MCVT Mill City Ventures III Ltd

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. In addition, unless expressly stated otherwise, the comparisons presented in this MD&A refer to the same period in the prior year. Our MD&A is presented in seven sections:

OVERVIEW

Mill City Ventures III, Ltd. was incorporated in the State of Minnesota on January 10, 2006. In this report, we generally refer to Mill City Ventures III, Ltd. in the first person “we.” On occasion, we refer to our company in the third person as “Mill City Ventures” or the “company.”

We provide non-bank lending and specialty finance to companies and individuals on both a secured and unsecured basis. The significant majority by dollar amount of loans we provide typically have maturities that range from 9 to 12 months and may involve a pledge of collateral or, in the case of loans made to companies, personal guarantees by the principals of the borrower. Our loans may be made for real estate acquisitions, renovation and sale; other real estate projects; title loans; cash inventory needs: receivables financing (e.g., factoring or similar); inventory financing, or for other purposes. We intend to remain opportunistic, however, and may engage in transactions that involve other rights (such as stock, warrants or other equity-linked investments) or that are structured differently or uniquely. Our business objective is to generate revenues from the interest and fees we charge, and capital appreciation from any related investments we make.

Our principal sources of income are interest, dividends and other fees associated with lending such as origination fees, closing fees or exit fees. We may also receive reimbursement of legal costs associated with loan documentation. Our statement of operations also reflect increases and decreases in the carrying value of our asset and investments (i.e. unrealized appreciation and depreciation). Our principal expenses relate to operating expenses, the largest components of which are generally professional fees, payroll, occupancy, and insurance expenses.

Our MD&A should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2020, as well as our reports on Forms 10-Q and 8-K and other publicly available information. All amounts herein are unaudited. In addition, the discussion of our results of operations and financial condition should be read in the context of this overview. Furthermore, we are including a full description of our business in this report.

BUSINESS

Overview

Mill City Ventures III, Ltd, (the “Company” or “we”), is a Minnesota corporation that was incorporated in January 2006. From our inception until December 13, 2012, we were a development-stage company involved in the gaming and entertainment industry. In 2013, we elected to become a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). We operated as a BDC until we withdrew our BDC election on December 27, 2019. Since that time, we have engaged in the business of providing short-term specialty finance solutions primarily to private businesses, micro- and small-cap public companies and high-net-worth individuals. To avoid again becoming subject to regulation under the 1940 Act, we generally seek to structure our transactions so they do not constitute “investment securities” for purposes of federal securities law, and we monitor our holdings as a whole to ensure that no more than 40% of our total assets may consist of investment securities.

Descriptions

The principal specialty finance solutions we provide are high-interest short-term lending arrangements. On occasion, these lending arrangements involve us obtaining collateral as security for the borrower’s repayment of funds to us. In some circles, short-term high-interest collateralized lending is referred to as “hard-money lending.”

We believe we are generally able to charge high interest for our specialty finance solutions because (i) banks and other traditional providers of credit may have neither the expertise nor the infrastructure needed to evaluate creditworthiness and risks in a timeframe suitable for a potential borrower, preferring instead to process transactions and structures that present few novel issues or risks; and (ii) we will often be able to devote time and attention to transactions involving a smaller dollar amount than an institutional lender will view as worthwhile. These beliefs essentially explain why we refer to our business as “specialty finance”— financing that may involve structures that are unique, creative, and often bespoke; and that may involve dollar amounts that are not suitable for institutional lenders.

We generally provide specialty finance solutions that are short-term in nature. By this, we mean lending arrangements that mature or come due within nine months of the lending date. We view the provision of short-term finance as desirable for two principal reasons. First, short-term lending requires a potential borrower to identify for us a near-term source of repayment for the funds they borrow from us. This permits us to evaluate that source of repayment clearly and carefully, thus helping identify the potential risks involved in a particular transaction and how we may be able to include structural terms that mitigate these risks. Second, short-term lending permits us to avail ourselves of a court-recognized exception for treating promissory notes (evidencing a loan) as “investment securities” under federal securities law. In sum, this exception generally applies to promissory notes with short-term maturities of nine months. Our ability to avail ourselves of this exception, and to more generally structure our transactions in such a way as to avoid them being properly considered as “investment securities” under federal securities laws, is important to our ability to avoid once again becoming subject to regulation under the 1940 Act. Below we discuss our process for evaluating transactional terms and structures with a view to remaining outside of the regulatory regime of the 1940 Act (please refer to “Investment Process” below).

Examples of the kinds of the specialty finance solutions we have considered or provided to date, and may continue to provide in the future, include:

In addition, we are presently evaluating our ability to enter into other kinds of short-term specialty finance transactions. Examples include the expansion of our efforts to purchase adjudicated settlements, the purchase (at discounted rates) of receivables owing to professionals on account of certain workers’ compensation claim, and short-term consumer finance lending.

Sourcing Transactions

We believe that our management’s strong combination of experience and contacts in the investment sector, including the experience and contacts of our independent directors, should be sufficient to continue attracting suitable prospective investment opportunities. To date, the network of contacts of our management and directors has been successful thus far in sourcing all of the transactions in which we have participated. Accordingly, we presently do not have any plans to hire any business development professionals to assist us with transactional volume.

Competition

The market for specialty finance is competitive, largely as a result of the participation of various types of professionally managed pooled investment funds (e.g., hedge funds, debt/mezzanine debt funds, private equity funds) seeking the high returns that are possible in specialty finance and hard-money lending.

Nevertheless, we believe we are well positioned to compete successfully due to our flexibility and creativity with our transactional structures and terms. We expect to continue to have significant flexibility in selecting and structuring our transactions. In part, this is because we will not be subject to many of the regulatory limitations that govern traditional or institutional lenders. We believe this will afford us broad latitude as to the nature of the transactions in which we may participate, and the specific terms to which we may agree. We believe that this flexible approach to structuring our transactions and investments will facilitate positive, long-term relationships with our borrowers. In addition, the freedom afforded to us through the lack of substantive regulation governing the types of transactions we enter into and our methods of operation in general permits us to allocate resources to those types of transactions that we believe may lead to the highest risk-adjusted returns or the steadiest stream of such returns.

The only significant limitation on our ability to flexibly structure transactions arises from our desire to remain outside the regulations of the 1940 Act. In order to meet this goal, we intend and aim to structure the vast majority of our transactions (by dollar amount) in ways such that they are not properly considered investment securities under federal securities laws, including the 1940 Act.

Finally, we believe we are able to manage the evaluation and due-diligence process swiftly and efficiently, largely as a result of our management team’s diverse experience in transactional finance.

Other Matters

We do not believe that we are dependent in any material way on any particular borrower, type of specialty finance transaction, or industry.

We do not own or use through license any patents, trademarks, or other intellectual properties and we do not believe that any such assets would be material to our business.

Sometimes the types of transactions we engage in are governed by particular laws, regulations, or rules. For example, lending transactions in which high-net-worth individuals are the borrower will nearly always involve state law usury limitations. Transactions in which we seek and obtain collateral as security for obligations owed to us involve legal issues arising under the Uniform Commercial Code or its various state law iterations. To date, we have not engaged in transactions that require us to obtain licensure or a permit prior to entering into the transaction—e.g., brokering transactions or engaging in licensed consumer finance activities.

Pending the consummation of transactions and deployment of cash, we generally keep the majority of our assets in cash, cash equivalents such as money-market investments, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment.

Our Investment Process

We have identified several criteria that we believe are generally important guidelines for us to meet our financial objectives. These criteria are, however, only general guidelines for our investment decisions and, in the case of some transactions in which we invest, fewer than all—or even none—of these criteria will be met.

If we believe a potential transaction generally meets the characteristics described above or if we otherwise determine that a potential transaction may be desirable to enter into, we may perform a more rigorous due-diligence examination of the prospective borrower, the likely source or sources of liquidity for their repayment to us, and other aspects of the borrower or its assets (e.g., assets of the borrower that may serve as collateral security for the obligations that may be owing to us). Our due-diligence examination for each transaction will necessarily be unique and tailored to the specific transaction, but will generally be undertaken in light of the following facts and circumstances:

The assessments described above outlines our general approach for our investment decisions, although not all of such activities will be followed in each instance, or some may be stressed moreso than others depending on facts and circumstances. Upon successful completion of this preliminary evaluation, we will typically (1) evaluate our own regulatory concerns (i.e., to what extent the potential transaction may properly be considered an investment in an “investment security” for purposes of the 1940 Act and, if necessary, consider alternative structures to alleviate any risks to our company relating thereto), and (2) decide whether to move forward towards negotiating a letter of intent and, thereafter, definitive documentation for our transaction. Depending on timing, we may not use a letter of intent and will instead proceed directly to definitive documentation.

As indicated above, to avoid becoming subject to the regulatory requirements of the 1940 Act, we monitor our investment holdings as a whole to ensure that investments and other holdings which may be considered “investment securities” do not comprise more than 40% of our total assets. We undertake this analysis (1) on a quarterly basis and in connection with the review and preparation of our financial statements filed as part of our quarterly and annual reports with the U.S. Securities and Exchange Commission, and (2) at other times when we are considering how to structure a new transaction that is of a significant size (with “significance” largely based on the outcome of our most recent quarterly review). This review is generally undertaken by our Chief Financial Officer and may involve our outside legal counsel, in particular in a case where we are considering the structure of a potential new transaction.

In general, our analysis starts with the length or duration of a potential new transaction. Although federal securities laws define “investment securities” in such a way as to include promissory notes, the U.S. Supreme Court held in Reves v. Ernst & Young, 110 S. Ct. 945 (1990), that certain kinds of promissory notes are not properly considered securities. Over time, court precedent has developed to identify these kinds of promissory notes as generally not constituting investment securities:

In addition to the types of financing arrangements noted above, court precedent indicates that there may be facts and circumstances surrounding the transaction that may cause other promissory notes to not be considered investment securities under federal securities laws. For example, it is presumed that a promissory note which matures in more than nine months is a “security,” but this presumption may be rebutted (with the conclusion that such a promissory note is not a properly considered a security) upon an evaluation of the following factors:

While the application of these factors can be helpful in some instances, often the factors and the proper manner of weighting them are unclear. As a result, the analyses we periodically undertake focuses on the more bright-line types of lending arrangements enumerated above—i.e., promissory notes maturing in nine months or less, etc.

Our Prior Business as a BDC

The analysis of our transactions and transactional holdings is undertaken with a view to ensuring that we do not become subject to the 1940 Act. Generally from 2013 through 2019, we were governed by the 1940 Act. During that time, we were a business development company under the 1940 Act, or “BDC,” primarily focused on investing in or lending to private and small-cap public companies and making managerial assistance available to such companies. As a BDC, our investments included stock of or membership interests (typically referred to as units) in private companies, small-cap public company stocks, and promissory notes. In some cases, the stock or membership interests we acquired were preferred stock or units, and in other cases the stock or membership interests acquired were common stock or units. In connection with our investments in promissory notes, we frequently obtained warrants to purchase common stock.

In our financial statements for the year ended December 31, 2019, revenues from our operations (as a BDC) relate to the earnings we received from our portfolio investments.

Our Management and Employees

Currently, Mr. Douglas M. Polinsky, the Chief Executive Officer and Chairman of our Board of Directors, and Joseph A. Geraci, II, our Chief Financial Officer and a director of the Company, serve as our senior management team. These are also the only two persons who are employees of the Company.

INVESTMENT ACTIVITY

During the six months ended June 30, 2021, we made $13,250,664 of investments and had $9,889,827 of redemptions and repayments, resulting in net investments at amortized cost of $11,864,762 at the end of the period.

During the six months ended June 30, 2020, we made $6,217,296 of investments and had $1,192,824 of redemptions and repayments, resulting in net investments at amortized cost of $7,200,566 at the end of the period.

Our investment composition by major class, based on fair value at June 30, 2021, was as follows:

Investment Income

We generate revenue primarily in the form of interest income and capital gains, if any, on the debt instruments we own. We may also generate revenue from dividends and capital gains on equity investments we make, if any, or on warrants or other equity interests that we may acquire. In some cases, the interest on our investments may accrue or be paid in the form of additional debt. The principal amount of the debt instruments, together with any accrued but unpaid interest thereon, will generally become due at the maturity date of those debt instruments. We may also generate revenue in the form of commitment, origination, structuring, diligence, or consulting fees. Any such fees will be recognized as earned.

For the three and six months ended June 30, 2021, our total investment income was $675,549 and $1,222,391, respectively. For the three and six months ended June 30, 2020, our total investment income was $283,456 and $468,435, respectively. The increase is due to the change in our business structure which now focuses on short-term non-bank lending. Our loan portfolio generates interest income, with an average rate on the loans of 25%.

Professional Fees

For the three and six months ended June 30, 2021, we had $77,539 and $220,347 professional fees expense, respectively. For the three and six months ended June 30, 2020, we had $90,529 and $74,297 professional fees expense, respectively The increase for the six months in 2021 is due to legal costs incurred to close on several new short-term banking loans. In 2020, we received a refund during the first quarter of $59,957 relating to certain audit expenses incurred during 2018 and 2019.

Net Realized Gain from Investments

For the three and six months ended June 30, 2021, we had $4,853,170 and $9,889,827, respectively, of sales of investments, resulting in $621,600 and $3,529,599, respectively, of realized gains. For the three and six months ended June 30, 2020, we had $971,044 and $1,192,824, respectively, of sales of investments, resulting in $175,222 and $199,724, respectively, of realized gains.

Net Change in Unrealized Appreciation (Depreciation) on Investments

For the three and six months ended June 30, 2021, our investments had $83,100 of unrealized appreciation and $430,150 of unrealized depreciation, respectively. For the three and six months ended June 30, 2020, our investments had $348,602 of unrealized appreciation and $37,405 of unrealized depreciation, respectively.

Changes in Net Assets from Operations

For the three and six months ended June 30, 2021, we recorded a net increase in net assets from operations of $781,506 and $2,526,548, respectively. Based on the weighted-average number of shares of common stock outstanding for the three and six months ended June 30, 2021, our per-share net increase in net assets from operations was $0.07 and $0.23, respectively. For the three and six months ended June 30, 2020, we recorded a net increase in net assets from operations of $593,370 and $311,452, respectively. Based on the weighted-average number of shares of common stock outstanding for the three and six months ended June 30, 2020, our per-share net increase in net assets from operations was $0.05 and $0.03, respectively.

Cash Flows for the Six Months Ended June 30, 2021 and 2020

The level of cash flows used in or provided by operating activities is affected by the purchases of investments, redemptions and repayments of investments, among other factors. For the six months ended June 30, 2021, net cash used in operating activities was $3,401,681. Cash flows used in operating activities for the six months ended June 30, 2021 were primarily related to purchases of investments of $13,250,664, offset mostly by redemptions and repayments of investments totaling $9,889,827. For the six months ended June 30, 2020, net cash used in operating activities was $3,457,399. Cash flows provided in operating activities for the six months ended June 30, 2020 were primarily related to purchases of investments of $6,217,296, offset mostly by redemptions and repayments of investments totaling $1,192,824.

FINANCIAL CONDITION

As of June 30, 2021, we had cash of $1,515,005, a decrease of $3,925,574 from December 31, 2020. The primary use of our existing funds and any funds raised in the future is expected to be for investments, cash distributions to our shareholders or for other general corporate purposes, including paying for operating expenses or debt service to the extent we borrow or issue senior securities. Pending investment, our investments may consist of cash, cash equivalents, U.S. government securities or high quality debt securities maturing in one year or less from the time of investment.

To the extent our Board of Directors determines in the future, based on our financial condition and capital market conditions, that additional capital would allow us to take advantage of additional investment opportunities, we may seek to raise additional equity capital or to engage in borrowing.

CRITICAL ACCOUNTING ESTIMATES

Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America, or U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Critical accounting policies are those that require the application of management’s most difficult, subjective or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods.

In preparing the financial statements, management will make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. In preparing the financial statements, management also will utilize available information, including our past history, industry standards and the current economic environment, among other factors, in forming its estimates and judgments, giving due consideration to materiality. Actual results will almost certainly differ from these estimates. In addition, other companies may utilize different estimates, which may impact the comparability of our results of operations to those of companies in similar businesses. As our expected operating results occur, we will describe additional critical accounting policies in the notes to our financial statements. Our most critical accounting policies relate to the valuation of our investments and revenue recognition. For more information, refer to our Annual Report on Form 10-K for the year ended December 31, 2020.

OFF-BALANCE-SHEET ARRANGEMENTS

During the six months ended June 30, 2021, we did not engage in any off-balance sheet arrangements as described in Item 303(a)(4) of Regulation S-K.

FORWARD-LOOKING STATEMENTS

Some of the statements made in this section of our report are forward-looking statements based on our management’s current expectations for our company. These expectations involve assumptions and are subject to substantial risks and uncertainties that could cause actual results to differ materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to future events or our future financial performance, and can ordinarily be identified by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “targets,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. Important assumptions include our ability to identify and consummate new investments, achieve certain margins and levels of profitability, the availability of any needed additional capital, and the ability to maintain compliance with regulations applicable to us. Some of the forward-looking statements contained in this report relate to, and are based our current assumptions regarding, the following:

The foregoing list is not exhaustive. For a more complete summary of the risks and uncertainties facing our company and its business and relating to our forward-looking statements, please refer to our Annual Report on Form 10-K filed on March 10, 2021 (related to our year ended December 31, 2020) and in particular the section thereof entitled “Risk Factors.” Because of the significant uncertainties inherent in forward-looking statements pertaining to our company, the inclusion of those statements should not be regarded as a representation or warranty by us or any other person that our objectives, plans, expectations or projections that are contained in this filing will be achieved in any specified time frame, if ever. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this filing. The forward-looking statements made in this report relate only to events as of the date on which the statements are made, and are excluded from the safe harbor protection provided by Section 21E of the Securities Exchange Act of 1934.