PARTY CITY CORP, 10-K, 2000-09-29

PARTY CITY CORP
10-K, 2000-09-29
MISCELLANEOUS SHOPPING GOODS STORES

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE YEAR ENDED DECEMBER 31, 1998

COMMISSION FILE NUMBER 0-27826
------------------------

PARTY CITY CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S> <C>
DELAWARE 22-3033692
(STATE OF OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

400 COMMONS WAY, ROCKAWAY, NJ 07866
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
</TABLE>

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (973) 983-0888

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

<TABLE>
<CAPTION>
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
<S> <C>
NONE NONE
</TABLE>

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $0.01 PER SHARE

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ ] No [X]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

The aggregate market value of voting stock held by non-affiliates of the
Registrant on September 20, 2000, based on the closing sale price on such date,
was approximately $30,855,782.

The number of shares outstanding of each of the Registrant's classes of
common stock, $0.01 par value, as of September 20, 2000 was 12,722,205.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the November 15, 1999
Annual Meeting of Stockholders are incorporated by reference into Part III.

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TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I
Item 1 Business.................................................... 2
Item 2 Properties.................................................. 12
Item 3 Legal Proceedings........................................... 12
Item 4 Submission of Matters to a Vote of Security Holders......... 13
PART II
Item 5 Market for Registrant's Common Equity and Related
Stockholder Matters......................................... 13
Item 6 Selected Financial Data..................................... 14
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 16
Item 7A Quantitative and Qualitative Disclosures About Market
Risk........................................................ 20
Item 8 Financial Statements and Supplementary Data................. 20
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 20
PART III
Item 10 Directors and Executive Officers of the Registrant.......... 21
Item 11 Executive Compensation...................................... 21
Item 12 Security Ownership of Certain Beneficial Owners and
Management.................................................. 21
Item 13 Certain Relationships and Related Transactions.............. 21
PART IV
Item 14 Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 21
</TABLE>

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PART I

ITEM 1. BUSINESS

Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party goods stores within the continental United
States and sells franchises on an individual store and area franchise basis
throughout the United States, Puerto Rico, Spain, Portugal and Canada. As of
December 31, 1998, the Company had 207 Company-owned stores and 167 franchise
stores in its network.

FINANCING AND RELATED DEVELOPMENTS

On April 24, 1998, the Company refinanced and replaced its then existing
$20 million loan facility with a $60 million secured revolving line of credit
agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit
Agreement"). Advances under the Credit Agreement originally bore interest, at
the Company's option, at the agent bank's base rate (the higher of the bank's
prime rate or the federal funds rate plus 1/2% per annum) or LIBOR plus an
applicable margin. The Company did not meet certain of its financial and
reporting covenants, including those relating to timely filing of consolidated
financial statements, minimum levels of profitability, net worth, liquidity,
fixed charge coverage and others. Consequently, the Company's debt under the
Credit Agreement was subject to acceleration and is classified as a current
liability in the consolidated balance sheet at December 31, 1998. The Credit
Agreement was secured by all the assets of the Company. Additionally, the Credit
Agreement restricted the payment of dividends.

On August 16, 1999, the Company entered into agreements with its existing
bank lenders under the Credit Agreement (the "Banks"), a new group of investors
(the "Investors") and its trade vendors. The Banks and the Company entered into
a Standstill and Forbearance Agreement (the "Bank Forbearance Agreement"). Under
the Bank Forbearance Agreement, the Banks agreed not to exercise rights and
remedies based upon any existing defaults until June 30, 2000, unless a further
event of default occurred. The Company also agreed to reduce its outstanding
borrowings from $58.6 million to $15 million by October 30, 1999. The interest
rate on its bank debt was increased to 2% over the bank's prime interest rate,
and the Company paid a forbearance fee of $580,000.

On August 17, 1999, the Company received $30 million in financing from the
Investors. The Investors purchased senior secured notes and warrants pursuant to
separate securities purchase agreements (the "Securities Purchase Agreements")
each dated as of August 16, 1999. Under these Securities Purchase Agreements,
the Company issued (i) $10 million of its 12.5% Secured Notes due 2003 (the "A
Notes"); (ii) $5 million of its 13.0% Secured Notes due 2003 (the "B Notes");
(iii) $5 million of its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10
million of its 14.0% Secured Notes due 2004 (the "D Notes", and together with
the A Notes, the B Notes and the C Notes, the "Notes"); and (v) warrants (the
"Warrants") to purchase 6,880,000 shares of the Company's common stock at an
initial exercise price of $3.00 per share. The Warrants were valued at
$1,965,000 based on management's estimate using certain fair value methodologies
and represent an original issue discount to the C Notes and D Notes. Up to $15
million of the Notes were secured by a first lien that was pari pasu with the
liens under the Credit Agreement. The Notes are also secured by a junior lien on
all of the Company's assets. The Company issued the Warrants in connection with
the sale of the C Notes and the D Notes. The Warrants may be exercised before
the close of business on August 16, 2006. The shares of Common Stock reserved
for issuance under the Warrants represent approximately 35% of the shares of
Common Stock outstanding after giving effect to the exercise of the Warrants.
The proceeds from the $30 million in new financing were used for the purchase of
seasonal inventory, payment of amounts due under the Credit Agreement,
transaction fees and working capital.

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Company's assets, or (c) any rights or options to acquire any of the foregoing
from any person; (ii) make or in any way participate in any "solicitation" of
"proxies" (as such terms are defined in the rules of the Securities Exchange Act
of 1934, as amended) to vote, or seek to advise or influence any person with
respect to the voting of any voting securities of the Company; or (iii) make any
public announcement with respect to any transaction between the Company or any
of its securities holders and the Investors, including without limitation, any
tender or exchange offer, merger or other business combination of a material
portion of the assets of the Company. These standstill provisions terminate if
the Company's consolidated earnings before interest, taxes, depreciation and
amortization and exclusive of special charges ("EBITDA") does not meet specified
targets. The Company achieved its target EBITDA for the calendar year 1999.
Also, in connection with these transactions, one outside director of the Company
resigned and two representatives of the Investors joined the Board of Directors.
The Company has amended the restriction that prohibited the Investors from
purchasing the Company's stock up to an aggregate amount of $1.5 million of the
Company's common stock.

Party City's trade vendors representing approximately $36.4 million of
trade debt also entered into an agreement with the Company. Pursuant to a Vendor
Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"), these
trade vendors agreed to forbear from taking any action against Party City until
January 15, 2000. The trade vendors received promissory notes from Party City
totaling approximately $12.2 million representing one-third of their unpaid
balances as of May 1, 1999 (the "Trade Notes"). The Trade Notes bore interest at
a rate of 10% per year and were scheduled to mature on November 15, 1999.
Interest on the Trade Notes was due on January 15, 2000, unless the bank debt
was refinanced before such date. Separately, certain seasonal trade vendors
agreed to provide trade credit to the Company for 30% of purchases for the
Halloween, Thanksgiving and year-end holiday seasons. Those vendors received a
shared lien on the Company's inventory for the amount of the credit.

In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company identified stores for sale to existing franchisees to
generate working capital. Eighteen stores with a net book value of approximately
$9.8 million were sold to franchisees. In order to facilitate the sale of these
stores, franchise fees were negotiated at lower than normal rates for specific
periods. The total proceeds from the sales of these stores was approximately
$9.9 million. The net proceeds from the sale of stores was required under the
Bank Forbearance Agreement to be used to pay down the outstanding borrowings
under the Credit Agreement.

On January 14, 2000, the Company replaced the Credit Agreement with a new
Loan and Security Agreement (the "Loan Agreement") with Congress Financial
Corporation ("Congress"), as lender. Under the terms of the Loan Agreement, the
Company may from time to time borrow amounts based on a percentage of its
eligible inventory, up to a maximum of $40 million at any time outstanding.
Advances bear interest, at the Company's option, (i) at the adjusted Eurodollar
rate plus the applicable margin, which was initially 2.75% per annum (subject to
possible reduction to an interest rate as low as 2.25% from and after June 30,
2001, based on the Company's pre-tax income and excess availability) or (ii) at
the rate of 3/4% per annum above the prime rate. The term of the Loan Agreement
is three years, and is secured by a lien on substantially all of the assets of
the Company. At September 15, 2000, there was $15.8 million outstanding and
approximately $24.2 million was available for borrowing under this revolving
credit facility.

On January 14, 2000, Party City also received $7 million in cash proceeds
from the sale to certain of its existing Investors (the "Investor Group") of a
new series of senior secured notes pursuant to a First Amendment (the "First
Amendment") to the Securities Purchase Agreements. Pursuant to the First
Amendment, the Company issued $7 million in aggregate principal amount of its
14.0% Secured Notes due 2002 (the "E Notes"). The E Notes are secured by a lien
on substantially all of the Company's assets. The Investor Group, together with
other existing Investors and Congress, have entered into an intercreditor
agreement. In consideration for waivers and forbearances granted by the
Investors to various defaults under the terms of the Company's A Notes, B Notes,
C Notes and D Notes, the Company also agreed to amend and restate the terms of
the Warrants held by the Investors to acquire 6,880,000 shares of the Company's
Common Stock. The amended and restated Warrants (the "Amended Warrants") provide
for an exercise price of $1.07 per share and were issued upon surrender of the
Warrants which had an exercise price of $3.00 per share. The Amended Warrants
were valued at $3,156,000 based on management's estimate using certain
3
<PAGE> 5

fair value methodologies and represent an original issue discount to the C Notes
and D Notes. This discount is being amortized using the effective interest
method. The effective yield is 28.6% and 28.9% on the C Notes and D Notes,
respectively.

The Company used the proceeds from the sale of the E Notes and initial
amounts borrowed under the Loan Agreement (i) to pay off all amounts owed under
the Credit Agreement, (ii) to pay all amounts owed on the Trade Notes, and (iii)
to pay the remaining amounts owed to various seasonal trade vendors for credit
extended for inventory purchased by the Company for the 1999 Halloween,
Thanksgiving and year-end holiday seasons. All the remaining unpaid vendor
balances that were originally due May 1, 1999, were satisfied by individual
arrangements with such vendors.

GENERAL

The Company is a specialty retailer of party supplies through its network
of discount stores. At December 31, 1998, the Company owned and operated 207
Company-owned stores in the United States and its franchisees operated an
additional 167 stores in the United States, Puerto Rico, Canada, Portugal and
Spain. The Company, based in Rockaway, New Jersey, believes it is one of the
largest party supplies specialty chains. The Company authorized the first
franchise store in 1989 and opened its first Company-owned store in January
1994.

The Company operates and franchises party supplies stores that generally
range in size from 10,000 square feet to 12,000 square feet. These stores offer
a broad selection of merchandise (branded as well as private label) for a wide
variety of celebratory occasions, including birthday parties, weddings, and baby
showers as well as seasonal events such as Halloween, Christmas, New Year's Eve,
Graduation, Easter, Valentine's Day, Thanksgiving, St. Patrick's Day, the Super
Bowl and the Fourth of July. Party City seeks to offer customers a "one-stop"
party store that provides a wide selection of merchandise at everyday low
prices. A key element of delivering customer satisfaction is stocking inventory
in sufficient quantities to satisfy customer needs for parties of virtually all
sizes and types.

INDUSTRY OVERVIEW

The retail party supplies business has traditionally been fragmented, with
consumers purchasing party-related products from single owner-operated party
supplies stores and designated departments in drug stores, general mass
merchandisers, supermarkets, and department stores of local, regional and
national chains. According to industry sources, the market for party and special
occasion merchandise, comprised of party supplies, greeting cards, gift wrap and
related items had estimated retail sales of $11.5 billion in 1998.

The Company believes that the increasing breadth of party supplies
merchandise produced by manufacturers over the past few years has been a driving
factor in the marketplace's acceptance of the party supplies store concept.
Further, the Company believes that the significant revenues experienced by its
Company-owned and franchise stores in the fourth calendar quarter can be
attributed, to a large extent, to the growth in the number of persons
celebrating Halloween and the increased demand for costumes and party supplies
utilized in such celebrations. The Company has noted the marketplace's
acceptance of other types of superstores and mega-retailers in various
categories such as food, home furnishings and pet supplies, among others. The
success of such superstores and mega-retailers in other industries has prompted
the Company to expand its product lines to include a wider breadth of
merchandise in order to make its stores increasingly attractive destination
shopping locations for party supplies. In addition, the Company believes that
the increased breadth of related and integrated merchandise available to
customers in superstores and mega-retailers influences

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consumers to increase the number of purchases in a given trip to a retailer. As
such, the Company believes that the broad selection, and relatively low price
points, of merchandise offered by its stores often stimulates customers to
purchase additional items on impulse.

BUSINESS STRATEGY

The Company's objective is to continue to expand its position as a leading
category-dominant national chain of party supplies stores. The Company believes
that it has transformed the party supplies business by introducing increased
product and marketing focus and greater mass merchandising sophistication. Key
components of the Company's strategy are:

Offer the Broadest Selection of Merchandise in an Exciting Shopping
Environment. The Company tries to provide party-planners and party-goers
with convenient one-stop shopping for party supplies and offers what it
believes is one of the most extensive selections of party supplies. A
typical Party City store contains approximately 14,000 SKUs. Within its
many product categories, Party City offers a wide variety of patterns,
colors and styles. The Company has been expanding the range of items which
it offers in order to create consumer loyalty and generate repeat business
by striving to maintain a new and exciting product selection. Further, the
Company believes that its broad selection of merchandise and relatively low
price points often stimulates consumers to purchase additional party
supplies on impulse.

Establish Convenient Store Locations. While the Company believes that
its stores typically are destination shopping locations, it seeks to
maximize customer traffic and quickly build the visibility of new stores by
situating its stores in high traffic areas. Site selection criteria
include: population density; demographics; traffic counts; complementary
retailers; storefront visibility and presence (either in a stand-alone
building or in a strip or power shopping center); competition; lease rates;
and accessible parking. The Company believes there is an extensive number
of suitable locations available for future stores.

Maintain Everyday Low Pricing. The Company, using the buying power of
its Company-owned and franchise stores, obtains volume discounts from its
vendors on most products, allowing the stores to offer a broad line of high
quality merchandise at competitive prices. The Company reinforces
customers' expectations of savings by prominently displaying signs
announcing its everyday low prices. The Company also maintains a lowest
price guaranty policy, to which it suggests its franchisees adhere; this
policy guarantees that Party City will meet and discount the advertised
prices of a competitor's products. The Company believes that this policy
has helped foster the Company's image of offering consumers exceptional
value for their money.

Provide Excellent Customer Service. The Company views the quality of
its customers' shopping experience as critical to its continued success.
The Company is committed to making shopping in its stores an enjoyable
experience through the employment of friendly, knowledgeable and energetic
sales associates who provide customers with personalized shopping
assistance. At Halloween, an important selling season for the Company, each
store increases significantly the number of sales associates in the store
to ensure prompt service. Sales associates assist customers in selecting or
finding a certain item, which provides the sales associates with a
cross-selling opportunity to suggest accessories or other complementary
products. The Company believes that the compensation of its store managers
and other personnel is competitive and enables the Company to attract and
retain well-qualified, motivated employees who are committed to providing
excellent customer service.

EXPANSION PLANS

The Company's long-term goal regarding expansion is to increase its market
share in existing markets and penetrate new markets with a goal of expanding its
position as a category-dominant retailer of party supplies merchandise. The
Company intends to focus its efforts to create the necessary management
infrastructure and control environment to support continued growth. Over the
next few years, the Company intends to balance growth between Company-owned
stores and opening franchise stores to meet its growth objectives.

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STORE LOCATIONS

As of December 31, 1998, there were 374 Party City stores open in the
United States, Canada, Puerto Rico, Portugal and Spain. Of these, 207 were
Company-owned and 167 were operated by the Company's independent franchisees.
The following table shows the growth in the Company's network of stores during
the last five years.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
------------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
COMPANY-OWNED:
Stores open at beginning of year........................ -- 7 16 36 117
Stores opened........................................... 7 9 20 57 81
Stores acquired from franchisees........................ -- -- -- 24 9
--- --- --- --- ---
Stores open at end of year.............................. 7 16 36 117 207
FRANCHISE:
Stores open at beginning of year........................ 58 99 132 164 158
Stores opened........................................... 42 35 32 19 19
Stores closed........................................... (1) (2) -- (1) (1)
Stores purchased by the Company......................... -- -- -- (24) (9)
--- --- --- --- ---
Stores open at end of year.............................. 99 132 164 158 167
--- --- --- --- ---
TOTAL COMPANY AND FRANCHISE STORES.............. 106 148 200 275 374
=== === === === ===
</TABLE>

The Company typically seeks sites for new stores that are stand-alone
buildings or which are located in a strip or power shopping center near high
traffic routes. The Company seeks to lease sites rather than own the real
estate. Often the site may be a shopping center under construction or renovation
and may be available for occupancy typically in a period ranging from three
months to one year. The Company's site selection criteria include, but are not
limited to: population density, demographics, traffic count, complementary
retailers, storefront visibility and presence, competition, lease rates, and
accessible parking. In addition, the Company carefully considers the presence of
existing, and the potential for future, competition in the market when selecting
a site. The Company believes there is an extensive number of suitable locations
available for future sites. All Company-owned stores are in leased locations.

MERCHANDISING

Store Layout.

Party City stores are designed to give the shopper a feeling of excitement
and create a festive atmosphere. The Company's goal is for the customer to be
pleasantly surprised by his or her shopping experience. The Company's strategy
to achieve this goal is to maintain an in-stock position of the widest selection
of party supplies; this helps ensure that the Company will reduce the
possibility of missed sale opportunities.

Party City stores range in size from 6,750 to 15,876 square feet with a
typical store size between 10,000 and 12,000 square feet. The stores are divided
into various sections of different categories of party supplies, displayed to
emphasize the everyday low prices and breadth of merchandise available. The
floor plan is designed to impress the customer with the broad selection in each
product category.

Product Categories.

The typical Party City store offers a broad selection of merchandise
consisting of over 14,000 SKUs divided into the following categories:

Halloween. An important merchandising concept for Party City stores
is to provide an extensive selection of costumes for Halloween through its
"Halloween Costume Warehouse(R)" department. The stores also carry a broad
array of decorations and accessories for the Halloween season. The
Halloween merchandise is prominently displayed to provide an exciting and
fun shopping experience for customers.

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The Company, because of the buying power of the Party City system, is often
able to obtain supplies of the most sought after Halloween-related
merchandise. The stores display Halloween-related merchandise throughout
the year to position the Company as the customer's Halloween shopping
resource. The Company believes that the importance of Halloween, among both
young children and adults, is growing significantly.

Seasonal. Customer purchases made for seasonal holiday events compose
a significant part of Party City's business. The seasonal category includes
products which are carried for the Super Bowl, Valentine's Day, St.
Patrick's Day, Passover, Easter, First Communion, graduation, the Fourth of
July, Christmas, Hanukkah and New Year's Eve. Some of the major items
within this category are tableware, decorations, cutouts, lights and
balloons tailored to the particular event.

Birthdays. The birthday product category includes a wide assortment
of merchandise to fulfill customer needs for celebrating birthdays,
including special ones such as "first," "sweet sixteen" and other milestone
birthdays such as 40th and 50th birthdays. Some of the products in this
category include invitations, thank you cards, tableware, hats, horns,
banners, cascades, balloons, novelty gifts, pinatas and candies.

Party Favors. The Company maintains a party favors department which
includes a broad selection of packaged and bulk favors appealing to
different age groups. The assortment includes different product lines
varying in price points designed to offer customers a variety of purchasing
options.

Candy. The candy product category includes novelty and packaged candy
sold to enhance children's parties or to be used as pinata fillers. Candy
is sold both in individual units and in bulk packaging for customers'
convenience.

Balloons. The Company maintains a balloon department which carries a
wide selection of basic and decorative latex balloons in many sizes,
qualities, colors and package sizes. The mylar balloon department consists
of numerous sizes, shapes and designs relating to birthday, seasonal,
anniversary and other themes.

Baby Shower. The Company maintains a baby shower department, which
includes tableware, decorations, balloons, favors, centerpieces and
garlands.

Bridal/Wedding/Anniversary. This product category includes
personalized invitations, tableware, balloons, favors, place setting cards,
confetti, honeycomb bells and personalized ribbons. Personalized invitation
books, which contain numerous samples of customizable event invitations,
are carried from the leading invitation stationers at discounted prices.

Catering Supplies. Party City stores offer a broad selection of
catering supplies that consists of trays, platters, foil, bowls, warming
racks and fuel.

Gift Wrap. This product category includes wide assortments of gift
bags, bows, tissue paper, ribbons (both solid and printed), glossy printed
bags, solid gift wrap, printed gift wrap and foil gift wrap.

Greeting Cards. This product category includes greeting cards from a
quality national card vendor at everyday low prices.

General. The Company carries a wide range of other products,
including decorative tableware, solid tableware, plastic and paper table
covers, cutlery, crepe paper, cups and tumblers. Party City stores carry
private label items, as well as its typical branded merchandise.

Product Selection, Purchasing and Suppliers.

The Company's management continuously reviews new and existing product
selections to provide the widest and most current assortment of party supplies.
In pursuit of this goal, management attends various industry trade shows
including the National Annual Halloween Trade Show in Rosemont, Illinois and the
Toy Fair in New York. In an effort to keep abreast of new and popular
merchandise, management views presentations given specifically for the Company
by its major vendors. The Company utilizes its inventory tracking system to give
the purchasing staff constant feedback on customers' preferences.
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<PAGE> 9

The Company had two suppliers which in total constituted 24% of the
Company's purchases for the year ended December 31, 1998. The loss of either one
or both of these suppliers would adversely affect the Company's operations. The
Company considers numerous factors in supplier selection, including price,
credit terms, product offerings and quality. The Company negotiates pricing with
suppliers on behalf of all stores in the system (both Company-owned and
franchise) and believes that such buying power enables it to not only receive
the most favorable pricing terms, but, as importantly, to more readily obtain
high demand merchandise, especially popular Halloween costumes.

In order to maintain consistency throughout its store network, the Company
has established an approved list of items that are permitted to be sold in Party
City stores. Pursuant to the terms of the Company's franchise agreements,
franchise stores must adhere to these guidelines. The Company establishes a
standard store merchandise layout and presentation format to be followed by
Company-owned and franchise stores. Any layout or format changes developed by
the Company are communicated to the managers of stores on a periodic basis. All
of the merchandise purchased by Party City stores is shipped directly from
suppliers to the stores.

STORE OPERATIONS

Each Party City store is typically managed by a general manager and two
assistant managers. These managers are responsible for all aspects of the
store's day-to-day operations, including employee hiring and training, work
scheduling, inventory control, expense control, maintenance activities and
communications with central office staff. The sales and stocking staff ranges
from three to eight people, except during certain holiday selling seasons when
additional store employees are used. The Company seeks to pay its store managers
toward the higher end of the competitive pay scale in order to hire and retain
experienced and dedicated managers. In addition, store managers are eligible for
stock option grants under the Company's stock option plan.

Training. In Company-owned stores, corporate store managers are trained
for a minimum of two weeks prior to the opening of a store. During the store
set-up, a manager receives additional training from the Company's store set-up
team. During the first few days after the initial opening of a store, corporate
headquarters' personnel spend concentrated time in the store overseeing the
operations.

In franchise locations, all new franchisees go through a comprehensive
training program consisting of one week in the classroom and one week in the
store to learn the fundamentals of the store's operation. During the set up of
their store, the franchisee receives additional training from the team leader of
the set-up crew that is dispatched by the Company to assist the franchisee with
the store opening. Shortly after a store opens, a representative from the
Company visits the franchise and spends several days assisting with the
day-to-day operations of running the store. To ensure efficient operations and
that the systems, policies and processes are being followed, subsequent visits
are scheduled on a regular basis to review what was covered during the initial
training.

CUSTOMER SERVICE

Customer service and shopping convenience are integral components of Party
City's one-stop shopping concept. The Company views the quality of its
customers' shopping experience as critical to its continued success. To this
end, the Company seeks to employ friendly, knowledgeable and energetic sales
associates who provide customers with personalized shopping assistance. For
example, at Halloween, the most important selling season for the Company, each
store increases significantly the number of sales associates in the store. These
employees will assist customers in selecting a costume, which provides the sales
associates with a cross-selling opportunity to suggest various accessories and
other complementary products. Also, at Halloween the associates utilize two-way
radios, which the Company believes help stock personnel to quickly fill
requested items, thus expediting sales and reducing lost business caused by slow
service.

The Company believes that the compensation of its store managers and other
personnel is competitive and enables the Company to attract and retain
well-qualified, highly motivated employees who are committed to providing
excellent customer service.
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<PAGE> 10

COMPANY-OWNED STORES

At December 31, 1998, there were 207 Company-owned Party City stores,
including 81 stores opened in 1998 and nine franchise stores purchased by the
Company in 1998 at December 31, 1998, the Company's stores are located in the
following States:

<TABLE>
<CAPTION>
DECEMBER 31
------------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
STATE:
California.............................................. 1 2 8 21 36
Connecticut............................................. 1 1 1 3 4
Florida................................................. 2 3 6 11 18
Illinois................................................ 1 1 3 8 15
New York................................................ 1 2 7 16 33
Pennsylvania............................................ 1 1 1 5 8
Maryland................................................ -- 1 2 3 4
Michigan................................................ -- 4 5 7 7
Ohio.................................................... -- 1 1 2 7
Nevada.................................................. -- -- 1 2 3
New Jersey.............................................. -- -- 1 9 14
Indiana................................................. -- -- -- 5 5
Minnesota............................................... -- -- -- 3 5
Missouri................................................ -- -- -- 3 3
Texas................................................... -- -- -- 15 22
Virginia................................................ -- -- -- 3 5
Wisconsin............................................... -- -- -- 1 1
Colorado................................................ -- -- -- -- 2
Kentucky................................................ -- -- -- -- 1
Georgia................................................. -- -- -- -- 1
Kansas.................................................. -- -- -- -- 1
Massachusetts........................................... -- -- -- -- 3
North Carolina.......................................... -- -- -- -- 2
Tennessee............................................... -- -- -- -- 4
Utah.................................................... -- -- -- -- 1
Washington.............................................. -- -- -- -- 2
-- -- -- --- ---
TOTAL........................................... 7 16 36 117 207
== == == === ===
</TABLE>

Of the leases for the stores listed above, one expires in 1999, four expire
in 2001, five in 2002 and the balance in 2003 or thereafter.

FRANCHISE OPERATIONS

Until opening its first Company-owned store in January 1994, the Company
operated exclusively as a franchisor. As of December 31, 1998, the Company was
the franchisor for 167 Party City franchise stores throughout the United States,
Puerto Rico, Canada, Portugal and Spain. A Party City store run by a franchisee
utilizes the Company's format, design specifications, methods, standards,
operating procedures,

9
<PAGE> 11

systems and trademarks. At December 31, 1998, the Company's 167 franchise stores
are located in the following states and foreign countries:

<TABLE>
<S> <C>
Alabama..................................................... 6
Arizona..................................................... 6
Arkansas.................................................... 1
California.................................................. 9
Colorado.................................................... 1
Connecticut................................................. 4
Delaware.................................................... 1
Florida..................................................... 14
Georgia..................................................... 15
Hawaii...................................................... 1
Illinois.................................................... 1
Kansas...................................................... 2
Louisiana................................................... 6
Maryland.................................................... 4
Mississippi................................................. 1
Missouri.................................................... 1
New Jersey.................................................. 18
New Mexico.................................................. 2
New York.................................................... 10
North Carolina.............................................. 11
Ohio........................................................ 3
Oregon...................................................... 3
Pennsylvania................................................ 8
South Carolina.............................................. 4
Tennessee................................................... 4
Texas....................................................... 8
Virginia.................................................... 5
Puerto Rico................................................. 4
Canada...................................................... 10
Portugal.................................................... 1
Spain....................................................... 3
---
TOTAL............................................. 167
===
</TABLE>

The Company receives revenue from its franchisees, including an initial
one-time fee ($35,000 at December 31, 1998) and an ongoing royalty fee (4.0% of
net sales for new franchisees, payable monthly at December 31, 1998). In
addition, each franchisee has a mandated advertising budget, which consists of a
minimum of $5,500 to promote the initial store opening and thereafter the lesser
of 3.0% of net sales or $60,000 per year for local advertising and promotions.
Further, the franchisee must pay an additional 1.0% of net sales to a Party City
group advertising fund to cover common advertising materials related to the
Party City store concept. The Company does not offer financing for a
franchisee's initial investment. A franchisee's start-up costs include the
franchise fee, rent, leasehold improvements, equipment and furniture, initial
inventory, opening promotion, signs, other deposits, insurance, training
expenses and professional fees.

Current franchise agreements provide for an assigned area or territory that
typically equals a three-mile radius from the franchisee's store location and
the right to use the Party City logo type and trademark "The Discount Party
Super Store.(R)" In most stores, the franchisee or the majority shareholder of a
corporate franchisee devotes full time to the management, operation and
on-premises supervision of the franchise.

10
<PAGE> 12

Although such locations are generally obtained and secured by the
franchisee, pursuant to the franchise agreement entered into with franchisees,
all site locations must be approved by the Company. As franchisor, Party City
also supplies valuable and proprietary information pertaining to the operation
of the Party City Super Store business, as well as advice regarding location,
improvements and promotion. The Company also supplies consultation in the areas
of purchasing, inventory control, pricing, marketing, merchandising, hiring,
training, improvements and new developments in the franchisee's business and
general business operations, as well as the provision of assistance in opening
and initially promoting the store.

As of December 31, 1998 the Company had seven territory agreements with
certain franchisees. These agreements permit the holder of the territory rights
to open a minimum of two and in some cases three or more stores within a stated
time period. If stores are not opened pursuant to the schedule, the territory
agreement may be terminated. The following areas are governed by territory
agreements: North Carolina; Louisiana/Alabama; Phoenix, AZ and Santa
Fe/Albuquerque, NM; Atlanta, GA; Canada; Spain/Portugal; Puerto Rico.

COMPETITION

The party supplies retailing business is highly competitive. Party City
stores compete with a variety of smaller and larger retailers, including single
owner-operated party supplies stores, specialty party supplies retailers
(including superstores), designated departments in drug stores, general mass
merchandisers, supermarkets and department stores of local, regional and
national chains. Many of these competitors have substantially greater financial
resources than the Company.

Management believes that Party City stores maintain a leading position in
the party supplies business by offering a wider breadth of merchandise, greater
selection within merchandise class and discount prices offered on most items in
the stores. The Company believes that the significant buying power resulting
from the size of the Party City store system is an integral advantage.

TRADEMARKS

The Company has licensed from a wholly-owned subsidiary a number of
trademarks and service marks registered with the United States Patent and
Trademark Office, including the marks Party City(R), The Discount Party Super
Store(R) and Halloween Costume Warehouse(R).

GOVERNMENT REGULATION

As a franchisor, the Company must comply with regulations adopted by the
Federal Trade Commission (the "FTC") and with several state laws that regulate
the offer and sale of franchises. The Company also must comply with a number of
state laws that regulate certain substantive aspects of the
franchisor-franchisee relationship. The FTC's Trade Regulation Rule on
Franchising (the "FTC Rule") requires that the Company furnish prospective
franchisees with a franchise offering circular containing information prescribed
by the FTC Rule. State laws that regulate the offer and sale of franchises
require the Company to register before the offer and sale of a franchise can be
made in that state.

State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees and by regulating discrimination among franchisees
with regard to charges, royalties or fees. Those laws also restrict a
franchisor's rights with regard to the termination of a franchise agreement (for
example, by requiring "good cause" to exist as a basis for the termination) by
requiring the franchisor to give advance notice to the franchisee of the
termination and give the franchisee an opportunity to cure any default, and by
requiring the franchisor to repurchase the franchisee's inventory or provide
other compensation. To date, those laws have not precluded the Company from
seeking franchisees in any given area and have not had a material adverse effect
on the Company's operations.

11
<PAGE> 13

Each Party City store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties or failures
in obtaining the required licenses or approvals can delay and sometimes prevent,
the opening of a new store.

Party City stores must comply with federal and state environmental
regulations, but the cost of complying with those regulations has not been
material. More stringent and varied requirements of local governmental bodies
with respect to zoning, land use, and environmental factors can delay, and
sometimes prevent, development of new stores in particular locations.

The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters such as minimum wages,
overtime and other working conditions. The Company and its franchisees also must
comply with the provisions of the Americans with Disabilities Act, which require
that employers provide reasonable accommodation for employees with disabilities
and that stores be accessible to customers with disabilities.

EMPLOYEES

As of December 31, 1998, the Company employed approximately 1,750 full-time
and 2,960 part-time employees. The Company considers its relationships with its
employees to be good. None of the Company's employees is covered by a collective
bargaining agreement.

ITEM 2. PROPERTIES

As of December 31, 1998, the Company leased all of its 207 stores. The
Company maintains its headquarters at 400 Commons Way, Rockaway, New Jersey
07866. At December 31, 1998, the Company occupied approximately 12,201 square
feet of office space for its headquarters under a lease expiring in 2005.

ITEM 3. LEGAL PROCEEDINGS

Securities Litigation

The Company has been named as a defendant in the following twelve class
action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David
Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp.
and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party
City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4)
Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No.
99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David
Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven
Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party
City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven
Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City
Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel
v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No.
99-CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber,
Civ. Action No. 99-CV-2238; and (12) Gross v. Party City Corp., Steven Mandell
and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief
Executive Officer and former Chief Financial Officer and Executive Vice
President of Operations have also been named as defendants. The complaints have
all been filed in the United States District Court for the District of New
Jersey. The complaints were filed as class actions on behalf of persons who
purchased or acquired Party City common stock during various time periods
between February 1998 and March 19, 1999. In October 1999, plaintiffs filed an
amended class action complaint and in February 2000, plaintiffs filed a second
amended complaint.

The second amended class action complaint alleges, among other things,
violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934
and Rule 10b-5 promulgated thereunder, and seeks unspecified damages. The
plaintiffs allege that defendants issued a series of false and misleading
statements and failed to disclose material facts concerning, among other things,
the Company's financial condition, adequacy of internal controls and compliance
with certain loan covenants. The plaintiffs further allege that because of the

12
<PAGE> 14

issuance of a series of false and misleading statements and/or failure to
disclose material facts, the price of Party City common stock was artificially
inflated.

Defendants have moved to dismiss the second amended complaint on the ground
that it fails to state a cause of action. The Court has not yet issued a
decision with respect to the motion to dismiss. Because this case is in its
early stages, no opinion can be expressed as to its likely outcome.

Other

The Company was named as a defendant in a complaint filed with the Supreme
Court of the State of New York, County of New York, on January 16, 1998 (the
"Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung,
Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of
Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in
the suit have existing Party City franchise stores, with the remaining plaintiff
possessing a right of first refusal to develop a Party City store in Watchung,
New Jersey.

The Complaint stated various causes of action, including unjust enrichment,
unfair competition, fraud and misrepresentation, breach of contract,
misappropriation of information and violations of the New Jersey Franchise
Practices Act and the New York State Franchise Sales Act. The crux of the
Complaint was that the Company undertook a course of conduct intentionally
designed to adversely impact the value of the Plaintiffs' franchise stores in
order to permit the Company to purchase such stores at a substantially reduced
value. The Company settled the lawsuit on June 30, 1999, at no cost to the
Company. In connection with the settlement, the Company agreed to sell the
plaintiff one store at its fair value.

On April 23, 1999, plaintiff Emil Asch, Inc. filed a Complaint in the
United States District Court for the Eastern District of New York against the
Company and co-defendants Amscan, Inc., Hallmark, Inc., and Rubie's Costume. The
Complaint alleges five violations of the Robinson-Patman Act, which pertains to
price discrimination, unfair competition, tortious interference with contractual
relations, and false and deceptive advertising.

Plaintiff seeks damages of $2 million, as well as treble and/or punitive
damages for certain counts. On February 3, 2000, Emil Asch amended its Complaint
by adding Ron's: The Party Store, Inc., as an additional plaintiff to the suit.
The Amended Complaint asserts the same causes of action against the same
defendants and seeks the same damages that were sought in the original
Complaint. The Company has answered the Amended Complaint, and discovery is
proceeding. At this point, no opinion can be expressed as to the likely outcome
of the litigation.

Although the Company's management is unable to express a view on the likely
outcome of these litigations because they are in their early stages, they could
have a material adverse effect on the Company's business and results of
operations.

In addition to the foregoing, the Company is from time to time involved in
routine litigation incidental to the conduct of its business. The Company is
aware of no other material existing or threatened litigation to which it is or
may be a party.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended December 31, 1998.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's common stock traded on the Nasdaq National Market under the
symbol "PCTY" until the Company was delisted on July 20, 1999. The Common Stock
now trades on the OTC Bulletin Board, an electronic quotation service for NASD
Market Makers. There can be no assurance that the common stock will continue to
trade on the OTC Bulletin Board. It is the Company's intention to again seek to
be listed on Nasdaq if and when the Company satisfies the requirements for
listing.

13
<PAGE> 15

The following table sets forth the high and low closing sales prices of the
common stock through December 31, 1998.

<TABLE>
<CAPTION>
HIGH LOW
------------ ------------
<S> <C> <C>
1998
December 31, 1998........................................... 21 9 3/16
September 30, 1998.......................................... 30 19/32 8 11/16
June 30, 1998............................................... 35 1/4 24 3/4
March 31, 1998.............................................. 35 16 3/4
1997
December 31, 1997........................................... 21 1/2 15 15/16
September 30, 1997.......................................... 20 1/16 10 3/4
June 30, 1997............................................... 11 1/8 8 7/8
March 31, 1997.............................................. 11 1/8 10
</TABLE>

At September 20, 2000, the approximate number of holders of record of the
common stock was approximately 5,700.

DIVIDENDS

Except for the S Corporation distribution of a portion of previously
undistributed earnings to the Company's stockholders in 1994 upon the Company's
election to be taxed as a C Corporation, the Company has never paid cash
dividends on its capital stock and does not intend to pay cash dividends for the
foreseeable future. The Company expects that earnings will be retained for the
continued growth and development of the Company's business. Future dividends, if
any, will depend upon the Company's earnings, financial condition, working
capital requirements, compliance with covenants in agreements to which the
Company is or may be subject, future prospects and other factors deemed relevant
by the Company's Board of Directors. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Liquidity and Capital
Resources."

UNREGISTERED SECURITIES

On August 17, 1999 the Company issued the Notes and the Warrants to the
Investors for an aggregate of $30 million. The Investors were led by Tennenbaum
& Co., LLC, a Los Angeles-based investment firm.

The Amended Warrants are exercisable for an aggregate of 6,880,000 shares
of Common Stock at an initial exercise price of $1.07 per share and may be
exercised at any time before 5:00 p.m. (New York City time) on August 16, 2006.
The shares of Common Stock reserved for issuance under the Amended Warrants
represent approximately 35% of the shares of Common Stock outstanding after
giving effect to the exercise of the Amended Warrants. The private placement of
the issuance and sale of the Notes and Amended Warrants to the Investors was
exempt from the registration requirements of the Securities Act of 1933, as
amended (the "Securities Act"), pursuant to Section 4 (2) of the Securities Act.

ITEM 6. SELECTED FINANCIAL DATA

The following Selected Financial Data for each of the years ended December
31, 1994 and 1995 are derived from financial statements of the Company not
included herein. The selected Consolidated Balance Sheet as of December 31, 1997
and 1998 and the selected Consolidated Statements of Operations for the three
years ended December 31, 1998 are derived from the consolidated financial
statements of the Company, included elsewhere in this Annual Report on Form
10-K, which have been audited by Deloitte & Touche LLP, independent public
accountants, as stated in their report appearing elsewhere herein. The financial
data set forth below should be read in conjunction with "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and the
Consolidated Financial Statements, including the notes thereto appearing
elsewhere in this Annual Report on Form 10-K. On December 18, 1997, the Board of
Directors

14
<PAGE> 16

declared a three-for-two common stock split effective January 16, 1998. The
common stock data has been retroactively adjusted for the stock split.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------------
1994 1995 1996 1997 1998
------ ------- ------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA)
------------------------------------------------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Total revenue................................ $8,853 $23,120 $48,591 $141,714 $294,334
====== ======= ======= ======== ========
Company-owned stores
Net sales.................................. $3,992 $16,118 $39,144 $131,028 $282,923
Cost of goods sold and occupancy costs..... 2,687 10,758 25,937 86,372 194,761
------ ------- ------- -------- --------
Gross profit............................... 1,305 5,360 13,207 44,656 88,162
Store operating and selling expense........ 1,240 4,255 10,116 31,880 73,970
------ ------- ------- -------- --------
Company-owned stores profit contribution... 65 1,105 3,091 12,776 14,192
Franchise stores:
Royalty fees............................... 3,836 6,075 8,512 10,224 10,841
Franchise fees............................. 1,025 927 935 462 570
------ ------- ------- -------- --------
Total franchise revenues................... 4,861 7,002 9,447 10,686 11,411
Total franchise expense.................... 2,050 2,944 3,729 3,998 4,114
------ ------- ------- -------- --------
Franchise profit contribution.............. 2,811 4,058 5,718 6,688 7,297
General and administrative expenses.......... 1,930 3,024 3,160 7,049 15,939
------ ------- ------- -------- --------
Income before interest and income taxes...... 946 2,139 5,649 12,415 5,550
Interest expense (income), net............... (62) (23) (476) (212) 2,636
------ ------- ------- -------- --------
Income before income taxes................... 1,008 2,162 6,125 12,627 2,914
Income taxes................................. 466 863 2,369 4,957 1,127
------ ------- ------- -------- --------
Net income................................... $ 542 $ 1,299 $ 3,756 $ 7,670 $ 1,787
====== ======= ======= ======== ========
Basic earnings per share..................... (a) $ 0.16 $ 0.38 $ 0.65 $ 0.14
======= ======= ======== ========
Diluted earnings per share................... (a) $ 0.16 $ 0.38 $ 0.64 $ 0.14
======= ======= ======== ========
Weighted average shares
outstanding -- Basic....................... 7,513 7,984 9,802 11,749 12,411
Weighted average shares
outstanding -- Diluted..................... 7,513 7,984 9,996 12,039 12,704
EBITDA (b)................................... $1,045 $ 2,461 $ 6,395 $ 15,209 $ 12,148
====== ======= ======= ======== ========
OPERATING DATA:
Number of Company-owned stores (end of
year)...................................... 7 16 36 117 207
Increase in Company-owned same store sales... NA 26.6% 17.9% 15.5% 11.3%
Number of franchise stores (end of year)..... 99 132 164 158 167
Increase in franchise same store sales....... 13.1% 10.3% 19.5% 14.8% 6.8%
Average sales per Company-owned store........ $ 570 $ 1,510 $ 1,662 $ 1,740 $ 1,684
Depreciation and amortization................ 99 322 746 2,794 6,598
BALANCE SHEET DATA:
Working capital (deficiency)................. $2,088 $ 1,999 $17,419 $ 13,931 $(15,039)
Total assets................................. 6,009 10,308 34,603 89,615 144,032
</TABLE>

15
<PAGE> 17

---------------
(a) Until April 1994, the Company elected to be taxed as an S Corporation under
the Internal Revenue Code. If the Company had been taxed as a C Corporation
for the year ended December 31, 1994, pro forma income taxes, pro forma net
income and pro forma basic and diluted earnings per share would have been
$410,000, $598,000 and $0.08, respectively.

(b) The Company's definition of EBITDA is earnings before interest, taxes,
depreciation and amortization.

(c) Excludes borrowings under the Credit Agreement of $46.8 million included in
current liabilities at December 31, 1998.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

RESULTS OF OPERATIONS

The Company's revenues and earnings are generated primarily from its two
business segments -- Retail and Franchising.

Year Ended December 31, 1998 Compared to Year Ended December 31, 1997

A summary of the Company's new store openings, store acquisitions and store
sales is as follows:

<TABLE>
<CAPTION>
NEW TOTAL
STORES STORES STORES BEGINNING END OF
OPENED ACQUIRED ADDED OF PERIOD PERIOD
------ -------- ------ --------- ------
<S> <C> <C> <C> <C> <C>
Quarter ended
March 31, 1997................................ 6 6 12 36 48
June 31, 1997................................. 9 -- 9 48 57
September 30, 1997............................ 29 18 47 57 104
December 31, 1997............................. 13 -- 13 104 117
-- -- --
57 24 81

Quarter ended
March 31, 1998................................ 12 1 13 117 130
June 31, 1998................................. 15 3 18 130 148
September 30, 1998............................ 40 5 45 148 193
December 31, 1998............................. 14 -- 14 193 207
-- -- --
81 9 90
</TABLE>

Retail. Net sales from Company-owned stores increased 116% to $282.9
million in the year ended December 31, 1998 from $131.0 million in the year
ended December 31, 1997. The 1998 results include 117 stores which were open at
the beginning of that year plus 81 stores opened during the year and nine stores
acquired during the year. Of the total sales increase, 48.8% is attributable to
new store openings in 1998. Same store sales increased 11.3% in 1998. Gross
profit reflects the cost of goods sold and store occupancy costs including rent,
common area maintenance, real estate taxes, repair and maintenance, depreciation
and utilities. Gross profit for the year ended December 31, 1998 increased 97.4%
to $88.2 million compared to $44.7 million in 1997. The increase in 1998 was
primarily due to increased sales volume. Gross margin was 31.2% and 34.1% of
sales for the years ended December 31, 1998 and 1997, respectively. The decrease
in gross margin was related primarily to increases in the provision for
slow-moving inventory of $2.8 million and increased inventory losses of $2.1
million as compared to the loss experience in 1997. Additionally, the gross
margin percentage was effected by increased store occupancy costs of $4.0
million without a corresponding increase in sales.
16
<PAGE> 18

Store operating and selling expenses increased 132% to $74.0 million for
the year ended December 31, 1998 compared to $31.9 million in 1997. The increase
in store operating expenses is primarily attributable to the increased number of
stores operated by the Company during 1998. Store operating expenses were 26.1%
and 24.3% of sales for 1998 and 1997, respectively, due to increased store
operating payroll costs related to new store openings. Company-owned store
profit contribution was $14.2 million for the year ended December 31, 1998,
compared to a profit contribution of $12.8 million for 1997.

Franchising. Franchise revenue is composed of the initial franchise fees
which are recorded as revenue when a franchise store opens, and ongoing royalty
fees, generally 4.0% of the store's net sales. Royalty fees increased 6.1% to
$10.8 million in the year ended December 31, 1998 from $10.2 million in 1997.
Franchise fees, recognized on 19 store openings during the year ended December
31, 1998 increased 23.4% to $570,000 compared to $462,000 during 1997 recognized
on 19 store openings. Franchise same store sales increases for the years ended
December 31, 1998 and 1997 were 6.8% and 14.8%, respectively.

Expenses directly related to franchise revenue increased 2.9% to $4.1
million for the year ended December 31, 1998 from $4.0 million for the year
ended December 31,1997. This increase is primarily attributable to additional
franchise personnel required to operate this portion of the Company's business
and the necessary infrastructure to support such employees. As a percentage of
franchise revenue, franchise expenses were 36.0% and 37.4% for the years ended
December 31, 1998 and 1997, respectively.

Franchise profit contribution was increased 9.1% to $7.3 million for the
year ended December 31, 1998 compared to $6.7 million for the year ended
December 31, 1997. The increase in franchise profit contribution is due to the
increase in royalty fees and franchise fees, offset in part by an increase in
franchise expenses, as discussed above.

General and Administrative. General and administrative expenses increased
126% to $16.0 million in the year ended December 31, 1998 compared to $7.0
million in the year ended December 31, 1997. The increase is primarily
attributable to an increase in payroll and related benefits, recruitment and
moving of new employees, professional and consulting fees, and increased travel
as a result of establishing the organizational infrastructure to allow the
Company to build the Company owned store base. As a percentage of sales, general
and administrative expenses were 5.6% and 5.4% for the years ended December 31,
1998 and 1997, respectively.

Interest Expense. Interest expense increased to $2.6 million for the year
ended December 31, 1998 from interest income of $212,000 in the year ended
December 31, 1997. This is attributable to additional borrowings under the
Credit Agreement outstanding during the year related to store expansion.

Income Taxes. Income taxes decreased 77.3% to $1.1 million for the year
ended December 31, 1998 from $5.0 million for the year ended December 31, 1997.
This decrease is related primarily to the decrease in pre-tax earnings of 76.9%
for 1998 compared to 1997.

Net Income. Net income decreased 76.7% to $1.8 million or $0.14 per basic
and diluted share, in the year ended December 31, 1998 as compared to net income
of $7.7 million, or $0.65 per share in the year ended December 31, 1997. All
earnings per share data have been retroactively adjusted for the three-for-two
stock split that occurred on January 16, 1998.

Year Ended December 31, 1997 Compared to Year Ended December 31, 1996

Retail. Net sales from Company-owned stores increased 234% to $131.0
million in the year ended December 31, 1997 up from $39.1 million in the year
ended December 31, 1996. The 1997 results include 36 stores that were open at
the beginning of that year plus 57 stores opened during the year (of which 19
were opened in September, 10 in October, and three in December) and 24 stores
acquired during the year. The 1996 amount represents sales from 16 stores that
were open at the beginning of the year plus 20 stores opened during the year
(five of which were opened in September and two in October). Of the total sales
increase, 74.4% is attributable to new store openings in 1997. Same store sales
increased 15.5% in 1997. Gross profit reflects the cost of goods sold and store
occupancy costs including rent, common area maintenance, repair and maintenance,
depreciation and utilities. Gross profit for the year ended December 31, 1997
increased 238% to
17
<PAGE> 19

$44.7 million, compared to $13.2 million for the year ended December 31, 1996.
The increase in 1997 was due to increased sales volume. Gross margin was 34.1%
and 33.7% of sales for the years ended December 31, 1997 and 1996, respectively.

Store operating and selling expenses increased 216% to $31.9 million for
the year ended December 31, 1997 compared to $10.1 million for 1996. The
increase in store operating expenses is attributable to the increased number of
stores operated by the Company during 1997. Store operating expenses were 24.3%
and 25.8% of sales for the years ended December 31, 1997 and 1996, respectively.
Company-owned store profit contribution increased 313% to $12.8 million for the
year ended December 31, 1997, compared to a profit contribution of $3.1 million
for the comparable 1996 period.

Franchising. Franchise revenue is composed of the initial franchise fees
that are recorded as revenue when a franchise store opens, and ongoing royalty
fees, generally 4.0% of the store's net sales. Royalty fees increased 20.1% to
$10.2 million in the year ended December 31, 1997, up from $8.5 million in the
comparable 1996 period. The increase was attributable primarily to sales
increases in stores opened as of December 31, 1996. Franchise same store sales
increases for the years ended December 31, 1997 and 1996 were 14.8% and 19.5%,
respectively. Franchise fees, recognized on 19 store openings during the year
ended December 31, 1997 were $462,000 compared to $935,000 representing 32 store
openings during 1996. The reduction in franchise fees attributed to fewer store
openings was partially offset by the increase in such fees from $30,000 to
$35,000 per store with respect to franchise agreements signed after January 1,
1996.

Expenses directly related to franchise revenue increased 7.2% to $4.0
million for the year ended December 31, 1997 from $3.7 million for the year
ended December 31, 1996. As a percentage of franchise revenue, franchise
expenses were 37.4% and 39.5% for the years ended December 31, 1997 and 1996,
respectively. Franchise profit contribution was increased 17.0% to $6.7 million
for the year ended December 31, 1997, compared to $5.7 million for the year
ended December 31, 1996. The increase in franchise profit contribution is due to
the increase in royalty fees offset by a decrease in franchise fees and increase
in franchise expenses as discussed above.

General and Administrative Expense. General and administrative expenses
increased 123% to $7.0 million in the year ended December 31, 1997, compared
with $3.1 million in the year ended December 31, 1996. The increase is primarily
attributable to an increase in payroll and related benefits of approximately
$1.8 million as a consequence of establishing the necessary organizational
infrastructure to allow the Company to build its Company-owned store base,
professional fees increases of approximately $226,000 due primarily to increases
in legal and accounting fees and travel expense increases of approximately
$730,000 which increased primarily due to the increase in the number of stores.
In addition, the Company had other increases in general and administrative
expenses related to insurance, investor relations expenditures and general
corporate expenses. As a percentage of sales, general and administrative
expenses were 5.4% and 8.1% for the years ended December 31, 1997 and 1996,
respectively. This decrease as a percentage of revenue resulted from increased
leverage of general and administrative expenses over a larger sales base.

Interest Income. Interest income decreased 55.5% to $0.2 million during
the year ended December 31, 1997, as compared to $0.5 million during the year
ended December 31, 1996. This decrease related primarily to the decrease in
average funds available for investment during the period.

Income Taxes. The provision for income tax expense increased 109% to $5.0
million during for the year ended December 31, 1997 as compared to the $2.4
million recorded in 1996. This increase related primarily to the increase in
pre-tax earnings of 106% for the 1997 period over 1996.

Net Income. As a result of the foregoing factors, net income increased
104% to $7.7 million, or $0.65 per basic share and $0.64 per diluted share, in
the year ended December 31, 1997 compared with $3.8 million, or $0.38 per basic
and diluted share in the year ended December 31, 1996.

ACCOUNTING AND REPORTING CHANGES

In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 130 "Reporting
Comprehensive Income," which establishes standards for the reporting and display
of comprehensive income and its components (revenues, expenses, gains and

18
<PAGE> 20

losses) in a full set of general-purpose financial statements. This statement
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. Comprehensive income is equivalent to the Company's reported net
income. The adoption of this statement had no impact on the consolidated
financial statements.

Effective January 1, 1998, the Company adopted AICPA Statement of Position
(the "SOP") 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which requires the Company to capitalize certain
software development costs. Generally, once the capitalization criteria of the
SOP have been met, external direct costs of materials and services used in
development of internal-use software, payroll and payroll-related costs for
employees directly involved in the development of internal-use software and
interest costs incurred when developing software for internal use are to be
capitalized. The adoption of the SOP had no impact on the consolidated financial
statements because the SOP requires the change to be implemented prospectively.

Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information ("SFAS No. 131")." SFAS
No. 131 establishes standards for the way that business enterprises report
information about operating segments in financial statements and related
disclosures about products and services, geographical areas and major customers.
The Company has adopted this statement and expanded its disclosure of its retail
and franchise segments.

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
instruments and Hedging Activities ("SFAS No. 133")." SFAS No. 133 establishes
accounting and reporting standards for derivative instruments and hedging
activities. SFAS No. 133 requires an entity to recognize all derivatives as
either assets or liabilities in the statement of financial position and to
measure those instruments at fair value. For fiscal year 2001, the Company is
required to adopt SFAS No. 133. The Company has determined that the application
of SFAS No. 133 will not have a material impact on its financial position or
results of operations.

In November 1999, the SEC issued Staff Accounting Bulletin 101, "Revenue
Recognition." This bulletin sets forth the SEC Staff's position regarding the
point at which it is appropriate for a Registrant to recognize revenue. The
Staff believes that revenue is realizable and earned when all of the following
criteria are met: persuasive evidence of an arrangement exists; delivery has
occurred or service has been rendered; the seller's price to the buyer is fixed
or determinable; and collectibility is reasonably assured. The Company uses the
above criteria to determine whether revenue can be recognized, and therefore
believes that the issuance of this bulletin does not have a material impact on
its consolidated financial statements.

LIQUIDITY AND CAPITAL RESOURCES

The Company's cash used in operating activities was $2.7 million in the
year ended December 31, 1998 compared to cash provided by operating activities
of $9.0 million and $3.6 million in the years ended December 31, 1997 and
December 31, 1996, respectively. The decrease in cash provided by operating
activities in 1998 in comparison with 1997 was primarily attributable to
increases in merchandise inventories and other current assets as well as
increased store and corporate operating expenses, without corresponding
increases in accounts payable and accrued expenses as compared to 1997. The
increase in cash provided by operating activities in 1997 compared to 1996 was
primarily attributable to an increase in net income due to the increased number
of stores in operation in 1997.

Cash used in investing activities was $39.1 million, $39.9 million and $4.9
million in the years ended December 31, 1998, 1997 and 1996, respectively. Cash
used in investing activities in the year ended December 31, 1998 was spent
increasing the existing store base by 81 new stores and in the acquisition of
nine stores. The increase in cash used in investing activities in 1997 compared
to 1996 was attributable to increased purchases of property and equipment
necessary to support the growth in Company-owned stores and the acquisition of
24 franchise stores.

Cash provided by financing activities was $45.4 million, $19.2 and $15.2
for the years ended December 31, 1998, 1997 and 1996 respectively. The cash
provided by financing activities in 1998 was primarily attributable to
borrowings on the credit facility to finance store expansion. The cash provided
by financing

19
<PAGE> 21

activities in 1997 was primarily attributable to the proceeds of the Company's
secondary public offering as well as to borrowings on the credit facility.

See "Business -- Financing and Related Developments" for an explanation of
the Company's liquidity issues and subsequent financing developments.

IMPACT OF INFLATION

The Company believes that inflation did not have a material impact on its
operations for the periods reported. Significant increases in the cost of
merchandise purchased labor, employee benefits and other operating expenses
could have a material adverse effect on the Company's performance.

SEASONALITY

The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
and substantially all of its cash flow and net income for the year during the
fourth calendar quarter of the year, principally due to the sales in October for
the Halloween season and, to a lesser extent, due to sales for end of year
holidays. The Company's results of operations may also fluctuate significantly
as a result of a variety of other factors, including the timing of new store
openings.

FORWARD-LOOKING STATEMENTS

This Form 10-K (including the information incorporated herein by reference)
contains forward-looking statements within the meaning of The Private Securities
Litigation Reform Act of 1995. The statements are made a number of times
throughout the document and may be identified by forward-looking terminology as
"estimate," "project," "expect," "believe," "may," "will," "intend" or similar
statements or variations of such terms. Such forward-looking statements involve
certain risks and uncertainties, and include among others, the following: levels
of sales, store traffic, acceptance of product offerings, competitive pressures
from other party supplies retailers, availability of qualified personnel,
availability of suitable future store locations, schedules of store expansion
plans and year 2000 readiness issues relating to the Company's internal systems
and those of third parties, the ability of the Company to refinance its existing
debt on terms acceptable to it and other factors. As a result of the foregoing
risks and uncertainties, actual results and performance may differ materially
from that projected or suggested herein. Additional information concerning
certain risks and uncertainties that could cause actual results to differ
materially from that projected or suggested may be identified from time to time
in the Company's Securities and Exchange Commission filings and the Company's
public announcements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In 1998, the Company utilized an interest rate swap as part of its cash
management strategy. The notional amount is $20 million. The interest rate swap
expired in April 1999. At December 1998, the interest rate swap arrangement
provided for the payment of interest based on a fixed rate and the receipt
interest based upon 3-month LIBOR. As a result, the Company remained subject to
a moderate amount of market risk through the maturity of the swap. The Company
estimates the fair value of the interest rate swap based upon quoted market
price, to be $108,000 at December 31, 1998.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The response to this item is submitted as a separate section of this Report
commencing on page F-1.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

20
<PAGE> 22

PART III

In accordance with general instruction G(3) of Form 10-K, the information
called for by Items 10, 11, 12 and 13 of Part III is incorporated by reference
to the Company's definitive Proxy Statement for its 1999 Annual Meeting of
Stockholders.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) List of Documents filed as part of this Annual Report on Form 10-K.

1. The following consolidated financial statements of the Company are filed
as a separate section of this Report commencing on page F-1.

Independent Auditors' Report -- Deloitte & Touche LLP
Consolidated Balance Sheets -- December 31, 1997 and 1998
Consolidated Statements of Operations for the years ended December 31,
1996, 1997 and 1998
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the years ended December 31,
1996, 1997 and 1998
Notes to Consolidated Financial Statements for the years ended December
31, 1996, 1997 and 1998

2. Financial Statement Schedules -- Not Applicable.

3. List of Exhibits.

The following exhibits are included as a part of this Annual Report on Form
10-K or incorporated herein by reference.

<TABLE>
<C> <C> <S>
3.1(1) -- Certificate of Incorporation of the Company.
3.2(1) -- Bylaws of the Company.
4.1(1) -- Specimen stock certificate evidencing the Common Stock.
10.1(1) -- Form of Unit Franchise Agreement entered into by the Company
and franchisees.
10.2(1) -- Employment Agreement, dated as of January 1, 1994 and
amended as of January 16, 1996, by and between the Company
and Steve Mandell.
10.3(3) -- Amendment to Employment Agreement dated as of March 5, 1997,
by and between the Company and Steven Mandell.
10.4(1) -- Employment Agreement, dated as of January 1, 1994 and
amended as of January 16, 1996, by and between the Company
and Perry Kaplan.
10.5(1) -- Employment Agreement of David Lauber, dated as of June 12,
1995, by and between the Company and David Lauber.
10.6(1) -- Employment Agreement of Lawrence Fine, dated as of October
13, 1995, by and between the Company and Lawrence Fine.
10.7(2) -- Amended Stock Option Plan of the Company.
10.8(2) -- Amended and Restated 1994 Stock Option Plan of the Company
10.9(1) -- Loan and Security Agreement, dated as of August 15, 1995 and
amended as of October 6, 1995, by and between the Company
and Midlantic Bank, N.A.
10.10(3) -- Commitment Letter between PNC Bank and the Company.
</TABLE>

21
<PAGE> 23

<TABLE>
<S> <C> <C>
10.11(4) -- Asset Purchase Agreement dated as of September 2, 1997 by and among the Company and Hammond
Retailing of Mesquite, L.C., Hammond Retailing of West Plano, L.C., Hammond Retailing of Richardson,
L.C., Hammond Retailing of Arlington, L.C., Hammond Retailing of Carrollton, L.C., Hammond Retailing
of Irving, L.C., Hammond Retailing of Medallion, L.C., Hammond Retailing of Red Bird LLC, Hammond
Retailing of Vista Ridge, LLC, Hammond Retailing of Pleasant Grove, LLC, Hammond Retailing of White
Rock, LLC, Hammond Communications, Inc. and Mr. Geoffrey Hammond (without exhibits or schedules).
10.12(4) -- Letter Agreement by and between the Company and Hammond Retailing of Plano East, LLC dated as of
July 7, 1997.
10.13(4) -- Third Amendment to Loan and Security Agreement, dated as of June 16, 1997, by and between the
Company and PNC Bank, National Association.
10.14(5) -- Fourth Amendment to the Loan and Security Agreement dated as of March 10, 1998 between the Company
and PNC Bank, National Association.
10.15(5) -- $60,000,000 credit facility Commitment Letter, dated March 9, 1998 by and between the Company and
PNC Bank N.A., as agent, for a syndicate of banks.
10.16(5) -- Employment Agreement of David Lauber, dated as of September 23, 1997, by and between the Company and
David Lauber.
21.1 -- Subsidiaries--The wholly owned subsidiary of the Company is Party City Michigan, Inc., incorporated
on October 23, 1997, in the State of Delaware. This subsidiary does business under the name Party
City Michigan, Inc.
23.1 -- Independent Auditor's Consent.
24.1 -- Power of Attorney (contained on the signature page of this Report).
27.1 -- Financial Data Schedule.
</TABLE>

---------------
NOTES

(1) Incorporated by reference to the Company's Registration Statement as amended
on Form S-1 Number 333-350 as filed with the Commission on January 18, 1996.

(2) Incorporated by reference to the Company's Registration Statement on Form
S-8 as filed with the Commission on January 9, 1997.

(3) Incorporated by reference to the Company's Registration Statement on Form
S-1 as filed with the Commission on March 6, 1997.

(4) Incorporated by reference to the Company's Current Report on Form 8-K as
filed with the Commission on September 12, 1997, as amended November 10,
1997.

(5) Incorporated by reference to the Company's Annual Report on Form 10-K as
filed with the Commission on March 31, 1998.

(b) Reports on Form 8-K.

None

22
<PAGE> 24

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on September 27, 2000.

PARTY CITY CORPORATION

By: /s/ JAMES SHEA
------------------------------------
James Shea, Chief Executive Officer

By: /s/ THOMAS E. LARSON
------------------------------------
Thomas E. Larson, Chief Financial
Officer

By: /s/ LINDA M. SILUK
------------------------------------
Linda M. Siluk, Chief Accounting
Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
NAME TITLE DATE
---- ----- ----
<C> <S> <C>
/s/ RALPH DILLON Non-Executive Chairman of September 27, 2000
--------------------------------------------------- the Board, Director
Ralph Dillon

/s/ JACK FUTTERMAN Director September 27, 2000
---------------------------------------------------
Jack Futterman

/s/ L. R. JALENAK, JR. Director September 27, 2000
---------------------------------------------------
L. R. Jalenak, Jr.

/s/ HOWARD LEVKOWITZ Director September 27, 2000
---------------------------------------------------
Howard Levkowitz

/s/ DUAYNE WEINGER Director September 27, 2000
---------------------------------------------------
Duayne Weinger
</TABLE>

23
<PAGE> 25

INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of Party City Corporation
Party City Corporation
Rockaway, New Jersey

We have audited the accompanying consolidated balance sheets of Party City
Corporation and subsidiary as of December 31, 1997 and 1998 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each year in the three year period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Party City
Corporation and subsidiary as of December 31, 1997 and 1998 and the consolidated
results of their operations and their cash flows for each of year in the three
year period ended December 31, 1998 in conformity with accounting principles
generally accepted in the United States of America.

Deloitte & Touche LLP
Parsippany, New Jersey
September 27, 2000

F-1
<PAGE> 26

PARTY CITY CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

<TABLE>
<CAPTION>
DECEMBER 31
-------------------
1997 1998
------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 3,235 $ 6,892
Merchandise inventory..................................... 39,041 56,590
Other current assets...................................... 7,840 9,817
------- --------
Total current assets................................... 50,116 73,299
Property and equipment, net................................. 24,199 49,704
Goodwill, net............................................... 14,130 19,189
Other assets................................................ 1,170 1,840
------- --------
Total assets........................................... $89,615 $144,032
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $24,927 $ 31,846
Accrued expenses.......................................... 6,994 8,873
Advances under Credit Agreement........................... -- 46,800
Income taxes payable...................................... 3,080 --
Other current liabilities................................. 1,184 819
------- --------
Total current liabilities.............................. 36,185 88,338
Long-term liabilities:
Revolving credit agreement................................ 3,150 --
Deferred rent............................................. 2,987 5,446
Other long-term liabilities............................... 1,510 880

Commitments and contingencies

Stockholders' equity:
Common stock.............................................. 123 125
Additional paid-in capital................................ 32,246 34,042
Retained earnings......................................... 13,414 15,201
------- --------
Total stockholders' equity............................. 45,783 49,368
------- --------
Total liabilities and stockholders' equity........... $89,615 $144,032
======= ========
</TABLE>

See accompanying notes to consolidated financial statements.
F-2
<PAGE> 27

PARTY CITY CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
-------------------------------
1996 1997 1998
------- -------- --------
<S> <C> <C> <C>
Revenues:
Net sales............................................... $39,144 $131,028 $282,923
Royalty fees............................................ 8,512 10,224 10,841
Franchise fees.......................................... 935 462 570
------- -------- --------
Total revenues....................................... 48,591 141,714 294,334
Expenses:
Cost of goods sold and occupancy costs.................. 25,937 86,372 194,761
Company-owned stores operating and selling expense...... 10,116 31,880 73,970
Franchise expense....................................... 3,729 3,998 4,114
General and administrative expense...................... 3,160 7,049 15,939
------- -------- --------
Total expense........................................ 42,942 129,299 288,784
------- -------- --------
Income before interest and income taxes................... 5,649 12,415 5,550
Interest expense (income), net.......................... (476) (212) 2,636
------- -------- --------
Income before income taxes................................ 6,125 12,627 2,914
Provision for income taxes.............................. 2,369 4,957 1,127
------- -------- --------
Net income................................................ $ 3,756 $ 7,670 $ 1,787
======= ======== ========
Basic earnings per share.................................. $ 0.38 $ 0.65 $ 0.14
======= ======== ========
Weighted average shares outstanding -- basic............ 9,802 11,749 12,411
======= ======== ========
Diluted earnings per share................................ $ 0.38 $ 0.64 $ 0.14
======= ======== ========
Weighted average shares outstanding -- diluted.......... 9,996 12,039 12,704
======= ======== ========
</TABLE>

See accompanying notes to consolidated financial statements.
F-3
<PAGE> 28

PARTY CITY CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(IN THOUSANDS, EXCEPT NUMBER OF SHARES)

<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL
-------------------- PAID IN RETAINED
SHARES AMOUNT CAPITAL EARNINGS TOTAL
---------- ------ ---------- -------- -------
<S> <C> <C> <C> <C> <C>
Balance at January 1, 1996........... 7,836,000 $ 78 $ 2,515 $ 1,988 $ 4,581
Sale of common stock................. 2,550,000 25 16,975 -- 17,000
Expenses incurred on sale of common
shares............................. -- -- (1,990) -- (1,990)
Exercise of stock options............ 55,001 1 174 -- 175
Tax effect of non-qualified
options............................ -- -- 39 -- 39
Net income........................... -- -- -- 3,756 3,756
---------- ---- ------- ------- -------
Balance at December 31, 1996......... 10,441,001 104 17,713 5,744 23,561
Sale of common stock................. 1,800,000 18 15,582 -- 15,600
Expenses incurred on sale of common
shares............................. -- -- (1,415) -- (1,415)
Exercise of stock options............ 59,094 1 266 -- 267
Tax effect of non-qualified
options............................ -- -- 100 -- 100
Net income........................... -- -- -- 7,670 7,670
---------- ---- ------- ------- -------
Balance at December 31, 1997......... 12,300,095 123 32,246 13,414 45,783
Exercise of stock options............ 152,274 2 722 -- 724
Tax effect of non-qualified
options............................ -- -- 1,074 -- 1,074
Net income........................... -- -- -- 1,787 1,787
---------- ---- ------- ------- -------
Balance at December 31, 1998......... 12,452,369 $125 $34,042 $15,201 $49,368
========== ==== ======= ======= =======
</TABLE>

See accompanying notes to consolidated financial statements.
F-4
<PAGE> 29

PARTY CITY CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
-----------------------------
1996 1997 1998
------- ------- -------
<S> <C> <C> <C>
Cash flow from operating activities:
Net income................................................ $ 3,756 $ 7,670 $ 1,787
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Depreciation and amortization.......................... 746 2,794 6,598
Deferred rent.......................................... 706 1,813 2,459
Provision for doubtful accounts........................ 6 275 127
Loss on abandonment of property and equipment.......... 11 99 --
Deferred tax asset..................................... (152) (543) (933)
Changes in assets and liabilities:
Merchandise inventory.................................. (5,464) (23,853) (15,618)
Other current assets................................... (1,170) (5,197) (1,201)
Other assets........................................... (5) (335) (639)
Accounts payable....................................... 3,016 19,950 6,919
Accrued expenses....................................... 755 5,013 1,879
Income taxes payable................................... 1,390 1,176 (3,080)
Other current liabilities.............................. (37) (11) (365)
Other long-term liabilities............................ -- 197 (630)
------- ------- -------
Net cash provided by (used in) operating
activities........................................ 3,558 9,048 (2,697)
Cash flow from investment activities
Purchases of property and equipment....................... (4,872) (18,272) (30,638)
Stores acquired........................................... -- (21,653) (8,456)
------- ------- -------
Net cash used in investing activities.................. (4,872) (39,925) (39,094)
Cash flow from financing activities
Net proceeds from sale of stock........................... 15,010 14,185 --
Proceeds from exercise of stock options................... 174 267 724
Tax effect of non-qualified stock options................. 39 100 1,074
Net advances from Credit Agreement........................ (72) 4,610 43,650
------- ------- -------
Net cash provided by financing activities.............. 15,151 19,162 45,448
------- ------- -------
Net increase (decrease) in cash and cash equivalents........ 13,837 (11,715) 3,657
Cash and cash equivalents, beginning of year................ 1,113 14,950 3,235
------- ------- -------
Cash and cash equivalents, end of year...................... $14,950 $ 3,235 $ 6,892
======= ======= =======
Supplemental disclosure of cash flow information
Income taxes paid......................................... $ 1,148 $ 4,219 $ 3,433
Interest paid............................................. 41 294 2,402
</TABLE>

See accompanying notes to consolidated financial statements.
F-5
<PAGE> 30

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidated Financial Statements

Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party supplies stores within the continental United
States and sells franchises on an individual store and area franchise basis
throughout the United States, Puerto Rico, Spain, Portugal and Canada. As of
December 31, 1998, the Company had 207 Company-owned stores and 167 franchise
stores in its network. The consolidated financial statements of the Company
include the accounts of the Company and its wholly-owned subsidiary, Party City
Michigan, Inc. All significant intercompany balances and transactions have been
eliminated.

The Company was delayed in issuing its audited financial statements for the
year ended December 31, 1998 and was unable to timely file its 1998 Annual
Report on Form 10-K with the Securities and Exchange Commission ("SEC")
primarily because of difficulties associated with taking the year-end physical
inventories and the related reconciliation process. The Company took a complete
physical inventory as of July 3, 1999, and completed the reconciliation process
necessary to prepare consolidated financial statements for the year ended
December 31, 1998. As a result of the failure to file the Form 10-K by March 31,
1999, the Company was in default of Nasdaq's continued listing requirements.
Trading in the Company's common stock was halted on May 6, 1999, and the Company
was delisted on July 20, 1999.

Cash and Cash Equivalents

The Company considers its highly liquid investments purchased as part of
daily cash management activities to be cash equivalents.

Fair Value of Financial Instruments

Financial instruments consist of cash equivalents, accounts receivable,
accounts payable and debt obligations. The carrying amounts reported in the
balance sheets of such financial instruments approximate their fair market
values due to their short-term maturity.

Allowance for Doubtful Accounts

The allowance for doubtful accounts on receivables from franchisees at
December 31, 1997 and 1998 was $48,000 and $166,000 respectively.

Merchandise Inventory

The Company values its inventory at the lower of average cost (which
approximates FIFO) or market. Provision for slow moving inventory is charged to
operations in the period in which such estimates are determined by management.

Advertising Fund

Pursuant to its franchise agreements, the Company collects 1% of the net
sales of its franchise stores for contribution into the Advertising Fund (the
"Ad Fund"). These amounts are restricted in their use for advertising on behalf
of the franchisees. Receipts and disbursements are not recorded as income or
expense since the Company does not have full discretion over the use of the
funds. The Company also contributes 1% of net sales of its owned stores into the
Ad Fund. To cover the expenses of fund administration, the Company charges the
Ad Fund a management fee equal to 5% of the funds contributed by franchisees.
During 1996, 1997, and 1998, Ad Fund management fees of $134,000, $210,000 and
$278,000, respectively, were collected by the Company and credited to general
and administrative expense.

F-6
<PAGE> 31
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Property and Equipment

Property and equipment are recorded at cost. Depreciation and amortization
are provided using the straight-line method over the estimated useful lives of
the assets or, where applicable, the terms of the respective leases, whichever
is shorter. The Company uses estimated useful lives of five to seven years for
furniture, fixtures and equipment. Capitalized software costs are amortized on a
straight-line basis over their estimated lives of three to five years, beginning
in the year the assets were placed into service.

Maintenance and repairs are charged directly to expense as incurred. Major
renewals or replacements of fixed assets are capitalized after making the
necessary adjustments to the asset and accumulated depreciation of the items
renewed or replaced.

Impairment of Long-Lived Assets and Intangibles

The Company follows Statement of Financial Accounting Standards ("SFAS")
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, which requires impairment losses to be recorded on
long-lived assets used in operations when indicators of impairment are present
and the undiscounted cash flows estimated to be generated by those assets are
less than the assets' carrying amount. In evaluating the fair value and future
benefits of long-lived assets, the Company performs an analysis of the
anticipated undiscounted future net cash flows of the related long-lived assets
and reduces their carrying value by the excess, if any, of the result of such
calculation. Management believes at this time that the carrying value and useful
life of goodwill and fixed assets continues to be appropriate.

Intangibles

Trademarks, which are included in other assets, consist primarily of
capitalized legal costs and are being amortized using the straight-line method
over the estimated useful lives of the assets. The excess of purchase price over
the fair value of the net assets acquired in connection with the purchase of
stores ("goodwill") is being amortized on a straight-line basis over 15 years.
At December 31, 1997 and 1998, the cost of goodwill was $14.6 million and $20.8
million, respectively.

Deferred Rent

The Company accounts for scheduled rent increases contained in its leases
on a straight-line basis over the noncancelable lease term.

Income Taxes

The Company files a consolidated Federal income tax return. Separate state
income tax returns are filed with each state in which the Company conducts
business. The Company accounts for its income taxes using the asset and
liability method. Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to the differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit carryforwards. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the year in which those temporary differences are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in earnings in the period
that includes the enactment date.

Stock Options

As permitted under SFAS No. 123, "Accounting for Stock-Based Compensation",
the Company has elected not to adopt the fair value based method of accounting
for its stock-based compensation plans. The Company will continue to apply the
provisions of Accounting Principles Board ("APB") Opinion No. 25,

F-7
<PAGE> 32
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

"Accounting for Stock Issued to Employees". The Company has complied with the
disclosure requirements of SFAS No. 123.

Earnings Per Share

Basic earnings per share is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted
earnings per common share also includes the dilutive effect of potential common
shares (dilutive stock options) outstanding during the period. All earnings per
share data for the years ended December 31, 1996, 1997 and 1998, has been
retroactively adjusted for the three-for-two common stock split that occurred on
January 16, 1998.

Revenue Recognition

The Company operates predominately as a retailer through its Company owned
stores. The retail segment recognizes revenue at the point of sale.

The Company's franchise segment generates revenues through franchise fees
and royalties. Revenue from individual franchise sales, recorded as franchise
fees, is recognized by the Company upon completion of certain initial services,
which normally coincide with the opening of the franchisee's store. The Company
is obligated in accordance with the terms of each franchisee's respective
agreement to provide the following initial services: advice on site location,
store design and layout, training and pre-opening assistance. On an ongoing
basis, the Company provides assistance regarding sources of supply, pricing,
advertising and promotion programs and other defined assistance. Royalty fees
are recorded on a monthly basis as a percentage of the franchisee's net sales.

Area franchise sales represent agreements with franchisees to open a
specified number of franchises within defined geographic areas and development
periods. The Company's policy is to receive a deposit in advance for each of the
potential stores, based on its standard initial franchise fee at the time the
contract is signed. Upon receipt, the deposit is recorded as deferred revenue.
When the Company satisfies its initial obligations to the franchisee and the
store is opened, the Company recognizes the deposit as revenue. Information
regarding franchise activity follows:

<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
--------------------
1996 1997 1998
---- ---- ----
<S> <C> <C> <C>
Franchise stores in operation at beginning of the year...... 132 164 158
Franchise stores opened..................................... 32 19 19
Franchise stores acquired................................... -- (24) (9)
Franchise stores closed..................................... -- (1) (1)
--- --- ---
Franchise stores in operation at the end of the year........ 164 158 167
=== === ===
</TABLE>

Store Opening and Closing Costs

New store opening costs are expensed as incurred. In the event a store is
closed before its lease expires, the estimated lease obligation, less any
sublease rental income, is provided in the period of closing.

Advertising Costs

The costs associated with store advertising are expensed in the period in
which the related promotion and sales occur. Advertising expense was
approximately $2.3 million, $7.0 million and $16.0 million for the years ended
December 31, 1996, 1997 and 1998, respectively.

F-8
<PAGE> 33
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Effect of New Accounting Standards

In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130 "Reporting Comprehensive Income," which establishes standards for the
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. This statement requires that all items that are required to be
recognized under accounting standards as components of comprehensive income be
reported in a financial statement that is displayed with the same prominence as
other financial statements. Comprehensive income is equivalent to the Company's
reported net income. The adoption of this statement had no impact on the
consolidated financial statements.

Effective January 1, 1998, the Company adopted AICPA Statement of Position
(the "SOP") 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which requires the Company to capitalize certain
software development costs. Generally, once the capitalization criteria of the
SOP have been met, external direct costs of materials and services used in
development of internal-use software, payroll and payroll-related costs for
employees directly involved in the development of internal-use software and
interest costs incurred when developing software for internal use are to be
capitalized. The adoption of this SOP had no impact on the consolidated
financial statements because the SOP requires the change to be implemented
prospectively.

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives
Instruments and Hedging Activities ("SFAS No. 133")." SFAS No. 133 establishes
accounting and reporting standards for derivative instruments and hedging
activities. SFAS No. 133 requires an entity to recognize all derivatives as
either assets or liabilities in the statement of financial position and to
measure those instruments at fair value. For fiscal year 2001, the Company is
required to adopt SFAS No. 133. The Company has determined that the application
of SFAS No. 133 will not have a material impact on its financial position or
results of operations.

In November 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin 101, "Revenue Recognition." This bulletin sets forth
the SEC Staff's position regarding the point at which it is appropriate for a
registrant to recognize revenue. The Staff believes that revenue is realizable
and earned when all of the following criteria are met: persuasive evidence of an
arrangement exists; delivery has occurred or service has been rendered; the
seller's price to the buyer is fixed or determinable; and collectibility is
reasonably assured. The Company uses the above criteria to determine whether
revenue can be recognized, and therefore believes that the issuance of this
bulletin does not have a material impact on these financial statements.

Seasonality

The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
during the fourth calendar quarter of the year, principally due to the sales in
October for the Halloween season and, to a lesser extent, due to sales for end
of year holidays. The Company's results of operations may also fluctuate
significantly as a result of a variety of other factors, including the timing of
new store openings, store closings and store sales. The Company believes this
general pattern will continue in the future.

F-9
<PAGE> 34
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. Significant estimates include provision for slow-moving inventory and
a liability for incurred but not reported medical claims.

Concentration

The Company relies on its suppliers for the purchase of its merchandise.
That Company had two suppliers who in the aggregate constituted approximately
24% of the Company's purchases for the year ended December 31, 1998. The loss of
either of these suppliers would adversely affect the Company's operations.

Reclassifications

Certain reclassifications have been made to the consolidated financial
statements in prior periods to conform to the current period presentation.

2. ACQUISITIONS

1997 Acquisitions

On February 28, 1997, the Company acquired six franchise stores. Four of
the stores acquired were owned by Steven Mandell, then the Company's Chairman
and President through May 1999, a member of the Board of Directors until
September 17, 1999 and a significant stockholder of the Company. Such stores
were acquired for an aggregate purchase price of $5.2 million. The remaining two
stores were owned by Perry Kaplan, a former executive officer and Director of
the Company. Such stores were acquired for an aggregate purchase price of $1.3
million. On August 1, 1997, the Company acquired three franchise stores; two
stores in the Southern California market and one store in Staten Island, New
York. Through these transactions, the Company acquired certain development
rights to the Southern California and Staten Island, New York markets. The
aggregate purchase price of these transactions was approximately $3.3 million.
On August 27, 1997 the Company acquired two franchise stores in the Chicago
market and on September 12, 1997 the Company acquired two franchise stores in
Virginia. The aggregate purchase price of these transactions was approximately
$3.9 million. On September 2, 1997, the Company acquired 11 franchise stores in
the Dallas/Fort Worth market. The purchase price of this transaction was
approximately $8.2 million. Additionally, the acquisition agreement provides
that the Company acquired the rights for any future development in the
Dallas/Fort Worth market.

1998 Acquisitions

On March 27, 1998, the Company acquired one franchise store in the Miami,
Florida market. The purchase price of this transaction was approximately $0.3
million. On June 28, 1998, the Company acquired three franchise stores in the
Memphis, Tennessee market. The purchase price of this transaction was
approximately $1.9 million. As discussed in Note 18, in order to meet cash flow
requirements, the Company sold the three Memphis stores to a franchisee in
August 1999. On August 31, 1998, the Company acquired four franchise stores in
the Chicago market from Duayne Weinger, a director of the Company. The purchase
price of this transaction was $3.9 million. On September 23, 1998, the Company
acquired one franchise store in the Houston market. The purchase price of this
store was approximately $0.5 million.

F-10
<PAGE> 35
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The acquisitions have been accounted for under the purchase method of
accounting. The results of operations of the acquired stores are included in the
financial statements from the date of acquisition. Goodwill of $14.6 million in
1997 and $6.2 million in 1998 was recorded in connection with these acquisitions
and is being amortized on a straight-line basis over 15 years.

Assuming the stores acquired during the years ended December 31, 1997 and
1998, were acquired on January 1, 1997, the pro forma results would have been as
follows (in thousands, except per share amounts) (unaudited):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------
1997 1998
---------- ----------
<S> <C> <C>
Total Revenues.............................................. $174,817 $301,913
Net Income.................................................. 8,834 2,368
Basic EPS................................................... $ 0.75 $ 0.19
Diluted EPS................................................. 0.73 0.19
</TABLE>

The pro forma results are not necessarily indicative of the results of
operations that would have occurred had the transactions been consummated as
indicated nor are they intended to indicate results that may occur in the
future.

3. OTHER CURRENT ASSETS

Other current assets consist of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1997 1998
------ ------
<S> <C> <C>
Restricted cash from advertising fund....................... $ 290 $ 90
Receivables from franchisees:
Royalty fees........................................... 1,069 1,201
Other.................................................. 386 795
Deferred income taxes....................................... 382 1,284
Prepaid expenses and other current assets................... 5,713 6,447
------ ------
$7,840 $9,817
====== ======
</TABLE>

F-11
<PAGE> 36
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

4. PROPERTY AND EQUIPMENT

Property and equipment consists of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1997 1998
------- -------
<S> <C> <C>
Equipment................................................... $ 9,041 $22,142
Furniture................................................... 10,974 21,894
Leasehold improvements...................................... 7,550 14,543
Automobiles................................................. 118 102
------- -------
27,683 58,681
Less: Accumulated depreciation and amortization............. (3,484) (8,977)
------- -------
$24,199 $49,704
======= =======
</TABLE>

5. OTHER ASSETS

Other assets consist of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1997 1998
------ ------
<S> <C> <C>
Deferred income taxes....................................... $ 572 $ 603
Other....................................................... 598 1,237
------ ------
$1,170 $1,840
====== ======
</TABLE>

6. FINANCIAL INSTRUMENTS

In 1998, the Company utilized an interest rate swap as part of its cash
management strategy. The notional amount is $20 million. The interest rate swap
expired in April 1999. At December 31, 1998, the interest rate swap arrangement
provided for the payment of interest based on a fixed rate and the receipt
interest based upon 3-month LIBOR. As a result, the Company remained subject to
a moderate amount of market risk through the maturity of the swap. The Company
estimates the fair value of the interest rate swap, based upon quoted market
price, to be $108,000 at December 31, 1998.

7. ACCRUED EXPENSES

Accrued expenses consist of the following (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1997 1998
------ ------
<S> <C> <C>
Accrued compensation........................................ $2,228 $1,761
Sales and use taxes......................................... 1,709 2,204
Other....................................................... 3,057 4,908
------ ------
$6,994 $8,873
====== ======
</TABLE>

8. FINANCING AGREEMENTS

F-12
<PAGE> 37
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

amended, the "Credit Agreement"). Advances under the Credit Agreement originally
bore interest, at the Company's option, at the agent bank's base rate (the
higher of the bank's prime rate or the federal funds rate plus 1/2% per annum)
or LIBOR plus an applicable margin. The Company's failure to issue its
consolidated financial statements on a timely basis was a default under the
Credit Agreement. In addition to this default, the Company did not meet certain
of its financial covenants, including those relating to minimum levels of
profitability, net worth, liquidity, fixed charge coverage and others.
Consequently, the Company's debt was subject to acceleration and is classified
as a current liability in the consolidated balance sheet at December 31, 1998.
The Credit Agreement was secured by all the assets of the Company. Additionally,
the Credit Agreement restricted the payment of dividends. See additional
discussion in Note 18 to the consolidated financial statements.

9. EARNINGS PER SHARE

The following table sets forth the computations of basic and diluted
earnings per share (in thousands, except per share amounts):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------
1996 1997 1998
------ ------- -------
<S> <C> <C> <C>
Net income.................................................. $3,756 $ 7,670 $ 1,787
Weighted average shares outstanding......................... 9,802 11,749 12,411
Earnings per share -- basic................................. $ 0.38 $ 0.65 $ 0.14
Dilutive effect of stock options............................ 194 290 293
Weighted average common and common equivalent shares
outstanding............................................... 9,996 12,039 12,704
Earnings per share -- diluted............................... $ 0.38 $ 0.64 $ 0.14
</TABLE>

---------------

Options to purchase, 60,000, 193,250, and 134,000 common shares at prices
ranging from $1.67 to $34.44 per share were outstanding at December 31, 1996,
1997 and 1998, respectively, but were not included in the computation of
dilutive earnings per share because the exercise price of the options exceeds
the average market price.

10. STOCKHOLDERS' EQUITY AND STOCK OPTIONS

The Company has 25,000,000 shares authorized of its $.01 par value common
stock at December 31, 1997 and 1998. Shares issued and outstanding were
12,300,095 and 12,452,369 at December 31, 1997 and 1998, respectively.

On March 27, 1996, the Company completed an initial public offering ("IPO")
of 2,550,000 shares of common stock, $.01 par value, issued by the Company, at
an IPO price of $6.67 per share. Proceeds to the Company, net of offering
expenses of $1,990,000, were $15,010,000.

On May 8, 1997, the Company completed a secondary public offering of its
common stock. The total offering was for 3,360,000 shares of common stock, of
which 1,800,000 shares were offered by the Company and 1,560,000 were offered by
certain selling stockholders. The offering price was $8.67 per share. Proceeds
to the Company net of offering expenses were $14,185,000. On December 18, 1997,
the Board of Directors declared a three-for-two common stock split effective
January 16, 1998. All common stock and per share data has been retroactively
adjusted for the stock split.

The Company maintains the Amended and Restated 1994 Stock Option Plan (the
"1994 Plan") pursuant to which options may be granted to employees, directors
and consultants for the purchase of the common stock of the Company. On March 6,
1998, the Board of Directors of the Company amended the 1994

F-13
<PAGE> 38
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Option Plan to increase the number of shares available for the grant of options
under the 1994 Plan from 900,000 shares to 1,800,000 shares. This amendment was
ratified by the Company's stockholders on June 22, 1998.

The 1994 Plan, as amended, permits the Company to grant incentive and
non-qualified stock options to purchase an aggregate of 1,800,000 shares of the
Company's common stock, as adjusted for the three-for-two common stock split
that occurred on January 16, 1998. Such options may be incentive stock options
or non-qualified options. Any employee of the Company or any subsidiary of the
Company is eligible to receive incentive stock options and non-qualified stock
options under the 1994 Plan. Non-qualified stock options may be granted to
employees as well as non-employee directors and consultants of the Company under
the 1994 Plan as determined by the Board or the Compensation Committee.

The term of an option is determined by the Compensation Committee of the
Board. The exercise price of the shares covered by an incentive stock option may
not be less than the fair value of the shares at the time of grant. The exercise
price of the shares covered by a non-qualified option need not be equal to the
fair value of the stock at the date of grant, but may be granted with an
exercise price as determined by the Compensation Committee. The options granted
prior to November 1997 vest one-third each year, over a period of three years.
Options granted after November 1997 vest over four-year and five-year periods,
vesting ratably starting in the second year after the date of grant.

The following tables summarize information about stock option transactions
for the 1994 Plan:

<TABLE>
<CAPTION>
NUMBER OF WEIGHTED AVERAGE
SHARES EXERCISE PRICE
--------- ----------------
<S> <C> <C>
Balance at January 1, 1996.................................. 255,000 $ 2.69
Granted................................................... 422,250 9.59
Exercised................................................. (54,999) 3.18
Canceled.................................................. (88,001) 6.00
--------- ------
Balance at December 31, 1996................................ 534,250 7.54
Granted................................................... 583,625 12.66
Exercised................................................. (56,600) 4.62
Canceled.................................................. (64,250) 10.59
--------- ------
Balance at December 31, 1997................................ 977,025 10.51
Granted................................................... 453,000 19.73
Exercised................................................. (152,274) 4.75
Canceled.................................................. (203,000) 20.37
--------- ------
Balance at December 31, 1998................................ 1,094,751 13.30
=========
Options Exercisable at:
December 31, 1996......................................... 142,500
December 31, 1997......................................... 244,650
December 31, 1998......................................... 352,251
</TABLE>

F-14
<PAGE> 39
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------- --------------------------
NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED
OUTSTANDING AT AVERAGE AVERAGE EXERCISABLE AT AVERAGE
DECEMBER 31, REMAINING EXERCISE DECEMBER 31, EXERCISE
RANGE OF EXERCISE PRICES 1998 CONTRACTUAL LIFE PRICE 1998 PRICE
------------------------ -------------- ---------------- -------- -------------- --------
<S> <C> <C> <C> <C> <C>
$1.67 to $9.50............. 135,650 7.67 $ 6.94 65,150 $ 5.73
$9.67 to $10.00............ 214,000 8.04 9.99 109,500 10.00
$10.17 to $11.00........... 252,201 8.45 10.60 74,451 10.28
$11.33 to $13.63........... 186,650 8.64 12.69 51,400 12.59
$13.72 to $23.25........... 183,250 9.00 16.79 51.750 16.25
$23.38 to $34.44........... 123,000 9.18 27.31 -- --
--------- ---- ------ ------- ------
$1.67 to $34.44............ 1,094,751 8.48 $13.30 352,251 $10.56
</TABLE>

The Company measures compensation cost under APB No. 25, "Accounting for
Stock Issued to Employees." Accordingly, no compensation cost has been
recognized in connection with the 1994 Plan in the accompanying consolidated
financial statements. In accordance with SFAS No. 123, "Accounting for Stock-
Based Compensation," the fair value of each option grant is estimated on the
date of grant using the Black-Scholes option-pricing model using the following
assumptions for grants in the respective periods:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------
1996 1997 1998
--------- --------- ---------
<S> <C> <C> <C>
Expected volatility...................................... 35% 40% 100%
Expected lives........................................... 6.0 years 4.3 years 5.0 years
Risk-free interest rate.................................. 6.50% 5.7% 5.2%
Expected dividend yield.................................. 0% 0% 0%
</TABLE>

Set forth below are the Company's net income and earnings per share
presented "as reported" and pro forma as if compensation cost were recognized in
accordance with the provisions of SFAS No. 123 (in thousands, except per share
data):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1996 1997 1998
------ ------ ------
<S> <C> <C> <C>
Net Income:
As reported............................................... $3,756 $7,670 $1,787
Pro-forma................................................. 3,345 6,944 174
Basic EPS:
As reported............................................... $ 0.38 $ 0.65 $ 0.14
Pro-forma................................................. 0.34 0.59 0.01
Diluted EPS:
As reported............................................... $ 0.38 $ 0.64 $ 0.14
Pro-forma................................................. 0.33 0.58 0.01
</TABLE>

F-15
<PAGE> 40
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

11. INCOME TAXES

The provision for income tax expense consists of the following (in
thousands):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1996 1997 1998
------ ------ ------
<S> <C> <C> <C>
Current:
Federal................................................... $1,963 $4,519 $1,721
State..................................................... 558 981 339
------ ------ ------
2,521 5,500 2,060
Deferred:
Federal................................................... (128) (464) (796)
State..................................................... (24) (79) (137)
------ ------ ------
(152) (543) (933)
------ ------ ------
$2,369 $4,957 $1,127
====== ====== ======
</TABLE>

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying value of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes.

Significant components of the net deferred tax asset at December 31, 1997
and 1998, respectively, are as follows (in thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1997 1998
------ -------
<S> <C> <C>
Current:
Inventory................................................. $ 274 $ 1,030
Vacation pay accrual...................................... 94 158
Other..................................................... 14 96
------ -------
Net current deferred tax asset............................ $ 382 $ 1,284
====== =======
Non-current:
Deferred rent............................................. $1,259 $ 2,261
Start-up costs............................................ 20 (381)
Property and equipment.................................... (672) (1,798)
AMT Credit................................................ -- 437
Deferred state taxes...................................... (35) 84
------ -------
Non-current deferred tax asset............................ $ 572 $ 603
====== =======
</TABLE>

The following table reconciles the statutory Federal income tax rate with
the effective rate of the Company for the periods ended:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
1996 1997 1998
----- ----- -----
<S> <C> <C> <C>
Federal statutory rate...................................... 34.0% 35.0% 34.0%
State income taxes net of federal benefit................... 5.6 4.7 5.4
Other....................................................... (0.9) (0.4) (0.7)
----- ----- -----
Effective tax rate.......................................... 38.7% 39.3% 38.7%
===== ===== =====
</TABLE>

F-16
<PAGE> 41
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

12. EMPLOYEE BENEFIT PLANS

The Company has a defined contribution 401(k) savings plan (the "401(k)
Plan") covering all eligible employees. Participants may defer between 1% and
15% of annual pre-tax compensation subject to statutory limitations. The Company
contributes an amount as determined by the Board of Directors. Such amount has
been established as 50% of the employee's contribution up to $1,000. For the
years ended December 31, 1996, 1997 and 1998, $45,000, $65,000, and $121,000 was
expensed under the 401(k) Plan.

13. RELATED PARTY TRANSACTIONS

Steven Mandell, the former president of the Company and a major
stockholder, owned all of the outstanding shares of two party supplies stores
for which no royalty fees were charged. Steven Mandell was also the majority
owner of two additional franchise stores and was a 50% owner of one franchise
through 1995. The Company received royalty fees based on 3.0% of net sales from
the majority owned stores. In addition, a former director of the Company owned
two franchises and was a 50% owner of one franchise through 1995, for which the
franchisee paid royalty fees of 2.0% of net sales. On February 28, 1997, the
Company acquired six of these franchise stores.

Furthermore, another former officer of the Company owned two franchises. On
August 1, 1997, the Company acquired one of these stores. The Company charged
the officer approximately $0 and $19,000 for rent for the years ended December
31, 1996 and 1997. As of December 31, 1998, a current executive of the Company
owned one franchise store.

Royalty fees of $208,000, $24,000 and $58,000 relating to the above are
included in the accompanying consolidated financial statements for the years
ended December 31, 1996, 1997 and 1998, respectively.

The Company provided bookkeeping and office services for certain of these
related parties. The Company charged such parties approximately $94,000, $14,000
and $15,000 for the years ended December 31, 1996, 1997, and 1998 respectively.
As of July 3, 1999, all such services were terminated. Personnel and office
costs allocated to the affiliate were based upon the percentage of time
individuals devoted to services for the affiliate stores and square footage
occupied.

On August 31, 1998, the Company acquired four franchise stores in the
Chicago market from a director of the Company at a purchase price of $3.9
million.

14. LEASE COMMITMENTS

Leases

The Company leases real estate in connection with the operation of
corporate retail stores as well as its corporate office. The store leases are
for properties ranging in size from 6,750 to 15,900 square feet. The terms range
from five years to twenty years, and expire by 2016. The leases contain
escalation clauses, renewal options from five years to ten years and obligations
for reimbursement of common area maintenance and real estate taxes. Certain
leases contain contingent rent based upon specified sales volume. For the years
ended December 31, 1996, 1997 and 1998, no such contingent rent was paid.

At December 31, 1998, the Company leased 23 motor vehicles. The terms range
from 24 to 36 months, and expire by March 2002.

In August 1997, the Company entered into a five-year capital lease with a
present value of approximately $1.6 million for computer hardware and software.
The Company has the option to purchase the equipment for a nominal cost at the
termination of the lease.

F-17
<PAGE> 42
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Future minimum lease payments under outstanding leases at December 31,
1998, are as follows (in thousands):

<TABLE>
<CAPTION>
CAPITAL LEASE OPERATING LEASES
------------- ----------------
<S> <C> <C>
Year ending December 31:
1999........................................................ $ 366 $ 33,936
2000........................................................ 366 34,581
2001........................................................ 366 35,326
2002........................................................ 225 35,378
2003........................................................ -- 34,815
Thereafter.................................................. -- 142,998
--------
Total minimum lease payments........................... 1,323 $317,034
========
Less amount representing interest........................... (182)
------
Present value of net minimum lease payments................. 1,141
Less current maturities, included in other liabilities...... (318)
------
Long-term obligation................................... $ 823
======
</TABLE>

Rent expense for all operating leases was $3.8 million, $12.0 million and
$27.3 million for the years ended December 31, 1996, 1997, and 1998,
respectively. The Company is obligated for guarantees, subleases or assigned
lease obligations for six of its franchisees through 2008. The aggregate future
minimum payments under these leases are approximately $8,902,000.

15. COMMITMENTS AND CONTINGENCIES

Securities Litigation. The Company has been named as a defendant in the
following twelve class action complaints: (1) Weber v. Party City Corp., Steven
Mandell, and David Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP
v. Party City Corp. and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein
and Shiffrin v. Party City Corp., Steven Mandell and David Lauber, Civ. Action
No. 99-CV-1325; (4) Flynn v. Party City Corp., David Lauber and Steven Mandell,
Civ. Action No. 99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell
and David Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp.
and Steven Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell
and Party City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp.,
Steven Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v.
Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396;
(10) Hormel v. Party City Corp., Steven Mandell and David Lauber, Civ. Action
No. 99- CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David
Lauber, Civ. Action No. 99-CV-2238; and (12) Gross v. Party City Corp., Steven
Mandell and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief
Executive Officer and former Chief Financial Officer and Executive Vice
President of Operations have also been named as defendants. The complaints have
all been filed in the United States District Court for the District of New
Jersey. The complaints were filed as class actions on behalf of persons who
purchased or acquired Party City common stock during various time periods
between February 1998 and March 19, 1999. In October 1999, plaintiffs filed an
amended class action complaint and in February 2000, plaintiffs filed a second
amended complaint.

The second amended class action complaint alleges, among other things,
violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934
and Rule 10b-5 promulgated thereunder, and seek unspecified damages. The
plaintiffs allege that defendants issued a series of false and misleading
statements and failed to disclose material facts concerning, among other things,
the Company's financial condition, adequacy of internal controls and compliance
with certain loan covenants. The plaintiffs further allege that because of the

F-18
<PAGE> 43
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

issuance of a series of false and misleading statements and/or failure to
disclose material facts, the price of Party City common stock was artificially
inflated.

Other

16. SEGMENT INFORMATION

The Company owns, operates and franchises party supplies stores in the
United States and, to a limited extent in Europe. The Company's management
reporting system evaluates performance based on a number of factors; however,
the primary measure of performance is the pre-tax operating profit of each
segment. Accordingly, the Company reports two segments -- retail and
franchising. The retail segment generates revenue through the sale of primarily
third-party branded party goods through Company-owned stores. The franchising
segment generates revenue through the charge for initial franchise fees and a
royalty on retail
F-19
<PAGE> 44
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

sales. The accounting policies are described in the summary of significant
accounting policies. The Company has no intersegment sales. No single customer
accounts for 10% or more of total revenues. Revenues from Europe were not
significant in all periods presented. All assets of the Company are located in
North America.

The following table contains key financial information of the Company's
business segments (in thousands):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1996 1997 1998
------- -------- --------
<S> <C> <C> <C>
RETAIL:
Net revenue............................................... $39,144 $131,028 $282,923
Operating earnings........................................ 3,091 12,776 14,192
Identifiable assets....................................... 32,441 84,939 133,435
Depreciation/amortization................................. 563 2,433 5,721
Capital expenditures...................................... 4,356 37,200 32,845
FRANCHISING:
Net revenue............................................... $ 9,447 $ 10,686 $ 11,411
Operating earnings........................................ 5,718 6,688 7,297
Identifiable assets....................................... 1,193 1,455 1,996
Depreciation/amortization................................. -- -- --
Capital expenditures...................................... -- -- --
CORPORATE/OTHER:
Net revenue............................................... $ -- $ -- $ --
Operating expense......................................... (3,160) (7,049) (15,939)
Identifiable assets....................................... 969 3,221 8,601
Depreciation/amortization................................. 183 361 877
Capital expenditures...................................... 516 2,725 6,249
CONSOLIDATED TOTALS:
Net revenue............................................... $48,591 $141,714 $294,334
Operating earnings........................................ 5,649 12,415 5,550
Interest expense (income), net............................ (476) (212) 2,636
------- -------- --------
Income before income taxes................................ 6,125 12,627 2,914
Provision for income taxes................................ 2,369 4,957 1,127
------- -------- --------
Net income................................................ $ 3,756 $ 7,670 $ 1,787
======= ======== ========
Identifiable assets....................................... $34,603 $ 89,615 $144,032
Depreciation/amortization................................. 746 2,794 6,598
Capital expenditures...................................... 4,872 39,925 39,094
</TABLE>

F-20
<PAGE> 45
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

17. SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (IN THOUSANDS, EXCEPT
PER SHARE DATA)

<TABLE>
<CAPTION>
QUARTER ENDED
------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- ------- ------------- -----------
<S> <C> <C> <C> <C>
1996
Total revenues.................................. $ 5,981 $ 8,286 $ 9,908 $ 24,416
Cost of goods sold and occupancy costs.......... 3,334 4,363 5,340 12,900
Net income (loss)............................... (167) 499 346 3,078
Basic earnings (loss) per share................. (0.02) 0.05 0.03 0.30
Diluted earnings (loss) per share............... (0.02) 0.05 0.03 0.29
1997
Total revenues.................................. $14,612 $22,455 $28,016 $ 76,631
Cost of goods sold and occupancy costs.......... 9,383 13,756 18,152 45,081
Net income (loss)............................... (288) 897 (244) 7,305
Basic earnings (loss) per share................. (.03) .07 (.02) 0.59
Diluted earnings (loss) per share............... (.03) .07 (.02) 0.57
1998
Total revenues.................................. $40,714 $56,558 $58,374 $138,688
Cost of goods sold and occupancy costs.......... 28,548 36,698 39,512 90,003
Net income (loss)............................... (1,271) 1,041 (2,161) 4,178
Basis earnings (loss) per share................. (0.10) 0.08 (0.17) 0.34
Diluted earnings (loss) per share............... (0.10) 0.08 (0.17) 0.33
</TABLE>

18. SUBSEQUENT EVENTS

On August 16, 1999 the Company entered into agreements with its existing
bank lenders under the Credit Agreement (the "Banks"), a new group of investors
(the "Investors") and its trade vendors. The bank lenders and the Company
entered into a Standstill and Forbearance Agreement (the "Bank Forbearance
Agreement"). Under the Bank Forbearance Agreement, the Banks agreed not to
exercise rights and remedies based upon any existing defaults until June 30,
2000 unless a further event of default occurred. The Company also agreed to
reduce its outstanding bank borrowings from the $58.6 million outstanding at
July 3, 1999, to $15 million by October 30, 1999, to increase the interest rate
on its bank debt to 2% over the bank's prime interest rate and to pay a
forbearance fee of $580,000.

On August 17, 1999, the Company received $30 million in financing from the
Investors. The Investors purchased senior secured notes and warrants pursuant to
separate securities purchase agreements (the "Securities Purchase Agreements")
each dated as of August 16, 1999. Under these Securities Purchase Agreements,
the Company issued (i) $10 million of its 12.5% Secured Notes due 2003 (the "A
Notes"); (ii) $5 million of its 13.0% Secured Notes due 2003 (the "B Notes");
(iii) $5 million of its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10
million of its 14.0% Secured Notes due 2004 (the "D Notes", and together with
the A Notes, the B Notes and the C Notes, the "Notes"); and (v) warrants (the
"Warrants") to purchase 6,880,000 shares of the Company's common stock at an
initial exercise price of $3.00 per share. The Warrants were valued at
$1,965,000 based on management's estimate using certain fair value methodologies
and represents an original issue discount to the C Notes and the D Notes. Up to
$15 million of the Notes is secured by a first lien that is pari pasu with the
liens under the Credit Agreement. The Notes are secured by a junior lien on all
of the Company's assets. The Company issued the Warrants in connection with the
sale of

F-21
<PAGE> 46
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

the C Notes and the D Notes. The Warrants may be exercised before the close of
business on August 16, 2006. The shares of Common Stock reserved for issuance
under the Warrants represent approximately 35% of the shares of Common Stock
outstanding after giving effect to the exercise of the Warrants. The proceeds
from the $30 million in new financing were used for the purchase of seasonal
inventory, payment of amounts due under the Credit Agreement, transaction fees
and working capital.

The Company also entered into an Investor Rights Agreement (the "Investor
Rights Agreement") with the Investors and Jack Futterman, then the chief
executive officer of the Company. In this agreement, the Company granted
registration rights with respect to shares of common stock. Under the Investor
Rights Agreement, the Investors agreed that they will not, without the prior
written consent of the Board of Directors, (i) acquire or agree to acquire,
publicly offer or make any public proposal with respect to the possible
acquisition of (a) beneficial ownership of any securities of the Company, (b)
any substantial part of the Company's assets, or (c) any rights or options to
acquire any of the foregoing from any person; (ii) make or in any way
participate in any "solicitation" of "proxies" (as such terms are defined in the
rules of the Securities Exchange Act of 1934, as amended) to vote, or seek to
advise or influence any person with respect to the voting of any voting
securities of the Company; or (iii) make any public announcement with respect to
any transaction between the Company or any of its securities holders and the
Investors, including without limitation, any tender or exchange offer, merger or
other business combination of a material portion of the assets of the Company.
These standstill provisions terminate if the Company's consolidated earnings
before interest, taxes, depreciation and amortization and exclusive of special
charges ("EBITDA") do not meet specified targets. The Company achieved its
target EBITDA for the calendar year 1999. Also, in connection with these
transactions, one outside director of the Company resigned and two
representatives of the Investors joined the Board of Directors. The Company has
amended the restriction that prohibited the Investors from purchasing the
Company's stock to permit purchase up to an aggregate amount of $1.5 million of
the Company's common stock.

Party City's trade vendors representing approximately $36.4 million of
trade debt also entered into an agreement with the Company. Pursuant to a Vendor
Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"), these
trade vendors agreed to forbear from taking any action against Party City until
January 15, 2000. The trade vendors have received promissory notes from Party
City representing one-third of their unpaid balances as of May 1, 1999 (the
"Trade Notes"). The Trade Notes bore interest at a rate of 10% per year and were
scheduled to mature on November 15, 1999. Interest on the Trade Notes was due on
January 15, 2000, unless the bank debt was refinanced before such date.
Separately, certain seasonal trade vendors agreed to provide trade credit to the
Company for 30% of the purchases for the Halloween, Thanksgiving and year-end
holiday season. These vendors received a shared lien on the Company's inventory
for the amount of the credit.

In June 1999, Steven Mandell, a major stockholder and director of the
Company granted an option to acquire 1,000,000 shares of the shareholder's
common stock to Jack Futterman. The option vested immediately and has an
exercise price of $3.00 a share, the fair value of the common stock at date of
grant. The option expires in June 2004.

In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company began a program to identify stores for sale to existing
franchisees to generate working capital. Eighteen stores with a net book value
of approximately $9.8 million were sold to franchisees. In order to facilitate
the sale of these stores, franchise fees were negotiated at lower than normal
rates for specific periods. The total proceeds from the sales of these stores
was approximately $9.9 million. The net proceeds from the sale of stores was
required under the Bank Forbearance Agreement to be used to pay down the
outstanding borrowings under the Credit Agreement.

F-22
<PAGE> 47
PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

On January 14, 2000, the Company replaced the Credit Agreement with a new
Loan and Security Agreement (the "Loan Agreement") with Congress Financial
Corporation ("Congress"), as lender. Under the terms of the Loan Agreement, the
Company may from time to time borrow amounts based on a percentage of its
eligible inventory, up to a maximum of $40 million at any time outstanding.
Advances bear interest, at the Company's option, (i) at the adjusted Eurodollar
rate plus the applicable margin, which will initially be 2.75% per annum
(subject to possible reduction to an interest rate as low as 2.25% from and
after June 30, 2001, based on the Company's pre-tax income and excess
availability) or (ii) at the rate of 3/4% per annum above the prime rate. The
term of the Loan Agreement is three years, and is secured by a lien on
substantially all of the assets of the Company. At September 15, 2000, there was
$15.8 million outstanding and approximately $24.2 million was available to be
borrowed under this revolving credit facility.

On January 14, 2000, Party City also received $7 million in cash proceeds
from the sale to certain of its existing Investors (the "Investor Group") of a
new series of senior secured notes pursuant to a First Amendment (the "First
Amendment") to the Securities Purchase Agreements. Pursuant to the First
Amendment, the Company issued $7,000,000 in aggregate principal amount of its
14.0% Secured Notes due 2002 (the "E Notes"). The E Notes are secured by a lien
on substantially all of the Company's assets. The Investor Group, together with
other existing Investors and Congress, have entered into an intercreditor
agreement. In consideration for waivers and forbearances granted by the
Investors to various defaults under the terms of the Company's A Notes, B Notes,
C Notes and D Notes, the Company also agreed to amend and restate the terms of
the Warrants held by the Investors to acquire 6,880,000 shares of the Company's
Common Stock. The amended and restated Warrants (the "Amended Warrants") provide
for an exercise price of $1.07 per share and were issued upon surrender of the
Warrants which had an exercise price of $3.00 per share. The Amended Warrants
were valued at $3,156,000 based on management's estimate using certain fair
value methodologies and represent an original issue discount to the C Notes and
D Notes. This discount is being amortized using the effective interest method.
The effective yield is 28.6% and 28.9% on the C Notes and D Notes, respectively.

The Company used the proceeds from the sale of the E Notes and initial
amounts borrowed under the Loan Agreement (i) to pay off all amounts owed under
the Credit Agreement, (ii) to pay all amounts owed on the Trade Notes and (iii)
to pay the remaining amounts owed to various seasonal trade vendors for credit
extended for inventory purchased by the Company for the 1999 Halloween,
Thanksgiving and year-end holiday seasons. All the remaining unpaid vendor
balances that were originally due May 1, 1999, were satisfied by individual
arrangements with such vendors.

F-23