows  from financing activities                                               |       |       |       |       |       |
| Proceeds  from exercise of stock options                                            |       | 365,218    |       | 90,055     |       |
| Dividends  paid to common shareholders                                              |       | (312,481   | )          | —     |       |
| Payments to  retire common stock                                                    |       | (91,564    | )          | (65,902    | )          |
|                                                                                |       |       |       |       |       |
| Net cash  provided by (used in) financing activities                                |       | (38,827    | )          | 24,153     |       |
|                                                                                |       |       |       |       |       |
| Net  (decrease) increase in cash and cash equivalents                               |       | (22,469    | )          | 57,684     |       |
|                                                                                |       |       |       |       |       |
| Cash and  cash equivalents at beginning of year                                     |       | 155,314    |       | 97,630     |       |
|                                                                                |       |       |       |       |       |
| Cash and  cash equivalents at end of year                                           |       | $          | 132,845    |       | $          | 155,314 |   |
|                                                                                |       |       |       |       |       |
| Cash paid  during the year for                                                      |       |       |       |       |       |
|                                                                                |       |       |       |       |       |
| Interest                                                                            |       | $          | 10,093     |       | $          | 16,678 |   |
|                                                                                |       |       |       |       |       |
| Income taxes                                                                        |       | $          | 664,330    |       | $          | 41,613 |   |
|                                                                                |       |       |       |       |       |
| Non-cash  items                                                                     |       |       |       |       |       |
|                                                                                |       |       |       |       |       |
| Dividends  declared                                                                 |       | $          | —     |       | $          | 312,481 |   |
| Deferred tax  benefit from stock option exercise                                    |       | 212,300    |       | —     |       |

 

The accompanying notes are an integral part of these statements.

 

F-5

----

 

PaulsonCapital Corp. and Subsidiary

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE A – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Paulson Capital Corp. (the Company) is aholding company whose wholly-owned subsidiary, Paulson Investment Company, Inc.(the Subsidiary), is a registered broker-dealer in securities under theSecurities Exchange Act of 1934, as amended. The Subsidiary provides broker-dealer services in securities on both anagency and principal basis to its customers who are fully introduced to NationalFinancial Services, LLC (NFS), a Fidelity Investments Company. The Subsidiaryalso acts as lead or participating selling group member for Nasdaq and AmericanStock Exchange securities offerings.  TheSubsidiary conducts business throughout the United States.  The Subsidiary is exempt from the reserverequirements under SEC Rule 15c3-3(k)(2)(ii), since it does not handle or carrycustomer securities or cash.

 

A summary of the significant accountingpolicies applied in the preparation of the accompanying financial statementsfollows.

 

1.   Principlesof Consolidation

 

The accompanying consolidated financialstatements include the accounts of Paulson Capital Corp. and its wholly-ownedsubsidiary, Paulson Investment Company, Inc. All significant intercompany balances and transactions have beeneliminated in consolidation.

 

2.   SecuritiesTransactions

 

Securities transactions and related revenueare recorded on a trade date basis. Underwriting revenues are recognized at the time the underwriting iscompleted.  Revenue from the receipt ofunderwriter warrants received in corporate finance transactions is recognizedbased on the estimated fair value of the securities received. Underwriterwarrants are valued at estimated fair value using the Black-Scholesoption-pricing model, taking into account the exercise price, remaining life ofthe warrant, the current price of the underlying stock and its expectedvolatility, expected dividends on the stock and the risk-free interest rate forthe remaining term of the warrant. Changes in the estimated fair value of these underwriter warrants arereflected currently in the results of operations.  Marketable securities are valued at marketvalue and securities not readily marketable are valued at fair value asdetermined by management.  The fair valueof not readily marketable securities is estimated by management using availableinformation including the following: quoted market prices of similar securities(i.e., unrestricted shares of the same company); price of recent known tradesof the same or similar securities; the cost of the security if recentlypurchased adjusted for changes in the financial condition of the issuer; allother information available from review of available documents related to theissuer or discussions with management of the issuer.  Changes in the value of these securities arereflected currently in the results of operations.

 

3.   FairValue of Financial Instruments

 

The carrying amounts reflected in the balancesheet for cash, cash equivalents, notes and other receivables and payablesapproximate their respective fair values due to the short term nature of theseinstruments.

 

4.   Furnitureand Equipment

 

Depreciation of furniture and equipment isgenerally computed by the straight-line method over their estimated usefullives (5 years).  Leasehold improvementsare amortized over the lesser of their estimated useful life or the lives oftheir related leases.

 

F-6

----

 

5.   CashFlows

 

For purposes of reporting cash flows, cashand cash equivalents include cash on hand, cash due from banks and brokerageaccounts, certificates of deposit and highly liquid debt instruments purchasedwith a maturity of three months or less.

 

6.   Useof Estimates

 

In preparing financial statements inconformity with accounting principles generally accepted in the United Statesof America (US GAAP), management is required to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, the disclosure ofcontingent assets and liabilities at the date of the financial statements, andthe reported amounts of revenues and expenses during the reportingperiod.  Actual results could differ from those estimates.

 

7.   EarningsPer Share

 

Basic earnings per share is computed based onthe weighted average number of common shares outstanding during the year.Diluted earnings per share is computed using the weighted average number ofcommon and dilutive common equivalent shares outstanding during the year.  Common equivalent shares from stock optionsare excluded from the computation when their effect is antidilutive.  (Note I).

 

8.   IncomeTaxes

 

The Company provides for income taxes underthe liability method.  Deferred taxassets and liabilities are determined based on differences between thefinancial reporting and tax basis of assets and liabilities as measured by theenacted tax rates which are expected to be in effect when these differencesreverse.  Income tax expense (benefit) isthe current tax payable (recoverable) for the period and the change during theperiod in net deferred tax assets and liabilities. The Company establishes avaluation allowance when necessary to reduce the deferred tax assets to theamounts that more likely than not will be realized.

 

9.   Advertising

 

Advertising costs of are charged to expensewhen incurred. Advertising expense for the years ended December 31, 2004 andDecember 31, 2003, totaled $142,336 and $52,335, respectively.

 

10. Stock Options

 

The Company has a stock-based employeecompensation plan. As allowed under SFAS No. 123, “Accounting for Stock-BasedCompensation,” the Company continues to account for stock options for employeesunder APB No. 25, “Accounting from Stock Issued to Employees,” and has adoptedthe disclosure only requirements of SFAS No. 123.

 

F-7

----

 

There we no stock option awards during fiscal2004. The Company granted stock options in 2003, however, no stock-basedemployee compensation cost is reflected in net income in 2003, as all optionsgranted under the plan had an exercise price equal to the market value of theunderlying common stock on the date of grant. The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS No. 123, *Accounting for Stock-BasedCompensation*, to stock-based employee compensation for the yearended December 31, 2003. The fair value of each option grant during 2003,is estimated on the date of grant using the Black-Scholes option-pricing modelwith the following weighted-average assumptions: annual expected dividend yield1.23%; expected volatility 57.3%; risk-free interest rate of 3.49%; andexpected life of 5 years.

 
| ** **                                                                                                                                    | ** ** | **Year Ended  December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| Net income,  as reported                                                                                                                      |       | $                                      | 4,040,277  |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |       | (154,700                               | )          |
| Pro forma  net income                                                                                                                         |       | $                                      | 3,885,577  |   |
| Income per  share:                                                                                                                            |       |                                   |       |
| Basic - as  reported                                                                                                                          |       | $                                      | 1.30       |   |
| Diluted – as  reported                                                                                                                   |       | $                                      | 1.29       |   |
| Basic – pro  forma                                                                                                                       |       | $                                      | 1.25       |   |
| Diluted -  pro forma                                                                                                                          |       | $                                      | 1.24       |   |

 

11. Reclassifications

 

Certain 2003 amounts have been reclassifiedto conform to the 2004 presentation.

 

NOTE B - RECEIVABLE FROM AND PAYABLE TO CLEARING ORGANIZATION

 

The Subsidiary introduces all customertransactions in securities traded on U.S. securities markets to NFS on afully-disclosed basis.  The agreementbetween the Subsidiary and its clearing broker provides that the Subsidiary isobligated to assume any exposure related to nonperformance by customers orcounterparties.  The Subsidiary monitorsclearance and settlement of all customer transactions on a daily basis.

 

The exposure to credit risk associated withthe nonperformance of customers and counterparties in fulfilling theircontractual obligations pursuant to these securities transactions is directlyaffected by volatile trading markets which may impair the customer’s orcounterparty’s ability to satisfy their obligations to the Subsidiary.  In the event of nonperformance, theSubsidiary may be required to purchase or sell financial instruments atunfavorable market prices which could result in a loss.  Management does not anticipate nonperformanceby customers and counterparties in the above situations.

 

In addition to the clearing servicesprovided, NFS also lends money to the Subsidiary to finance its tradingaccounts.

 

F-8

----

 

NOTE C – NOTES AND OTHER RECEIVABLES

 

Notes and other receivables consist of thefollowing at December 31, 2004:

 

| Officers             |   | $       | 40,253  |   |
|----------------------|--------|---------|---------|--------|
| Employees            |   | 137,473 |    |
| Independent  brokers |   | 46,393  |    |
| Other                |   | 218,815 |    |
|                 |   |    |    |
|                 |   | $       | 442,934 |   |

 

Employee and independent broker receivablesrelate principally to advances, expenses, inventory losses and settlementscharged to the registered representatives of the Subsidiary in excess ofcommission earnings.  For the years endedDecember 31, 2004 and 2003, receivables from employees and independentbrokers of $684,429 and $367,796, respectively, were determined by managementto be uncollectible and written off to bad debt expense. Included in the bad debtexpense for the year ended December 31, 2004, is $599,250 related to alegal settlement that was charged to the broker and deemed uncollectible.

 

NOTE D – TRADING AND INVESTMENT SECURITIES

 

Trading securities and securities sold notyet purchased represent the market value of securities held long and short bythe Subsidiary.

 

The categories of trading securities andtheir related market values at December 31, 2004 are as follows:

 

| ** **                       | ** ** | **Owned** | ** ** | **Sold,  Not Yet  Purchased** | ** ** |
|----------------------------------|------------|-----------|------------|-------------------------------|------------|
|                             |       |      |       |                          |       |
| Corporate  equities              |       | $         | 2,809,083  |                          | $          | 50,144 |   |
| State and  municipal obligations |       | 220,243   |       | —                        |       |
|                             |       |      |       |                          |       |
|                             |       | $         | 3,029,326  |                          | $          | 50,144 |   |

 

As a securities broker-dealer, the Subsidiaryis engaged in various securities trading and brokerage activities asprincipal.  In the normal course of business,the Subsidiary has sold securities that it does not currently own and willtherefore be obligated to purchase such securities at a future date.  This obligation is recorded in the financialstatements at the market value of the related securities and will result in atrading loss on the securities if the market price increases and a trading gainif the market price decreases subsequent to December 31, 2004.

 

F-9

----

 

Investment securities held by the Subsidiarywhich are readily marketable are stated at market value.  Included in investment securities are certainsecurities which are not readily marketable. Securities not readily marketable include investment securities (a) forwhich there is no market on a securities exchange or no independent publiclyquoted market, (b) that cannot be publicly offered or sold unless registrationhas been effected under the Securities Act of 1933, or (c) that cannot beoffered or sold because of other arrangements, restrictions, or conditionsapplicable to the securities or to the Subsidiary.  At December 31, 2004 these securitiesconsisted of corporate stocks and warrants at estimated fair value ofapproximately $1,739,984.  A summary ofthe investment securities portfolio at December 31, 2004 follows:

 

| Corporate  equities |   | $         | 20,774,645 |   |
|---------------------|--------|-----------|------------|--------|
| Corporate  warrants |   | 9,416,000 |       |
|                |   |      |       |
|                |   | $         | 30,190,645 |   |

 

Realized loss included in the determinationof net earnings was $410,233 and $2,317,543 for the years ended December 31,2004 and 2003, respectively.

 

NOTE E – UNDERWRITER WARRANTS

 

The estimated fair value of warrants isdetermined by management using the Black-Scholes option-pricing model, takinginto account the exercise price, remaining contractual life of the warrant, thecurrent price of the underlying stock and its expected volatility, expecteddividends on the stock and the risk-free interest rate for the remaining termof the warrant (see Note A2).  Thewarrants generally have a five-year expiration date and vest immediately.  The warrants are generally subject to aone-year restriction period in which the Company cannot exercise thewarrants.  The expected volatilityfactors were determined using historical volatility of the underlying stock ifavailable and historical volatility of a peer group if volatility for theunderlying stock is not available.

 

The following table summarized activity inunderwriter warrants:

 

| Estimated  fair value at December 31, 2003  |   | $          | 6,311,000 |   |
|--------------------------------------------------|--------|------------|-----------|--------|
| Warrants  received, net of employee compensation |   | 5,232,636  |      |
| Warrants  expired                                |   | (3,294     | )         |
| Unrealized  depreciation in estimated value      |   | (2,124,342 | )         |
| Estimated  fair value at December 31, 2004  |   | $          | 9,416,000 |   |

 

The net increase in the estimated fair valueof the underwriter warrants is reflected currently in earnings. The fair valueof the underwriter warrants received during 2004 of $7,288,588 is included inthe Company’s corporate finance revenues. Additionally, $2,055,952 wasrecognized as compensation expense related to the receipt of the warrants,resulting in net warrants received of $5,232,636. The amount of the underwriterwarrants expired of $3,294, and the unrealized depreciation in the fair valueof the underwriter warrants of $2,124,342 is included in investment income for2004.

 

F-10

----

 

NOTE F – FURNITURE AND EQUIPMENT

 

Furniture and equipment are stated at costand consist of the following at December 31, 2004:

 
| Office  equipment                               |   | $         | 1,635,700 |   |
|-------------------------------------------------|--------|-----------|-----------|--------|
| Vehicles                                        |   | 65,619    |      |
| Leasehold  Improvements                         |   | 6,418     |      |
|                                            |   | 1,707,737 |      |
| Less  accumulated depreciation and amortization |   | 1,468,709 |      |
|                                            |   |      |      |
|                                            |   | $         | 239,028   |   |

 

NOTE G – INCOME TAXES

 

Income tax expense (benefit) consists of thefollowing:

 
| ** **                     | ** ** | **2004**  | ** ** | **2003**   | ** ** |
|--------------------------------|------------|-----------|------------|------------|------------|
|                           |       |      |       |       |       |
| Current tax  expense (benefit) |       |      |       |       |       |
| Federal                        |       | $         | (140,657   | )          | $          | (868,670 | ) |
| State and  local               |       | 24,923    |       | (153,294   | )          |
|                           |       |      |       |       |       |
|                           |       | (115,734  | )          | (1,021,964 | )          |
|                           |       |      |       |       |       |
| Deferred tax  expense          |       |      |       |       |       |
| Federal                        |       | 1,974,306 |       | 3,020,150  |       |
| State and  local               |       | 548,294   |       | 105,550    |       |
|                           |       |      |       |       |       |
|                           |       | 2,522,600 |       | 3,125,700  |       |
|                           |       |      |       |       |       |
|                           |       | $         | 2,406,866  |       | $          | 2,103,736 |   |

 

Income tax expense for each year varies fromthe amount computed by applying the statutory federal income tax rate toearnings before income taxes as follows:

 
| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Income tax  expense at statutory federal tax rate        |       | $        | 2,004,798  |     | $          | 2,089,000 |   |
| State and  local taxes net of federal benefit            |       | 353,098  |       | 368,000  |       |
| Permanent  and other differences                         |       | (2,830   | )          | 10,036   |       |
| Change in  valuation allowance on net deferred tax asset |       | 51,800   |       | (363,300 | )          |
|                                                     |       |     |       |     |       |
|                                                     |       | $        | 2,406,866  |     | $          | 2,103,736 |   |

 

F-11

----

 

The deferred income tax asset (liability)consists of the following at December 31, 2004:

 
| Unrealized  appreciation on securities        |   | $        | (6,870,760 | ) |
|-----------------------------------------------|--------|----------|------------|---|
| Accrued  expenses                             |   | 435,670  |       |
| Net  operating loss carryforwards and credits |   | 934,063  |       |
| Capital loss  carryfowards                    |   | 183,775  |       |
| Fixed asset  depreciation                     |   | (17,025  | )          |
| Contribution  carryover                       |   | 55,277   |       |
| Valuation  allowance                          |   | (157,000 | )          |
|                                          |   |     |       |
|                                          |   | $        | (5,436,000 | ) |

 

The Company has recorded a valuationallowance in the amount of $157,000 based upon management’s assessment that itis more likely than not that a portion of the net deferred tax asset related tocertain state net operating loss carryforwards will not be fully realized.  Management will continue to review the net deferredtax asset and may adjust the valuation allowance in future periods based upontheir assessment.

 

Federal net operating losses of approximately$1.0 million expire in 2024. State net operating loss carryforwards ofapproximately $9.3 million began to expire in 2004.

 

F-12

----

 

NOTE H – COMMON STOCK

 

The Company’s 1999 Stock Option Plan reserves500,000 shares of the Company’s common stock for issuance upon exercise ofoptions granted under the plan.  At December 31,2004, 260,500 options were available for grant. The Plan provides for the grant of incentive options and nonqualifiedoptions.  There were no options grantedduring 2004. The options granted during 2003 have an exercise price of $8.10and $8.91, vested immediately, and expire on November 9, 2008. The marketprice of the Company’s stock at the date of the grant in 2003 was $8.10. Theweighted average fair value of the options at the date of grant in 2003, ascalculated using the Black-Scholes option-pricing model, was $3.82 per share.

 

The following table presents the optionsgranted under the plan during 2003:

 
| ** **                                                                            | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Fair  Value** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------------------|------------|----------------------------------------|------------|
|                                                                                  |       |                   |       |                               |       |                                   |       |
| Options  whose exercise price equals the market price of the stock on the grant date  |       | 50,000                 |       | $                                  | 3.8687     |                                   | $          | 8.10 |   |
|                                                                                  |       |                   |       |                               |       |                                   |       |
| Options  whose exercise price exceeds the market value of the stock on the grant date |       | 17,500                 |       | 3.6800                             |       | 8.91                                   |       |
|                                                                                       |            |                        |            |                                    |            |                                        |            |  |  |

 

The following table summarizes activity underthe Plan for the years ended December 31, 2004 and 2003:

 
| ** **                         | ** ** | **Shares  Under  Option** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life** | ** **  |
|------------------------------------|------------|---------------------------|------------|----------------------------------------|------------|----------------------------------------|-------------|
|                               |       |                      |       |                                   |       |                                   |        |
| Balance at December 31,  2002 |       | 141,000                   |       | $                                      | 5.33       |                                   | 2.469 years |   |
| Granted                            |       | 67,500                    |       | 8.31                                   |       |                                   |        |
| Exercised                          |       | (14,000                   | )          | 4.44                                   |       |                                   |        |
| Canceled                           |       | —                    |       |                                   |       |                                   |        |
|                               |       |                      |       |                                   |       |                                   |        |
| Balance at December 31,  2003 |       | 194,500                   |       | 6.43                                   |       | 2.735 years                            |        |
| Granted                            |       | —                    |       |                                   |       |                                   |        |
| Exercised                          |       | (78,500                   | )          | 4.66                                   |       |                                   |        |
| Canceled                           |       | (6,000                    | )          | 4.44                                   |       |                                   |        |
|                               |       |                      |       |                                   |       |                                   |        |
| Balance at December 31,  2004 |       | 110,000                   |       | 7.80                                   |       | 3.188 years                            |        |
|                                    |            |                           |            |                                        |            |                                        |             |  |

 

All outstanding options at December 31,2004 and 2003 were exercisable.

 

F-13

----

 

As of December 31, 2004, outstandingstock options consist of the following:

 
| **Exercise Price Range** | ** **       | **Options** | ** ** | **Weighted  Average** | ** ** | **Remaining  Life** | ** ** |
|--------------------------|------------------|-------------|------------|-----------------------|------------|---------------------|------------|
|                     |             |        |       |                  |       |                |       |
| $                        | 7.01 – 7.71 |        |       | 45,000                |       | $                   | 7.05       |   | 2.2137 |   |
| 8.10 - 8.91              |             |        | 65,000     |                  | 8.31       |                | 3.8630     |   |
| Total                    |             | 110,000     |       |                  |       |                |       |
|                          |                  |             |            |                       |            |                     |            |  |  |  |

 

NOTE I – EARNINGS PER SHARE

 

The following table is a reconciliation ofthe numerators and denominators of the basic and diluted per share computationsfor each of the two years in the period ended December 31, 2004

 
| ** **                                 | ** ** | **Income  (Numerator)** | ** ** | **Weighted  Average  Shares  (Denominator)** | ** ** | **Per  Share  Amount** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|----------------------------------------------|------------|------------------------|------------|
|                                       |       |                    |       |                                         |       |                   |       |
| 2003                                       |       |                    |       |                                         |       |                   |       |
| Basic  earnings per share                  |       |                    |       |                                         |       |                   |       |
| Income  available to common stockholders   |       | $                       | 4,040,277  |                                         | 3,116,786  |                   | $          | 1.30 |   |
|                                       |       |                    |       |                                         |       |                   |       |
| Effect of  dilutive securities             |       |                    |       |                                         |       |                   |       |
| Stock  options                             |       | —                  |       | 14,819                                       |       |                   |       |
|                                       |       |                    |       |                                         |       |                   |       |
| Diluted  earnings per share                |       |                    |       |                                         |       |                   |       |
| Earnings  available to common stockholders |       | $                       | 4,040,277  |                                         | 3,131,605  |                   | $          | 1.29 |   |
|                                       |       |                    |       |                                         |       |                   |       |
| 2004                                       |       |                    |       |                                         |       |                   |       |
| Basic  earnings per share                  |       | $                       | 3,489,600  |                                         | 3,183,194  |                   | $          | 1.10 |   |
| Income  available to common stockholders   |       |                    |       |                                         |       |                   |       |
|                                       |       |                    |       |                                         |       |                   |       |
| Effect of  dilutive securities             |       |                    |       |                                         |       |                   |       |
| Stock  options                             |       | —                  |       | 3,695                                        |       |                   |       |
|                                       |       |                    |       |                                         |       |                   |       |
| Diluted  earnings per share                |       |                    |       |                                         |       |                   |       |
| Earnings  available to common stockholders |       | $                       | 3,489,600  |                                         | 3,186,889  |                   | $          | 1.09 |   |

 

F-14

----

 

NOTE J – LEASES

 

Future minimum payments required undernon-cancelable operating leases with remaining terms of one year or moreconsist of the following:

 
| **Year ending  December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
|                               |       |       |       |
| 2005                               |       | $          | 469,214    |   |
| 2006                               |       | 484,430    |       |
| 2007                               |       | 502,248    |       |
| 2008                               |       | 515,839    |       |
| Thereafter                         |       | 430,239    |       |
|                               |       | $          | 2,401,970  |   |

 

The leases provide for payment of taxes andother expenses by the Company.  Rentalexpense for the years ended December 31, 2004 and 2003 approximated$518,779 and $494,383, respectively.

 

NOTE K – EMPLOYEE BENEFIT PLANS

 

Retirement benefits for employees of theCompany, who have completed certain service requirements, are provided by adefined contribution profit-sharing plan. Plan contributions are determined by the Board of Directors.  Contributions to the plan for the years endedDecember 31, 2004 and 2003 were $250,000 and $150,000, respectively.

 

NOTE L – CONTINGENCIES

 

The Company has been named by individuals incertain legal actions, some of which claim state and federal securities lawviolations and claim principal and punitive damages. Included in the financialstatements is an accrual for $1.1 million for settlements agreed to near andsubsequent to the Company’s year end. As preliminary hearings and discovery inthe remaining cases is not complete, it is not possible to assess the degree ofliability, the probability of an unfavorable outcome or the impact on theCompany’s financial statements, if any. The Company’s management denies the charges in the remaining legalactions and is vigorously defending against them.  No provision for any liability that mayresult from the remaining contingencies has been made in the financialstatements.

 

NOTE M – NET CAPITAL REQUIREMENT

 

The Subsidiary is subject to the net capitalrule (Rule 15c3-1) of the Securities and Exchange Commission.  This rule prohibits the Subsidiary from engagingin any securities transaction at a time when its “aggregate indebtedness”exceeds fifteen times its “net capital” as those terms are defined by therule.  At December 31, 2004, theSubsidiary’s net capital and required net capital were $14,104,972 and $213,214,respectively, and its ratio of aggregate indebtedness to net capital was 0.23to 1.  The Subsidiary’s absolute minimumnet capital requirement is $100,000. Trading and investment securities represent potentially volatilecomponents of net capital.

 

F-15

----

 

NOTE N – CONCENTRATION OF RISK

 

The Company’s trading and investmentsecurities include investments in the common stock of the following companies,which represent more than 10 percent of trading and investment securities at December 31,2004:

 
| **Company**                | ** ** | **Investment Amount** | ** ** | **Percentage of Total** | ** ** |
|----------------------------|------------|-----------------------|------------|-------------------------|------------|
| AVI  Biopharma, Inc.       |       | $                     | 2,760,511  |                    | 11.6       |   |
| Charles and  Colvard, Ltd. |       | 11,479,719            |       | 48.2                    |       |
| Total                      |       | $                     | 14,240,230 |                    | 59.8       |   |

 

NOTE O – NEW ACCOUNTING STANDARDS

 

In December 2004, the FASB issued FAS123R, which requires that compensation costs relating to share-based paymentsbe recognized in the Company’s financial statements. The Company currentlyaccounts for those payments under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations. The Company ispreparing to implement this standard effective January 1, 2006.  Although we have not yet determined whetherthe adoption of 123(R) will result in amounts that are similar to the currentpro form data (see Note A10), we expect the adoption may have a material impacton future financial statements.  Thisestimate is based on preliminary information and could materially change basedon the actual facts and circumstances and the terms of future option grants.

 

NOTE P – SUBSEQUENT EVENT

 

On January 27, 2005, the Companyannounced the authorization by the Board of Directors of a $0.15 special cashdividend to shareholders of record on February 10, 2005. The dividendpayment date is March 3, 2005.

 

In 2002, the Subsidiary and one of itsregistered representatives were named as defendants in lawsuits filed by formercustomers related to certain investment transactions entered into on behalf ofthe customers.  Arbitration of this casewas scheduled to begin on January 24, 2005, however, the claims weresettled prior to the arbitration. On March 4, 2005, the Company paid $1.1million to settle the e.Digital portion of this case. The Company paid thesettlement amount because the insurance company, who previously agreed to paythe settlement, refused to pay. The Company has filed suit against theinsurance carrier to recover the settlement amount.  Recovery of the settlement amounts (if any)will be reflected in the period received. Included in accounts payable andaccrued liabilities as of December 31, 2004 is $1.1 million related to thissettlement.

 

F-16

----

 

Paulson Capital Corp. andSubsidiary

 

SUPPLEMENTARY SCHEDULE OF WARRANTS OWNED

 

December 31, 2004

 
| **Description**                                  | ** ** | **Number  of  Warrants** | ** ** | **Exercise  Price Per  Share/Unit** | ** ** | **Expiration  Date** | ** **  |
|--------------------------------------------------|------------|--------------------------|------------|-------------------------------------|------------|----------------------|-------------|
|                                             |       |                     |       |                                |       |                 |        |
| AdStar, Inc.  ERC* 9-25-01                       |       | 149,000                  |       | $                                   | 1.80       |                 | 2005, 09/25 |   |
| Adstar, Inc.  ERC 1-17-02                        |       | 22,137                   |       | $                                   | 0.75       |                 | 2007, 01/16 |   |
| Adstar, Inc.  ERC 03-31-04                       |       | 78,705                   |       | $                                   | 1.87       |                 | 2009, 03/31 |   |
| AVI  Biopharma, Inc. ERC 7-26-01                 |       | 151,014                  |       | $                                   | 8.70       |                 | 2005, 07/26 |   |
| Beta Oil  & Gas, Inc. #2 ERC 6-29-01         |       | 1,850                    |       | $                                   | 9.25       |                 | 2006, 06/29 |   |
| Creative  Products Intl. ERC 7-01-01             |       | 30,000                   |       | $                                   | 1.50       |                 | 2006, 06/30 |   |
| Daystar  Technologies, Inc. (units) ERC 2-05-05  |       | 129,949                  |       | $                                   | 6.00       |                 | 2009, 02/05 |   |
| Edgar  Online, Inc. (units) ERC 11-22-04         |       | 196,250                  |       | $                                   | 2.40       |                 | 2009, 05/25 |   |
| GMX  Resources (units) ERC 2-12-01               |       | 76,475                   |       | $                                   | 9.60       |                 | 2006, 02/12 |   |
| GMX  Resources #2 ERC 7-18-02                    |       | 126,650                  |       | $                                   | 6.60       |                 | 2006, 07/18 |   |
| I-Sector  Corp. ERC 5-07-05                      |       | 29,653                   |       | $                                   | 19.92      |                 | 2009, 05/07 |   |
| Imageware  Systems, Inc. (units) ERC 3-30-01     |       | 106,323                  |       | $                                   | 9.60       |                 | 2005, 03/30 |   |
| Lumera  Corporation ERC 7-23-05                  |       | 346,085                  |       | $                                   | 8.34       |                 | 2009, 07/22 |   |
| Medinex  Systems, Inc. ERC 1-31-02               |       | 169,050                  |       | $                                   | 0.23       |                 | 2005, 01/31 |   |
| microHelix,  Inc. (units) ERC 11-16-02           |       | 127,462                  |       | $                                   | 7.20       |                 | 2006, 11/16 |   |
| Milestone  Scientific, Inc. (units) ERC 2-17-05  |       | 99,857                   |       | $                                   | 7.82       |                 | 2009, 02/16 |   |
| Pacific  Mercantile Bancorp ERC 6-15-01          |       | 158,350                  |       | $                                   | 9.60       |                 | 2005, 06/14 |   |
| Pacific  Mercantile Bancorp ERC 12-08-04         |       | 136,118                  |       | $                                   | 11.10      |                 | 2008, 12/08 |   |
| Path 1  Network Technologies (units) ERC 7-31-04 |       | 87,292                   |       | $                                   | 12.96      |                 | 2008, 07/30 |   |
| Q Comm  International, Inc. (units) ERC 6-25-04  |       | 61,552                   |       | $                                   | 15.60      |                 | 2008, 06/24 |   |
| Smart Pros  Ltd. (units) ERC 4-17-05             |       | 32,970                   |       | $                                   | 15.30      |                 | 2009, 10/19 |   |

 

----

* Date exercisable

 

F-17

----

 

Schedule II

 

Paulson Capital Corp. andSubsidiary

 

Valuation and QualifyingAccounts

 

Years ended December 31,2004 and 2003

 
| **Description**                   | ** ** | **Balance  Beginning  of Year** | ** ** | **Additions-Charges  to Cost and  Expenses** | ** ** | **Deductions  Write-offs** | ** ** | **Balance  at End  of Year** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|----------------------------------------------|------------|----------------------------|------------|------------------------------|------------|
|                              |       |                            |       |                                         |       |                       |       |                         |       |
| Allowance  for doubtful accounts: |       |                            |       |                                         |       |                       |       |                         |       |
|                              |       |                            |       |                                         |       |                       |       |                         |       |
| Year ended  Dec. 31, 2004         |       | $                               | —     |                                         | $          | 684,429                    |       | $                            | 684,429    |   | $ | — |   |
| Year ended  Dec. 31, 2003         |       | —                          |       | 367,796                                      |       | 367,796                    |       | —                       |       |
|                                   |            |                                 |            |                                              |            |                            |            |                              |            |  |  |  |  |

 

F-18

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