** **

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON D.C. 20549**

 

----

 

**FORM10-QSB**

 
| **ý  QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                               |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                               |
| **For the quarterly period ended September 30, 2004**                                                                                                                                                              |
|                                                                                                                                                                                                               |
| **o  TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                         |
|                                                                                                                                                                                                               |
| **For the transition period from                  to                ** |
|                                                                                                                                                                                                               |
| **Commission file number: 0-18188**                                                                                                                                                                                |

 
| **PAULSON  CAPITAL CORP.**                                        |
|-------------------------------------------------------------------|
| (Exact name of small business issuer as specified in its charter) |
|                                                              |
| **Oregon**                                                        |
| (state or other jurisdiction of incorporation or organization)    |
|                                                              |
| **93-0589534**                                                    |
| (IRS employer identification number)                              |
|                                                              |
| **811 S.W. Naito Parkway  Portland, OR 97204**                    |
| (Address of principal executive offices)                          |
|                                                              |
| **(503) 243-6000**                                                |
| (Issuer’s telephone number)                                  |

 

Indicate by check mark whether the issuer (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theissuer was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý    No  o

 

Number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

 

Common stock, no par value 3,195,710 as of November 12, 2004

 

Transitional Small Business Disclosure Format (check one):Yes  o    No  ý

 

 

 

1

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**PART I —FINANCIAL INFORMATION**

 

ITEM 1. FINANCIAL STATEMENTS

 

PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETS

 
|                                                                                                                                |   | **09/30/04**    |       | **12/31/03** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------|------------|--------------|--------|
|                                                                                                                                |   | **(unaudited)** |       |         |   |
| **ASSETS**                                                                                                                          |   |            |       |         |   |
|                                                                                                                                |   |            |       |         |   |
| Cash and cash equivalents                                                                                                           |   | $               | 117,744    |         | $      | 155,314 |   |
| Receivable from clearing organization                                                                                               |   | 7,908,599       |       | 7,162,477    |   |
| Notes and other receivables                                                                                                         |   | 457,056         |       | 666,474      |   |
| Income taxes receivable                                                                                                             |   | —          |       | 1,084,900    |   |
| Trading securities, at market value                                                                                                 |   | 3,032,789       |       | 1,474,649    |   |
| Investment securities, at market value                                                                                              |   | 18,121,782      |       | 17,588,454   |   |
| Underwriter warrants, at estimated fair value                                                                                       |   | 8,036,000       |       | 6,311,000    |   |
| Prepaid and deferred expenses                                                                                                       |   | 1,292,993       |       | 1,418,537    |   |
| Furniture and equipment, net                                                                                                        |   | 232,117         |       | 208,327      |   |
|                                                                                                                                |   |            |       |         |   |
| Total assets                                                                                                                        |   | $               | 39,199,080 |         | $      | 36,070,132 |   |
|                                                                                                                                |   |            |       |         |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                      |   |            |       |         |   |
|                                                                                                                                |   |            |       |         |   |
| **LIABILITIES**                                                                                                                     |   |            |       |         |   |
| Accounts payable and accrued liabilities                                                                                            |   | $               | 157,210    |         | $      | 446,076 |   |
| Dividends payable                                                                                                                   |   | —          |       | 312,481      |   |
| Payable to clearing organization                                                                                                    |   | 1,900,829       |       | 496,181      |   |
| Compensation, employee benefits and payroll taxes                                                                                   |   | 1,022,211       |       | 2,075,735    |   |
| Securities sold, not yet purchased, at market value                                                                                 |   | 55,083          |       | 19,051       |   |
| Income taxes payable                                                                                                                |   | 99,083          |       | —       |   |
| Deferred income taxes                                                                                                               |   | 3,766,781       |       | 3,125,700    |   |
|                                                                                                                                |   |            |       |         |   |
| Total liabilities                                                                                                                   |   | 7,001,197       |       | 6,475,224    |   |
|                                                                                                                                |   |            |       |         |   |
| **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, 3,195,710 at 09/30/04 and 3,124,811 at 12/31/03 |   | 1,710,308       |       | 1,173,045    |   |
| Retained earnings                                                                                                                   |   | 30,487,575      |       | 28,421,863   |   |
|                                                                                                                                |   |            |       |         |   |
| Total shareholders’ equity                                                                                                     |   | 32,197,883      |       | 29,594,908   |   |
|                                                                                                                                |   |            |       |         |   |
| Total liabilities and shareholders’ equity                                                                                     |   | $               | 39,199,080 |         | $      | 36,070,132 |   |

 

The accompanying notes are an integral part of these statements.

 

 

2

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 PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENTS OF INCOME(unaudited)

 
|                                                   |   | **Three  months ended** |      | **Nine  months ended** |   |
|--------------------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                                   |   | **9/30/04**             |      | **9/30/03**            |   | **9/30/04** |   | **9/30/03** |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| **Revenues**                                           |   |                    |      |                   |   |   |   |   |   |
| Commissions                                            |   | $                       | 4,088,558 |                   | $      | 4,625,295 |   | $ | 13,367,465 |   | $ | 11,352,034 |   |
| Corporate finance                                      |   | 3,996,238               |      | 2,513,121              |   | 10,227,410 |   | 4,875,912 |   |
| Investment income (loss)                               |   | 796,771                 |      | 2,467,777              |   | (2,742,211 | ) | 3,016,495 |   |
| Trading income                                         |   | 664,686                 |      | 541,819                |   | 1,127,923 |   | 976,282 |   |
| Interest and dividends                                 |   | 16,978                  |      | 17,145                 |   | 25,133 |   | 47,698 |   |
| Other                                                  |   | 340                     |      | 340                    |   | 1,489 |   | 1,983 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
|                                                   |   | 9,563,571               |      | 10,165,497             |   | 22,007,209 |   | 20,270,404 |   |
| **Expenses**                                           |   |                    |      |                   |   |   |   |   |   |
| Commissions and salaries                               |   | 4,941,263               |      | 5,173,758              |   | 14,228,450 |   | 12,407,210 |   |
| Underwriting expenses                                  |   | 303,588                 |      | 142,421                |   | 766,891 |   | 253,719 |   |
| Rent, telephone and quotation services                 |   | 308,088                 |      | 301,378                |   | 919,448 |   | 853,685 |   |
| Interest expense                                       |   | 9,520                   |      | 16,678                 |   | 10,093 |   | 16,678 |   |
| Professional fees                                      |   | 198,436                 |      | 132,020                |   | 677,923 |   | 451,505 |   |
| Bad debt expense                                       |   | 4,947                   |      | 30,000                 |   | 72,527 |   | 190,000 |   |
| Travel and entertainment                               |   | 31,641                  |      | 73,310                 |   | 328,030 |   | 191,744 |   |
| Depreciation and amortization                          |   | 20,950                  |      | 29,740                 |   | 74,748 |   | 106,394 |   |
| Other                                                  |   | 505,000                 |      | 627,319                |   | 1,519,468 |   | 1,242,006 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
|                                                   |   | 6,323,433               |      | 6,526,624              |   | 18,597,578 |   | 15,712,941 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| Earnings before income taxes                           |   | 3,240,138               |      | 3,638,873              |   | 3,409,631 |   | 4,557,463 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| Income tax expense (benefit)                           |   |                    |      |                   |   |   |   |   |   |
| Current                                                |   | 239,803                 |      | 247,587                |   | 659,129 |   | 247,587 |   |
| Deferred                                               |   | 996,169                 |      | 1,202,413              |   | 641,081 |   | 1,552,413 |   |
|                                                   |   | 1,235,972               |      | 1,450,000              |   | 1,300,210 |   | 1,800,000 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| **Net  Earnings**                                      |   | $                       | 2,004,166 |                   | $      | 2,188,873 |   | $ | 2,109,421 |   | $ | 2,757,463 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| Earnings per share, basic                              |   | $                       | 0.63      |                   | $      | 0.70 |   | $ | 0.66 |   | $ | 0.88 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| Earnings per share, diluted                            |   | $                       | 0.62      |                   | $      | 0.70 |   | $ | 0.66 |   | $ | 0.88 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| Weighted average number of shares outstanding, basic   |   | 3,192,454               |      | 3,117,811              |   | 3,179,308 |   | 3,117,979 |   |
|                                                   |   |                    |      |                   |   |   |   |   |   |
| Weighted average number of shares outstanding, diluted |   | 3,209,877               |      | 3,120,501              |   | 3,184,418 |   | 3,124,186 |   |

 

The accompanying notes are an integral part of these statements.

 

 

3

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PAULSON CAPITAL CORP. AND SUBSIDIARYCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITYFor the year ended December 31, 2003and the nine month period ended September 30, 2004

 
|                                                                                   |   | **Common  Stock** |   | **Retained** |      |
|----------------------------------------------------------------------------------------|--------|-------------------|--------|--------------|-----------|
|                                                                                   |   | **Shares**        |   | **Amount**   |      | **Earnings** |   |
|                                                                                   |   |              |   |         |      |   |   |
| 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 income 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 (unaudited) |   | 78,500            |   | 539,997      |      | — |   |
|                                                                                   |   |              |   |         |      |   |   |
| Redemption of common stock (unaudited)                                                 |   | (7,601            | )      | (2,734       | )         | (43,709 | ) |
|                                                                                   |   |              |   |         |      |   |   |
| Net earnings for the year to date (unaudited)                                          |   | —            |   | —       |      | 2,109,421 |   |
|                                                                                   |   |              |   |         |      |   |   |
| Balance at September 30, 2004 (unaudited)                                              |   | 3,195,710         |   | $            | 1,710,308 |   | $ | 30,487,575 |   |

 

The accompanying notes are an integral part of these statements.

 

 

4

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 PAULSON CAPITAL CORP. ANDSUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)

 
|                                                                                           |   | **Nine  months ended** |      |
|------------------------------------------------------------------------------------------------|--------|------------------------|-----------|
|                                                                                           |   | **09/30/04**           |      | **09/30/03** |   |
|                                                                                           |   |                   |      |   |   |
| Cash flows from operating activities                                                           |   |                   |      |   |   |
| Net earnings                                                                                   |   | $                      | 2,109,421 |   | $ | 2,757,463 |   |
| Adjustments to reconcile net earnings to net cash provided by (used  in) operating activities: |   |                   |      |   |   |
| Receipt of underwriter warrants                                                                |   | (6,761,240             | )         | (3,217,453 | ) |
| Unrealized depreciation and expiration of underwriter warrants                                 |   | 3,093,668              |      | 255,846 |   |
| Noncash compensation associated with underwriter warrants                                      |   | 1,942,572              |      | 936,107 |   |
| Depreciation and amortization                                                                  |   | 74,748                 |      | 106,394 |   |
| Deferred income taxes                                                                          |   | 641,081                |      | 1,552,413 |   |
| Change in assets and liabilities                                                               |   |                   |      |   |   |
| Receivables                                                                                    |   | 209,418                |      | (106,622 | ) |
| Receivables from/payable to clearing organization                                              |   | 658,526                |      | (4,520,753 | ) |
| Trading and investment securities                                                              |   | (2,091,468             | )         | 179,644 |   |
| Prepaid and deferred expenses                                                                  |   | 125,544                |      | (94,683 | ) |
| Accounts payable and accrued liabilities                                                       |   | (1,342,388             | )         | 124,680 |   |
| Securities sold, not yet purchased                                                             |   | 36,032                 |      | 59,552 |   |
| Income taxes payable/receivable                                                                |   | 1,183,983              |      | 2,139,055 |   |
|                                                                                           |   |                   |      |   |   |
| Net cash provided by (used in) operating activities                                            |   | (120,103               | )         | 171,643 |   |
|                                                                                           |   |                   |      |   |   |
| Cash flows from investing activities                                                           |   |                   |      |   |   |
| Additions to furniture and equipment                                                           |   | (98,540                | )         | (62,114 | ) |
|                                                                                           |   |                   |      |   |   |
| Net cash used in investing activities                                                          |   | (98,540                | )         | (62,114 | ) |
|                                                                                           |   |                   |      |   |   |
| Cash flows from financing activities                                                           |   |                   |      |   |   |
| Proceeds from exercise of stock options and tax benefit from stock  option exercise            |   | 539,997                |      | — |   |
| Dividends paid to common shareholders                                                          |   | (312,481               | )         | — |   |
| Payments to retire common stock                                                                |   | (46,443                | )         | (65,900 | ) |
|                                                                                           |   |                   |      |   |   |
| Net cash provided by (used in) financing activities                                            |   | 181,073                |      | (65,900 | ) |
|                                                                                           |   |                   |      |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                      |   | (37,570                | )         | 43,629 |   |
|                                                                                           |   |                   |      |   |   |
| Cash and cash equivalents at beginning of period                                               |   | 155,314                |      | 97,630 |   |
|                                                                                           |   |                   |      |   |   |
| Cash and cash equivalents at end of period                                                     |   | $                      | 117,744   |   | $ | 141,259 |   |
|                                                                                           |   |                   |      |   |   |
| Cash paid during the period for:                                                               |   |                   |      |   |   |
|                                                                                           |   |                   |      |   |   |
| Interest                                                                                       |   | $                      | 10,093    |   | $ | 16,678 |   |
| Income taxes                                                                                   |   | $                      | 314,330   |   | $ | 36,388 |   |

 

The accompanying notes are an integral part of these statements.

 

 

5

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**PAULSONCAPITAL CORP. AND SUBSIDIARY**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**(unaudited)

 

1.Basis of Presentation

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with the instructions for interim financial statements in Item 310(b)of Regulation S-B, and therefore do not include all information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica (US GAAP) for complete financial statements.  In the opinion of management, the interim financial statementsinclude all adjustments (consisting only of normal recurring adjustments)necessary to state fairly the information shown therein.  The nature of the Company’s business is suchthat the results of any interim period are not necessarily indicative ofresults for a full fiscal year.

 

2. Securities Owned

Gainsand losses from the disposition of trading securities are reflected as tradingrevenues in the income statement for the period. Gains and losses from thedisposition of investment securities are reflected as investment revenues inthe income statement for the period.

 

3. Commitments andContingencies

In March 2002, PaulsonCapital Corp.’s  (the “Company”) 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.  Barinaga and Mackenzie allegethat PIC and Mr. Cox participated in and materially aided the sale of the notesand, therefore, are liable under state securities law.  Barinaga and Mackenzie allege damages of$717,000 and $165,000, respectively, plus interest and attorney fees. PICasserted that the claims are subject to arbitration. Plaintiffs have abatedtheir lawsuit and refiled their claims before the NASD.  Claimant Barinaga amended his arbitrationstatement of claim to include claims for breach of fiduciary duty, violationsof federal and state securities laws, fraud and negligence relating totransactions 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 seeks $12,165,103 plus interest and fees on thee.Digital claims.  The e.Digital stockin question was subject to an agreement entered into between Barinaga and UBSPaineWebber, Inc.  An arbitrationhearing has been set to begin on January 24, 2005.  PIC believes it has meritorious defenses andintends to defend this matter vigorously.

In October 2002, PIC wasnamed as a defendant in a lawsuit filed by Special Situations Fund III, LP andSpecial Situations Cayman Fund, LP.  Thelawsuit was 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 betweenAugust 25, 2000 and November 14, 2001.  The federal district court has dismissed the claims againstPIC.  Plaintiffs have filed a notice ofappeal.  PIC believes it has meritoriousdefenses and intends to defend this matter vigorously.

In January 2004, PIC andone of its registered representatives, David Harris, were named as respondentsin a NASD complaint filed by a former customer of PIC, PatriciaMendelsohn.  Claimant Mendelsohn allegesthat Harris recommended unsuitable investments and caused her losses ofapproximately $90,000.  ClaimantMendelsohn also alleges that PIC failed to adequately supervise Harris while hewas handling her account.  Discovery hasnot yet started.  PIC believes it hasmeritorious defenses and intends to defend this matter vigorously.

Anadverse outcome in certain of the matters described above could have a materialadverse effect on PIC or the Company. PIC also has been named in certain otherlegal proceedings and has received notice that certain customers may commencelegal proceedings against PIC. The Company has no additional legal proceedingsother than through PIC. The Company believes, based upon information receivedto date and, where the Company believes it appropriate, discussions with legalcounsel, that resolution of this additional pending or threatened litigationwill have no material adverse effect on the consolidated financial condition,results of operations, or business of the Company.

 

6

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4.Stock Options

 

TheCompany has a stock-based employee compensation plan. As allowed under SFAS No.123 “Accounting for Stock-Based Compensation,” the Company continues to accountfor stock options for employees under APB No. 25, “Accounting for Stock Issuedto Employees,” and has adopted the disclosure only requirements of SFAS No.123. There were no stock option grants in the nine month periods endedSeptember 30, 2004 or 2003. Accordingly, no pro forma income effect is shown.

 

5.Earnings Per Share

 

Thefollowing table is a reconciliation of the numerators and denominators of thebasic and diluted per share computations for each of the three months endedSeptember 30, 2004 and September 30, 2003.

 

|                                                                           |   | **Income**      |      | **Weighted  Average Shares** |      | **Per Share  Amount** |   |
|--------------------------------------------------------------------------------|--------|-----------------|-----------|------------------------------|-----------|-----------------------|--------|
|                                                                           |   | **(Numerator)** |      | **(Denominator)**            |      |                  |   |
|                                                                           |   |            |      |                         |      |                  |   |
| Three Months Ended September 30, 2004 Income available to common stockholders  |   | $               | 2,004,166 |                         | 3,192,454 |                  | $      | 0.63 |   |
|                                                                           |   |            |      |                         |      |                  |   |
| Effect of dilutive securities - options                                        |   | —          |      | 17,423                       |      |                  |   |
|                                                                           |   |            |      |                         |      |                  |   |
| Diluted earnings per share                                                     |   | $               | 2,004,166 |                         | 3,209,877 |                  | $      | 0.62 |   |
|                                                                           |   |            |      |                         |      |                  |   |
| Three Months Ended September 30, 2003 Income available to common  stockholders |   | $               | 2,188,873 |                         | 3,117,811 |                  | $      | 0.70 |   |
|                                                                           |   |            |      |                         |      |                  |   |
| Effect of dilutive securities - options                                        |   | —          |      | 2,690                        |      |                  |   |
|                                                                           |   |            |      |                         |      |                  |   |
| Diluted earnings per share                                                     |   | $               | 2,188,873 |                         | 3,120,501 |                  | $      | 0.70 |   |

 

Thefollowing table is a reconciliation of the numerators and denominators of thebasic and diluted per share computations for each of the nine month periodsended September 30, 2004 and September 30, 2003.

 

|                                                                          |   | **Income**      |      | **Weighted  Average Shares** |      | **Per Share  Amount** |   |
|-------------------------------------------------------------------------------|--------|-----------------|-----------|------------------------------|-----------|-----------------------|--------|
|                                                                          |   | **(Numerator)** |      | **(Denominator)**            |      |                  |   |
|                                                                          |   |            |      |                         |      |                  |   |
| Nine Months Ended September 30, 2004 Income available to common  stockholders |   | $               | 2,109,421 |                         | 3,179,308 |                  | $      | 0.66 |   |
|                                                                          |   |            |      |                         |      |                  |   |
| Effect of dilutive securities - options                                       |   | —          |      | 5,110                        |      |                  |   |
|                                                                          |   |            |      |                         |      |                  |   |
| Diluted earnings per share                                                    |   | $               | 2,109,421 |                         | 3,184,418 |                  | $      | 0.66 |   |
|                                                                          |   |            |      |                         |      |                  |   |
| Nine Months Ended September 30, 2003 Income available to common  stockholders |   | $               | 2,757,463 |                         | 3,117,979 |                  | $      | 0.88 |   |
|                                                                          |   |            |      |                         |      |                  |   |
| Effect of dilutive securities - options                                       |   |            |      | 6,207                        |      |                  |   |
|                                                                          |   |            |      |                         |      |                  |   |
| Diluted earnings per share                                                    |   | $               | 2,757,463 |                         | 3,124,186 |                  | $      | 0.88 |   |

 

 

7

----

 

6.Reclassifications

 

Certain2003 amounts have been reclassified to conform to the 2004 presentation.

 

ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION

 

**General**

 

FORWARD-LOOKINGSTATEMENTS

 

Thisreport, including, without limitation, “Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” contains orincorporates both historical and “forward-looking” statements within themeaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Words suchas “anticipates”, “believes”, “expects”, “intends”, “future” and similarexpressions identify forward-looking statements.  Any such forward-looking statements in this report reflect ourcurrent views with respect to future events and financial performance and aresubject to a variety of factors that could cause our actual results to differmaterially from historical results or from anticipated results expressed orimplied by such forward-looking statements. Because of such factors, we cannot assure you that the resultsanticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business aresubject to extreme volatility often as a result of factors beyond our abilityto anticipate or control.  Inparticular, factors, such as the condition of the securities markets, which arein turn based on popular perceptions of the health of the economy generally,can be expected to affect the volume of our business as well as the value ofthe securities maintained in our trading and investment accounts.  Other factors that may affect our future financialcondition or results of operations include the following:

 

•                  The performance of companieswhose securities we have underwritten or otherwise sold to our customers mayaffect our reputation with other potential syndicate and selling group membersand institutional and other retail accounts and may also affect the amount ofmoney in our customers’ portfolios available for the kinds of investments thatwe offer.

 

•                  The value of our investmentportfolio, including the value of securities without a readily ascertainablemarket value, that we have estimated for the purpose of reporting on ourfinancial condition and results of operations, may be significantly andadversely affected by changes in the value of the companies themselves or ofcomparable companies whose stock values we use in estimating the value of ourportfolio securities.

 

•                  We are subject to a veryhigh degree of regulation and are responsible for compliance with applicableregulations by all of our personnel.  Asignificant regulatory infraction by us or any of our registered representativescould result in significant penalties, including the loss of our license toconduct securities business in one or more jurisdictions.

 

•                  Alternatives available toour customers to transact securities trades could affect our ability to continueto execute our brokerage customers’ transactions.

 

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

 

**Overview**

 

Substantiallyall of our business consists of the securities brokerage and investment bankingactivities of our wholly owned subsidiary, Paulson Investment Company, Inc., orPIC.  PIC has operations in fourprincipal categories, all of them in the financial services industry.  These categories are:

 

•                  securities brokerageactivities for which PIC earns commission revenues;

•                  corporate finance revenuesconsisting principally of underwriting discounts and underwriter warrants;

•                  securities trading fromwhich PIC records profit or loss, depending on trading results; and

•                  investment income resultingfrom earnings on, and increases or decreases in the value of, PIC’s investmentportfolio.

 

 

8

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Because we operate in thefinancial services industry, our revenues and earnings are substantiallyaffected by general conditions in financial markets. In our securitiesbrokerage and corporate finance business, the amount of our revenues depends onlevels of market activity requiring the services we provide.  Our investment banking activity, whichconsists primarily of acting as the managing underwriter of initial andfollow-on public offerings for smaller companies, is similarly affected by thestrength of the market for new equity offerings, which has historicallyexperienced substantial cyclical fluctuation. Although we attempt to match operating costs with activity levels, manyof our expenses are either fixed or difficult to change on short notice.  Accordingly, fluctuations in brokerage andinvestment banking revenues tend to result in sharper fluctuations, on apercentage basis, in net income or loss.

Our investment income or loss and, to a lesser extent, our tradingincome or loss are affected by changes in market valuation of securitiesgenerally and, in particular, by changes in valuation of the equity securitiesof microcap companies in which our investments and trading activities tend tobe concentrated.  Equity markets ingeneral, and microcap equity markets in particular, have always experiencedsignificant volatility and this volatility has, in recent years, beenextreme.  The results of this volatilityon the value of our investment portfolio and securities held in connection withour trading and investment activities include large quarterly fluctuations inincome or loss and substantial increases or decreases in our net worth as oursecurities holdings are marked to market. The securities in the investmentaccount are held for investment, not actively traded, and not deemed part ofoperations in accordance with management intentions.

A substantial portion of our investment banking business consists ofacting as managing underwriter of initial and follow-on public offerings formicrocap companies.  As a part of ourcompensation for this activity, we typically receive warrants exercisable topurchase securities identical to those that we offer and sell to thepublic.  Generally, the warrants are notexercisable for the first year after the offering in which they are earned andare thereafter exercisable 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, the warrantswill remain “under water” and will ultimately expire unexercised.

 

### **Critical Accounting Policies**

The following discussion and analysis of our financial condition andresults of operations is based upon our consolidated financial statements,which have been prepared in accordance with US GAAP.  In preparing our consolidated financial statements, we must makeestimates and judgments that affect the reported amounts of assets andliabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities at the date of our financial statements.  Actual results are likely to differ fromthese estimates under different assumptions and conditions.

The critical accounting policies described below include those thatreflect significant judgments and uncertainties, which potentially couldproduce materially different results under different assumptions andconditions.  We believe our criticalaccounting policies are limited to those described below.

 

*Use of Estimates.* We are required to estimatethe value of securities that we hold at the date of any financial statementsand to include that value, and changes in such value, in those financialstatements.  Accordingly, the aggregateestimated value of securities, including warrants, as of the date of anybalance sheet is recorded as an asset on that balance sheet.  When a new warrant is received as a resultof our investment banking activity, its estimated value is included incorporate finance revenue on the date on which it is earned.  Subsequently, any change in estimated valueis recorded as investment income or loss. When a warrant is exercised, the book value is adjusted to reflect thevalue of the securities purchased, net of the exercise price, and theadjustment amount is recorded as income or loss for the relevant period. If thewarrant expires unexercised, the book value is adjusted to zero and thedecrease is recorded as a loss in the relevant period.

 

Weestimate the value of our underwriter warrants using the Black-Scholes Option PricingModel. The Black-Scholes model requires us to use historical price datacombined with certain assumptions and judgments as inputs for the model.  The most influential factor in this model isprice volatility, which we calculate for each issuing company’s warrants basedon the respective company’s own historical stock price movements as well as anindex of historical prices for comparable companies.  When we initially receive a new underwriter warrant from an initialpublic offering, its calculated volatility factor is entirely based on thevolatility of an index of comparable companies, since there is no price historyfor a new publicly traded company.  Aseach underwriter warrant approaches its expiration date, its volatility factoris derived primarily from the historical prices of its underlying commonstock.  We cannot assure you that wewill ultimately be able to exercise any of our warrants in a way that willrealize the value that we attribute to them in our financial statements basedon this model. As of September 30, 2004, our underwriter warrants, based on theBlack-Scholes Option Pricing Model, were valued at approximately $8.0 million,up from the estimated value of $6.3 million as of December 31, 2003.

 

 

9

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In addition to ourunderwriter warrants, we hold other securities, some of which have very limitedliquidity and some of which do not have a readily ascertainable marketvalue.  According to US GAAP, we arerequired to carry these securities at estimated fair value.

Asa result of the factors described above, our revenues and earnings are subjectto substantial fluctuation from period to period based on circumstances, manyof which are beyond our control.  Anincrease in financial market activity generally, and/or an increase in equityvaluations generally, will normally result in increases in our revenues,earnings and net worth as our activity levels and the value of our investmentportfolio increase.  Conversely, ageneral market retrenchment will typically lead to decreased revenues, earningsand net worth as a result both of decreased activity and the need to adjusthigh investment portfolio values to lower levels.  Accordingly, results for any historical period are notnecessarily indicative of similar results for any future period.

 

**Results of Operations**

PIC’srevenues and operating results are influenced by fluctuations in the equityunderwriting markets as well as general economic and market conditions,particularly conditions in the over-the-counter market, where PIC’s investmentaccount, trading inventory positions and underwriter warrants are heavilyconcentrated.  Significant fluctuationscan occur in PIC’s revenues and operating results from one period toanother.  PIC’s results of operationsdepend upon many factors, such as the number of companies that are seekingpublic financing, the quality and financial condition of those companies,market conditions in general, the performance of previous PIC underwritings andinterest in certain industries by investors. As a result, revenues and income derived from these activities may varysignificantly from year to year.  In thetables below, “Corporate Finance” revenues are a function of total proceedsfrom offerings done during the period, compensation per offering, and the fairvalue of underwriter warrants received. “Investment Income” includes realized gains from the exercise ofunderwriter warrants, gains and losses from the sales of investment securities,and unrealized gains and losses from underwriter warrants and other investmentsecurities.  “Trading Income” is the netgain or loss from trading positions before commissions paid to therepresentatives in the trading department.

 

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

 

**ThreeMonths Ended September 30, 2004 v. September 30, 2003**

 
|                         |   |                    |     |                |   | **Three  Months Ended** |   |
|------------------------------|--------|-------------------------|----------|---------------------|--------|-------------------------|--------|
|                         |   | **Increase/(Decrease)** |     | **Percent  Change** |   | **Sept. 30,  2004**     |   | **Sept. 30,  2003** |   |
| Revenues:                    |   |                    |     |                |   |                    |   |   |   |
| Sales Commissions            |   | $                       | (536,737 | )                   | (11.6  | )                       | $      | 4,088,558 |   | $ | 4,625,295 |   |
| Corporate Finance            |   | 1,483,117               |     | 59.0                |   | 3,996,238               |   | 2,513,121 |   |
| Investment Income            |   | (1,671,006              | )        | (67.7               | )      | 796,771                 |   | 2,467,777 |   |
| Trading Income               |   | 122,867                 |     | 22.7                |   | 664,686                 |   | 541,819 |   |
| Other                        |   | (167                    | )        | (1.0                | )      | 17,318                  |   | 17,485 |   |
|                         |   |                    |     |                |   |                    |   |   |   |
| Total                        |   | (601,926                | )        | (5.9                | )      | 9,563,571               |   | 10,165,497 |   |
|                         |   |                    |     |                |   |                    |   |   |   |
| Expenses:                    |   |                    |     |                |   |                    |   |   |   |
| Commissions and Salaries     |   | (232,495                | )        | (4.5                | )      | 4,941,263               |   | 5,173,758 |   |
| Underwriting Expenses        |   | 161,167                 |     | 113.2               |   | 303,588                 |   | 142,421 |   |
| Rent, Telephone & Quotes |   | 6,710                   |     | 2.2                 |   | 308,088                 |   | 301,378 |   |
| Other                        |   | (138,573                | )        | (15.2               | )      | 770,494                 |   | 909,067 |   |
|                         |   |                    |     |                |   |                    |   |   |   |
| Total                        |   | (203,191                | )        | (3.1                | )      | 6,323,433               |   | 6,526,624 |   |
|                         |   |                    |     |                |   |                    |   |   |   |
| Pretax Income                |   | $                       | (398,735 | )                   | (11.0  | )                       | $      | 3,240,138 |   | $ | 3,638,873 |   |

 

 

10

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**Three Months Ended September 30, 2004 vs. Three MonthsEnded September 30, 2003**

 

**Revenues**

Totalrevenues for the third quarter of 2004 decreased a total of $601,926. As shownin the table above, sales commissions—which are commissions generated from theretail stock brokerage business—decreased $536,737 or 11.6 percent from thesame period in the prior year. The revenue generated from sales commissions isrelated to the number of stock brokers and the trends in the stock marketgenerally. The Company had 144 stock brokers as of September 30, 2003, ascompared to 132 as of September 30, 2004, a decrease of 8 percent.

 

Corporatefinance revenues increased $1,483,117, or 59 percent, from the third quarter of2003 to the third quarter of 2004. The Company completed one corporate financetransaction in each of the third quarters of 2004 and 2003. As a comparison,the Company’s share of the corporate finance transaction completed in the thirdquarter of 2004 raised a total of $36.3 million compared to the corporatefinance transaction completed in the third quarter of 2003 that raised a totalof $15.5 million. Corporate finance revenues are directly related to the amountof money raised in corporate finance transactions. The transaction completed inthe third quarter of 2004 for the Lumera Corporation, was one of the largesttransactions ever completed by the Company.

 

Corporatefinance revenues also include the receipt of underwriter warrants ascompensation for the Company’s underwriting efforts. During the third quarterof 2004, the Company received underwriter warrants using the Black-Scholesoption-pricing model, resulting in unrealized revenue of $2,547,657, ascompared to underwriter warrants received during the third quarter of 2003valued at $1,804,075.

 

Investmentincome decreased $1,671,006 or 67.7 percent in the third quarter of 2004 ascompared to the third quarter of 2003. Investment income consists of (1) theunrealized and realized appreciation and depreciation of securities held basedon quoted market prices, (2) the unrealized and realized appreciation anddepreciation of securities held that are not readily marketable, based upon theCompany’s estimate of their fair value, and (3) the unrealized appreciation anddepreciation of underwriter warrants held by the Company.  The depreciation and expiration ofunderwriter warrants totaled $884,061 during the third quarter of 2004, ascompared to the depreciation and expiration of underwriter warrants of$1,051,133 for the third quarter of 2003. There was no change in the estimatedfair value of securities not readily marketable during the third quarter of2004. The remainder of the total investment income is the result of theunrealized and realized depreciation of securities with quoted market prices.

 

Tradingincome increased $122,867 in the third quarter of 2004 as compared to the thirdquarter of 2003, as a result of slightly more favorable market conditions forseveral of the securities in which the Company makes a market. PIC’s focus ison very small capitalization issues, especially those tied to PIC’s corporatefinance clients. Generally, favorable market conditions result in increasedrevenues for PIC.

 

**Expenses**

 

Totalexpenses decreased by $203,191 in the third quarter of 2004 from the third quarterof 2003, a decrease of 3.1 percent. The largest dollar decrease was incommissions and salaries with a decrease of $232,495 in the third quarter of2004 as compared to the third quarter of 2003. Combined in this net decrease isa decrease in commission expense primarily as a result of the decrease salescommissions revenues, a decrease in bonus and profit sharing accrual for thethird quarter of 2004 as compared to the third quarter of 2003, and an increasein administrative salaries as the Company added additional staff to handle theincreasing burdens of operating in a regulated industry and as a publiclytraded company. Underwriting expenses increased by $161,167 from the thirdquarter of 2003 because the single corporate finance transaction completed inthe third quarter of 2004 was significantly larger than the single corporatefinance transaction completed the third quarter of 2003, resulting inadditional expenses.  Other expensesdecreased 15.2 percent. The net decrease in other expenses is primarily theresult of a decrease in travel and entertainment of $42,000 as fewer trips weretaken in the third quarter of 2004 and a decrease in bad debt expense of$25,000 as the Company is more carefully managing its receivables. Thesedecreases were offset by an increase in legal expense of $66,000 as a result ofmore legal activity related to settlements. The remainder of the net decreasein other expenses consists of increases and decreases in various expensecategories.

 

 

11

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**Income**

 

TheCompany had pretax income of $3,240,138 in the third quarter of 2004 comparedto pretax income of $3,638,873 in the third quarter of 2003. Independent of thechange in the Black-Scholes value of the underwriter warrants and the incomeand expense associated with the receipt of the underwriter warrants, theCompany would have had pretax income totaling $2,388,138 for the third quarterof 2004, compared to pretax income of $3,342,373 for the third quarter of 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.

 

 

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

 

**Nine MonthsEnded September 30, 2004 v. September 30, 2003**

 
|                         |   |                    |       |                |   | **Nine  Months Ended** |   |
|------------------------------|--------|-------------------------|------------|---------------------|--------|------------------------|--------|
|                         |   | **Increase/(Decrease)** |       | **Percent  Change** |   | **Sept. 30,  2004**    |   | **Sept. 30,  2003** |   |
| Revenues:                    |   |                    |       |                |   |                   |   |   |   |
| Sales Commissions            |   | $                       | 2,015,431  |                | 17.8   |                   | $      | 13,367,465 |   | $ | 11,352,034 |   |
| Corporate Finance            |   | 5,351,498               |       | 109.8               |   | 10,227,410             |   | 4,875,912 |   |
| Investment Income            |   | (5,758,706              | )          | NA                  |   | (2,742,211             | )      | 3,016,495 |   |
| Trading Income               |   | 151,641                 |       | 15.5                |   | 1,127,923              |   | 976,282 |   |
| Other                        |   | (23,059                 | )          | (46.4               | )      | 26,622                 |   | 49,681 |   |
|                         |   |                    |       |                |   |                   |   |   |   |
| Total                        |   | 1,736,805               |       | 8.6                 |   | 22,007,209             |   | 20,270,404 |   |
|                         |   |                    |       |                |   |                   |   |   |   |
| Expenses:                    |   |                    |       |                |   |                   |   |   |   |
| Commissions and Salaries     |   | 1,821,240               |       | 14.7                |   | 14,228,450             |   | 12,407,210 |   |
| Underwriting Expenses        |   | 513,172                 |       | 202.3               |   | 766,891                |   | 253,719 |   |
| Rent, Telephone & Quotes |   | 65,763                  |       | 7.7                 |   | 919,448                |   | 853,685 |   |
| Other                        |   | 484,462                 |       | 22.0                |   | 2,682,789              |   | 2,198,327 |   |
|                         |   |                    |       |                |   |                   |   |   |   |
| Total                        |   | 2,884,637               |       | 18.4                |   | 18,597,578             |   | 15,712,941 |   |
|                         |   |                    |       |                |   |                   |   |   |   |
| Pretax Income                |   | $                       | (1,147,832 | )                   | (25.2  | )                      | $      | 3,409,631 |   | $ | 4,557,463 |   |

 

**Nine Months Ended September 30, 2004vs. Nine Months Ended September 30, 2003**

 

**Revenues**

 

Totalrevenues for the first nine months of 2004 increased $1,736,805. As shown inthe table above, sales commissions increased $2,015,431, or 17.8 percent forthe first nine months of 2004 as compared to the first nine months of 2003.This increase was primarily the result of increased trading activity in thefirst quarter of 2004 relative to the same period of 2003.

 

Corporate finance revenues increased $5,351,498, or109.8 percent, for the first three quarters of 2004, relative to the firstthree quarters of 2003. Five corporate finance transactions with the Company’sshare of the amount raised totaling approximately $69.5 million were completedduring the nine months of 2004, compared with two corporate financetransactions with proceeds totaling $32.0 million completed during the sameperiod in 2003. Corporate finance revenues are directly related to the amountof money raised in completed transactions.

 

Corporatefinance revenues also include the receipt of underwriter warrants ascompensation for the Company’s underwriting efforts. During the nine monthsended September 2004, the Company received underwriter warrants, valued usingthe Black-Scholes option-pricing model, resulting in unrealized revenue of$6,761,240, as compared to underwriter warrants received during the thirdquarter of 2003 valued at $3,217,453.

 

 

12

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Investment income decreased by $5,758,706 for thefirst nine months of 2004 compared to the first nine months of 2003, primarilyas a result of lower market values of the stocks in which the Company has aconcentration. During the first nine months of 2004, underwriter warrantexpiration and depreciation totaled $3.1 million, compared to underwriterwarrant expiration and depreciation of $255,846 during the first nine months of2003. Realized gain in the first nine months of 2004 totaled $546,950, comparedto realized loss of $1.0 million during the first nine months of 2003. Theremainder of the total investment income account is unrealized gain and lossesin securities with quoted market prices and securities not readily marketable.

 

Tradingincome increased a modest $151,641 for the nine months of 2004, compared to thefirst nine months of 2003. With the concerns related to energy prices duringthe first nine months of 2004 and the continued conflict overseas, overallmarket performance was less than robust.

 

**Expenses**

 

Total expenses for the first nine months of 2004increased $2,884,637, or 18.4 percent as compared to the first nine months of2003. The largest increase was in commissions and salaries. Commission andsalary expenses increased 14.7 percent, or $1,821,240. This increase was due tolarger retail and corporate finance commissions paid on higher commissionrevenues during the 2004 period and higher administrative salary expenses. Aspreviously discussed, the Company has experienced an increase in administrativesalaries 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 increaseda total of $513,172 in the comparative nine month periods as a result of theclosing of five corporate finance transactions in 2004 compared to the closingof two corporate finance transactions in 2003. The aggregate of all otherexpenses increased $484,462, or 22.0 percent, for the first nine months of2004. The increases in other expense included: travel and entertainmentincrease of $136,286 as a result of the investor conference held inJune 2004; professional fee increase of $226,418 as a result of increasedlegal activity related to settlements; and advertising expense increase of$19,700 as a result of PIC’s retention of a public relations firm during the firstnine months of 2004. The most significant decreases in other expenses weredecreases of $117,000 in bad debt expense as the Company has been moreeffective in its collection efforts, and $31,000 decrease in depreciationexpense.

 

**Income**

 

TheCompany had a decrease in pretax income of $1,147,832 for the nine months endedSeptember 30, 2004, as compared to the nine months ended September 30, 2003, asa result of the increase in expenses exceeding the increase in revenues.Independent of the change in the Black- Scholes value of the underwriterwarrants and the income and expense associated with the receipt of theunderwriter warrants, the Company would have had income totaling $1,684,631 forthe first nine months of 2004, as compared to pretax income of $2,531,963 forthe comparable period of 2003. Because of the Black-Scholes value ofunderwriter warrants and other factors, significant fluctuations often occur inPIC’s revenues and operating results from one period to another.

 

**Liquidity and Capital Resources**

 

The majority of PIC’s assets are cash and assetsreadily convertible to cash.  PIC’ssecurities inventory is stated at market value for the securities that arereadily marketable and estimated fair value for the securities that are notreadily marketable. The liquidity of the market for many of PIC’s securitiesholdings, however, varies with trends in the stock market.  Since many of the securities held by PIC arethinly traded, and PIC is in many cases a primary market maker in the issuesheld, any significant sales of PIC’s positions could adversely affect theliquidity of the issues held.  Ingeneral, falling prices in OTC securities (which make up most of PIC’s tradingpositions) lead to decreased liquidity in the market for these issues, whilerising prices in OTC issues tend to increase the liquidity of the market forthese securities.

 

13

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PICborrows money from its clearing firm in the ordinary course of its business,pursuant to an understanding under which the clearing firm agrees to financePIC’s trading accounts.  As of September30, 2004, no net loans were outstanding pursuant to this arrangement.  PIC and the Company are generally able tomeet their compensation and other obligations out of current liquid assets.

 

Anothersource of capital to PIC and the Company has been the underwriter warrantsissued to PIC in connection with its corporate finance activities and the saleof the underlying securities. There is no public market for the underwriter warrants.The securities receivable upon exercise of the underwriter warrants cannot beresold unless the issuer has registered these securities with the SEC and withthe states in which the securities will be sold unless exemptions areavailable.  Any delay or other problemin the registration of these securities would have an adverse impact upon PIC’sability to obtain funds from the exercise of the underwriter warrants and theresale of the underlying securities.  AtSeptember 30, 2004, PIC owned 18 underwriter warrants (from 14 issuers), allbut six of which were then exercisable; four had an exercise price below theSeptember 30, 2004 market price of the securities receivable uponexercise.  The intrinsic value of thesefour warrants is $604,737. There is little or no direct relationship betweenthe intrinsic value of PIC’s underwriter warrants at the end of any givenperiod and the fair value calculated using the Black-Scholes pricing model, asdescribed more fully in Critical Accounting Policies above. The prices of thesesecurities are influenced by general movements in the prices of OTC securitiesas well as the success of the issuers of the underwriter warrants.  The prices of the securities underlying theunderwriter warrants are very volatile, and substantial fluctuations in theCompany’s estimate of their value can be expected in the future.

 

Inthe nine months ended September 30, 2004, $120,103 of net cash was used inoperating 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$1,942,572; unrealized depreciation and expiration of underwriter warrants totaling$3,093,668; and income taxes payable/receivable of $1,183,983. The followingitems are negative adjustments to or a use of cash for operating activities: adecrease in accounts payable and accrued liabilities of $1,342,388; an increasein trading and investment securities of $2,091,468; and the receipt ofunderwriter warrants of $6,761,240. Net cash used in investing activities inthe first nine months of 2004 was for additions to furniture and equipment of$98,540. Net cash provided by financing activities in the first nine months of2004 totaled $181,073, resulting from proceeds from the exercise of employeestock options and income tax benefit from stock option exercise, dividends paidto common shareholders, and payments to retire common stock.

 

Asa securities broker-dealer, PIC is required by SEC regulations to meet certainliquidity and capital standards.  Webelieve we are in compliance with these standards.

 

AtSeptember 30, 2004, the Company had no material commitments for capitalexpenditures.

 

Ingeneral, the primary sources of PIC’s, and therefore the Company’s, liquidityinclude PIC’s trading positions, borrowings on those positions and profitsrealized upon the exercise of underwriter warrants. All of these sources dependin large part on the trend in the general markets for OTC securities.  Rising OTC price levels will tend toincrease the value and liquidity of PIC’s trading positions, the amount thatcan be borrowed from National Financial Services based upon those positions,and the value of PIC’s underwriter warrants. The Company believes its liquidity is sufficient to meet its needs forboth the short and long term horizon. The Company’s liquidity could be affectedby protracted unfavorable market conditions.

 

**Inflation**

 

BecausePIC’s assets are primarily liquid, they are not significantly affected byinflation.  The rate of inflationaffects PIC’s expenses, such as employee compensation, office leasing andcommunications costs.  These costs maynot readily be recoverable in the price of services offered by theCompany.  To the extent inflationresults in rising interest rates and has other adverse effects in thesecurities markets and the value of securities held in inventory or PIC’sinvestment account, it may adversely affect the Company’s financial positionand results of operations.

 

 

14

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ITEM3.  CONTROLS AND PROCEDURES

 

(a)           Our management, with theparticipation of our President and Chief Financial Officer, conducted anevaluation of our disclosure controls and procedures, as such terms are definedunder Rules 13a-15(e) and 15d-15(e) promulgated under the Securities ExchangeAct of 1934, as amended, as of the end of the period covered by this report.Based on their evaluation, our President and Chief Financial Officer concludedthat our disclosure controls and procedures were effective.

 

(b)           For the quarter ended September 30, 2004, there havebeen no changes in our internal control over financial reporting that havematerially affected or are reasonably likely to materially affect our internalcontrol over financial reporting.

 

 

15

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**PART IIOTHER INFORMATION**

 

Item1. Legal Proceedings.

 

SeeNote 3 to Condensed Consolidated Financial Statements in Part 1.

 

Item2. Unregistered Sales of Equity Securities and Use of Proceeds.

 

**SmallBusiness Issuer Purchases of 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** |   |
|----------------------|--------|------------------------------------------------------------------------------|--------|--------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------|--------|
| 07/01/04 to 07/31/04 |   | None                                                                         |   | N/A                                                                |   | None                                                                                                    |   | 233,195                                                                                               |   |
| 08/01/04 to 08/31/04 |   | 2,908                                                                        |   | $5.41                                                              |   | 2,908                                                                                                   |   | 230,287                                                                                               |   |
| 09/01/04 to 09/30/04 |   | 2,643                                                                        |   | $5.72                                                              |   | 2,643                                                                                                   |   | 227,644                                                                                               |   |
| Total                |   | 5,551                                                                        |   | $5.56                                                              |   | 5,551                                                                                                   |   | 227,644                                                                                               |   |

 

Allof the shares purchased were open-market transactions as part of a corporateplan for stock repurchase. The stock repurchase plan, approved by the board ofdirectors on September 17, 2001, authorizes the repurchase of up to 300,000shares. There is no expiration date on the stock repurchase plan.

 

Item3. Defaults upon Senior Securities.

 

None

 

Item4. Submission of Matters to a Vote of Security Holders.

 

                                None

 

Item5. Other Information.

 

None

 

Item6. Exhibits and Reports on Form 8-K

 

(a)Exhibits

 
| 31.1   |   | Certification  of Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. Filed herewith electronically.                                                     |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                              |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. 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.      |

 

 

 

16

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**SIGNATURES**

 

                Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                     |   | PAULSON  CAPITAL CORP. |
|--------------------------|--------|------------------------|
|                     |   |                   |   |
|                     |   |                   |   |
| Date:  November 12, 2004 |   | By:                    | /s/  CHESTER L.F. PAULSON |
|                     |   |                   | Chester  L.F. Paulson |
|                     |   |                   | President

Principal  Executive Officer |
|                     |   |                   |   |
| Date:  November 12, 2004 |   | By:                    | /s/  CAROL RICE |
|                     |   |                   | Carol  Rice |
|                     |   |                   | Chief  Financial Officer

Principal  Financial Officer |

 

17

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