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Prospectus Filed Pursuant to Rule 424(b)(1)
June 2, 1999 Registration Statement No. 333-74719
Zany Brainy, Inc.
6,100,000 Shares of Common Stock
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Zany Brainy: The Offering:
.We are a leading specialty .We are offering 3,807,669 of the
retailer of high quality toys, shares and existing
games, books and multimedia shareholders are offering
products for children. 2,292,331 of the shares.
.Zany Brainy, Inc. .The underwriters have an option
308 East Lancaster Avenue to purchase an additional
Wynnewood, PA 19096 915,000 shares from Zany
(610) 896-1500 Brainy.
Symbol and Market: .This is our initial public
offering, and no public market
currently exists for our
shares.
.ZANY/Nasdaq National Market .We plan to use the proceeds from
this offering to repay bank
debt, open our new
distribution center and
additional stores, implement
new enterprise software,
develop an internet shopping
site and for other working
capital and general corporate
purposes. We will not receive
any proceeds from the shares
sold by the selling
shareholders.
.Closing: June 8, 1999
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Per Share Total
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<S> <C> <C>
Public offering price: $10.00 $61,000,000
Underwriting fees: $ 0.70 $ 4,270,000
Proceeds to Zany Brainy: $ 9.30 $35,411,322
Proceeds to the selling shareholders: $ 9.30 $21,318,678
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</TABLE>
This investment involves risks. See "Risk Factors" beginning on page 6.
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Neither the SEC nor any state securities commission has determined whether this
prospectus is truthful or complete. Nor have they made, nor will they make, any
determination as to whether anyone should buy these securities. Any
representation to the contrary is a criminal offense.
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Donaldson, Lufkin & Jenrette
BT Alex. Brown
William Blair & Company
U.S. Bancorp Piper Jaffray
DLJdirect Inc.
<PAGE>
[Depicted on the front cover page is a jumping child]
[Depicted on the inside front cover page are photographs of Zany Brainy
stores, customers and a picture of a young girl painting with the following
text: "Zany Brainy on a Mission To provide a unique retail environment where
Inter-Activity reigns... where connections flourish. Between parents and
children. Kids and toys. Staff and families. Store and community. Friends and
peers. And, most importantly, between the ZANYNESS of play and the BRAINYNESS
of learning. Through the experience of Inter-Activity, we spark the
imagination and nurture the sense of accomplishment so vital to every child's
future."]
TABLE OF CONTENTS
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Page
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Prospectus Summary.................. 1
Risk Factors........................ 6
Forward-Looking Statements.......... 15
Use of Proceeds..................... 16
Dividend Policy..................... 16
Capitalization...................... 17
Dilution............................ 18
Selected Consolidated Historical
Financial and Operating Data....... 19
Management's Discussion and Analysis
of Financial Condition and Results
of Operations...................... 20
</TABLE>
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Page
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Our Business.......................................................... 29
Management............................................................ 39
Certain Transactions.................................................. 44
Principal and Selling Shareholders.................................... 46
Description of Capital Stock.......................................... 49
Shares Eligible for Future Sale....................................... 52
Underwriting.......................................................... 53
Experts............................................................... 56
Legal Matters......................................................... 56
Additional Information................................................ 57
Index to Consolidated Financial Statements............................ F-1
</TABLE>
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We have not authorized any dealer, salesperson or other person to give you
written information other than this prospectus or to make representations as
to matters not stated in this prospectus. You must not rely on unauthorized
information. This prospectus is not an offer to sell these securities or our
solicitation of your offer to buy the securities in any jurisdiction where
that would not be permitted or legal. Neither the delivery of this prospectus
nor any sales made hereunder after the date of this prospectus should create
an implication that the information contained in this prospectus or the
affairs of Zany Brainy have not changed since the date of this prospectus.
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<PAGE>
PROSPECTUS SUMMARY
The following summarizes information in other sections of our prospectus,
including our consolidated financial statements and the notes to these
statements. You should read the entire prospectus carefully. Our fiscal year
ends on the Saturday nearest to January 31 and is named for the calendar year
ending closest to that date. For example, our fiscal year ended January 30,
1999 is called "1998."
Zany Brainy
Zany Brainy is a leading and rapidly growing specialty retailer of high
quality toys, games, books and multimedia products for kids. We are a different
kind of toy store with a unique product mission and a passionate commitment to
our customers. We believe that learning should be fun. Our products entertain,
educate and spark the imaginations of children up to 12 years of age. Zany
Brainy combines this distinctive merchandise offering with superior customer
service and daily in-store events to create an interactive, "kid-friendly" and
exciting shopping experience for children and adults. We opened our first store
in Pennsylvania in 1991 and, as of May 1, 1999, we operated 82 stores in 23
states. We opened 23 new stores last year and plan to add approximately 25
stores in 1999, seven of which we had already opened as of May 1, 1999, and
approximately 25 stores in 2000. Our sales grew 36.6% in 1998 to $168.5 million
and we experienced comparable store sales growth of 9.1% in 1997, 9.9% in 1998
and 9.0% in the first quarter of 1999.
Our Unique Product Mission
We carefully select products that encourage children's educational,
emotional or physical development. Zany Brainy does not sell products that are
inconsistent with our mission, such as toys that may reinforce gender
stereotypes or encourage violence. In addition, we generally do not offer TV-
promoted, mass marketed items. Our extensive selection of over 15,000 stock
keeping units includes:
. Toys, games and puzzles . Infant development toys
. Books, audio cassettes and videotapes . Arts and crafts
. Computer software and electronic learning aids
. Building toys and trains
. Plush and dolls . Sport-theme toys
Many manufacturers of the specialty products we offer currently do not sell
their products through discounters or mass market retailers. Excluding books
and multimedia, we believe that generally less than 30% of the stock keeping
units that we carry are available at Toys "R" Us.
1
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Our Inviting and Interactive Stores
Our prototype 10,600 square foot stores are bright, colorful and inviting
and present our product offering in 11 major categories. Large banners with
unique graphics identify each of these categories to help customers find
specific items quickly. Our stores are fully-carpeted and have low shelving to
encourage children to see, touch and play with our products. Children can read
books in our reading area, try software products and play with electronic
learning aids at one of our interactive demonstration stations or watch movies
in our Zany Showtime Theater. Our stores also feature free fun every day,
offering scheduled events such as creative arts and crafts activities,
character and author appearances and mini-concerts by children's performers. We
believe these elements make our stores an attractive destination for children
and adults.
Our Knowledgeable and Highly-Trained Associates
Our highly-trained sales associates provide knowledgeable and enthusiastic
service that we believe helps us maintain the confidence, loyalty and trust of
our customers. Zany Brainy seeks employees that have a passion for addressing
the needs of our customers, enjoy working with children and appreciate how kids
learn through play. Accordingly, we actively recruit educators, child care
providers and back-to-work parents as sales associates. We train our sales
associates to proactively advise customers on product features, benefits and
age-appropriateness. In addition, we staff our stores with book, multimedia and
other specialists who have an in-depth knowledge of their product categories.
Principal Executive Offices
Zany Brainy, Inc.
308 East Lancaster Avenue
Wynnewood, PA 19096
Phone: 610-896-1500
Incorporation
We were incorporated in 1991 in Pennsylvania under the name Children's
Concept, Inc. and, in March 1999, we changed our name to Zany Brainy, Inc.
2
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The Offering
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<S> <C>
Common stock offered by:
Zany Brainy................. 3,807,669 shares
Selling shareholders........ 2,292,331 shares
----------------
Total..................... 6,100,000 shares
Common stock to be outstanding
after this offering.......... 20,490,780 shares
Use of proceeds............... We plan to use the proceeds from this offering
to repay bank debt, open a new distribution
center and additional stores, implement new
enterprise software, develop an internet
shopping site and for other working capital and
general corporate purposes. We will not receive
any proceeds from the shares sold by the selling
shareholders.
Nasdaq National Market
symbol....................... ZANY
</TABLE>
The number of shares of common stock to be outstanding after this offering
is based on shares outstanding at May 1, 1999:
. excluding 3,544,637 shares of common stock issuable upon the exercise of
options and warrants outstanding as of May 1, 1999 at a weighted average
exercise price of $5.44 per share and 2,068,758 shares reserved for
future grants under our 1993 stock incentive plan and our 1998 equity
compensation plan;
. including 25,000 shares to be sold in this offering, which were issued in
connection with the exercise of stock options on the date of this
prospectus; and
. including 22,430 shares, which were issued in connection with the
exercise of warrants held by affiliates of Donaldson, Lufkin & Jenrette
Securities Corporation on the date of this prospectus.
Generally, the information in this prospectus:
. assumes there is no exercise of the underwriters' over-allotment option;
and
. gives effect to the conversion of all outstanding shares of preferred
stock into shares of common stock.
3
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Summary Consolidated Financial Data
You should read the data set forth below together with our "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
our consolidated financial statements and related notes included elsewhere in
this prospectus. All fiscal years presented include 52 weeks of operations,
except 1995, which includes 53 weeks. When reading this summary, you should be
aware that:
. Gross profit represents net sales less cost of goods sold, which
includes buying, distribution and store occupancy costs.
. A store becomes comparable in the 14th full month of store operations.
. Sales per square foot and average sales per store are based on stores
opened for the entire period.
. Pro forma, as adjusted balance sheet data represents actual data, as
adjusted, to give effect to:
. the conversion of all preferred stock into 11,250,273 shares of
common stock;
. the sale of 3,807,669 shares of common stock offered by us at an
initial public offering price of $10.00 less underwriting fees,
estimated offering expenses and the application of the estimated
net proceeds;
. the issuance of 25,000 shares to be sold in this offering, which
were issued on the date of this prospectus in connection with the
exercise of stock options with an aggregate exercise price of
$16,750; and
. the issuance of 22,430 shares, which were issued on the date of
this prospectus in connection with the exercise on a cashless
basis of warrants to purchase 56,073 shares of common stock at an
exercise price of $6.00 per share.
4
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Thirteen
Fiscal Year Weeks Ended
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May 2, May 1,
1994 1995 1996 1997 1998 1998 1999
(in thousands, except per share, number of stores and
sales per square foot data)
Statement of Operations
Data:
<S> <C> <C> <C> <C> <C> <C> <C>
Net sales............. $23,471 $54,372 $92,563 $123,345 $168,471 $27,452 $40,577
Gross profit.......... 6,446 13,400 23,358 33,893 50,318 7,315 11,190
Selling, general and
administrative
expenses............. 13,310 21,110 28,732 33,581 46,376 9,659 12,986
Operating income
(loss)............... (6,864) (7,710) (5,374) 312 3,942 (2,344) (1,796)
Net income (loss)..... (6,658) (7,828) (6,023) (153) 8,999(a) (2,470) (1,378)
Net income (loss) per
common share:
Basic............... $ (1.35) $ (1.55) $ (1.19) $ (0.03) $ 1.67(a) $ (0.46) $ (0.26)
Diluted (b)......... (1.35) (1.55) (1.19) (0.03) 0.51(a) (0.46) (0.26)
Weighted average
shares outstanding:
Basic............... 4,930 5,065 5,068 5,085 5,373 5,363 5,384
Diluted (b)......... 4,930 5,065 5,068 5,085 17,770 5,363 5,384
Store Data:
Number of stores at
end of the period.... 16 31 43 52 75 53 82
Total square feet at
end of the period.... 189 387 538 630 868 641 942
Comparable store sales
increase............. 17.3% 0.3% 4.3% 9.1% 9.9% 6.8% 9.0%
Sales per square
foot................. $ 245 $ 202 $ 183 $ 203 $ 227 $ 43 $ 45
Average sales per
store................ 2,502 2,382 2,286 2,523 2,746 525 522
Operating Data:
Gross profit margin... 27.5% 24.6% 25.2% 27.5% 29.9% 26.6% 27.6%
Operating margin
(loss)............... (29.2) (14.2) (5.8) 0.3 2.3 (8.5) (4.4)
Capital expenditures.. $ 5,432 $ 7,377 $ 6,276 $ 6,420 $ 7,309 $ 779 $ 2,497
Depreciation and
amortization......... 730 2,115 3,713 5,017 6,859 1,385 1,888
</TABLE>
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At May 1, 1999
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Pro Forma,
Actual As Adjusted
<S> <C> <C>
Balance Sheet Data:
Inventories............................................. $52,375 $52,375
Working capital......................................... 22,899 57,543
Total assets............................................ 94,052 115,268
Short-term borrowings................................... 12,402 --
Capitalized lease obligations, including current
portion................................................ 4,047 4,047
Total shareholders' equity.............................. 46,919 80,997
</TABLE>
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(a) Net income for 1998 includes a net income tax benefit of $6,187 due to the
$7,166 benefit recorded for our net operating loss carryforward, partially
offset by income tax expense of $979.
(b) Stock options, warrants and preferred stock convertible into common stock
were excluded from the calculation of diluted net loss per common share
for 1994 through 1997 and the 13 weeks ended May 2, 1998 and May 1, 1999
as they were anti-dilutive due to the losses in each of those periods.
5
<PAGE>
RISK FACTORS
You should carefully consider the following factors and other information in
this prospectus before deciding to invest in shares of our common stock.
Risks Relating to Our Business
We have a history of net losses, and we may not be profitable in the future
Since our inception in 1991, we have reported net losses for each year
except for 1998, when we reported net income for the first time. We may incur
additional net losses in the future, which could cause our stock price to
decline. We cannot assure that we will be profitable in future years. Our net
losses were $6.0 million in 1996 and $153,000 in 1997. Our net income was $9.0
million in 1998, which included a net income tax benefit of $6.2 million due to
the $7.2 million benefit recorded for our net operating loss carryforward,
partially offset by income tax expense of $1.0 million.
We have limited experience with the performance of our prototype stores, and
these stores may not generate sales at or exceeding historical levels
Our current prototype store is 10,600 square feet. Most of the stores we
opened in 1997 and 1998, as well as most of the approximately 25 stores to be
opened in 1999, are based on this prototype store, which is smaller than many
of our older stores. Although the move to our current prototype has decreased
our average store size, our average sales per store have increased from
approximately $2.5 million in 1997 to approximately $2.7 million in 1998. Sales
per square foot also have increased from $203 in 1997 to $227 in 1998. Because
our actual experience with our prototype stores is generally limited, we cannot
be certain that our new stores will generate sales or sales per square foot at
or exceeding historical levels. If sales or sales per square foot at our new
stores do not exceed these levels, the price of our stock could decline.
Our business is highly seasonal, and our annual results are highly dependent
on the success of our Christmas selling season
Seasonal shopping patterns affect our business. A significant portion of our
sales occur in the fourth quarter, coinciding with the Christmas holiday
shopping season. Therefore, our results of operations for the entire year
depend largely on our fourth quarter results. In fact, since inception, we have
never been profitable in any quarter other than the fourth quarter of any
fiscal year, and we expect this trend to continue. Factors that could cause our
sales and profitability to suffer include:
. the availability of and customer demand for particular products;
. the timing of new store openings;
. adverse weather conditions;
. unfavorable economic conditions;
. inability to hire adequate temporary personnel;
. inability to maintain appropriate inventory levels; and
. a late Thanksgiving, which reduces the number of days between
Thanksgiving and Christmas.
6
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If we are not able to implement our store expansion program, our growth will
suffer
Our growth depends in large part on our ability to open and profitably
operate new stores in both existing and new geographic markets. We plan to open
approximately 25 stores during 1999, seven of which we had already opened as of
May 1, 1999, and approximately 25 stores in 2000. We may not be able to achieve
our planned expansion. We plan to open approximately 14 stores, four of which
we have already opened, in markets where we do not currently have a presence.
The opening of stores in new geographic markets could present competitive and
operational challenges different from those we currently face or previously
faced in entering our existing geographic markets. For example, we may incur
higher costs related to advertising, administration and distribution as we
enter these new markets. Because our continued growth is dependent, in part, on
our ability to increase sales in our existing stores, our overall profitability
will suffer if the opening of new stores in existing markets draws business
from our existing stores. We generally prefer to open new stores in the first
three quarters of the year. Our failure to open stores on schedule may
particularly impair our results because of our dependence on the Christmas
holiday shopping season.
Our ability to open and operate new stores will depend on a number of
factors, including our ability to:
. identify suitable sites;
. negotiate acceptable leases at attractive rents;
. access adequate capital to fund store expansion;
. construct and open stores on schedule;
. obtain acceptance in markets in which we currently have limited or no
presence; and
. locate, hire, train and retain competent managers.
On average, the net cost of opening a new store in 1996, 1997 and 1998 was
approximately $826,000, $842,000 and $750,000, respectively.
We may not have sufficient management, operational, distribution, financial
and information systems resources to accommodate our planned growth. Our
expansion strategy also presents some cultural risks, including our ability to
maintain our product mission, customer service commitment and quality control
as we become larger in size. In addition, if our new stores do not perform as
expected, we may curtail our store expansion, which would impair our financial
growth and profitability.
Our comparable store sales will fluctuate
Changes in our comparable store sales results could cause the price of our
common stock to fluctuate. A number of factors have historically affected, and
will continue to affect, our comparable store sales results, including:
. competition;
. our new store openings;
. general regional and national economic conditions;
. consumer trends and preferences;
7
<PAGE>
. changes in our co-tenants;
. new product introductions and changes in our product mix;
. timing and effectiveness of promotional events; and
. weather.
Comparable store sales may not increase at the rates achieved in 1997 and
1998.
The relocation of our distribution center and corporate headquarters could
disrupt our operations
In 1999, we intend to close our distribution center in Delaware and relocate
to a larger facility in New Jersey. Approximately 80% of our products are
distributed through our Delaware facility. This transition to a new
distribution center could disrupt the receipt and distribution of our
merchandise, particularly if there are any unforseen delays or interruptions in
the transition process. Any disruption in distribution could impede our
business operations, resulting in reduced profitability. In addition, if we are
unable to generate increased sales and profit sufficient to absorb increased
overhead and other costs associated with our relocation, we would likely
experience lower operating profit margins.
In 1999, we also plan to relocate our corporate headquarters to a larger
facility in Pennsylvania. Any delay in relocating our headquarters or
disruption to our operations as a result of the move could have a negative
impact on our business.
Additional financing may not be available when needed or could substantially
increase our interest expense, dilute your shareholdings and limit our ability
to pay dividends
We may need additional financing to support more rapid growth than currently
anticipated or to respond to competitive pressures or unanticipated events.
Additional financing, if needed, may not be available on satisfactory terms or
at all. Any additional equity financing may cause dilution to existing
investors. Any debt financing may result in additional restrictions on our
spending or ability to pay dividends.
Restrictive loan covenants may limit our ability to take various corporate
actions
Our credit facility contains covenants which require us to satisfy ongoing
financial requirements and which limit our ability to borrow additional money,
pay dividends, divest assets and make additional corporate investments. If we
are unable to meet any of our debt service obligations or to comply with these
covenants, our lenders can accelerate our debt. If that were to occur and we
are unable to obtain alternative financing, our long term viability could be
impaired.
Our computer systems and those of our key suppliers, credit card processors
and telecommunications providers may not be Year 2000 compliant, which may
disrupt our operations
Zany Brainy faces risks associated with the fact that many existing computer
systems and software products do not properly recognize dates after
December 31, 1999. This could result in system failures or miscalculations
causing disruptions of operations, including, among others, a temporary
inability to receive shipments, process financial information or credit card
transactions, deliver products or engage in similar normal business activities.
8
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We have recently upgraded our enterprise software system, Systems For
Retailers (SFR), to a Year 2000 compliant version. However, because the
manufacturer of SFR is no longer in business, we may be particularly vulnerable
if the new version of SFR does not operate properly on January 1, 2000.
We are also engaged in efforts to upgrade certain in-store systems which are
not Year 2000 compliant. If our various store systems cease to operate on
January 1, 2000, we believe that we would be able to perform necessary
functions through manual intervention. However, the use of the manual
intervention would significantly disrupt store operations.
We have initiated formal communications with many of our significant
suppliers to determine our vulnerability if they fail to remedy their own Year
2000 problems. We believe that Year 2000 issues faced by our key suppliers,
credit card processors and telecommunication providers, if not effectively
remediated, could disrupt our operations. Moreover, while we would seek to
migrate to other third parties if service providers with whom we currently have
a relationship are not Year 2000 compliant, we may not be able to identify
suitable third party substitutes on a basis that would avoid disruptions to our
operations.
Our operations could be disrupted if our information systems fail
Our business depends on the efficient and uninterrupted operation of our
computer and communications software and hardware systems. We regularly make
investments to upgrade, enhance and replace our systems. We must appropriately
expand the capacity of our information systems to accommodate our anticipated
growth or our operations could suffer.
SFR, the current provider of our enterprise software system, is no longer in
business. Although we have the source code and have hired former SFR employees
as consultants, we intend to replace SFR with a new software system from JDA
Software, Inc. (JDA) early in the year 2000. Any disruptions affecting our
information systems or any delays or difficulties in transitioning to JDA or
other new systems could make it more difficult to effectively operate our
business.
We have no formal disaster recovery plan to prevent delays or other
complications arising from information systems failure. Our business
interruption insurance may not adequately compensate us for losses that may
occur.
We are dependent on executive management and other personnel
We believe that our continued growth and profitability depend on the
continued employment of our management team. If one or more members of our
executive management team were unable or unwilling to continue in their present
positions, our profitability could suffer. We do not carry key person life
insurance on any member of our executive management team.
Our growth and profitability also depend on hiring and retaining quality
managers and sales associates in our stores. We plan to expand our employee
base to manage our anticipated growth. Competition for personnel, particularly
for employees with retail expertise, is intense. Additionally, our ability to
maintain consistency in the quality of customer service in our stores is
critical to our operations. If we are unable to hire and retain sales
associates capable of providing a high level of customer service, our brand and
reputation could be damaged. This damage could impair our ability to retain
current customers and attract new customers, which could cause our sales to
decline.
9
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Risks Relating to Our Industry
The intense competition we face from other retail companies may cause us to
lose market share
Competition from mass market retailers and discounters, which have
greater brand recognition and financial and other resources
Many mass market retailers and discounters, such as Toys "R" Us, Wal-Mart
and Target, have much greater brand recognition and greater financial,
marketing and other resources than ours. We could be at a disadvantage in
responding to these competitors' merchandising and pricing strategies,
advertising campaigns and other initiatives. In addition, an increase in focus
on the specialty retail market or the sale by these competitors of more product
similar to ours could cause us to lose market share.
Competition from smaller format, specialty educational and creative toy
retailers, whose growth can impair our sales growth
Our direct competitors are smaller format, specialty educational and
creative toy and game retailers, including Noodle Kidoodle and LearningSmith.
These retailers are continuing to expand and could impede our ability to
increase our sales.
Competition from non-toy specialty retailers, which compete with our
children's book and software businesses and could limit our ability to
expand in these categories
Non-toy specialty retailers, such as Barnes & Noble and CompUSA, are
competing with our children's book and software businesses. We believe that
some of these competitors have exclusivity restrictions in their leases that
restrict co-tenants from selling similar products. Such restrictions could
hinder our expansion strategy by limiting our ability to sell some products at
those sites.
Competition from internet-only retailers, which may have a cost advantage
and reach a broader market
We currently do not have an internet-based sales channel and face growing
competition from internet-based retailers, such as eToys and Amazon.com.
Because internet-based retailers do not operate retail stores, they may enjoy
an overall operating cost advantage. In addition, if we fail to develop an
internet-based sales channel and the internet continues to expand, due to the
nature of electronic commerce, the internet-based retailers may reach a broader
market.
With respect to all of our competitors, our sales and profitability could
suffer if:
. new competitors enter markets in which we are currently operating;
. our competitors implement aggressive pricing strategies;
. our competitors expand their operations;
. our suppliers sell their products directly or enter into exclusive
arrangements with our competitors; or
. our competitors adopt innovative store formats, retail sales methods or
merchandising strategies that are similar to ours.
10
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If our suppliers and distributors do not provide us with sufficient
quantities of our products, our sales and profitability will suffer
A disruption in the operations of any of our key suppliers could cause a
decline in our sales
Products supplied to us by our top ten suppliers represented approximately
40% of purchases in 1998. Our dependence on our principal suppliers involves
risk, and if there is a disruption in supply from a principal supplier or
distributor, we may be unable to obtain the merchandise we desire to sell.
While no one supplier represented greater than 10% of purchases in 1998, a
disruption in the operations of any of our key suppliers could cause a decline
in our sales.
Our sales also could decline if key specialty suppliers sell more products
through mass market retailers.
Many of our suppliers currently provide us with incentives, such as return
privileges, volume purchasing allowances and cooperative advertising. A
reduction or discontinuation of these incentives could reduce our profits.
In mid-1998, we entered into a relationship with a subsidiary of Ingram
Industries Inc. (Ingram Books) to be our principal book distributor. We
previously purchased books from numerous publishers and distributors,
including Ingram Books. In 1998, our purchases from book suppliers accounted
for approximately 12% of all our purchases.
If a shipment of products that we import is interrupted or delayed, our
inventory levels and sales could decline
We do not own or operate any manufacturing facilities. Instead, we buy all
of our products from manufacturers and distributors. In 1998, we imported
approximately 9% of our purchases, including most of our private label
products, directly from foreign manufacturers. In addition, we believe that a
significant portion of the products that we purchase from domestic suppliers
are manufactured abroad. We anticipate that our dependence on foreign-sourced
merchandise will increase. We are subject to the following risks inherent in
relying on foreign manufacturers:
. the inability to return products;
. fluctuations in currency exchange rates;
. economic and political instability;
. transportation delays;
. restrictive actions by foreign governments;
. the laws and policies of the United States affecting importation of
goods, including duties, quotas and taxes;
. foreign trade and tax laws;
. foreign labor practices;
. trade infringement claims; and
. increased liability as importer of record.
11
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Interruptions or delays in our imports could cause shortages in our product
inventory and a decline in our sales unless we secure alternative supply
arrangements. Even if we could locate alternative sources, their products may
be of lesser quality or more expensive than those we currently purchase. Our
sales could also suffer if our suppliers experience similar problems with
foreign manufacturers.
If we are unable to predict or react to changes in consumer demand, we may
lose customers and our sales may decline
Our success depends on our ability to anticipate and respond in a timely
manner to changing consumer demand and preferences regarding toys, games, books
and multimedia products for children. Our products must appeal to a broad range
of consumers whose preferences cannot be predicted with certainty and are
subject to change. If we misjudge the market for our merchandise, we may
overstock unpopular products and be forced to take significant inventory
markdowns, which may have a negative impact on our profitability.
It is also common in the toy industry for some popular products, such as
Beanie Babies, Crazy Bones and yoyos, to achieve high sales, but for
unpredictable periods of time. In 1998, Beanie Babies represented over 5% of
our sales and in the first quarter of 1999, Beanie Babies and Crazy Bones
represented over 10% and over 5% of our sales, respectively. Consumer demand
for these products or others could decrease significantly and without warning.
If we are unable to identify new products that will enjoy strong consumer
demand, we may lose customers and our sales may decline. In addition, the
introduction of new products may depress sales of existing products. Moreover,
because we sell only those products that conform to our product mission, we may
choose not to sell some products that our customers desire and thus lose
potential sales.
We are subject to inventory shrinkage, which could reduce the overall
profitability of our business
As is the case in our industry generally, we are subject to loss resulting
from, among other things, theft of our products, breakage and paperwork errors.
In 1998, this inventory shrinkage represented approximately 1% of total sales.
Although we have implemented loss prevention procedures, we remain susceptible
to inventory shrinkage, which could have a negative impact on our
profitability.
We may be unable to protect our intellectual property, which could impair our
brand and reputation
Our efforts to protect our proprietary rights may be inadequate. We regard
our intellectual property, particularly our trademark for "Zany Brainy," as
important to our marketing strategy. To protect our proprietary rights, we rely
generally on copyright, trademark and trade secret laws, confidentiality
agreements with employees and third parties and license agreements with
consultants and suppliers. However, a third party could, without authorization,
copy or otherwise appropriate information from us. Employees, consultants and
others who participate in development activities could breach their
confidentiality agreements, and we may not have adequate remedies for any such
breach. Our failure or inability to protect our proprietary rights could
materially decrease their value, and our brand and reputation could be
impaired.
We may be exposed to product liability lawsuits and other claims if we fail
to comply with government and toy industry safety standards
Children can sustain injuries from toys. We may be subject to claims or
lawsuits resulting from such injuries. There is a risk that claims or
liabilities may exceed our insurance coverage. Moreover,
12
<PAGE>
we may be unable to retain adequate liability insurance in the future. We are
subject to regulation by the Consumer Product Safety Commission and similar
state regulatory agencies. If we fail to comply with government and toy
industry safety standards, we may be subject to claims, lawsuits, fines and
adverse publicity.
Risks Relating to this Offering
Provisions of Pennsylvania law and our articles of incorporation could delay
or prevent the acquisition or sale of Zany Brainy
Section 1751 of the Pennsylvania Business Corporation Law provides that our
directors are not required to regard the interests of the shareholders as being
dominant or controlling in considering the best interests of Zany Brainy.
Therefore, it could be more difficult for a third party to acquire control of
us, even if such change in control would be beneficial to shareholders. Our
articles of incorporation provide that our board of directors may issue
preferred stock without shareholder approval. The issuance of preferred stock
could make it more difficult for a third party to acquire us.
Future sales by our current shareholders may cause the market price of our
stock to decline
The market price of our common stock could decline as a result of sales of a
large number of shares in the market after this offering or the perception that
such sales could occur. These factors also could make it more difficult for us
to raise funds through future offerings of common stock.
There will be 20,490,780 shares of common stock outstanding immediately
after this offering. Of these shares, the shares sold by us in this offering
and approximately 16.6 million additional shares will be freely transferable
without restriction or further registration under the Securities Act of 1933,
except for any shares held by our affiliates. The remaining shares will be
restricted and may be sold in the future only pursuant to an exemption under
the Securities Act. The holders of approximately 13.1 million shares of common
stock have agreed not to sell any such securities for 135 days after the date
of this prospectus and not to sell two-thirds of such securities until January
31, 2000 without the prior written consent of Donaldson, Lufkin and Jenrette
Securities Corporation (DLJ). DLJ may, however, in its sole discretion, release
all or any portion of the securities subject to such lock-up agreements.
The holders of approximately 8.2 million shares of common stock, all of
which are subject to the lock-up agreements described above, have registration
rights. If they exercise such rights, shares covered by a registration
statement can be sold in the public market. We also intend to register
approximately 5.6 million shares of common stock that we have issued or may
issue under our benefit plans or pursuant to option agreements. After such
registration statement is effective, shares issued upon exercise of stock
options to persons other than affiliates will be eligible for resale in the
public market without restriction, which could cause our stock price to
decline. Absent such registration, such shares could nevertheless be sold,
subject to limitations on the manner of sale. Sales by affiliates could also
occur, subject to limitations, under Rule 144 of the Securities Act.
Because a small number of shareholders own a significant percentage of our
common stock, they may control all major corporate decisions, and our other
shareholders may not be able to influence these corporate decisions
Following this offering, our executive officers and directors will
beneficially own a total of approximately 34.2% of our outstanding common
stock. In addition, a small number of our investors
13
<PAGE>
will beneficially own approximately 22.3% of our outstanding common stock after
this offering. If these parties act together, they can elect all directors and
approve actions requiring the approval of a majority of our shareholders. The
interests of our management or these investors could conflict with the
interests of our other shareholders.
Investors will be subject to market risks typically associated with initial
public offerings
There has not been a public market for our common stock. We cannot predict
the extent to which a trading market will develop or how liquid that market
might become. If you purchase shares of common stock in this offering, you will
pay a price that was not established in the public trading markets. The initial
public offering price was determined by negotiations among the underwriters,
the selling shareholders and us. You may not be able to resell your shares at
or above the initial public offering price and may suffer a loss on your
investment.
The market price of our common stock is likely to be highly volatile as the
stock market in general has been highly volatile. Factors that could cause
fluctuation in the stock price may include, among other things:
. actual or anticipated variations in quarterly operating results;
. changes in financial estimates by securities analysts;
. conditions or trends in our industry;
. changes in the market valuations of other retail companies;
. announcements by us or our competitors of significant acquisitions,
strategic partnerships, divestitures, joint ventures or other strategic
initiatives;
. capital commitments;
. additions or departures of key personnel; and
. sales of common stock.
Many of these factors are beyond our control. These factors may cause the
market price of our common stock to decline, regardless of our operating
performance.
Purchasers of shares in this offering will experience immediate and
substantial dilution
The initial public offering price per share significantly exceeds our net
tangible book value per share. Accordingly, the purchasers of shares sold in
this offering will experience immediate and substantial dilution in their
investment.
14
<PAGE>
FORWARD-LOOKING STATEMENTS
We have made statements under the captions "Prospectus Summary," "Risk
Factors," "Use of Proceeds," "Management's Discussion and Analysis of Financial
Condition and Results of Operations," "Business" and elsewhere in this
prospectus that are forward-looking statements. You can identify these
statements by forward-looking words such as "may," "will," "expect,"
"anticipate," "believe," "estimate" and "continue" or similar words. Forward-
looking statements may also use different phrases. Forward-looking statements
address, among other things:
.our future expectations;
.projections of our future results of operations or of our financial
condition; or
.other "forward looking" information.
We believe it is important to communicate our expectations to our investors.
However, there may be events in the future that we are not able to accurately
predict or which we do not fully control that could cause actual results to
differ materially from those expressed or implied by our forward-looking
statements, including:
. our inability to manage our growth, open new stores on a timely basis and
expand in new and existing markets;
. changes in general economic and business conditions and in the specialty
retail or toy industry in particular;
. actions by our competitors;
. the level of demand for our products;
. changes in our business strategies; and
. other factors discussed under "Risk Factors."
15
<PAGE>
USE OF PROCEEDS
The net proceeds we will receive from the sale of 3,807,669 shares in this
offering will be approximately $34.1 million. This is based upon an initial
public offering price of $10.00 per share and after deducting estimated
underwriting fees and expenses payable by us estimated at $4.0 million. We will
receive additional net proceeds of up to approximately $8.5 million if the
underwriters exercise the option granted to them in connection with this
offering to purchase additional shares of our stock to cover over-allotments.
We will not receive any proceeds from the sale of shares by the selling
shareholders.
We plan to use $15.0 million of the proceeds from this offering to repay
bank debt, $13.0 million to open our new distribution center and additional
stores, $2.0 million to implement new enterprise software and the balance for
other working capital and general corporate purposes. Our bank debt consists of
a $35.0 million revolving credit facility. At May 1, 1999, the outstanding
balance under our credit facility was $12.4 million. Borrowings under the
credit facility bear interest at variable rates, and the weighted average
interest rate at May 1, 1999 was 7.75%. Although the initial term of the credit
facility expires on October 8, 2000, it is anticipated that our current credit
facility will be replaced promptly after completion of this offering with a new
$30.0 million revolving credit facility. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources." A portion of the proceeds from this offering may be used to
implement an internet shopping site. We may also use a portion of the proceeds
to acquire other companies. Although Zany Brainy from time to time is engaged
in negotiations related to possible acquisitions, no agreements relating to
acquisitions are pending.
Pending uses of the net proceeds, we intend to invest the net proceeds in
short-term investment grade securities.
DIVIDEND POLICY
We have never declared or paid any cash dividends on our common stock and do
not anticipate paying any cash dividends in the foreseeable future. We
currently intend to retain future earnings, if any, to finance operations and
the expansion of our business. Our current credit facility prohibits payment of
any dividends, as will our planned new credit facility when implemented.
16
<PAGE>
CAPITALIZATION
The following table sets forth our actual and pro forma, as adjusted cash,
short term debt and total capitalization May 1, 1999. Our pro forma, as
adjusted, capitalization gives effect to:
. the conversion of all outstanding shares of preferred stock into
11,250,273 shares of common stock upon the consummation of this offering;
. the issuance and sale of the 3,807,669 shares of common stock offered by
us in this offering;
. the application of the estimated net proceeds from the sale of our common
stock based on an initial public offering price of $10.00 per share and
after deducting underwriting fees and estimated offering expenses payable
by us;
. the issuance of 25,000 shares to be sold in this offering, which were
issued on the date of this prospectus in connection with the exercise of
stock options for an aggregate purchase price of $16,750; and
. the issuance of 22,430 shares, which were issued on the date of this
prospectus in connection with the exercise on a cashless basis of
warrants to purchase 56,073 shares of common stock at an exercise price
of $6.00 per share.
You should read this table in conjunction with the consolidated financial
statements and the notes to those statements and the other financial
information included in this prospectus.
<TABLE>
<CAPTION>
At May 1, 1999
--------------------
Pro Forma,
Actual As Adjusted
(in thousands)
<S> <C> <C>
Cash..................................................... $ 923 $22,705
======= =======
Short term debt and current portion of capitalized lease
obligations............................................. $14,057 $ 1,655
======= =======
Capitalized lease obligations, net of current portion.... $ 2,392 $ 2,392
------- -------
Shareholders' equity:
Preferred stock......................................... 24 --
Common stock (a)........................................ 54 205
Additional paid-in capital.............................. 60,832 94,783
Accumulated deficit..................................... (13,991) (13,991)
------- -------
Total shareholders' equity............................. 46,919 80,997
------- -------
Total capitalization................................. $49,311 $83,389
======= =======
</TABLE>
- --------
(a) Pro forma, as adjusted, excludes an aggregate of 3,544,637 shares issuable
upon exercise of stock options and warrants outstanding at May 1, 1999,
plus an additional 2,068,758 shares reserved for issuance in connection
with future stock options and other awards under our 1993 stock incentive
plan and 1998 equity compensation plan.
17
<PAGE>
DILUTION
Our pro forma net tangible book value as of May 1, 1999 was $46.8 million or
$2.81 per share. Our pro forma net tangible book value per share is determined
by subtracting the total amount of our liabilities from the total amount of our
tangible assets and dividing the remainder by the number of shares of our
common stock outstanding after giving effect to the conversion of preferred
stock into 11,250,273 shares of common stock, the issuance of 25,000 shares of
common stock to be sold in this offering, which were issued on the date of this
prospectus in connection with the exercise of stock options with an aggregate
exercise price of $16,750, and the issuance of 22,430 shares, which were issued
on the date of this prospectus in connection with the exercise on a cashless
basis of warrants to purchase 56,073 shares of common stock at an exercise
price of $6.00 per share. The pro forma net tangible book value per share after
this offering will be $3.95. Therefore, purchasers of shares of common stock in
this offering will realize immediate dilution of $6.05 per share. The following
table illustrates this dilution.
<TABLE>
<S> <C> <C>
Initial public offering price per share........................... $10.00
Pro forma net tangible book value per share as of May 1, 1999... $2.81
Increase in net tangible book value per share attributable to
new investors.................................................. 1.14
-----
Pro forma net tangible book value per share after this offering... 3.95
------
Dilution per share purchased in this offering..................... $ 6.05
======
</TABLE>
The following table presents, as of May 1, 1999 and utilizing an initial
public offering price of $10.00 per share, for our existing shareholders and
our new investors:
. the number of shares of our common stock purchased from us;
. the total cash consideration paid;
. the average price per share paid before deducting estimated underwriting
fees and our estimated offering expenses;
. the average price per share paid by the existing holders of common stock
including the holders of common stock after giving effect to the
conversion of preferred stock into 11,250,273 shares of common stock, the
issuance of 25,000 shares of common stock to be sold in this offering,
which were issued on the date of this prospectus in connection with the
exercise of stock options with an aggregate exercise price of $16,750,
and the issuance of 22,430 shares, which were issued on the date of this
prospectus in connection with the exercise on a cashless basis of
warrants to purchase 56,073 shares of common stock at an exercise price
of $6.00 per share.
<TABLE>
<CAPTION>
Shares Purchased Total Consideration Average
------------------ -------------------- Price
Number Percent Amount Percent Per Share
---------- ------- ------------ ------- ---------
<S> <C> <C> <C> <C> <C>
Existing shareholders......... 16,683,111 81.4% $ 64,897,897 63.0% $ 3.89
New investors................. 3,807,669 18.6 38,076,690 37.0 10.00
---------- ----- ------------ -----
Total....................... 20,490,780 100.0% $102,974,587 100.0%
========== ===== ============ =====
</TABLE>
Except as specifically noted, the tables on this page exclude all
outstanding options and warrants. See "Management--Stock Option Plan" and note
9 to our consolidated financial statements. The exercise of outstanding options
and warrants having an exercise price less than the initial public offering
price would increase the dilution effect to new investors that is shown on the
tables. Also, the second table on this page does not give effect to sales of
shares by the selling shareholders. Sales by the selling shareholders in this
offering will reduce the number of shares held by existing shareholders to
14,390,780 shares, or 70.2% of the shares outstanding, and will increase the
number of shares held by new investors to 6,100,000 shares, or 29.8% of the
shares outstanding.
This offering will benefit our existing shareholders. The selling
shareholders will receive approximately $21.3 million in net proceeds. In
addition, the current shareholders, including members of management, will
benefit from the creation of a public market for our common stock and any
increase in the market value of any shares they hold. Upon consummation of this
offering, the unrealized appreciation in the value of the common stock held by
existing shareholders will be $83.8 million.
18
<PAGE>
SELECTED CONSOLIDATED HISTORICAL FINANCIAL AND OPERATING DATA
Our statement of operations data for 1996, 1997 and 1998 and the balance
sheet data as of January 31, 1998 and January 30, 1999 have been derived from
the consolidated financial statements, which have been audited by Arthur
Andersen LLP, independent public accountants, and are included in this
prospectus. Our statement of operations data for fiscal 1994 and 1995 and the
selected balance sheet data as of January 28, 1995, February 3, 1996 and
February 1, 1997 have been derived from our audited consolidated financial
statements which are not included in this prospectus. You should read the data
set forth below together with "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the consolidated financial
statements and the notes relating to those statements appearing in the
prospectus.
When reading this data, you should be aware that:
. All fiscal years presented include 52 weeks of operations, except 1995,
which includes 53 weeks.
. A store becomes comparable in the 14th full month of store operations.
. Sales per square foot and average sales per store are based on stores
opened for the entire period.
<TABLE>
<CAPTION>
Thirteen
Fiscal Year Weeks Ended
---------------------------------------------- ----------------
May 2, May 1,
1994 1995 1996 1997 1998 1998 1999
(in thousands, except per share, number of stores and
sales per square foot data)
<S> <C> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Net sales............. $23,471 $54,372 $ 92,563 $123,345 $168,471 $27,452 $40,577
Cost of goods sold,
including occupancy
costs................ 17,025 40,972 69,205 89,452 118,153 20,137 29,387
------- ------- -------- -------- -------- ------- -------
Gross profit.......... 6,446 13,400 23,358 33,893 50,318 7,315 11,190
Selling, general and
administrative
expenses............. 13,310 21,110 28,732 33,581 46,376 9,659 12,986
------- ------- -------- -------- -------- ------- -------
Operating income
(loss)............... (6,864) (7,710) (5,374) 312 3,942 (2,344) (1,796)
Interest income
(expense), net....... 206 (118) (649) (465) (1,130) (126) (427)
------- ------- -------- -------- -------- ------- -------
Income (loss) before
income tax benefit... (6,658) (7,828) (6,023) (153) 2,812 (2,470) (2,223)
Income tax benefit.... -- -- -- -- 6,187 -- 845
------- ------- -------- -------- -------- ------- -------
Net income (loss)..... $(6,658) $(7,828) $ (6,023) $ (153) $ 8,999(a) $(2,470) $(1,378)
======= ======= ======== ======== ======== ======= =======
Net income (loss) per
common share:
Basic................. $ (1.35) $ (1.55) $ (1.19) $ (0.03) $ 1.67(a) $ (0.46) $ (0.26)
Diluted (b)........... (1.35) (1.55) (1.19) (0.03) 0.51(a) (0.46) (0.26)
Weighted average
shares outstanding:
Basic................. 4,930 5,065 5,068 5,085 5,373 5,363 5,384
Diluted (b)........... 4,930 5,065 5,068 5,085 17,770 5,363 5,384
Store Data:
Number of stores at
end of the period.... 16 31 43 52 75 53 82
Total square feet at
end of the period.... 189 387 538 630 868 641 942
Comparable store sales
increase............. 17.3% 0.3% 4.3% 9.1% 9.9% 6.8% 9.0%
Sales per square
foot................. $ 245 $ 202 $ 183 $ 203 $ 227 $ 43 $ 45
Average sales per
store................ 2,502 2,382 2,286 2,523 2,746 525 522
Operating Data:
Gross profit margin... 27.5% 24.6% 25.2% 27.5% 29.9% 26.6% 27.6%
Operating margin
(loss)............... (29.2) (14.2) (5.8) 0.3 2.3 (8.5) (4.4)
Capital expenditures.. $ 5,432 $ 7,377 $ 6,276 $ 6,420 $ 7,309 $ 779 $ 2,497
Depreciation and
amortization......... 730 2,115 3,713 5,017 6,859 1,385 1,888
Balance Sheet Data:
Inventories........... $11,097 $20,538 $ 24,278 $ 29,822 $ 43,252 $34,713 $52,375
Working capital....... 9,509 15,220 21,599 20,085 25,542 18,158 22,899
Total assets.......... 25,238 41,393 56,376 59,552 82,141 59,683 94,052
Capitalized lease
obligations, less
current portion...... 422 2,231 2,620 1,407 2,860 1,239 2,392
Total shareholders'
equity............... 16,535 28,372 38,547 39,219 48,291 36,761 46,919
</TABLE>
- -------
(a) Net income for 1998 includes a net income tax benefit of $6,187 due to the
$7,166 benefit recorded for our net operating loss carryforward, partially
offset by income tax expense of $979.
(b) Stock options, warrants and preferred stock convertible into common stock
were excluded from the calculation of diluted net loss per common share for
1994 through 1997 and the 13 weeks ended May 2, 1998 and May 1, 1999 as
they were anti-dilutive due to the losses in each of those periods.
19
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
You should read the following discussion and analysis in conjunction with
the "Selected Consolidated Financial Data" and our consolidated financial
statements and the related notes which are included in this prospectus.
Overview
Zany Brainy is a rapidly growing specialty retailer of high quality toys,
games, books and multimedia products for children, with 82 stores operating in
23 states as of May 1, 1999. From 1995 to 1998, our net sales grew at a
compound annual growth rate of 45.8%, while our operating income increased from
a loss of $7.7 million to income of $3.9 million. These increases were
principally due to the opening of new stores and comparable store sales growth.
We achieved comparable store net sales growth of 4.3%, 9.1% and 9.9% in 1996,
1997 and 1998, respectively, and 6.8% and 9.0% for the 13 weeks ended May 2,
1998 and May 1, 1999, respectively.
We opened our first store in 1991 and embarked on an aggressive store
opening strategy in 1994. We opened 11 stores in 1994, 15 stores in 1995 and 12
stores in 1996; however, our operating results in 1995 and 1996 were
disappointing. At this time we hired our current management team, which
evaluated Zany Brainy's business strategies and reached the following
conclusions:
. sales per store did not materially differ based on store size, but our
larger stores had higher expenses;
. the clustering of stores in the same markets led, in some instances, to
significant sales cannibalization;
. our merchandise selection did not include several key product categories
and was not updated frequently enough;
. we had a poor price image; and
. our marketing efforts did not effectively reach our target customers.
To address these problems, our new management reduced the size of our
prototype store to 10,600 square feet and modified our expansion strategy to
emphasize entering new markets and opening fewer stores in any single market.
We began to update the merchandise in our stores more frequently to attract
repeat customers and added new product categories. We also took steps to
improve our price image by focusing our advertising and in-store communications
on competitive pricing and overall value. Finally, we revised our marketing
strategy by developing an enhanced and enlarged customer database. With the
information provided by this database, we used direct mail to more effectively
target our marketing efforts and expand our customer base. These strategies
have resulted in improved operating results.
With our new prototype store in place, we opened nine stores in 1997 and 23
in 1998, increasing our store base from 43 stores at the end of 1996 to 75
stores at the end of 1998. We plan to open approximately 25 new stores in 1999,
seven of which we had already opened as of May 1, 1999, and approximately 25
new stores in 2000.
20
<PAGE>
Over the last three years, we have decreased the average size of the new
stores we have opened from 12,476 square feet for those opened during 1996 to
10,447 square feet for those opened during 1998. As a result, our chain-wide
average store size has decreased. During the same period, our average sales per
store increased from $2.3 million to $2.7 million, and our sales per square
foot increased from $183 to $227. In addition, because smaller stores typically
have lower occupancy costs, our new stores have contributed to improved gross
margins.
Our fiscal year includes 52 or 53 weeks, ends on the Saturday closest to
January 31 and is named for the calendar year ending closest to that date. The
fiscal years ended February 1, 1997, January 31, 1998 and January 30, 1999
include 52 weeks. For purposes of calculating comparable store sales, a store
is deemed to become comparable in its 14th full month of operations in order to
eliminate grand opening sales distortions. Also, cost of goods sold includes
buying, distribution and store occupancy costs.
Results of Operations
The following table presents our financial data expressed as a percentage of
net sales and store data for the periods indicated:
<TABLE>
<CAPTION>
Thirteen Weeks
Fiscal Year Ended
--------------------- -------------------
May May
2, 1,
1996 1997 1998 1998 1999
<S> <C> <C> <C> <C> <C> <C>
Net sales................... 100.0 % 100.0 % 100.0 % 100.0 % 100.0 %
Cost of goods sold.......... 74.8 72.5 70.1 73.4 72.4
----- ----- ----- ----- -----
Gross profit.............. 25.2 27.5 29.9 26.6 27.6
Selling, general and
administrative expenses.... 31.0 27.2 27.6 35.1 32.0
----- ----- ----- ----- -----
Operating income (loss)... (5.8) 0.3 2.3 (8.5) (4.4)
Interest expense, net....... (0.7) (0.4) (0.6) (0.5) (1.1)
----- ----- ----- ----- -----
Income (loss) before
income taxes............. (6.5)% (0.1)% 1.7 % (9.0)% (5.5)%
===== ===== ===== ===== =====
Comparable store sales
increase................... 4.3 % 9.1 % 9.9 % 6.8 % 9.0 %
===== ===== ===== ===== =====
</TABLE>
Thirteen Weeks Ended May 1, 1999 Compared to the Thirteen Weeks Ended May 2,
1998
Net Sales. Net sales increased by $13.1 million, or 47.8%, to $40.6 million
for the 13 weeks ended May 1, 1999 from $27.5 million in the comparable 1998
period. This increase resulted from a comparable store sales increase of $2.5
million, or 9.0%, $9.2 million in sales from stores opened in 1998 not included
in our comparable sales base and sales of $1.4 million from seven new stores
opened during the period. The sales growth was primarily due to an increase in
customer transaction level, as well as strong sales of popular items such as
Beanie Babies and Crazy Bones.
Gross Profit. Gross profit increased by $3.9 million, or 53.0%, to $11.2
million during the period, from $7.3 million in the same period last year. As a
percentage of net sales, gross profit increased to 27.6% for the thirteen weeks
ended May 1, 1999 from 26.6% in the comparable 1998 period. The increase in the
gross profit percentage was primarily due to greater leveraging of store
occupancy expenses partially offset by a slight decrease in product margins.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $3.3 million to $13.0 million for the
thirteen weeks ended May 1, 1999, from $9.7 million in the same period last
year. The dollar increase in these expenses was primarily attributable
21
<PAGE>
to an increase of $2.0 million in store payroll and other selling expenses
primarily associated with an additional 29 stores open over the same period
last year. As a percentage of net sales, selling, general and administrative
expenses decreased by 3.1% to 32.0% of net sales for the thirteen weeks ended
May 1, 1999, from 35.1% in the comparable 1998 period. Preopening expense
increased $526,000 over the same period last year due to the opening of seven
new stores, an increase of six stores from the same period last year. Corporate
expenses increased $307,000 to support the additional store growth. The
percentage decrease in selling, general and administrative expenses was
primarily related to the leveraging of corporate expenses over a larger revenue
base.
Interest Expense, Net. Net interest expense was $427,000 for the period, an
increase of $301,000 from the comparable period in 1998. This increase was due
to greater borrowing to fund working capital needs and open seven stores during
the period.
Income Tax Benefit. For the 13 weeks ended May 1, 1999, we recorded a net
income tax benefit of $845,000 primarily related to the Federal tax benefit of
the net loss. For the 13 weeks ended May 2, 1998, no benefit was recorded with
respect to the net operating loss carryforward because we established a
valuation allowance.
1998 Compared to 1997
Net Sales. Net sales increased by $45.2 million, or 36.6%, to $168.5 million
in 1998 from $123.3 million in 1997. Sales for the 23 stores opened in 1998
contributed $25.7 million of the increase in net sales. Comparable store net
sales increased 9.9% over the prior year and contributed $11.7 million of the
increase in net sales. The growth in comparable store sales was due primarily
to an increase in the number of customer transactions. Stores open prior to
February 1, 1998 but not qualifying as comparable stores contributed $7.8
million of the increase in net sales.
Gross Profit. Gross profit increased by $16.4 million to $50.3 million in
1998 from $33.9 million in 1997. As a percentage of net sales, gross profit
increased to 29.9% in 1998 from 27.5% in 1997. The increase in the gross profit
percentage was primarily attributable to improved product margins and
leveraging store occupancy, buying and distribution costs over a higher revenue
base. Product margins increased by 1.0% of net sales in 1998 primarily due to
an increase in sales of products with a higher gross margin. The decrease in
store occupancy expense of 0.9% of net sales is primarily due to the 9.9%
increase in comparable store sales and the timing of new store openings. The
decrease in the buying and distribution costs of 0.6% of net sales was due to
the application of fixed costs over a higher revenue base.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $12.8 million to $46.4 million in 1998
from $33.6 million in 1997. The dollar increase in these expenses was due
principally to an increase of $4.3 million in store payroll and $1.2 million in
store preopening costs primarily due to an increase in the number of stores in
1998, an increase of $2.7 million in corporate expenses associated with the
expansion of our store base and corporate infrastructure to support our
continued growth and an increase of $1.9 million in marketing and promotion
expenditures primarily related to the opening of stores in new market areas. In
addition, in 1998 we incurred a $450,000 charge in connection with the
abandonment of certain assets and the estimated loss associated with assignment
of a lease (see Note 4 to the consolidated financial statements). As a
percentage of net sales, selling, general and administrative expenses increased
by 0.4% to 27.6% of net sales in 1998 from 27.2% of net sales in 1997. This
percentage increase was primarily related to an increase of 0.7% of net sales
in marketing and promotion and an increase of 0.5% of net sales in store
preopening expenses associated with opening 23 stores in 1998 versus nine
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<PAGE>
stores in 1997. These were partially offset by a decrease of 0.5% of net sales
in store payroll and other selling expenses due to an increase in comparable
store sales during 1998.
Interest Expense, Net. Net interest expense, principally attributable to
borrowings under our credit facility, increased by $665,000 to $1.1 million in
1998 from $465,000 in 1997, due to an increase in the average outstanding loan
balance to $6.4 million in 1998 from $1.5 million in 1997. The increase in
average borrowings in 1998 reflected the opening of 23 new stores and
additional working capital requirements to support those stores.
Income Tax Benefit. In 1998, we recorded a net income tax benefit of $6.2
million due to the $7.2 million benefit recorded for our net operating loss
carryforward, partially offset by the 1998 income tax expense of $979,000. In
previous years, no benefit was recorded with respect to the net operating loss
carry forward because we established a valuation allowance. We reversed the
valuation allowance as a result of management's assessment that it is more
likely than not that our net deferred tax assets will be realized through
future taxable earnings. Management's assessment was based on the trend toward
income in 1996 and 1997, the utilization of $5.8 million of the net operating
loss carryforward in 1998 and 1999 and 2000 financial projections.
1997 Compared to 1996
Net Sales. Net sales increased by $30.7 million, or 33.3%, to $123.3 million
in 1997 from $92.6 million in 1996. Sales for the nine stores opened in 1997
contributed $14.8 million of the increase in net sales. Comparable store net
sales increased 9.1% over the prior year and contributed $7.9 million of the
increase in net sales. We believe the increase in comparable store sales in
1997 was primarily the result of an increase in the size of our average
customer transaction. Stores open prior to 1997 but not qualifying as a
comparable store contributed $8.0 million of the increase in net sales.
Gross Profit. Gross profit increased by $10.5 million to $33.9 million in
1997 from $23.4 million in 1996. As a percentage of net sales, gross profit
increased to 27.5% in 1997 from 25.2% in 1996. This increase was primarily due
to a reduction in store occupancy, buying and distribution expense as a
percentage of net sales. The decrease in store occupancy expense of 1.2% of
sales was primarily due to the 9.1% increase in comparable store sales and the
timing of new store openings. The decrease in buying and distribution costs of
0.9% of net sales was due to the application of fixed costs over a higher
revenue base.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by $4.9 million to $33.6 million in 1997 from
$28.7 million in 1996. The dollar increase in these expenses was primarily
attributable to $3.2 million in store payroll and other selling expenses
associated with the opening of nine stores in 1997. As a percentage of net
sales, selling, general and administrative expenses decreased by 3.8% to 27.2%
of net sales in 1997 from 31.0% of net sales in 1996. This decrease was
primarily due to a 2.2% decrease as a percent of net sales in corporate
expenses, reflecting the application of fixed costs over a higher revenue base
and a 1.2% decrease as a percent of net sales in store payroll and other
expense.
Interest Expense, Net. Net interest expense, principally attributable to our
credit facility, decreased by $184,000 to $465,000 in 1997 from $649,000 in
1996.
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Quarterly Results of Operation and Seasonality
The following table presents certain unaudited results of operations for our
nine fiscal quarters ended May 1, 1999. The unaudited quarterly information
includes all normal recurring adjustments which we consider necessary for a
fair presentation of the information shown. We do not believe that these
quarterly results are necessarily indicative of future results.
<TABLE>
<CAPTION>
1997 1998 1999
------------------------------------- ------------------------------------- -------
First Second Third Fourth First Second Third Fourth First
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
------- ------- ------- ------- ------- ------- ------- ------- -------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net sales............... $22,382 $21,943 $23,446 $55,574 $27,452 $29,654 $30,661 $80,704 $40,577
As a % of full year.... 18.1 % 17.8 % 19.0 % 45.1% 16.3 % 17.6 % 18.2 % 47.9% N/A
Gross profit............ $ 5,252 $ 4,992 $ 6,331 $17,318 $ 7,315 $ 7,544 $ 8,590 $26,869 $11,190
As a % of full year.... 15.5 % 14.7 % 18.7 % 51.1% 14.5 % 15.0 % 17.1 % 53.4% N/A
As a % of net sales.... 23.5 22.8 27.0 31.2 26.6 25.4 28.0 33.3 27.6
Operating income
(loss)................. $(2,420) $(2,677) $(1,916) $ 7,325 $(2,344) $(4,048) $(3,485) $13,819 $(1,796)
As a % of net sales.... (10.8)% (12.2)% (8.2)% 13.2% (8.5)% (13.7)% (11.4)% 17.1% (4.4)%
Number of stores:
Opened during period... 2 1 5 1 1 4 8 10 7
Open at end of period.. 45 46 51 52 53 57 65 75 82
Comparable store sales
increase............... 9.5 % 8.2 % 7.0 % 10.4% 6.8 % 13.4 % 9.1 % 10.0% 9.0%
</TABLE>
We have experienced, and we expect to continue to experience, substantial
seasonal fluctuations in our sales and operating results, which is typical of
many retailers. This is primarily due to the Christmas holiday shopping season
as well as the contribution of new stores opened during the year. We have
historically experienced net operating losses in the first three quarters of
each year, which we expect to continue. In addition, the timing of new store
openings and related preopening expenses and the revenue contributions of new
and existing stores may cause our quarterly results to fluctuate.
Liquidity and Capital Resources
Our main sources of liquidity have been cash flows from operations,
borrowing under our credit facilities and proceeds from equity financings. We
require cash principally to finance capital investment in new stores, new store
inventories and seasonal working capital. We opened 12 stores in 1996, nine
stores in 1997, 23 stores in 1998 and seven stores during the 13 weeks ended
May 1, 1999 versus one store opened during the 13 weeks ended May 2, 1998.
Cash flows used in operating activities were $11.6 million for the 13 weeks
ended May 1, 1999, compared to $3.9 million for the 13 weeks ended May 2, 1998.
Cash flows used in operating activities for the 13 weeks ended May 1, 1999 were
primarily due to a net loss, adjusted for depreciation and amortization and the
deferred portion of the income tax benefit, an increase in inventories and
prepaid expenses and a decrease in accrued liabilities. Cash used in operating
activities for the 13 weeks ended May 2, 1998 was primarily due a net loss,
adjusted for depreciation and amortization, and an increase in inventories and
prepaid expenses partially offset by an increase in accounts payable.
Cash flows provided by our operating activities were $5.4 million in 1998,
compared to $3.5 million in 1997. Cash flows provided by operating activities
in 1998 were primarily from net income, adjusted for depreciation and
amortization and the deferred portion of the income tax benefit, and an
increase in accounts payable partially offset by an increase in inventories.
Cash provided by
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<PAGE>
operating activities in 1997 reflects increases in payables, accrued
liabilities and depreciation and amortization partially offset by an increase
in inventories. Cash flows used in operating activities were $2.7 million in
fiscal 1996 primarily due to a loss of $6.0 million offset by the impact of
depreciation and amortization.
Cash flows used in investing activities were $2.5 million for the 13 weeks
ended May 1, 1999, compared to $779,000 for the 13 weeks ended May 2, 1998. Our
cash used in investing activities primarily represents our capital expenditures
in opening new stores and continued infrastructure development. Cash used in
investing activities in 1998 was $7.3 million, compared to $6.4 million in 1997
and $6.3 million in 1996. Our cash used in investing activities primarily
represents our capital expenditures in opening new stores and continued
infrastructure development.
Cash flows provided by financing activities were $13.3 million for the 13
weeks ended May 1, 1999, compared to $191,000 for the 13 weeks ended May 2,
1998. Our cash provided by financing activities in 1999 primarily represents
borrowings under our credit agreement. Cash used in financing activities in
1998 was $1.4 million and $782,000 in 1997. Cash provided by financing
activities was $15.2 million in 1996. Over the last three years our primary
financing activities have involved borrowings and repayments under our credit
agreement and sales of equity securities. Cash used in financing in 1997 and
1998 was primarily from the repayment of capital leases partially offset in
1997 by proceeds from the exercise of warrants. Our cash provided by financing
activities in 1996 was from the sale of $16.2 million of preferred stock.
Our principal use of operating cash is to purchase inventory for our stores.
Our need for working capital to purchase inventory is reduced by supplier
credit terms that allow us to finance a portion of our purchases.
Our primary long-term capital requirement is for the opening of new stores.
We lease all of our stores. We currently expect to open approximately 25 stores
in 1999, seven of which we had already opened as of May 1, 1999, and
approximately 25 stores in 2000. The average net cost of opening a store in
1998 was approximately $750,000. This amount included approximately $320,000 of
inventory, net of accounts payable, $340,000 for leasehold improvements and
fixtures, net of landlord allowances, and $90,000 for pre-opening expenses. We
expense our pre-opening expenses as they are incurred. Our actual cost to open
new stores varies widely and depends on factors such as the extent and expense
of required construction, changes in store format and any landlord allowances.
We estimate that capital expenditures for 1999 will be approximately $17.0
million, and will be used to develop new stores, enhance our management
information systems and purchase fixtures and equipment for our new
distribution facility. This estimate does not include any expenditure that we
may make to develop an internet shopping site.
We currently have a credit facility that provides for revolving loans in an
aggregate outstanding principal amount of up to $35.0 million, including up to
$7.5 million in the form of letters of credit, with an option to increase the
total available to $60.0 million under certain conditions. The actual
availability under our credit facility is limited to a seasonally-based
calculation of 55% to 65% of our eligible inventory, less any letters of credit
outstanding. At May 1, 1999, the total borrowing limit, including the letters
of credit, was $27.5 million. At May 1, 1999, $12.4 million of borrowings and
$656,000 of letters of credit were outstanding. Interest on outstanding
indebtedness under the revolving credit facility accrues at the lender's prime
commercial lending rate or, if we elect, at LIBOR plus 2.5%. Our obligations
under the loan agreement are secured by interests in substantially
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<PAGE>
all of our personal property, including, our accounts receivable, inventories,
equipment, machinery, contract rights and chattels and the securities of our
subsidiaries. The credit facility matures on October 8, 2000. We use our credit
facility to meet our seasonal working capital requirements.
The credit facility contains a tangible net worth covenant and other
restrictions regarding our ability to merge, consolidate or acquire non-
subsidiary entities, make loans, incur debts or liens, pay cash dividends or
engage in substantial asset sales. As of May 1, 1999, we were in compliance
with the terms of the credit facility.
Promptly upon completion of this offering, we plan to obtain a new $30.0
million unsecured revolving line of credit, a portion of which may be in the
form of letters of credit. The proposed line will bear interest at prime or
LIBOR plus 1.75% at our option.
At May 1, 1999, we had a deferred tax asset of $5.7 million for net
operating loss carryforwards which is available for use in future periods.
We believe that cash flow from operations, funds available under our credit
facilities and the net proceeds from this offering will be sufficient to
satisfy our capital requirements for at least the next 12 months.
Year 2000 Compliance
Zany Brainy is conducting a comprehensive review of its computer systems and
other microprocessor-based equipment to identify how we may be affected by the
Year 2000 issue. The Year 2000 issue results from the writing of computer
programs using two digits, rather than four, to define the applicable year. As
a result, commencing in 2000, date-sensitive software may recognize a date
using "00" as 1900 rather than 2000. This could result in a systems failure or
miscalculations causing disruptions of operations, including a temporary
inability to receive shipments, process financial information, process credit
card transactions, deliver products or engage in other normal business
activities.
Our Year 2000 Readiness
Information Technology Systems. Our core business is run on SFR, an
enterprise software system. The functions supported by SFR include buying,
replenishment, physical distribution, general ledger and payables. SFR is a
product from CDS, a subsidiary of Sterling Software. CDS has recently
discontinued operations. The upgrade to version 7.0, which is Year 2000
compliant, was completed in the first quarter of 1999.
Late in 1998, we agreed to purchase new enterprise software from JDA. This
software will replace SFR for all of the functional areas currently served by
SFR. This software has been certified Year 2000 compliant by the Information
Technology Association of America and runs on IBM AS400 hardware which has been
certified by IBM to be Year 2000 compliant. We intend to have the conversion
process completed and ready for implementation in December 1999. However, given
the increased business volume during the Christmas season, we have decided to
defer implementation until after the Christmas selling season. In the event the
SFR system fails to operate on January 1, 2000, we believe we will be
positioned to implement the Year 2000 compliant JDA software.
Our in-store systems consist of two application suites and a common
Microsoft NT server network which is Intel based. The application suites are
supplied by ICL Retail, Inc. (ICL), and provide point-of-sale (POS) and store
inventory systems (SIS) support for store management
26
<PAGE>
functions. We have determined that our POS and SIS systems are not Year 2000
compliant, but we have received compliant versions from ICL. We expect to
complete our independent testing of these versions by the third quarter of
1999.
Due to potential compatibility issues, we plan to upgrade the Microsoft NT
operating systems in all stores. The new operating system has been certified by
Microsoft to be Year 2000 compliant. We are currently testing the new operating
system, and expect to complete testing in the second quarter of 1999. Some of
the store register hardware is not Year 2000 compliant, but we believe that we
can achieve compliance by rebooting the system and adjusting time and date
parameters. We intend to take these measures prior to the opening of businesses
following December 31, 1999. We are engaged in a project with ICL that is
designed to achieve Year 2000 compliance by the third quarter of 1999.
We are currently assessing the Year 2000 readiness of our server, SIS
workstation hardware, email applications and software demonstration stations.
We anticipate that this assessment will be completed in the second quarter of
1999. We plan to have our store systems achieve Year 2000 compliance for
software, operating systems and hardware in the third quarter of 1999.
Non-Information Technology Systems. Non-information technology systems
include the security systems in our stores, headquarters and distribution
centers, faxes and voicemail. Based on our assessment of these systems, we have
determined that these systems do not raise Year 2000 issues.
Significant Third Party Relationships. We have initiated formal
communications with our significant suppliers to determine our vulnerability if
these third parties fail to remedy their own Year 2000 problems. We believe
that Year 2000 issues faced by our key suppliers, credit card processors and
telecommunications providers, if not effectively remediated, could adversely
affect our business. We are not currently able to assess the scope of such
issues as they may affect these suppliers and providers or the effect of such
issues on us.
Possible Consequences of Year 2000 Issue
If store systems should cease to operate on January 1, 2000, we have several
options available to continue to process sales and receipts in our stores. In a
worst case scenario, the existing disaster procedure to hand-write receipts
would be put into place. The receipt of purchase orders and transfers would
also be recorded manually. If the situation were a result of the registers' and
servers' failure to recognize the new year, the capability exists to set the
system dates back to 1999 and continue to process sales transactions. Sales
receipts would need to be date stamped by hand. Additional effort would be
required to ensure sales and receipt data is subsequently processed correctly.
This would require incremental manual intervention. While the cost of manual
intervention would not be material, the use of manual intervention would
significantly disrupt store operations.
If our telecommunications and credit card processing service providers are
not Year 2000 compliant on a timely basis, our operations could be materially
adversely affected. If our telecommunications providers are not compliant, we
would be required to migrate our service to a compliant vendor. If our credit
card processor is not compliant, we would be required to approve and settle
credit requests manually.
Anticipated Costs of Year 2000 Compliance
We have incurred approximately $25,000 in costs associated with Year 2000
issues, all of which is attributable to software upgrades, including version
7.0 of SFR. The total cost associated with
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<PAGE>
modifications, upgrades and/or replacements to become Year 2000 compliant is
not expected to be material to our financial position. We currently estimate
that we will incur costs of approximately $150,000 relating to Year 2000
compliance, including $110,000 for software and operating system compliance and
$40,000 for hardware compliance. These costs will be expensed as incurred. We
intend to use funds from operations to cover our Year 2000 costs.
Lack of Contingency Plans
We have not developed a formal contingency plan. If Year 2000 problems are
discovered, we will address these issues as they occur.
Inflation
We do not believe that inflation has had a material effect on our financial
position or results of operations during the past three years. However, we
cannot predict the future effects of inflation.
28
<PAGE>
OUR BUSINESS
Zany Brainy is a leading and rapidly growing specialty retailer of high
quality toys, games, books and multimedia products for kids. We are a
different kind of toy store with a unique product mission and a passionate
commitment to our customers. We believe that learning should be fun. We sell
over 15,000 products that entertain, educate and spark the imaginations of
children up to 12 years of age. Zany Brainy combines this distinctive
merchandise offering with superior customer service and daily in-store events
to create an interactive, "kid-friendly" and exciting shopping experience for
children and adults.
We opened our first store in Wynnewood, Pennsylvania in 1991. The current
management team assumed leadership during 1995 and 1996. This team refined our
store model and operating strategies and, starting in 1997, accelerated our
store growth. We opened 23 new stores last year and, as of May 1, 1999,
operated 82 stores in 23 states. We plan to add approximately 25 stores in
1999, seven of which we had already opened as of May 1, 1999, and
approximately 25 stores in 2000. Our sales grew 36.6% in 1998 to $168.5
million and we experienced comparable store sales growth of 9.1% in 1997, 9.9%
in 1998 and 9.0% in the first quarter of 1999.
Our Strategies
Our goals are to establish Zany Brainy as the leading specialty retailer of
high quality toys, games, books and multimedia products for kids and to build
Zany Brainy into a national brand that represents the "best stuff for kids."
The key elements of our growth and operating strategies to achieve these goals
include:
Pursue Store Expansion Program
We believe that Zany Brainy has nationwide appeal and significant new store
expansion opportunities over the next several years. We anticipate opening
approximately 25 stores in 1999, seven of which we had already opened as of
May 1, 1999, and approximately 25 stores in 2000. Our expansion strategy is to
continue to open new stores in markets where we believe we can become the
dominant retailer of high quality toys, games, books and multimedia products
for children, as well as to open more stores in our existing markets. In 1999,
we plan to open approximately 14 stores in new markets, four of which we had
already opened as of May 1, 1999, and to open approximately 11 stores in
existing markets.
Increase Sales Productivity of Existing Store Base
We are committed to increasing productivity in existing stores through the
following initiatives:
. frequently updating our merchandise presentation and selection to attract
repeat customers;
. utilizing advertising to attract and retain customers and expand consumer
awareness of our brand;
. continuing to invest in the training of sales associates; and
. further improving our in stock position and speed-to-market with new
products by upgrading our distribution and management information systems
infrastructure.
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Offer a Unique Merchandise Mix
We strive to carry a product selection that addresses the needs of our
customers and which meaningfully differs from that of our competitors. We
believe that our selection represents a comprehensive offering for customers
seeking products that enable their children to have fun while learning. We do
not sell products that we believe are inconsistent with our mission, such as
toys that may reinforce gender stereotypes or encourage violence. In addition,
we generally do not offer TV-promoted, mass marketed items. Excluding books and
multimedia, we believe that less than 30% of the stock keeping units that we
carry are available at Toys "R" Us. We seek to keep our merchandise selection
new and exciting, and to satisfy our customers' changing preferences.
Accordingly, we seek to update at least 20% of our merchandise each year. To
further differentiate our merchandise selection, we work closely with several
specialty suppliers to secure exclusive product or licensing arrangements.
Provide Exceptional Customer Service
We believe that our high level of service differentiates the shopping
experience at our stores, enables us to attract customers and creates customer
loyalty and trust. We actively recruit educators, child care providers and
back-to-work parents as sales associates because we believe they have a respect
and affection for children and an appreciation of how children learn through
play. Our employees participate in an extensive training program and learn to
proactively assist our customers in selecting products. In addition, we staff
our stores with book, multimedia and other specialists who have an in-depth
knowledge of their specific areas. We also provide convenient services, such as
free gift wrapping and shipping at cost.
Provide a Destination Store Environment
We design our stores to be a destination for both children and adults to
enjoy free fun every day. We offer daily, in-store events such as mini-
concerts, story time, face-painting, character appearances and a summer reading
club. We provide a hands-on shopping experience and encourage children to play
with our products in the store. Our "kid-friendly" stores are colorful,
welcoming and exciting with attractive carpeting and designated play areas
located throughout the store.
Develop an Internet Sales Channel
We intend to implement an internet shopping site. We currently anticipate
that our internet shopping site may be developed through a joint venture
arrangement. Any internet venture could require us to commit significant
financial resources as well as internal resources such as personnel and
systems. In addition, an internet venture may result in substantial
participation of our management and affiliates for capital or other resources.
Any internet venture, however, would likely reduce Zany Brainy's equity
ownership of, and decrease its ability to control, the internet business. In
addition, selling our products on the internet could divert customers from our
stores and depress existing store sales. We cannot assure that we will
implement an internet shopping site or that, if implemented, we will generate
profits from our internet business. In addition, in the event we establish an
internet business, we may have to recognize all or a portion of any losses
associated with the business and consolidate such losses into our financial
statements.
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Industry and Competition
We believe that the market for our product categories was approximately
$14.0 billion in 1998. However, we do not sell some of the products included in
these categories because they are inconsistent with our product mission or
inappropriate for children 12 years and under.
The toy retailing market is comprised of:
. mass market retailers, including superstores such as Toys "R" Us and
discounters such as Wal-mart and Target;
. smaller format specialty educational and creative toy and game retailers
such as Noodle Kidoodle and LearningSmith;
. non-toy specialty retailers, such as traditional book, music, video and
software retailers;
. internet-only retailers; and
. a variety of other retailers offering a subset of our products including
card and gift shops, craft stores and department stores.
The mass market retailers have traditionally offered a broad range of
products with a particular focus on TV-promoted products. We believe that mass
market retailers' emphasis on these products, combined with the impersonal
environment and reduced service levels typical of a large format superstore,
limits their ability to meet the needs of our customers.
Some of the smaller format specialty educational and creative toy and game
retailers offer products similar to ours. However, we generally operate larger
stores, which enables us to carry a wider product assortment. In addition, some
of these competitors supplement their product offering with items that we
believe are inconsistent with our mission to sell the "best stuff for kids."
Moreover, we provide a broader program of special events than these
competitors.
Many non-toy speciality retailers, such as traditional book and software
retailers, offer an extensive selection of products in specific categories.
However, we believe our comprehensive merchandise offering of toys, games,
books and multimedia products for kids satisfies our customers' need for a
variety and selection of products. Internet-only retailers provide customers
with an on-line shopping forum. We believe we differentiate ourselves from
internet competitors by providing a high level of customer service and a "kid
friendly" environment in which children are encouraged to see, touch and play
with our products.
Our Merchandising Approach
We believe that our customers trust us to provide high quality merchandise
for kids at the right price. We carefully select products that encourage
children's educational, emotional or physical development. We do not sell
products that we believe are inconsistent with our mission, such as toys that
reinforce gender stereotypes or encourage violence. In addition, we generally
do not offer TV-promoted, mass marketed items. We believe that this
merchandising philosophy has enabled us to earn the confidence, loyalty and
trust of our customers.
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Our Distinctive Merchandise Selection
We purchase over 15,000 stock keeping units from more than 400 suppliers in
20 different countries. While our products generally range in price from less
than one dollar up to $200, the average price paid for a single product is less
than $10. We present our merchandise across 11 product categories to satisfy a
broad spectrum of customer needs. Our extensive selection of merchandise
includes:
<TABLE>
<CAPTION>
Category Description
- -------- -----------
<S> <C>
Toys and Games
Brainy Games and Puzzles......... Board games and puzzles.
Bright Start..................... Toys for ages up to three.
Creativity....................... Arts and crafts supplies and kits.
Good Sports...................... Indoor and outdoor sport-theme toys.
Kidtronics....................... Electronic learning aids and musical
instruments.
Let's Pretend.................... Pretend play, dress up and doll houses.
Our Planet....................... Science-related toys.
Plush and Dolls.................. Stuffed animals and dolls.
Young Builders................... Building toys and trains.
Books................................ Extensive selection of over 7,000 titles.
Multimedia........................... Software, audio and video.
</TABLE>
We regularly offer numerous limited distribution, innovative products. In
many cases, we have worked with suppliers to first introduce their products in
our stores. We believe many manufacturers of specialty products do not sell
their products through discounters or mass market retailers. To further
differentiate our merchandise offering, we also work closely with several
specialty suppliers to secure exclusive product or licensing arrangements. We
also supplement our merchandise offering with our own product development
efforts. We sell our private label products under such brand names as "Ready,
Set, Grow!" and "Kidstruments." In 1998, approximately 3.0% of sales were
attributable to our private label products. If consumers do not perceive these
private label products to be of high quality, our efforts to increase private
label sales may not succeed.
Our Competitive Pricing
We generally position ourselves to be competitive in price, but we do not
attempt to be the discount leader in a given market. We do, however, maintain a
policy of matching our competitors' advertised prices.
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Store Operations
Our Store Design
We design our stores to be bright, colorful and inviting for children and
adults. Our current store prototype is 10,600 square feet and contains 11 major
categories of products. Large banners with unique graphics identify each of
these categories to enable customers to find specific items quickly. Our stores
are fully carpeted and have low shelving to encourage children to see, touch
and play with our products. Departments are located around the perimeter of the
store in a "racetrack" style to promote browsing and impulse sales. We have a
play center in the middle of our stores that is surrounded with large red
pillars so children can locate it easily. We also provide seating in the play
center so adults can comfortably play with their children. We typically locate
our Zany Showtime Theater, which is used to show the latest video releases,
adjacent to the play center so we can combine the two spaces to accommodate
larger special events. A reading area is situated next to our book department,
and software demonstration stations are placed near our multimedia department
to encourage sampling of these items.
[Store layout graphic]
Our Store Associates
We strive to complement our innovative store design with superior customer
service to provide an enjoyable shopping experience. We believe our prompt,
knowledgeable and enthusiastic service fosters the confidence and loyalty of
our customers and differentiates us from our competitors. We actively recruit
educators, child care providers and back-to-work parents as store employees
because we believe that these people are most likely to have a respect and
affection for children, and an appreciation of how children learn through play.
Because we consider customer relations and product knowledge to be critical
components of our merchandising strategy, we emphasize product and customer
service training. Our sales associates receive approximately 25 hours of
training within their first month of employment and are tested before they are
designated a "Certified Kidsultant." We train our sales associates to
proactively advise customers on product features, benefits and age-
appropriateness.
33
<PAGE>
In addition, some of our sales associates receive supplemental training to
become specialists in various areas including books, multimedia and events. We
also provide an abbreviated form of training for seasonal employees. Once a
year, all store managers attend a "Play Day" where they are introduced to and
trained in the features and benefits of various new products. The store
managers then train our sales associates in these products.
Our stores are typically staffed with a general manager, three assistant
managers, four specialists, and a varying number of part-time sales associates,
depending on store volume and time of year. The general manager and assistant
managers, who may be specialists, are responsible for building relationships
within the community. The operations of each store are supervised by one of 11
district managers who each in turn report to one of three regional managers.
Each regional manager reports to the vice president of stores.
Zany Brainy stores are open seven days a week, generally from 10:00 a.m. to
9:00 p.m. Monday through Saturday and 11:00 a.m. to 6:00 p.m. on Sunday.
Store Locations
We select geographic markets and store sites on the basis of demographic
information, quality and nature of co-tenants store visibility and
accessibility. Key demographics include population density, household income,
the number of households with children and education level. We locate our
stores primarily in suburban strip or power centers as well as in selected
free-standing locations. We typically seek sites with co-tenants that are
strong, destination and lifestyle-oriented retailers, such as Borders, Old
Navy, PETsMART, Bed, Bath & Beyond or upscale supermarkets.
34
<PAGE>
The map and store list below present the stores we operated as of May 1,
1999:
[Map of United States showing store locations]
Pre-1995 Openings
- -----------------------------
City, State Sq. Footage
- ---------------- -----------
Wilmington, DE 8,400
Marietta, GA 12,500
Sandy Springs,
GA 13,500
Annapolis, MD 12,045
Columbia, MD 12,000
Rockville, MD 12,368
East Brunswick,
NJ 12,000
Mount Laurel, NJ 10,208
Wayne, NJ 13,500
Jenkintown, PA 12,460
Lancaster, PA 12,150
Newtown, PA 10,846
Strafford, PA 8,500
Wynnewood, PA 10,875
Fairfax, VA 13,801
Sterling, VA 12,421
- -----------------------------
Average Sq.
Footage........ 11,723
1995 Openings
- -----------------------------
City, State Sq. Footage
- ---------------- -----------
Alpharetta, GA 13,582
Marietta, GA 11,100*
Norcross, GA 15,001
Northbrook, IL 15,058
Schaumburg, IL 15,000
Wheaton, IL 12,499
Eatontown, NJ 13,044
Princeton, NJ 11,372
Warrington, PA 12,500
Huntingdon
Valley, PA 12,500
Bailey's
Crossroads, VA 13,329
Woodbridge, VA 12,593
Fairfax, VA 12,814
Reston, VA 12,716
Springfield, VA 12,000
- -----------------------------
Average Sq.
Footage........ 13,007
1996 Openings
- -----------------------------
City, State Sq. Footage
- ---------------- -----------
Naperville, IL 12,481
Oak Brook, IL 12,996
Orland Park, IL 13,614
Durham, NC 13,010
Raleigh, NC 12,701
Marlton, NJ 15,520
Edison, NJ 14,000
Springfield, NJ 12,530
Akron, OH 10,052
Columbus, OH 12,015
Mayfield
Heights, OH 9,556
Fairless Hills,
PA 11,236*
- -----------------------------
Average Sq.
Footage......... 12,476
1997 Openings
- -----------------------------
City, State Sq. Footage
- ---------------- -----------
Birmingham, AL 10,000
San Diego, CA 10,500
Thousand Oaks,
CA 10,440
Torrance, CA 10,500
Indianapolis, IN 10,016
Louisville, KY 11,841
Charlotte, NC 12,500
Madison, WI 10,000
Milwaukee, WI 9,885
- -----------------------------
Average Sq.
Footage........ 10,631
1998 Openings
- -----------------------------
City, State Sq. Footage
- ---------------- -----------
Brea, CA 10,350
Concord, CA 10,500
Mission Viejo,
CA 11,116
Montclair, CA 10,816
Newport Beach,
CA 10,876
Orange, CA 10,644
Pasadena, CA 10,600
San Mateo, CA 10,687
Valencia, CA 10,081
Overland Park,
KS 10,600
Lexington, KY 12,850
Gaithersburg, MD 10,500
Ballwin, MO 10,600
Brentwood, MO 10,418
Scarsdale, NY 9,207
Winston-Salem,
NC 8,249
Columbus, OH 10,600
Cool Springs, TN 10,650
Brentwood, TN 10,088
Fredericksburg,
VA 8,039
Redmond, WA 10,479
Tukwila, WA 11,200
Brookfield, WI 11,122
- -----------------------------
Average Sq.
Footage........ 10,447
1999 Openings
- -----------------------------
City, State Sq. Footage
- ---------------- -----------
Dublin, CA 10,500
Huntington
Beach, CA 10,625
Colorado
Springs, CO 9,108
Timonium, MD 10,184
Roseville, MN 10,607
Omaha, NB 10,500
Murray, UT 9,470
- -----------------------------
Average Sq.
Footage........ 10,142
- ----------------
*Excludes square footage licensed to a third party.
35
<PAGE>
Marketing
Advertising
We use direct mail and newspaper advertising to promote Zany Brainy products
and increase awareness of our stores and brand. We primarily rely on direct
mail advertising, which allows us to capitalize on our growing, internally-
generated database. A variety of direct mail pieces, including our large, color
"Zany Zone" catalog, are mailed throughout the year to both current and
prospective customers. We also use full color newspaper inserts for broader
consumer reach during our peak selling periods. We advertise most heavily
during the Christmas holiday and back-to-school seasons. Our suppliers
contribute to some of our advertising costs through co-op advertising.
We use grand opening events to create traffic in new stores and to introduce
Zany Brainy to the community. Through a combination of advertising promotions,
public relations efforts and community outreach activities, we seek to generate
strong opening weekend sales, significant media exposure and community
involvement with Zany Brainy. For example, we design our grand opening events
to enable our store employees to initiate relationships with children-focused
organizations such as schools, museums, zoos and daycare centers.
Free Fun Every Day
The Zany Brainy store environment and special events program are integral
parts of our marketing strategy. We believe they provide an exciting shopping
and learning experience for kids and adults. Our stores always feature several
interactive areas, including play centers and software demonstration stations.
In addition, we show movies throughout the day at our Zany Showtime Theater. We
publish a monthly calendar of free events for our stores. Each of our stores
hosts regular daily activities for kids, including creative arts and crafts
activities, character and author appearances and mini-concerts by children's
performers. In order to enhance customer loyalty, we established a summer
reading club in 1993. In 1998, the summer reading club had approximately 26,000
members. The National Geographic Society and America Online are among the
organizations that have sponsored our summer reading club. We believe that
these activities create an enjoyable shopping experience and strengthen our
position as a family-oriented destination store.
Purchasing and Suppliers
We purchase merchandise from over 400 suppliers in 20 different countries.
We believe that our buying power and ability to make centralized purchases
enable us to acquire products on favorable terms.
In mid-1998, we entered into a relationship with Ingram Books to be our
principal book distributor. We believe that this arrangement provides a
comprehensive, cost-effective alternative to purchasing books from multiple
publishers and distributors. In addition, Ingram ships directly to each of our
stores, improving our in-stock position and ensuring that we carry current,
popular titles.
Additionally, we host vendor-supported in-store programs to increase
customer product knowledge in a friendly, hands-on environment. For example, we
periodically schedule "Young Builders Days," when representatives from
suppliers provide children with the opportunity to play with and learn about
their products.
Our central buying staff is comprised of one vice president, two divisional
merchandise managers and seven buyers, each of whom is responsible for
purchasing selected categories of our
36
<PAGE>
products. Our buyers generally have extensive purchasing experience with major
toy or other speciality retailers. We also maintain an in-house private label
product development team that develops products which are unique to Zany Brainy
and offer higher profit margins. In addition, we have a merchandise planning
team that manages inventory levels and the flow of merchandise through our
stores. This team works closely with our buying staff to react quickly to sales
trends and improve in stock levels at our stores.
Distribution
We currently operate one distribution center in Delaware that contains
approximately 120,000 square feet. Approximately 80% of our products are
distributed through this facility and the balance is shipped to the stores
directly by the manufacturer or supplier. Our automated inventory replenishment
system optimizes the inventory levels at each of our stores. This computerized
system retrieves sales information from our stores, enabling us to pick, price
and ship products to each of our stores on a weekly basis. This method of
allocation and distribution improves our operating performance by reducing
overall inventory costs while maintaining high in stock percentages.
After analyzing our distribution facilities and systems in light of our
anticipated growth, we decided to close our two distribution centers in
Delaware, one of which closed in April 1999, and consolidate distribution
center operations in a new 250,000 square foot facility in Swedesboro, New
Jersey. We anticipate closing the other Delaware facility in connection with
the opening of our new Swedesboro facility, which is scheduled to occur in the
summer of 1999. The new distribution center will be automated to increase
productivity. We also plan to implement a new warehouse management system as
part of the JDA software installation that we anticipate completing in the
first quarter of 2000. This more sophisticated system should enable us to
accept smaller but more frequent deliveries from suppliers, reducing inventory
in the distribution center and stockouts at our stores.
Management Information Systems
Our management information systems include a business-wide software package,
SFR, that supports our major back-office functions, including buying,
replenishment, physical distribution, general ledger and payables. In late
1998, we agreed to purchase a more sophisticated software package from JDA to
replace SFR. JDA will support the same business functions as SFR, but it also
includes forecasting capabilities and more advanced replenishment and trend
algorithms. We believe the implementation of JDA, which we anticipate
completing in the first quarter of 2000, will further increase our operating
efficiencies.
At the store level, we utilize a point-of-sale system to capture sales
transactions that includes a price look-up, UPC scanning, check and credit
authorization and zip code capture. Our store systems interface with our
business-wide software system to automatically replenish inventory, by stock
keeping unit, to each store. We also analyze this information to tailor our
merchandise assortment, determine markdowns, generate forecasts and evaluate
product and supplier performance.
Proprietary Rights
To protect our proprietary rights, we generally rely on copyright, trademark
and trade secret laws, confidentiality agreements with employees and third
parties and license agreements with consultants and suppliers. Each of "Zany
Brainy," "A Zillion Neat Things for Kids," "Zany Zone" and "Price Chomper" has
been registered as a service mark and/or trademark with the United States
37
<PAGE>
Patent and Trademark Office. In addition, we have numerous pending applications
for trademarks. "ZanyBrainy.com" has also been registered as an internet domain
name.
Employees
As of May 1, 1999, we employed approximately 1,700 employees, approximately
750 of whom were employed full-time. We also employ additional personnel during
peak selling periods. We consider our relationships with our employees to be
good. None of our employees are covered by collective bargaining agreements.
Properties
Our corporate headquarters are located at 308 East Lancaster Avenue in
Wynnewood, Pennsylvania, where we lease approximately 36,000 square feet. Our
lease expires June 30, 1999. We plan on relocating our corporate headquarters
to King of Prussia, Pennsylvania in June 1999 to increase our office space to
approximately 52,000 square feet. We have an option to lease another 10,000
square feet in the new location. The lease has an initial term of ten years
with two five-year renewal options.
We also currently lease one distribution center in New Castle, Delaware
consisting of approximately 120,000 square feet. This lease will expire in
March 2000. We plan on closing our New Castle distribution center and moving
into a facility in Swedesboro, New Jersey in the summer of 1999. The lease for
the distribution center in New Castle will be assumed by our new landlord
following our occupancy of the new facility in Swedesboro. The new distribution
center consists of approximately 250,000 square feet, and we have an option to
expand the distribution center by a minimum of 100,000 and up to 250,000 square
feet. The new distribution center lease has an initial term of five years with
two five-year renewal options. We closed a smaller distribution center in April
1999 when its lease expired.
We lease all of our stores. Initial lease terms are generally for ten years,
and most leases contain multiple five-year renewal options. We generally select
a new store site six to 18 months before its opening. Our stores are primarily
in suburban strip or power shopping centers as well as in selected free-
standing locations. As of May 1, 1999, we had 25 signed leases for stores we
plan to open in 1999, seven of which we had already opened, and two signed
leases for stores we plan to open in 2000.
Legal Proceedings
We are from time to time involved in litigation that we believe ordinarily
accompanies a retail business. We do not believe that any of our pending or
threatened litigation will result in an outcome that would materially affect
our business.
38
<PAGE>
MANAGEMENT
Executive Officers and Directors
Our executive officers and directors are:
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Keith C. Spurgeon......... 44 Chairman of the Board and Chief Executive Officer
Thomas G. Vellios......... 44 President
Robert A. Helpert......... 55 Chief Financial Officer, Secretary and Treasurer
C. Donald Dorsey.......... 57 Director
Robert A. Fox............. 69 Director
Gerald R. Gallagher....... 58 Director
Henry Nasella............. 52 Director
Yves B. Sisteron.......... 44 Director
David V. Wachs............ 73 Director
</TABLE>
The current executive officers and directors, along with their backgrounds,
are set forth below:
Keith C. Spurgeon has served as our Chairman of the Board and Chief
Executive Officer since January 1998. He served as our President and Chief
Executive Officer from June 1996 to January 1998. Prior to joining us, Mr.
Spurgeon was at Toys "R" Us for over ten years where he served in various
capacities, most recently as Vice President for Asia and Australia.
Thomas G. Vellios has served as our President since January 1998. He joined
Zany Brainy in November 1995 as Executive Vice President of Merchandising and
Marketing. Prior to joining us, Mr. Vellios was at Caldor, Inc. for nine
years, where he served in various capacities, most recently as Senior Vice
President and General Merchandise Manager.
Robert A. Helpert has served as our Chief Financial Officer, Secretary and
Treasurer since May 1995. Prior to joining us, from February 1994 to May 1995,
Mr. Helpert was the Executive Vice President and Chief Financial Officer for
Trans World Entertainment Corporation. Prior to joining Trans World, from 1988
to 1994, he was President and Chief Operating Officer of W.H. Smith, Inc., an
operator of hotel and airport newsstands and gift shops.
C. Donald Dorsey has served as one of our directors since June 1994. Mr.
Dorsey has served as Executive Vice President of PETsMART, Inc. since 1994.
From 1989 to February 1997 and November 1997 to March 1998, Mr. Dorsey also
served as PETsMART's Chief Financial Officer.
Robert A. Fox has served as one of our directors since January 1993. Mr.
Fox is the President of R.A.F. Industries, Inc. and affiliates, diversified
manufacturing, distribution and service companies, which he founded in 1979.
Mr. Fox also currently serves as a director of Safeguard Scientifics, Inc. and
Prime Bancorp, Inc.
Gerald R. Gallagher has served as one of our directors since June 1994. Mr.
Gallagher has been a general partner of Oak Investment Partners, a venture
capital firm, since 1987. Before joining Oak Investment Partners, he was Vice
Chairman of Dayton Hudson Corporation. Currently, Mr. Gallagher serves as a
director of P.F. Chang's China Bistro, Inc.
39
<PAGE>
Henry Nasella has served as one of our directors since October 1993. Mr.
Nasella has been the Chairman, Chief Executive Officer and President of Star
Markets Company, Inc., a Boston-based grocery retailer since September 1994.
From January 1994 to September 1994, he was a principal of Phillips-Smith
Specialty Venture Capital. Mr. Nasella formerly served as President and Chief
Operating Officer of Staples Inc. He currently serves as a director of Au Bon
Pain Co., Inc.
Yves B. Sisteron has served as one of our directors since June 1994. Mr.
Sisteron has been a principal of Global Retail Partners, L.P., an investment
fund, since January 1996 and a manager of U.S. investments for Carrefour S.A.
since 1993. Mr. Sisteron currently serves as a director of P.F. Chang's China
Bistro, Inc.
David V. Wachs has served as one of our directors since October 1993. Mr.
Wachs currently serves as a consultant to Charming Shoppes, Inc., a retail
company he co-founded.
Mr. Nasella was elected to our board pursuant to a provision of our
shareholders agreement that entitles David Schlessinger, the founder and former
chairman of Zany Brainy, to designate two directors to our board. In August
1998, Mr. Schlessinger waived his right to designate directors in the future.
Messrs. Fox and Wachs were elected to our board pursuant to a provision of our
shareholders agreement that entitles Mr. Fox to designate one director, in
addition to himself, to our board. Messrs. Gallagher and Sisteron were elected
to our board pursuant to a provision of our shareholders agreement that
entitles Oak Investment Partners V Limited Partnership and Fourcar B.V.,
respectively, to designate directors to our board. The shareholders agreement
terminates upon consummation of this offering.
Committees of the Board of Directors
The board of directors has established an audit committee, a compensation
committee and a nominating committee.
Messrs. Dorsey, Fox and Wachs comprise the audit committee. The audit
committee reviews with management our internal financial controls, accounting
procedures and reports. The audit committee also reviews the engagement of our
independent auditors, makes recommendations to the board of directors regarding
the selection of independent auditors and reviews the scope, fees and results
of any audit.
Messrs. Gallagher, Nasella and Sisteron comprise the compensation committee.
The compensation committee administers all of our salary and incentive
compensation policies. The compensation committee also administers our stock
option plans and establishes the terms and conditions of all stock option
grants.
Messrs. Nasella and Spurgeon comprise the nominating committee. The
nominating committee evaluates board performance and recommends nominees to the
board of directors.
Director Compensation
Directors do not receive any cash compensation for service as directors,
however, they are reimbursed for the expenses they incur in attending meetings
of the board or board committees. All directors are eligible to participate in
our stock option plans.
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<PAGE>
Executive Compensation
The following table sets forth information concerning the compensation
earned by our chief executive officer and our two other executive officers for
services rendered in all capacities to us in the year ended January 30, 1999.
Summary Compensation Table
<TABLE>
<CAPTION>
Annual
Compensation
----------------- All Other
Name and Principal Position Year Salary Bonus Compensation(a)
- --------------------------- ---- ------ -------- ---------------
<S> <C> <C> <C> <C>
Keith C. Spurgeon, Chairman and Chief
Executive Officer..................... 1998 $300,000 $135,000 $2,335
Thomas G. Vellios, President........... 1998 275,000 110,000 2,466
Robert A. Helpert, Chief Financial
Officer, Secretary and Treasurer...... 1998 262,500 91,875 6,666
</TABLE>
- --------
(a) Represents premiums paid by us with respect to term life insurance for the
benefit of the named executive officer.
Stock Option Information
There were no stock option grants to any of the executive officers named in
the Summary Compensation Table during fiscal year 1998.
In April 1999, Messrs. Spurgeon, Vellios and Helpert received options to
purchase 100,000, 125,000, and 25,000 shares of common stock, respectively, at
an exercise price of $11.75 per share. Each of the options vests in four equal
installments commencing on the first anniversary of the date of grant and
expires ten years from the date of grant.
The following table sets forth information with respect to the number and
value of outstanding options held by the executive officers named in the
Summary Compensation Table at the end of 1998.
Fiscal Year-End Option Values
<TABLE>
<CAPTION>
Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money Options
Options at Year End(#) at Year End ($)(a)
------------------------- -------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Keith C. Spurgeon........... 237,500 462,500 1,559,000 3,009,500
Thomas G. Vellios........... 175,000 275,000 1,150,500 1,784,000
Robert A. Helpert........... 113,750 161,250 752,850 1,057,950
</TABLE>
- --------
(a) Based on an initial public offering price of $10.00 per share, minus the
exercise price, multiplied by the number of shares underlying the option.
Stock Option Plans
1993 Stock Incentive Plan
We have a 1993 stock incentive plan, under which we have reserved for
issuance 2,500,000 shares of common stock. The 1993 plan provides for grants of
incentive stock options, nonqualified
41
<PAGE>
stock options, stock appreciation rights and stock awards to our key employees
and non-employee directors. The compensation committee of the board of
directors administers and interprets the plan.
The exercise price of common stock underlying an option may be greater, less
than or equal to fair market value. However, the exercise price of an incentive
stock option must be equal to or greater than the fair market value of a share
of common stock on the date such incentive stock option is granted, and the
exercise price of an incentive stock option granted to an employee who owns
more than 10% of the common stock may not be less than 110% of the fair market
value of the underlying shares of common stock on the date of grant.
The maximum term of an option is ten years from the date of grant except
that the term of an incentive stock option granted to an employee who owns more
than 10% of the common stock may not exceed five years from the date of grant.
The compensation committee may accelerate the exercisability of any or all
outstanding options in the event of a dissolution, liquidation or change in
control.
As of May 1, 1999, 2,450,487 options were outstanding under the 1993 plan.
Zany Brainy does not anticipate that any additional stock options will be
granted under the 1993 plan after the date of the offering.
1998 Equity Compensation Plan
We have a 1998 equity compensation plan under which we have reserved for
issuance 3,000,000 shares of common stock. The 1998 plan provides for grants of
incentive stock options, nonqualified stock options, stock appreciation rights,
restricted stock and performance units to our designated employees, advisors
and consultants and to non-employee directors. The 1998 plan provides that no
more than 500,000 shares in the aggregate may be granted to any individual in
any calendar year. The compensation committee of the board of directors
administers and interprets the plan.
The exercise price of common stock underlying an option may be greater, less
than or equal to fair market value. However, the exercise price of an incentive
stock option must be equal to or greater than the fair market value of a share
of common stock on the date such incentive stock option is granted, and the
exercise price of an incentive stock option granted to an employee who owns
more than 10% of the common stock may not be less than 110% of the fair market
value of the underlying shares of common stock on the date of grant.
The maximum term of an option is ten years from the date of grant except
that the term of an incentive stock option granted to an employee who owns more
than 10% of the common stock may not exceed five years from the date of grant.
The compensation committee may accelerate the exercisability of any or all
outstanding options at any time for any reason.
Upon a change of control, unless the compensation committee determines
otherwise:
. 50% of all unvested options shall immediately vest;
. the restrictions and conditions on all outstanding restricted stock shall
immediately lapse; and
. holders of performance units shall receive a payment in settlement of
such units, in an amount determined by the compensation committee in its
sole discretion.
As of May 1, 1999, 941,600 options were outstanding under the 1998 plan.
42
<PAGE>
Section 162(m). Under Section 162(m) of the Internal Revenue Code, we may be
precluded from claiming a federal income tax deduction for total remuneration
in excess of $1,000,000 paid to the chief executive officer or to any of the
other four most highly compensated officers in any one year. Total remuneration
would include amounts received upon the exercise of stock options granted under
the plan and the value of shares received when the shares of restricted stock
became transferable or such other time when income is recognized. An exception
does exist, however, for "performance-based compensation," including amounts
received upon the exercise of stock options pursuant to a plan approved by
shareholders that meets certain requirements. The 1998 plan has been approved
by shareholders and is intended to make grants of options thereunder meet the
requirements of "performance-based compensation." Awards of restricted stock
generally will not qualify as "performance-based compensation."
Nonqualified Stock Options
Prior to the adoption of the 1993 stock incentive plan and subsequent to the
1993 plan's adoption with respect to certain persons or entities unable to
receive grants under the 1993 plan, we granted to certain employees,
consultants and advisors non-qualified stock options under individual
agreements with the grantees. As of May 1, 1999, 130,000 options were
outstanding under these separate agreements. All of these options expire ten
years after the date of grant.
Employment Agreements
In 1996, we entered into employment agreements with each of Keith C.
Spurgeon, Thomas G. Vellios and Robert A. Helpert. Under these employment
agreements, Messrs. Spurgeon, Vellios and Helpert are entitled to receive a
base salary, which may be increased from time to time, and such additional
compensation as may be awarded to them. In addition, Messrs. Spurgeon, Vellios
and Helpert received stock option grants under these employment agreements for
400,000 shares, 200,000 shares and 140,000 shares, respectively, at an exercise
price of $4.00 per share. These stock option grants were subsequently repriced
to $3.33 per share and are governed by the terms of our 1993 stock incentive
plan. The 1999 base salaries for Messrs. Spurgeon, Vellios and Helpert are
$300,000, $300,000 and $275,000, respectively.
Each of the employment agreements contains the following principal terms:
. severance payment equal to six months of the employee's base salary if
the employee is terminated for any reason other than for cause or a
change of control;
. severance payment equal to one year of the employee's base salary, if the
employee is terminated or the employee's responsibilities are
significantly reduced after a change in control; and
. the option to resign and still receive a severance payment equal to one
year of the employee's base salary within one year after a change of
control if, after the change in control, the successor organization does
not offer to extend the employee's employment agreement for two years on
substantially the same terms.
Each of the employment agreements may be terminated at will by either party.
43
<PAGE>
CERTAIN TRANSACTIONS
Issuance of Capital Stock
In September and November 1996, we issued 525,025 shares and 224,959 shares,
respectively, of series C convertible preferred stock for an aggregate of
$16,874,640. In order to encourage our existing shareholders to participate in
the series C financing, we also offered them the opportunity, in some
circumstances, to exchange their shares of series B preferred stock for an
equal number of shares of series BB preferred stock, which has a more favorable
conversion rate to common stock. As a result, in September 1996, we issued
748,334 shares of series BB convertible preferred stock in exchange for an
equal number of shares of series B convertible preferred stock. In addition, as
set forth below, one of our former shareholders also sold all of its shares of
common stock on a pro rata basis to the investors in the series C financing.
All of the shares of preferred stock will convert to common stock at the
closing of this offering.
Specifically, in connection with the series C preferred stock sale, we
issued:
. 8,940 shares of common stock to the C. Donald Dorsey and Lydia Dorsey
Family Trust dated August 5, 1993, for which C. Donald Dorsey, one of our
directors, serves as trustee;
. an aggregate of 164,590 shares of common stock to Robert A. Fox, one of
our directors, for himself and for a voting trust in his name;
. 121,755 shares and 2,740 shares of common stock to Oak Investment
Partners V, L.P. and Oak V Affiliates Fund, L.P., respectively,
partnerships in which Gerald R. Gallagher, one of our directors, is a
general partner;
. 810,805 shares, 131,530 shares and 51,050 shares of common stock to
Fourcar, B.V., Lacomble Retailing, SA and Fondation Consuelo,
respectively, each of which is an entity affiliated with Carrefour S.A.,
for which Yves Sisteron, one of our directors, serves as the manager of
U.S. investments;
. 70,620 shares of common stock to Frontenac VI Limited Partnership, one of
our greater than 5% shareholders;
. 1,015,455 shares and 5,040 shares of common stock to Nassau Capital
Partners II L.P., one of our greater than 5% shareholders, and NAS
Partners I L.L.C., respectively;
. 993,375 shares of common stock to Vulcan Ventures, Inc., one of our
greater than 5% shareholders; and
. an aggregate of 5,605 shares of common stock to employees of DLJ.
In connection with the exchange of series B convertible preferred stock for
series BB convertible preferred stock, we issued:
. 4,571 shares of common stock to the C. Donald Dorsey Trust;
. an aggregate of 448,388 shares of common stock to Mr. Fox, for himself
and for a voting trust in his name;
. 372,571 shares and 8,379 shares of common stock to Oak Investment
Partners V, L.P. and Oak V Affiliates Fund, L.P., respectively;
. 321,152 shares, 71,195 shares, 35,597 shares, 35,597 shares, 28,571
shares, 13,714 shares and 28,571 shares of common stock to Fourcar, B.V.,
Lacomble Retailing, SA, Fidas
44
<PAGE>
Business S.A., SG Cowen, Fundacion Juan March, Fundacion Appomatox and
Daniel Bernard, respectively, each of which is an entity affiliated with
Mr. Sisteron and which Fourcar, B.V. and Lacomble Retailing, SA are
entities affiliated with Carrefour S.A.;
. 761,911 shares of common stock to Frontenac VI Limited Partnership;
. 257,526 shares of common stock to Vulcan Ventures, Inc; and
. an aggregate of 2,550 shares of common stock to employees of DLJ.
On the date of this prospectus, DLJ Capital Corporation and DLJ First ESC
L.P. exercised their warrants to purchase 51,929 shares and 4,144 shares of
common stock, respectively, on a cashless basis and were issued 20,772 shares
and 1,658 shares of common stock, respectively. See "Underwriting."
Recent Sales of Securities by Shareholders
In September and November 1996, one of our former shareholders sold an
aggregate of 600,000 shares of common stock to certain of our shareholders for
an aggregate purchase price of $2.0 million, or $3.33 per share, including:
. 1,430 shares of common stock to the C. Donald Dorsey Trust;
. an aggregate of 26,334 shares of common stock to Mr. Fox, for himself and
for a voting trust in his name;
. 19,481 shares and 438 shares of common stock to Oak Investment Partners
V, L.P. and Oak V Affiliates Fund, L.P., respectively;
. 129,729 shares, 21,045 shares and 8,168 shares of common stock to
Fourcar, B.V., Lacomble Retailing, SA and Fondation Consuelo,
respectively;
. 11,300 shares of common stock to Frontenac VI Limited Partnership;
. 162,474 shares and 807 shares of common stock to Nassau Capital Partners
II L.P. and NAS Partners I L.L.C., respectively;
. 158,940 shares of common stock to Vulcan Ventures, Inc.; and
. an aggregate of 898 shares of common stock to employees of DLJ.
In July and August 1998, Mr. Schlessinger sold an aggregate of 410,000
shares of common stock to certain of our shareholders for an aggregate purchase
price of $2,460,000, or $6.00 per share, including:
. an aggregate of 40,261 shares of common stock to Mr. Fox, for himself and
for a voting trust in his name;
. 28,149 shares and 633 shares of common stock to Oak Investment Partners
V, L.P. and Oak V Affiliates Fund, L.P., respectively;
. 1,081 shares of common stock to Henry Nasella, one of our directors;
. 36,783 shares and 229 shares of common stock to Nassau Capital Partners
II L.P. and NAS Partners I L.L.C., respectively;
. 65,247 shares of common stock to Vulcan Ventures, Inc.; and
. 105,549 shares of common stock to DLJ and 1,071 shares of common stock to
an employee of DLJ.
In December 1998, DLJ transferred the 105,549 shares of common stock it
purchased from Mr. Schlessinger to Global Retail Partners, L.P., an investment
partnership of which Mr. Sisteron, one of our directors, is a principal, and to
its affiliates.
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<PAGE>
PRINCIPAL AND SELLING SHAREHOLDERS
The following table sets forth information regarding the beneficial
ownership of our common stock by:
. our chief executive officer, other executive officers and directors;
. each selling shareholder;
. all directors and executive officers as a group; and
. each person known to us to own beneficially more than 5% of our
outstanding shares.
A person has beneficial ownership of shares if he has the power to vote or
dispose of the shares. This power can be exclusive or shared, direct or
indirect. In addition, a person is considered by SEC rules to beneficially own
shares underlying options that are presently exercisable or will become
exercisable within 60 days. The shares listed in this table below under "Number
of Shares Underlying Options" include shares issuable upon the exercise of
options that are presently exercisable or will become exercisable within 60
days of May 1, 1999.
As of May 1, 1999, there were 16,635,681 shares of our common stock
outstanding, after giving effect to the conversion of all shares of preferred
stock into common stock. To calculate a shareholder's percentage of beneficial
ownership, we must include in the numerator and denominator those shares
underlying options that the shareholder is considered to beneficially own.
Shares underlying options held by other shareholders, however, are disregarded
in this calculation. Therefore, the denominator used in calculating beneficial
ownership among our shareholders may differ. In addition to the 3,807,669
shares of our common stock sold by us in this offering, outstanding shares
after this offering include 25,000 shares to be sold in this offering, which
were issued in connection with the exercise of stock options on the date of
this prospectus, and 22,430 shares, which were issued in connection with the
exercise of warrants on the date of this prospectus.
<TABLE>
<CAPTION>
Shares
Beneficially
Shares Beneficially Owned Prior to Owned After
Offering Offering
---------------------------------------- Number of -----------------
Number of Shares of
Number of Shares Common Stock
Outstanding Underlying to be Sold
Name of Beneficial Owner Shares Options Total Percent in Offering Number Percent
------------------------ ----------- ---------- ----- ------- ------------ --------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Executive Officers and Directors
Keith C. Spurgeon .............. 0 337,500 337,500 2.0% 0 337,500 1.6%
Thomas G. Vellios .............. 0 175,000 175,000 1.0 0 175,000 *
Robert A. Helpert .............. 0 148,750 148,750 * 0 148,750 *
C. Donald Dorsey (a)............ 19,512 34,000 53,512 * 0 53,512 *
Robert A. Fox (b)............... 1,840,912 4,000 1,844,912 11.1 148,604 1,696,308 8.3
Gerald R. Gallagher (c)......... 1,316,047 84,000 1,400,047 8.4 0 1,400,047 6.8
Henry Nasella .................. 8,336 41,500 49,836 * 0 49,836 *
Yves B. Sisteron (d)............ 3,220,836 4,000 3,224,836 19.4 0 3,224,836 15.7
David V. Wachs (e).............. 217,558 34,000 251,558 1.5 35,821 215,737 1.1
All executive officers and
directors as a group
(9 persons).................... 6,623,201 862,750 7,485,951 42.8 184,425 7,301,526 34.2
Five Percent Holders
Frontenac VI Limited
Partnership (f)................ 843,831 0 843,831 5.1 210,957 632,774 3.1
Fourcar, B.V. (g)............... 2,438,154 4,000 2,442,154 14.7 0 2,442,154 11.9
Nassau Capital
Partners II L.P. (h)........... 1,220,788 0 1,220,788 7.3 305,197 915,591 4.5
David Schlessinger (i).......... 2,054,550 0 2,054,550 12.4 1,200,000 854,550 4.2
Vulcan Ventures, Inc. (j)....... 2,141,757 0 2,141,757 12.9 0 2,141,757 10.5
</TABLE>
46
<PAGE>
<TABLE>
<CAPTION>
Shares
Beneficially
Shares Beneficially Owned Prior to Owned After
Offering Offering
-------------------------------------- Number of ---------------
Number of Shares of
Number of Shares Common Stock
Outstanding Underlying to be Sold
Name of Beneficial Owner Shares Options Total Percent in Offering Number Percent
- ------------------------ ----------- ---------- ----- ------- ------------ ------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Selling Shareholders
Robert S. Adelson....... 224,928 0 224,928 1.4% 39,428 185,500 *
Thomas A. Adelson....... 50,115 0 50,115 * 10,679 39,436 *
Arabella................ 76,187 0 76,167 * 19,046 57,141 *
Rosa Aukburg............ 0 30,000 30,000 * 25,000 5,000 *
Deanmore Holdings Ltd... 9,552 0 9,552 * 2,380 7,142 *
Dulverton Holdings Ltd.. 9,552 0 9,552 * 2,380 7,142 *
Craig J. Foley.......... 27,444 0 27,444 * 6,861 20,583 *
IPP95, L.P. (k)......... 297,375 0 297,375 1.8 74,343 223,032 1.1%
Brener International
Group, LLC. (l)........ 118,849 0 118,849 * 29,712 89,137 *
Alan Mirken 1997 Three-
Year
Trust (m).............. 467,376 0 467,376 2.8 116,844 350,532 1.7
David M. Rubenstein..... 10,559 0 10,559 * 2,639 7,920 *
Anthony L. Schaeffer.... 60,340 0 60,340 * 15,085 45,255 *
James R. Schaeffer (n).. 60,340 0 60,340 * 15,085 45,255 *
Robert D. Schaeffer..... 99,663 0 99,663 * 24,915 74,748 *
Shoemaker Family
Partners (o)........... 29,423 0 29,423 * 7,355 22,068 *
</TABLE>
- --------
* Percentage of shares of common stock beneficially owned does not exceed one
percent.
(a) 19,512 outstanding shares of common stock held by the C. Donald Dorsey and
Lydia Dorsey Family Trust Dated August 5, 1993.
(b) Outstanding shares include 594,416 shares held by Robert A. Fox, as Voting
Trustee pursuant to a Voting Trust Agreement Dated January 20, 1993, of
which 148,604 shares will be sold in this offering. Mr. Fox's address is
One Pitcairn Place, Suite 2100, 165 Township Line Road, Jenkintown, PA
19046.
(c) Includes:
(1) 1,287,099 shares owned by Oak Investment Partners V, Limited
Partnership;
(2) 82,152 shares of common stock underlying presently exercisable options
held by Oak Investment Partners V, Limited Partnership;
(3) 28,948 shares owned by Oak V Affiliates Fund, Limited Partnership; and
(4) 1,848 shares of common stock underlying presently exercisable options
held by Oak V Affiliates Fund, Limited Partnership.
The address for Oak Investment Partners V, Limited Partnership is 4550
Norwest Center, Minneapolis, MN 55401. Mr. Gallagher is a partner of Oak
Investment Partners with certain voting and investment power over such
shares. Although Mr. Gallagher may be deemed to be a beneficial owner of
such shares, he disclaims all such beneficial ownership, except to the
extent of any pecuniary interest therein which he may have.
(d) Outstanding shares include:
(1) 2,023,085, 414,119, 130,774, 130,769, 154,390, 104,708, 51,784 and
104,708 shares of common stock held by Fourcar, B.V., Lacomble Retailing,
SA, Fidas Business S.A., SG Cowen, Fondation Consuelo, Fundacion Juan
March, Fundation Appomatox and Daniel Bernard, respectively (collectively,
the "Sisteron Affiliates"); and
(2) 67,672, 4,399, 4,659, 20,165, 7,489 and 1,165 shares of common stock
held by Global Retail Partners, L.P., GRP Partners, L.P., Global Retail
Partners Funding, Inc., DLJ Diversified Partners, L.P., DLJ Diversified
Partners-A, L.P. and DLJ ESC II, L.P., respectively (collectively, the
"GRP Affiliates").
47
<PAGE>
Mr. Sisteron is a manager of U.S. investments of Carrefour S.A. and has
certain voting rights with respect to the shares owned by each of the
Sisteron Affiliates. Carrefour S.A. is a beneficial owner of the shares
owned by Fourcar, B.V. and Lacomble Retailing, SA. Although Mr. Sisteron
may be deemed to be a beneficial owner of the shares owned by the Sisteron
Affiliates, he disclaims all such beneficial ownership, except to the
extent of any pecuniary interest therein which he may have. Mr. Sisteron
is also a principal of Global Retail Partners, L.P. Global Retail
Partners, L.P. and the other GRP Affiliates are affiliated with DLJ.
Although Mr. Sisteron may be deemed a beneficial owner of the shares owned
by the GRP Affiliates, he disclaims all such beneficial ownership, except
to the extent of any pecuniary interest therein which he may have.
(e) Outstanding shares include 142,558 shares of common stock held by Wachs
Partners, of which 8,571 will be sold in this offering. Mr. Wachs is the
general partner of Wachs Partners. Mr. Wachs is selling 27,250 shares in
this offering.
(f) Frontenac's address is 135 S. LaSalle Street, Suite 3800, Chicago, Illinois
60603. Frontenac's general partners are Paul D. Carbery, James E. Cowie,
James E. Crawford, III, Rodney L. Goldstein, M. Laird Koldyke, Martin J.
Koldyke, Roger S. McEnvy, Laura P. Pearl and Jeremy H. Silverman.
(g) Outstanding shares include:
(1) 414,119 shares of common stock held by Lacomble Retailing, SA; and
(2) 950 shares of common stock held by Yves Sisteron.
The address for Fourcar B.V. is Gebouw Autumn, Overschiestraate No. 184P,
1062XK Amsterdam Netherlands.
(h) Outstanding shares include 6,076 shares of common stock held by NAS
Partners I L.L.C., of which 1,519 shares will be sold in this offering.
Nassau Capital Partners II L.P. is selling 303,678 shares in the offering
and its address is 22 Chambers Street, Princeton, NJ 08542. The two
managing members of NAS Partners are John G. Quigley and Randall A. Hack.
The general partner of Nassau Capital Partners is Nassau Capital LLC whose
members are Messrs. Quigley and Hack, Jonathan Sweemer and Robert L.
Honstein.
(i) Mr. Schlessinger resigned as one of our directors in August 1998. His
address is 125 Lincoln Avenue, Suite 400, Santa Fe, NM 87501.
(j) Vulcan Ventures, Inc's. address is 110--110th Avenue, N.E., Suite 550,
Bellevue, WA 98004. The sole owner of Vulcan Ventures, Inc. is Paul G.
Allen.
(k) The general partner of IPP95, L.P. is WESINVEST, Inc.
(l) The sole managing member of Brener International Group, LLC is Gabriel
Brener.
(m) Mitchell J. Rubin is the Trustee of the Alan Mirken 1997 Three Year Trust.
(n) Mr. Schaeffer's shares are held jointly with his spouse.
(o) Alvin Shoemaker is the sole general partner of Shoemaker Family Partners.
In addition, Peter Shoemaker has certain voting rights with respect to the
shares owned by Shoemaker Family Partners.
48
<PAGE>
DESCRIPTION OF CAPITAL STOCK
Our authorized capital stock consists of 100,000,000 shares of common stock,
par value $.01 per share, and 5,000,000 shares of preferred stock, par value
$.01 per share.
Common Stock
As of May 1, 1999, our outstanding common stock consisted of 16,635,681
shares of common stock, after giving effect to the conversion of all shares of
preferred stock into common stock upon the closing of this offering, held by
163 shareholders of record. Holders of common stock are entitled to one vote
for each share held of record on all matters on which shareholders may vote,
and do not have cumulative voting rights in the election of directors. Holders
of common stock are entitled to receive, as, when and if declared by the board
of directors from time to time, such dividends and other distributions in cash,
stock or property from our assets or funds legally available for such purposes
subject to any dividend preferences that may be attributable to our outstanding
preferred stock.
No preemptive, conversion, redemption or sinking fund provisions apply to
the common stock. All outstanding shares of common stock are fully paid and
non-assessable. In the event of our liquidation, dissolution or winding up,
holders of common stock are entitled to share ratably in the assets available
for distribution.
Preferred Stock
Upon the closing of this offering, we will have no outstanding shares of
preferred stock. Our board of directors, without further action by the
shareholders, is authorized to issue an aggregate of 5,000,000 shares of
preferred stock. We have no plans to issue a new series of preferred stock. Our
board of directors may issue preferred stock with dividend rates, redemption
prices, preferences on liquidation or dissolution, conversion rights, voting
rights and any other preferences, which rights and preferences could adversely
affect the voting power of the holders of common stock. Issuance of preferred
stock, while providing desirable flexibility in connection with possible
acquisitions or other corporate purposes, could have the effect of making it
more difficult for a third party to acquire, or could discourage or delay a
third party from acquiring control.
Common Stock Warrants
We have outstanding warrants which entitle the holders to purchase an
aggregate of 47,550 shares of common stock at an exercise price of $4.00 per
share. These warrants expire on various dates through January 2003.
The exercise price and number of shares of common stock issuable upon the
exercise of each of the warrants may be adjusted upon the occurrence of certain
events, including stock splits, stock dividends, reorganization,
recapitalization, merger or sale of all or substantially all of our assets.
Indemnification of Directors and Officers
Section 1741 of the Pennsylvania Business Corporation Law, as amended (BCL),
provides us with the power to indemnify any officer or director acting in his
or her capacity as a representative of
49
<PAGE>
Zany Brainy who was, is or is threatened to be made a party to any action or
proceeding for expenses, judgments, penalties, fines and amounts paid in
settlement in connection with such action or proceeding. The indemnity
provisions apply whether the action was instituted by a third party or arose by
or in our right. Generally, the only limitation on our ability to indemnify our
officers and directors is if the act violates a criminal statute or if the act
or failure to act is finally determined by a court to have constituted willful
misconduct or recklessness.
Our bylaws provide a right to indemnification to the full extent permitted
by law for expenses, attorney's fees, damages, punitive damages, judgments,
penalties, fines and amounts paid in settlement actually and reasonably
incurred by any director or officer whether or not the indemnified liability
arises or arose from any threatened, pending or completed proceeding by or in
our right by reason of the fact that such director or officer is or was serving
as our director, officer or employee or, at our request, as a director,
officer, partner, fiduciary or trustee of another corporation, partnership,
joint venture, trust, employee benefit plan or other enterprise, unless the act
or failure to act giving rise to the claim for indemnification is finally
determined by a court to have constituted willful misconduct or recklessness.
Our bylaws provide for the advancement of expenses to an indemnified party upon
receipt of an undertaking by the party to repay those amounts if it is finally
determined that the indemnified party is not entitled to indemnification.
Our bylaws authorize us to take steps to ensure that all persons entitled to
the indemnification are properly indemnified, including, if the board so
determines, purchasing and maintaining insurance.
Limitation of Liability
Our bylaws provide that none of our directors shall be personally liable to
us or our shareholders for monetary damages for any action taken or failure to
take any action, unless:
. such director has breached or failed to perform such person's duties
under the Pennsylvania corporate laws; and
. the breach or failure to perform constitutes self-dealing, willful
misconduct or recklessness.
We maintain directors and officers' liability insurance to provide directors
and officers with insurance coverage for losses arising from claims based on
breaches of duty, negligence, error and other wrongful acts. At present, there
is no pending litigation or proceeding, and we are not aware of any threatened
litigation or proceeding, involving any director, officer, employee or agent
where indemnification will be required or permitted under our bylaws.
Pennsylvania Takeover Laws
The BCL contains provisions applicable to publicly held Pennsylvania
corporations that may be deemed to have an anti-takeover effect. We have
specifically opted out of all but Section 1715 of the BCL, which remains
applicable to us.
Under Section 1715 of the BCL, our directors are not required to regard the
interests of the shareholders as being dominant or controlling in considering
the best interests of Zany Brainy. The directors may consider, to the extent
they deem appropriate, such factors as:
. the effects of any action upon any group affected by such action
(including our shareholders, employees, suppliers, customers and
creditors and upon communities in which we have stores, offices or other
establishments);
50
<PAGE>
. the short term and long term interests of Zany Brainy (including benefits
that may accrue to us from our long term plans and the possibility that
these interests may be best served by our continued independence);
. the resources, intent and conduct of any person seeking to acquire
control of Zany Brainy; and
. all other pertinent factors.
Section 1715 of the BCL further provides that any act of our board of
directors, a committee of the board or an individual director relating to or
affecting an acquisition or potential or proposed acquisition of control to
which a majority of our disinterested directors have assented will be presumed
to satisfy the standard of care set forth in the BCL, unless it is proven by
clear and convincing evidence that our disinterested directors did not consent
to such act in good faith after reasonable investigation. As a result of this
and the other provisions of Section 1715 of the BCL, our directors are provided
with broad discretion with respect to actions that may be taken in response to
acquisitions or proposed acquisitions of corporate control.
Section 1715 of the BCL may discourage open market purchases of our common
stock or a non-negotiated tender or exchange offer for our common stock and,
accordingly, may be considered disadvantageous by a shareholder who would
desire to participate in any such transaction. In addition, Section 1715 of the
BCL may have a depressive effect on the price of our common stock.
In addition, the ability of the board of directors to establish the rights
of, and to issue, substantial amounts of preferred stock without the need for
shareholder approval may discourage, delay or prevent a change in control. Such
preferred stock, among other things, may be used to create voting impediments
with respect to any changes in control or to dilute the stock ownership of
holders of common stock seeking to obtain control.
Registration Rights
After the consummation of this offering, the holders of approximately 8.2
million shares of common stock will be entitled to certain registration rights
with respect to the registrable securities. These rights are provided under the
terms of the registrable securities and agreements between us and the holders
of such securities. Such agreements and registrable securities provide, in
certain instances, demand registration rights. In addition, pursuant to these
agreements, some of the holders of such securities are entitled, subject to
certain limitations, to require us to include their registrable securities in
registration statements we file under the Securities Act of 1933. Registration
of shares of common stock pursuant to the exercise of registration rights under
the Securities Act of 1933 would result in such shares becoming freely tradable
without restriction under the Securities Act of 1933 immediately upon the
effectiveness of such registration.
Transfer Agent
The transfer agent for our common stock is StockTrans, Inc.
51
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Sales of substantial amounts of common stock in the public market following
the offering could adversely affect the market price of the common stock and
adversely affect our ability to raise capital at a time and on terms favorable
to us.
Of the 20,490,780 shares to be outstanding after the offering, the 3,807,669
shares of common stock offered by us and approximately 16.6 million additional
shares of common stock will be freely tradeable without restriction in the
public market unless such shares are held by "affiliates," as that term is
defined in Rule 144(a) under the Securities Act. For purposes of Rule 144, an
"affiliate" of an issuer is a person that, directly or indirectly through one
or more intermediaries, controls, or is controlled by or is under common
control with, such issuer. The remaining shares of common stock to be
outstanding after the offering are "restricted securities" under the Securities
Act and may be sold in the public market upon the expiration of certain holding
periods under Rule 144, subject to the volume, manner of sale and other
limitations of Rule 144.
In addition, as of May 1, 1999, there were outstanding warrants to purchase
47,550 shares of common stock, excluding warrants to purchase 56,073 shares of
common stock exercised on the date of this prospectus, and options to purchase
3,497,087 shares of common stock, excluding 25,000 options that were exercised
on the date of this prospectus. An additional 2,068,758 shares were reserved
for issuance under our option plans. We intend to register the shares of common
stock issued, issuable or reserved for issuance under our option plans or
separate option agreements as soon as practicable following the date of this
prospectus.
Certain holders of approximately 8.2 million shares of common stock are
entitled to certain registration rights with respect to such shares for resale
under the Securities Act. If such holders, by exercising their registration
rights, cause a large number of shares to be registered and sold in the public
market, such sales could have an adverse effect on the market price for the
common stock.
Lock-Up Arrangements
Our executive officers and directors and certain other shareholders, have
agreed not to sell or otherwise dispose of any shares of common stock for a
period of 135 days after the date of this prospectus and not to sell two-thirds
of such securities until January 31, 2000, without the prior written consent of
DLJ. We have agreed not to sell or otherwise dispose of any shares of our
common stock for a period of 180 days after the date of this prospectus. See
"Underwriting."
52
<PAGE>
UNDERWRITING
Subject to the terms and conditions contained in an underwriting agreement,
dated June 2, 1999, the underwriters named below, who are represented by
Donaldson, Lufkin & Jenrette Securities Corporation, BT Alex. Brown
Incorporated, William Blair & Company, L.L.C., U.S. Bancorp Piper Jaffray Inc.
and DLJdirect Inc. have severally agreed to purchase from the selling
shareholders and from us the respective number of shares of common stock set
forth opposite their names below.
<TABLE>
<CAPTION>
Number of
Underwriters Shares
------------ ---------
<S> <C>
Donaldson, Lufkin & Jenrette Securities Corporation............. 2,306,400
BT Alex. Brown Incorporated..................................... 1,587,600
William Blair & Company, L.L.C.................................. 465,500
U.S. Bancorp Piper Jaffray Inc.................................. 465,500
DLJdirect Inc. ................................................. 75,000
Bear, Stearns & Co. Inc. ....................................... 60,000
CIBC World Markets.............................................. 60,000
A.G. Edwards & Sons, Inc. ...................................... 60,000
ING Baring Furman Selz LLC...................................... 60,000
Lehman Brothers Inc. ........................................... 60,000
Merrill Lynch, Pierce, Fenner & Smith Incorporated.............. 60,000
Morgan Stanley & Co. Incorporated............................... 60,000
PaineWebber Incorporated........................................ 60,000
Salomon Smith Barney Inc. ...................................... 60,000
Gerard Klauer Mattison & Co., Inc. ............................. 60,000
Advest, Inc. ................................................... 30,000
Blackford Securities Corporation................................ 30,000
Burnham Securities Inc. ........................................ 30,000
Dain Rauscher Wessels........................................... 30,000
Fahnestock & Co. Inc. .......................................... 30,000
First Union Capital Markets Corp. .............................. 30,000
Gruntal & Co., L.L.C. .......................................... 30,000
Janney Montgomery Scott Inc. ................................... 30,000
Johnston, Lemon & Co. Incorporated.............................. 30,000
C.L. King & Associates, Inc. ................................... 30,000
Ladenburg Thalmann & Co. Inc. .................................. 30,000
Legg Mason Wood Walker, Incorporated............................ 30,000
McDonald Investments Inc., a KeyCorp Company.................... 30,000
Morgan Keegan & Company, Incorporated........................... 30,000
Parker/Hunter Incorporated...................................... 30,000
Pennsylvania Merchant Group..................................... 30,000
Pryor & Company, LLC............................................ 30,000
Sands Brothers & Co., Ltd. ..................................... 30,000
Stephens Inc. .................................................. 30,000
Tucker Anthony Cleary Gull...................................... 30,000
---------
Total......................................................... 6,100,000
=========
</TABLE>
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<PAGE>
The underwriting agreement provides that the obligations of the several
underwriters to purchase and accept delivery of the shares of common stock
included in this offering are subject to approval of legal matters by their
counsel and to customary conditions, including the effectiveness of the
registration statement, the continuing correctness of our representations and
those of the selling shareholders, the receipt of a "comfort letter" from our
accountants, the listing of the common stock for quotation on the Nasdaq
National Market and no occurrence of an event that would have a material
adverse effect on Zany Brainy. The underwriters are obligated to purchase and
accept delivery of all the shares of common stock, other than those covered by
the over-allotment option described below, if they purchase any of the shares
of common stock.
The underwriters propose to initially offer some of the shares of common
stock directly to the public at the initial public offering price set forth on
the cover page of this prospectus and some of the shares of common stock to
dealers (including the underwriters) at the initial public offering price less
a concession not in excess of $0.42 per share. The underwriters may allow, and
such dealers may re-allow, a concession not in excess of $0.10 share on sales
to other dealers. After the initial offering of the common stock to the public,
the representatives of the underwriters may change the public offering price
and such concessions. The underwriters do not intend to confirm sales to any
accounts over which they exercise discretionary authority. An electronic
prospectus is available on the website maintained by DLJdirect Inc.
The following table shows the underwriting fees to be paid to the
underwriters by the selling shareholders and by us in connection with this
offering. These amounts are shown assuming both no exercise and full exercise
of the underwriters' option to purchase additional shares of common stock.
<TABLE>
<CAPTION>
No Full
Exercise Exercise
---------- ----------
<S> <C> <C>
Zany Brainy:
Per share......................................... $ 0.70 $ 0.70
Total............................................. $2,665,368 $3,305,868
Selling shareholders:
Per share......................................... $ 0.70 $ 0.70
Total............................................. $1,604,632 $1,604,632
</TABLE>
Zany Brainy has granted to the underwriters an option, exercisable for 30
days after the date of the underwriting agreement, to purchase up to 915,000
additional shares of common stock at the initial public offering price less the
underwriting fees. The underwriters may exercise such option solely to cover
overallotments, if any, made in connection with this offering. To the extent
that the underwriters exercise such option, each underwriter will become
obligated, subject to conditions, to purchase a number of additional shares
approximately proportionate to such underwriter's initial purchase commitment.
We estimate expenses relating to this offering will be $1,350,000.
The selling shareholders, the underwriters and Zany Brainy have agreed to
indemnify each other against liabilities, including liabilities under the
Securities Act of 1933.
Our executive officers and directors and some of our shareholders have
agreed that, for a period commencing on the date of this prospectus and ending
on January 31, 2000, and subject to certain exceptions, they will not, without
the prior written consent of DLJ, do either of the following:
. offer, pledge, sell, contract to sell, sell any option or contract to
purchase, purchase any option or contract to sell, grant any option,
right or warrant to purchase or otherwise transfer
54
<PAGE>
or dispose of, directly or indirectly, any shares of common stock or any
securities convertible into or exercisable or exchangeable for common
stock; or
. enter into any swap or other arrangement that transfers all or a portion
of the economic consequences associated with the ownership of any common
stock;
provided, however, that with respect to one-third of the shares of common
stock held by each such shareholder, the restrictions set forth above shall
lapse 135 days after the date of this prospectus. We have also agreed to the
restrictions set forth above but for a period commencing on the date of this
prospectus and ending 180 days after the date of this prospectus.
Either of the foregoing transfer restrictions will apply regardless of
whether a covered transaction is to be settled by the delivery of common stock
or other securities, in cash or otherwise. In addition, during such period and
subject to certain exceptions, we have agreed not to file any registration
statement with respect to, and each of our executive officers and directors
and the selling shareholders, has agreed not to make any demand for, or
exercise any right with respect to, the registration of any shares of common
stock or any securities convertible into or exercisable for common stock
without the prior written consent of DLJ.
At our request, the underwriters have reserved up to five percent of the
shares offered by this prospectus for sale at the initial public offering
price to our employees, officers and directors and other individuals
associated with us and members of their families. The number of shares of
common stock available for sale to the general public will be reduced to the
extent these individuals purchase or confirm for purchase, orally or in
writing, such reserved shares. Any reserved shares not purchased or confirmed
for purchase will be offered by the underwriters to the general public on the
same basis as the other shares offered by this prospectus.
Our common stock has been approved for quotation on the Nasdaq National
Market under the symbol "ZANY."
Other than in the United States, no action has been taken by the selling
shareholders, the underwriters or us that would permit a public offering of
the shares of common stock included in this offering in any jurisdiction where
action for that purpose is required. The shares of common stock included in
this offering may not be offered or sold, directly or indirectly, nor may this
prospectus or any other offering material or advertisement in connection with
the offer and sale of any shares of common stock be distributed or published
in any jurisdiction, except under circumstances that will result in compliance
with the applicable rules and regulations of such jurisdiction. Persons who
receive this prospectus are advised to inform themselves about and to observe
any restrictions relating to this offering of the common stock and the
distribution of this prospectus. This prospectus is not an offer to sell or a
solicitation of an offer to buy any shares of common stock included in this
offering in any jurisdiction in which that would not be permitted or legal.
DLJ and certain of its affiliates, including Global Retail Partners, L.P.,
are shareholders of Zany Brainy. In June 1994, affiliates of DLJ acquired
five-year warrants to purchase an aggregate of 56,073 shares of common stock
at an exercise price of $6.00 per common share in connection with a
transaction in which DLJ acted as placement agent and performed other services
for Zany Brainy. On the date of this prospectus, the affiliates of DLJ
exercised these warrants on a cashless basis in connection with this offering
by exchanging the warrants for an aggregate of 22,430 shares of common stock.
DLJ and its employees and affiliates own an aggregate of less than three
percent of the issued and outstanding common stock. See "Certain
Transactions."
55
<PAGE>
Yves Sisteron, who is a principal of Global Retail Partners, L.P., and a
director of Zany Brainy, has been elected to the board of directors pursuant to
the provisions of a shareholders agreement which entitles Fourcar, B.V. to
elect two of the directors of Zany Brainy. Such shareholders agreement
will terminate upon consummation of this offering. See "Certain Transactions."
DLJ or its affiliates have provided and may in the future provide investment
banking or other financial services to us and our affiliates in the ordinary
course of business, for which they have received and are expected to receive
customary fees and expenses.
Stabilization
In connection with this offering, any of the underwriters may engage in
transactions that stabilize, maintain or otherwise affect the price of the
common stock. Specifically, the underwriters may overallot this offering,
creating a syndicate short position. The underwriters may bid for and purchase
shares of common stock in the open market to cover such syndicate short
position or to stabilize the price of the common stock. In addition, the
underwriting syndicate may reclaim selling concessions from syndicate members
and selected dealers if DLJ repurchases previously distributed common stock in
syndicate covering transactions, in stabilization transactions or otherwise or
if DLJ receives a report that indicates that the clients of such syndicate
members have "flipped" the common stock. These activities may stabilize or
maintain the market price of the common stock above independent market levels.
The underwriters are not required to engage in these activities, and may end
any of these activities at any time.
Pricing of this Offering
Prior to this offering, there has been no established market for the common
stock. The initial public offering price for the shares of common stock offered
by this prospectus was determined by negotiation among the selling
shareholders, the representatives of the underwriters and Zany Brainy. The
factors considered in determining the initial public offering price included:
. the history of, and the prospects for, the industry in which we compete;
. our past and present operations;
. our historical results of operations;
. our prospects for future earnings;
. the recent market prices of securities of generally comparable companies;
and
. the general conditions of the securities market at the time of this
offering.
EXPERTS
Our consolidated financial statements as of January 31, 1998 and January 30,
1999, and for the three fiscal years in the period ended January 30, 1999,
included in this prospectus have been audited by Arthur Andersen LLP,
independent public accountants, as indicated in their report with respect
thereto, and are included herein in reliance upon the authority of said firm as
experts in giving said report.
LEGAL MATTERS
The validity of the common stock offered hereby will be passed upon for us
by Morgan, Lewis & Bockius LLP, Philadelphia, Pennsylvania. Latham & Watkins,
Los Angeles, California, has acted as counsel for the underwriters in
connection with this offering.
56
<PAGE>
ADDITIONAL INFORMATION
We have filed with the SEC a registration statement on Form S-1 under the
Securities Act of 1933 with respect to the common stock offered in this
prospectus. This prospectus omits certain information set forth in the
registration statement and the exhibits and schedules thereto. For further
information with respect to Zany Brainy and the common stock offered in this
prospectus, reference is made to such registration statement, exhibits and
schedules.
The registration statement, including the exhibits and schedules filed
therewith, may be inspected free of charge at the public reference facilities
maintained by the SEC at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C. 20549 and at its regional offices located at 7 World Trade
Center, New York, New York 10048 and Northwest Atrium Center, 500 West Madison
Street, Suite 1400, Chicago, Illinois 60661. Copies of such material can be
obtained from the Public Reference Section of the SEC, Room 1024, Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 at prescribed rates and
from the SEC's internet site at http://www.sec.gov.
57
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS .................................. F-2
CONSOLIDATED BALANCE SHEETS ............................................... F-3
CONSOLIDATED STATEMENTS OF OPERATIONS ..................................... F-4
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY ........................... F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS ..................................... F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ................................ F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Zany Brainy, Inc.:
We have audited the accompanying consolidated balance sheets of Zany Brainy,
Inc. (formerly Children's Concept, Inc.) (a Pennsylvania corporation) and
subsidiaries as of January 31, 1998 and January 30, 1999 and the related
consolidated statements of operations, shareholders' equity and cash flows for
each of the three years in the period ended January 30, 1999. 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 generally accepted auditing
standards. 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Zany
Brainy, Inc. and subsidiaries as of January 31, 1998 and January 30, 1999, and
the results of their operations and their cash flows for each of the three
years in the period ended January 30, 1999 in conformity with generally
accepted accounting principles.
/s/ARTHUR ANDERSEN LLP
Philadelphia, Pa.,
March 5, 1999
F-2
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands except share data)
<TABLE>
<CAPTION>
January 31, January 30, May 1,
ASSETS 1998 1999 1999
------ ----------- ----------- -----------
(unaudited)
<S> <C> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents................ $ 5,030 $ 1,695 $ 923
Receivables, net......................... 1,631 3,390 3,039
Inventories, net......................... 29,822 43,252 52,375
Deferred tax asset....................... -- 4,313 5,158
Prepaid expenses......................... 672 940 2,728
-------- -------- --------
Total current assets................... 37,155 53,590 64,223
PROPERTY AND EQUIPMENT, net................ 21,996 25,905 26,514
DEFERRED TAX ASSET......................... -- 2,024 2,024
OTHER ASSETS, net.......................... 401 622 1,291
-------- -------- --------
$ 59,552 $ 82,141 $ 94,052
======== ======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Current portion of capitalized lease
obligations............................. $ 1,199 $ 1,682 $ 1,655
Line of credit........................... -- -- 12,402
Accounts payable......................... 8,596 16,161 18,708
Income taxes payable..................... -- 150 --
Accrued liabilities...................... 7,275 10,055 8,559
-------- -------- --------
Total current liabilities.............. 17,070 28,048 41,324
-------- -------- --------
DEFERRED RENT.............................. 1,856 2,942 3,417
-------- -------- --------
CAPITALIZED LEASE OBLIGATIONS, net of
current portion........................... 1,407 2,860 2,392
-------- -------- --------
COMMITMENTS AND CONTINGENCIES (Note 10)
SHAREHOLDERS' EQUITY
Convertible Preferred stock, $.01 par
value, 4,000,000 shares and 5,000,000
shares authorized at January 30, 1999
and May 1, 1999, respectively, 2,402,955
shares issued and outstanding,
liquidation value of $56,546 at January
30, 1999 and May 1, 1999................ 24 24 24
Common stock, $.01 par value, 25,000,000
shares and 100,000,000 shares authorized
at January 30, 1999 and May 1, 1999,
respectively, 5,361,523, 5,383,571 and
5,385,408 shares issued and outstanding,
respectively............................ 54 54 54
Additional paid-in capital............... 60,753 60,826 60,832
Accumulated deficit...................... (21,612) (12,613) (13,991)
-------- -------- --------
Total shareholders' equity............. 39,219 48,291 46,919
-------- -------- --------
$ 59,552 $ 82,141 $ 94,052
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these statements.
F-3
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share data)
<TABLE>
<CAPTION>
Thirteen
For the Fiscal Year Ended Weeks Ended
----------------------------------- ----------------
February 1, January 31, January 30, May 2, May 1,
1997 1998 1999 1998 1999
----------- ----------- ----------- ------- -------
<S> <C> <C> <C> <C> <C>
(unaudited)
NET SALES............... $92,563 $123,345 $168,471 $27,452 $40,577
COST OF GOODS SOLD,
including occupancy
costs.................. 69,205 89,452 118,153 20,137 29,387
------- -------- -------- ------- -------
Gross profit......... 23,358 33,893 50,318 7,315 11,190
SELLING, GENERAL AND
ADMINISTRATIVE EXPENSES 28,732 33,581 46,376 9,659 12,986
------- -------- -------- ------- -------
Operating income
(loss).............. (5,374) 312 3,942 (2,344) (1,796)
INTEREST INCOME......... 153 253 81 33 11
INTEREST EXPENSE........ (802) (718) (1,211) (159) (438)
------- -------- -------- ------- -------
Income (loss) before
income tax benefit.. (6,023) (153) 2,812 (2,470) (2,223)
INCOME TAX BENEFIT...... -- -- 6,187 -- 845
------- -------- -------- ------- -------
NET INCOME (LOSS)....... $(6,023) $ (153) $ 8,999 $(2,470) $(1,378)
======= ======== ======== ======= =======
NET INCOME (LOSS) PER
COMMON SHARE:
Basic................. $ (1.19) $ (0.03) $ 1.67 $ (0.46) $ (0.26)
Diluted............... $ (1.19) $ (0.03) $ 0.51 $ (0.46) $ (0.26)
WEIGHTED AVERAGE SHARES
OUTSTANDING:
Basic................. 5,068 5,085 5,373 5,363 5,384
Diluted............... 5,068 5,085 17,770 5,363 5,384
</TABLE>
The accompanying notes are an integral part of these statements.
F-4
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(dollars in thousands)
<TABLE>
<CAPTION>
Convertible Preferred Stock
--------------------------- Additional
Series Series Series Series Common Paid-In Accumulated
A B BB C Stock Capital Deficit Total
------ ------ ------ ------ ------ ---------- ----------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE, FEBRUARY 3,
1996................... $ 8 $ 8 $-- $-- $51 $43,741 $(15,436) $28,372
Exercise of stock
options............... -- -- -- -- -- 18 -- 18
Sale of 749,984 shares
of Series C and
conversion of 748,334
shares of Series B to
Series BB, net of
expenses of $715...... -- (7) 7 8 -- 16,152 -- 16,160
Issuance of warrants to
a consultant.......... -- -- -- -- -- 20 -- 20
Net loss............... -- -- -- -- -- -- (6,023) (6,023)
--- --- --- --- --- ------- -------- -------
BALANCE, FEBRUARY 1,
1997................... 8 1 7 8 51 59,931 (21,459) 38,547
Issuance of warrants to
a consultant.......... -- -- -- -- -- 40 -- 40
Exercise of stock
options............... -- -- -- -- -- 35 -- 35
Exercise of warrants... -- -- -- -- 3 747 -- 750
Net loss............... -- -- -- -- -- -- (153) (153)
--- --- --- --- --- ------- -------- -------
BALANCE, JANUARY 31,
1998................... 8 1 7 8 54 60,753 (21,612) 39,219
Exercise of stock
options............... -- -- -- -- -- 73 -- 73
Net income............. -- -- -- -- -- -- 8,999 8,999
--- --- --- --- --- ------- -------- -------
BALANCE, JANUARY 30,
1999................... 8 1 7 8 54 60,826 (12,613) 48,291
Exercise of stock
options (unaudited)... -- -- -- -- -- 6 -- 6
Net loss (unaudited)... -- -- -- -- -- -- (1,378) (1,378)
--- --- --- --- --- ------- -------- -------
BALANCE, MAY 1, 1999
(unaudited)............ $ 8 $ 1 $ 7 $ 8 $54 $60,832 $(13,991) $46,919
=== === === === === ======= ======== =======
</TABLE>
The accompanying notes are an integral part of these statements.
F-5
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Thirteen Weeks
For the Fiscal Year Ended Ended
----------------------------------- ----------------
February 1, January 31, January 30, May 2, May 1,
1997 1998 1999 1998 1999
----------- ----------- ----------- ------- -------
<S> <C> <C> <C> <C> <C>
(unaudited)
CASH FLOWS FROM OPERATING
ACTIVITIES:
Net income (loss)....... $(6,023) $ (153) $ 8,999 $(2,470) $(1,378)
Adjustments to reconcile
net income (loss) to
net cash provided by
(used in) operating
activities--
Depreciation and
amortization.......... 3,713 5,017 6,859 1,385 1,888
Provision for deferred
rent.................. 294 700 1,086 12 475
Issuance of warrants to
consultants........... 20 40 -- -- --
Deferred income tax
benefit............... -- -- (6,337) -- (845)
Changes in assets and
liabilities--
(Increase) decrease
in--
Receivables.......... (625) (457) (1,759) 903 351
Inventories.......... (3,740) (5,544) (13,430) (4,890) (9,123)
Prepaid expenses..... 107 840 (268) (1,326) (1,788)
Other assets......... (6) 33 (270) 79 (669)
Increase (decrease)
in--
Accounts payable..... 473 1,680 7,565 1,963 1,180
Accrued liabilities.. 3,132 1,388 2,780 436 (1,496)
Income tax payable... -- -- 150 -- (150)
------- ------- -------- ------- -------
Net cash provided by
(used in) operating
activities......... (2,655) 3,544 5,375 (3,908) (11,555)
------- ------- -------- ------- -------
CASH FLOWS FROM INVESTING
ACTIVITIES:
Purchases of property
and equipment, net..... (6,276) (6,420) (7,309) (779) (2,497)
------- ------- -------- ------- -------
CASH FLOWS FROM FINANCING
ACTIVITIES:
Proceeds on line of
credit, net............ -- -- -- -- 12,402
Net proceeds from sale
of convertible
preferred stock........ 16,160 -- -- -- --
Increase in bank
overdrafts -- -- -- 445 1,367
Payments on capitalized
lease obligations...... (1,002) (1,309) (1,379) (266) (495)
Debt issuance costs..... -- (258) (95) -- --
Proceeds from exercise
of stock options....... 18 35 73 12 6
Proceeds from exercise
of warrants............ -- 750 -- -- --
------- ------- -------- ------- -------
Net cash provided by
(used in) financing
activities......... 15,176 (782) (1,401) 191 13,280
------- ------- -------- ------- -------
NET INCREASE (DECREASE)
IN CASH AND CASH
EQUIVALENTS............. 6,245 (3,658) (3,335) (4,496) (772)
CASH CASH EQUIVALENTS,
BEGINNING OF PERIOD..... 2,443 8,688 5,030 5,030 1,695
------- ------- -------- ------- -------
CASH AND CASH
EQUIVALENTS, END OF
PERIOD.................. $ 8,688 $ 5,030 $ 1,695 $ 534 $ 923
======= ======= ======== ======= =======
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Background
Zany Brainy, Inc. (formerly Children's Concept, Inc.) was incorporated in
Pennsylvania on August 19, 1991. As of January 30, 1999, Zany Brainy, Inc.
operated 75 stores in 19 states, under the name "Zany Brainy," offering toys,
games, books and multimedia products for children. As of May 1, 1999, Zany
Brainy operated 82 stores in 23 states.
Subsequent Event (unaudited)
In March 1999, Children's Concept, Inc. changed its name to Zany Brainy,
Inc. All references have been updated to reflect this change.
Principles of Consolidation
The consolidated financial statements include the accounts of Zany Brainy,
Inc. and its wholly owned subsidiaries, Children's Products, Inc. and
Children's Development, Inc. (collectively, the "Company"). All significant
intercompany transactions and accounts have been eliminated in consolidation.
Fiscal Year-End
The Company operates under a 52-53-week fiscal year ending the Saturday
nearest January 31. The financial statements for the years ended February 1,
1997 (fiscal 1996), January 31, 1998 (fiscal 1997), and January 30, 1999
(fiscal 1998) each include 52 weeks.
Interim Financial Statements
The accompanying consolidated financial statements as of May 1, 1999 and for
the 13 weeks ended May 2, 1998 and May 1, 1999 are unaudited and in the opinion
of management include all adjustments (consisting only of normal recurring
adjustments) necessary for a fair presentation of the financial position and
results of operations for those interim periods. The results of operations for
the 13 weeks ended May 2, 1998 and May 1, 1999 are not necessarily indicative
of the results to be expected for any other interim period or the full year.
Fair Value of Financial Instruments
The Company's financial instruments consist primarily of cash and cash
equivalents, accounts receivable, accounts payable, accrued liabilities and
debt instruments. The carrying values of these assets and liabilities are
considered to be representative of their respective fair values.
Business and Credit Risk Concentration
Financial instruments which potentially subject the Company to
concentrations of credit risk are cash and cash equivalents and accounts
receivable. The Company limits its credit risk associated with cash and cash
equivalents by placing its investments in highly liquid funds. Receivables
associated
F-7
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
with third party credit cards are processed by financial institutions which are
monitored for financial stability. The Company is dependent on key suppliers to
provide sufficient quantities of inventory at competitive prices. No single
supplier represented 10% or more of purchases in 1998 and one supplier, Ingram
Books, represented 10.5% of purchases during the 13 weeks ended May 1, 1999. In
addition, one product represented greater than 10% of sales for the 13 weeks
ended May 1, 1999.
Use of Estimates
The presentation of these financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the
reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents. Included in cash and
cash equivalents are $3,489,000 and $672,000, of overnight investments in
repurchase agreements at January 31, 1998 and January 30, 1999, respectively.
At January 30, 1999, and May 1, 1999 cash and cash equivalents include $196,000
and $296,000, respectively, of funds held by a bank as collateral for
outstanding standby letters of credit.
Inventories and Cost of Goods Sold
Inventories are stated at the lower of cost or market. Cost is determined
using the first-in, first-out method based on moving average and includes
certain buying and distribution costs relating to the processing of
merchandise. Buying and distribution costs charged to cost of goods sold were
$5,142,000, $5,752,000, $6,833,000 and $1,227,000 and $1,717,000 during fiscal
1996, 1997, 1998 and for the 13 weeks ended May 2, 1998 and May 1, 1999,
respectively. Buying and distribution costs remaining in inventories at January
31, 1998, January 30, 1999 and May 1, 1999 were $1,423,000, $2,093,000, and
$2,497,000, respectively. Store occupancy costs include store rental, utilities
and maintenance expenditures and are included in cost of goods sold.
Property and Equipment
Property and equipment are stated at cost. Additions and improvements are
capitalized, while repairs and maintenance are charged to expense as incurred.
The straight-line method of depreciation is used for financial reporting
purposes. The estimated useful lives are three to ten years for furniture and
fixtures, computers and equipment and the shorter of ten years, or the lease
term, for leasehold improvements. Certain personnel costs and out-of-pocket
costs directly associated with the construction or remodeling of stores are
capitalized and amortized over the lease term.
Long-Lived Assets
The Company has adopted Statement of Financial Accounting Standards ("SFAS")
No. 121 "Accounting for Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of."
F-8
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
SFAS No. 121 requires that long-lived assets and certain identifiable
intangibles to be held and used by the Company be reviewed for possible
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If changes in circumstances
indicate that the carrying amount of an asset that an entity expects to hold
and use may not be recoverable, future cash flows expected to result from the
use of the asset and its disposition must be estimated. If the undiscounted
value of the future cash flows is less than the carrying amount of the asset,
impairment is recognized. Management believes that there has been no impairment
of the Company's long-lived assets as of January 30, 1999 and May 1, 1999.
Store Pre-opening Costs
Pre-opening costs incurred at new store locations are charged to expense as
incurred.
Debt Issuance Costs
Debt issuance costs of $258,000 and $51,000 were incurred in fiscal 1997 and
1998, respectively, in connection with the line of credit agreement and are
amortized on a straight-line basis over the life of the related debt. These
costs are included in other assets on the accompanying consolidated balance
sheets, net of accumulated amortization of $42,000, $186,000 and $229,000 at
January 31, 1998, January 30, 1999 and May 1, 1999, respectively.
Deferred Rent
Rent expense on leases is recorded on a straight-line basis over the lease
period. The excess of rent expense over the actual cash paid is recorded as
deferred rent.
Revenue Recognition
Revenue is recognized at the point of sale.
Advertising Costs
Advertising costs are charged to expense the first time the advertising
takes place. Advertising expense, including grand opening advertising, was
$2,082,000, $2,301,000, $5,036,000, $1,124,000 and $1,188,000 net of certain
vendor reimbursements, in fiscal 1996, 1997, 1998 and the 13 weeks ended May 2,
1998 and May 1,1999, respectively.
Supplemental Cash Flows Information
For fiscal 1996, 1997, 1998 and for the 13 weeks ended May 2, 1998 and May
1, 1999, the Company paid $802,000, $718,000, $1,211,000, $128,000 and
$303,000, respectively, for interest
F-9
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
expense. For fiscal 1998 and for the 13 weeks ended May 2, 1998 and May 1,
1999, the Company paid $57,000, $45,000 and $193,000 for income taxes.
Capitalized lease obligations of $1,911,000, $45,000 and $3,315,000 were
incurred on equipment leases entered into in fiscal 1996, 1997 and 1998,
respectively. There were no capital lease obligations incurred for the 13 weeks
ended May 2, 1998 and May 1, 1999.
Recently Issued Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income." This statement establishes standards
for reporting and disclosure of comprehensive income. In June 1997, the FASB
issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information." This statement establishes standards for reporting of information
about operating segments and requires the reporting of selected information
about operating segments in interim financial statements. These statements were
adopted by the Company on February 1, 1998 and had no impact as the Company has
no other comprehensive income and operated as a single segment.
2. PROPOSED INITIAL PUBLIC OFFERING:
The Company is in the process of preparing a registration statement for the
sale of common stock to the public in an initial public offering (the
"Offering"). Upon the closing of the Offering, the outstanding shares of
Preferred stock will be converted into Common stock.
3. NET INCOME (LOSS) PER SHARE:
Net income (loss) per share is calculated utilizing the principles of SFAS
No. 128, "Earnings per Share" ("EPS"). Basic EPS excludes potentially dilutive
securities and is computed by dividing net income available to common
shareholders by the weighted-average number of common shares outstanding for
the period. Diluted EPS is computed assuming the conversion or exercise of all
dilutive securities such as preferred stock, options and warrants.
F-10
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
Under SFAS No. 128, the Company's granting of certain stock options,
warrants and convertible preferred stock resulted in potential dilution of
basic EPS. The following table summarizes the differences between basic
weighted average shares outstanding and diluted weighted average shares
outstanding used to compute diluted EPS.
<TABLE>
<CAPTION>
Thirteen
Fiscal Year Ended Weeks Ended
----------------------------------- -------------------
February 1, January 31, January 30, May 2, May 1,
1997 1998 1999 1998 1999
----------- ----------- ----------- --------- ---------
<S> <C> <C> <C> <C> <C>
(unaudited)
Basic weighted average
number of shares
outstanding............ 5,068,223 5,085,153 5,373,365 5,363,493 5,384,307
Incremental shares
from assumed exercise
or conversion of:
Stock options....... -- -- 1,118,803 -- --
Warrants............ -- -- 27,496 -- --
Preferred stock..... -- -- 11,250,273 -- --
--------- --------- ---------- --------- ---------
Diluted weighted average
number of shares
outstanding............ 5,068,223 5,085,153 17,769,937 5,363,493 5,384,307
========= ========= ========== ========= =========
</TABLE>
The number of incremental shares from the assumed exercise of stock options
and warrants is calculated applying the treasury stock method. Stock options,
warrants and Preferred stock convertible into common shares were excluded from
the fiscal 1996 and 1997 and the 13 weeks ended May 2, 1998 and May 1, 1999
calculation as they were anti-dilutive.
4. PROPERTY AND EQUIPMENT (in thousands):
<TABLE>
<CAPTION>
January 31, January 30, May 1,
1998 1999 1999
----------- ----------- -----------
<S> <C> <C> <C>
(unaudited)
Furniture and fixtures............. $ 13,796 $ 18,739 $ 19,896
Computers and equipment............ 9,625 12,596 13,253
Leasehold improvements............. 10,459 13,158 13,880
-------- -------- -----------
33,880 44,493 47,029
Less--Accumulated depreciation and
amortization...................... (11,884) (18,588) (20,515)
-------- -------- -----------
$ 21,996 $ 25,905 $ 26,514
======== ======== ===========
</TABLE>
Due to the planned relocation of the Company's distribution center, the
Company recorded a charge of $450,000 in fiscal 1998. This charge was due to a
change in the estimated useful life of certain property to be abandoned and the
estimated loss associated with assignment of the existing lease. This charge is
included in selling, general and administrative expenses in fiscal 1998.
5. ACCRUED LIABILITIES (in thousands):
<TABLE>
<CAPTION>
January 31, January 30, May 1,
1998 1999 1999
----------- ----------- -----------
(unaudited)
<S> <C> <C> <C>
Payroll and related expenses.......... $2,079 $ 3,163 $1,740
Other................................. 5,196 6,892 6,819
------ ------- ------
$7,275 $10,055 $8,559
====== ======= ======
</TABLE>
F-11
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
6. LINE OF CREDIT AND MASTER LEASE AGREEMENT:
In fiscal 1996, the Company had a demand line of credit with a bank. The
Company could borrow up to $9,000,000, limited to a percentage of inventories,
as defined. The line bore interest at prime and was secured by substantially
all of the assets of the Company. At February 1, 1997, there were no borrowings
outstanding on the line.
In October 1997, the Company entered into a new line of credit agreement
with a bank. The Company can borrow up to $35 million (including up to $7.5
million in the form of letters of credit) limited to a percentage of
inventories, as defined, with an option to increase to $60 million under
certain conditions. Amounts may be borrowed on the line through October 8,
2000. The line bears interest at the lender's prime commercial lending rate or,
if the Company elects, at an annual rate of LIBOR plus 2.5% and is secured by
substantially all of the assets of the Company. At January 30, 1999, there were
no borrowings outstanding. At May 1, 1999, there was $27,500,000 available
under the line of which $12,402,000 was outstanding at an interest rate of
7.75%.
Under these lines, the highest amount outstanding was $8,039,000,
$12,207,000, $22,872,000, $741,000 and $12,344,000 in fiscal 1996, 1997, 1998
and for the 13 weeks ended May 2, 1998 and May 1, 1999, respectively. The
average amount outstanding was $2,400,000, $1,527,000, $6,388,000, $14,000 and
$7,308,000, and the weighted average interest rate was 8.25%, 8.92%, 9.04%,
8.50% and 8.33% in fiscal 1996, 1997, 1998 and for the 13 weeks ended May 2,
1998 and May 1, 1999, respectively. At January 31, 1998, January 30, 1999 and
May 1, 1999, there were $388,000, $914,000 and $656,000, respectively, in
outstanding letters of credit issued against the line. The line requires the
Company to comply with various covenants, as defined, and restricts the payment
of dividends.
In fiscal 1998, the Company entered into a master lease agreement with a
bank which provides for $5,000,000 for leasing new and used equipment. The
agreement requires that the leases be capital in nature and is subject to
certain covenants, as defined. In fiscal 1998, the Company financed $3,315,000
of equipment under the agreement. This agreement expired in March 1999 and
there were no additional financings under the agreement.
7. INCOME TAXES:
The Company files a consolidated Federal income tax return. The Company has
adopted SFAS No. 109, "Accounting for Income Taxes." The effect of this
statement is to take principally a balance sheet approach to providing deferred
income taxes. Deferred tax balances are regularly adjusted through the income
statement to reflect the current year estimate of future tax payments.
F-12
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
Income tax benefit consists of the following components (in thousands):
<TABLE>
<CAPTION>
Fiscal Year Ended
-----------------------------------
February 1, January 31, January 30,
1997 1998 1999
----------- ----------- -----------
<S> <C> <C> <C>
Current:
Federal........................... $ -- $ -- $ 136
State............................. -- -- 14
------ ---- -------
-- -- 150
------ ---- -------
Deferred:
Federal........................... 2,038 39 829
State............................. 210 4 --
------ ---- -------
2,248 43 829
------ ---- -------
Increase (decrease) in valuation
allowance.......................... 2,248 43 (7,166)
------ ---- -------
Income tax benefit................ $ -- $ -- $(6,187)
====== ==== =======
</TABLE>
The deferred tax effect of temporary differences giving rise to the
Company's deferred tax assets and liabilities consists of the following
components (in thousands):
<TABLE>
<CAPTION>
January 31, January 30,
1998 1999
----------- -----------
<S> <C> <C>
Deferred tax assets:
Deferred rent................................... $ 615 $ 984
Inventory reserves.............................. 194 613
Other........................................... 619 503
Net operating loss carryforwards................ 7,636 5,652
AMT credit carryforwards........................ -- 159
------- ------
Gross deferred tax asset...................... 9,064 7,911
------- ------
Deferred tax liabilities:
Depreciation.................................... (1,018) (694)
Other........................................... (200) (200)
------- ------
Gross deferred tax liabilities................ (1,218) (894)
------- ------
Gross deferred tax asset, before valuation........ 7,846 7,017
Less--Valuation allowance....................... (7,846) (680)
------- ------
Net deferred tax asset........................ $ -- $6,337
======= ======
</TABLE>
Valuation allowances, primarily attributable to the Federal net operating
loss carryforward, were established in fiscal 1996 and 1997 in accordance with
the provisions of FASB Statement No. 109, "Accounting for Income Taxes". The
Company reversed $7,166,000 of the valuation allowance in fiscal 1998 based on
management's assessment that it is more likely than not that the net deferred
tax assets will be realized through future taxable earnings.
F-13
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
The reconciliation of the Federal statutory rate to the Company's effective
income tax rate is as follows:
<TABLE>
<CAPTION>
Thirteen Weeks
Fiscal Year Ended Ended
----------------------------------- -------------------
February 1, January 31, January 30, May 2, May 1,
1997 1998 1999 1998 1999
----------- ----------- ----------- ------ ------
<S> <C> <C> <C> <C> <C>
Tax provision (benefit)
at Federal statutory
rate................... (34.0)% (34.0)% 34.0% (34.0)% (34.0)%
State taxes, net of
Federal benefit........ (3.5) (2.7) 0.3 (2.7) (4.0)
Other................... 0.2 8.1 0.5 -- --
Increase (decrease) in
valuation allowance.... 37.3 28.6 (254.8) 36.7 --
----- ----- ------ ------ ------
-- % -- % (220.0)% --% (38.0)%
===== ===== ====== ====== ======
</TABLE>
The Federal net operating loss carryforward expires as follows (in
thousands):
<TABLE>
<CAPTION>
Fiscal
------
<S> <C>
2014............................................................ $ 501
2015............................................................ 7,636
2016............................................................ 6,391
-------
$14,528
=======
</TABLE>
8. CONVERTIBLE PREFERRED STOCK:
The components of preferred stock as of January 31, 1998, January 30, 1999
and May 1, 1999 are as follows:
<TABLE>
<CAPTION>
Common
Preferred Stock
Stock Price/ Shares Shares Conversion Liquidation
Series Share Authorized Outstanding Rate Preferences
--------- ------ ---------- ----------- ---------- -----------
(in thousands)
<S> <C> <C> <C> <C> <C>
A....................... $24.00 1,000,000 806,559 4.57143 $19,357
B....................... 24.00 1,000,000 98,078 4.0 2,354
BB...................... 24.00 846,412 748,334 4.57143 17,960
C....................... 22.50 750,000 749,984 5.0 16,875
Unallocated............. -- 403,588 -- --
--------- --------- -------
4,000,000 2,402,955 $56,546
========= ========= =======
</TABLE>
The series A, B, BB and C preferred stock (collectively, the Preferred
stock) is convertible into Common stock based on a defined conversion rate and
must be converted upon the closing of a public Common stock offering, as
defined. The Preferred stock has voting rights equal to the number of Common
shares into which it is convertible, participates in dividends to the extent
they are declared on the Common stock and has preference in liquidation which
includes dividends accrued
F-14
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
but not yet paid. Upon liquidation, the series C holders would receive $11.25
per share plus accrued but unpaid dividends before any other distributions,
with the remainder paid in parity with the series A, B and BB preferred
holders.
9. COMMON STOCK OPTIONS AND WARRANTS:
The Company's 1993 Stock Incentive Plan provides for the granting of Common
stock, Common stock options and stock appreciation rights to key employees and
members of the Board of Directors. The Company's 1998 Equity Compensation Plan
provides for the granting of Common stock options, restricted stock, stock
appreciation rights and performance units to employees, Board members and
consultants. Required disclosure information regarding the 1993 Stock Incentive
Plan and the 1998 Equity Compensation Plan (collectively, the "Plans") have
been combined due to similarities in the Plans.
The Company had reserved 3,700,000 shares and 5,500,000 shares of its Common
stock for awards under the Plans as of January 31, 1999 and May 1, 1999,
respectively. The Company accounts for the Plans under APB Opinion No. 25,
under which no compensation cost has been recognized. Had compensation cost for
the options issued under the Plans and 20,000 options issued in fiscal 1995
outside the Plans been determined consistent with SFAS No. 123, "Accounting for
Stock-Based Compensation," the Company's net income (loss), basic EPS and
diluted EPS would have been equal to the pro forma amounts indicated below (in
thousands except per share data):
<TABLE>
<CAPTION>
Fiscal Year Ended
-----------------------------------
February 1, January 31, January 30,
1997 1998 1999
----------- ----------- -----------
<S> <C> <C> <C> <C>
Net income (loss)...... As reported........ $(6,023) $ (153) $8,999
Pro forma.......... (6,246) (626) 8,102
Basic EPS.............. As reported........ $ (1.19) $(0.03) $ 1.67
Pro forma.......... (1.23) (0.12) 1.51
Diluted EPS............ As reported........ $ (1.19) $(0.03) $ 0.51
Pro forma.......... (1.23) (0.12) 0.46
</TABLE>
The weighted average fair value of options granted in fiscal 1996, 1997 and
1998 was $0.92, $0.78 and $2.60, respectively. The fair value of each option
grant is estimated on the grant date using the Black-Scholes option pricing
model with the following assumptions:
<TABLE>
<CAPTION>
Fiscal Year Ended
-----------------------------------
February 1, January 31, January 30,
1997 1998 1999
----------- ----------- -----------
<S> <C> <C> <C>
Expected dividend rate..................... -- -- --
Expected volatility........................ -- -- 45.0%
Weighted average risk-free interest rate... 6.5% 6.4% 5.3%
Expected lives (years)..................... 4 4 4
</TABLE>
A volatility factor was utilized in fiscal 1998, as the financial statements
were prepared in conjunction with an initial public offering.
F-15
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
Because the SFAS No. 123 method of accounting is not required to be applied
to options granted prior to January 29, 1995, the resulting pro forma
compensation charge may not be representative of that to be expected in future
years.
In fiscal 1996, 1997 and 1998, the Company granted 758,101, 1,169,507 and
472,497 options, respectively, under the Plans to employees and directors to
purchase Common stock at prices ranging from $3.33 to $9.00 per share. Options
to purchase 400,000 shares of Common stock vest 100% after three years and
remaining options primarily vest over a four-year period from the date of
grant. All options were issued with exercise prices equal to or greater than
the fair market value on the grant date. The options are exercisable over a
maximum of 10 years.
Information with respect to all options outstanding, including options to
purchase 130,000 shares of Common stock issued outside the Plans prior to
fiscal 1996, is as follows:
<TABLE>
<CAPTION>
Weighted
Option Price Average Price
Shares Per Share Per Share
---------- ------------ -------------
<S> <C> <C> <C>
Options outstanding, February 3, 1996.. 1,047,093 $ 0.67-4.00 $3.79
Granted.............................. 758,101 4.00 4.00
Exercised............................ (4,878) 3.33-4.00 3.66
Canceled............................. (217,116) 3.33-4.00 3.97
---------- ----------- -----
Options outstanding, February 1, 1997.. 1,583,200 0.67-4.00 3.79
Granted.............................. 1,169,507 3.33-4.00 3.56
Exercised............................ (10,392) 3.33-4.00 3.46
Canceled............................. (186,583) 3.33-4.00 3.40
Change in exercise price--
Original price..................... (1,222,685) 4.00 4.00
New price.......................... 1,222,685 3.33 3.33
---------- ----------- -----
Options outstanding, January 31, 1998.. 2,555,732 0.67-4.00 3.39
Granted.............................. 472,497 4.00-9.00 6.26
Exercised............................ (22,048) 3.33 3.33
Canceled............................. (153,319) 3.33-9.00 3.83
---------- ----------- -----
Options outstanding, January 30, 1999.. 2,852,862 0.67-9.00 3.84
Granted (unaudited).................. 719,400 11.75 11.75
Exercised (unaudited)................ (1,837) 3.33-4.00 3.41
Canceled (unaudited)................. (48,338) 3.33-11.75 6.20
---------- ----------- -----
Options outstanding, May 1, 1999
(unaudited) .......................... 3,522,087 $0.67-11.75 $5.42
========== =========== =====
</TABLE>
At January 30, 1999, the weighted average contractual life of all options
outstanding was 7.8 years, there were 1,006,767 options vested at a weighted
average exercise price of $3.38 and there were 939,820 shares reserved under
the Plans which were not covered by stock options granted.
In fiscal 1996 and fiscal 1997, the Company granted warrants to purchase
15,000 shares and 32,550 shares of Common stock, respectively, to certain
consultants. The warrants have an exercise
F-16
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
price of $4.00 per share and are exercisable on various dates through January
2003. The agent who placed the series A preferred purchased for $561 warrants
to purchase 56,073 shares of Common stock at a price of $6.00 per share. The
warrants expire in June 1999.
10. COMMITMENTS AND CONTINGENCIES:
Leases
The Company leases retail, distribution and office space and equipment under
various operating leases. Most store leases typically have an average initial
term of ten years, with two five-year renewal options. Certain leases provide
for additional rent contingent upon store sales levels. Base rent expense for
fiscal 1996, 1997, 1998 and for the weeks ended May 2, 1998 and May 1, 1999 was
approximately $9,654,000, $11,468,000, $13,927,000, $3,062,000 and $4,264,000,
respectively.
The Company has entered into several leases for store and distribution
center equipment and fixtures that have been accounted for as capital leases.
The capitalized cost of $5,034,000 and $6,961,000 and related accumulated
amortization of $1,970,000 and $2,336,000 has been included in property and
equipment at January 31, 1998 and January 30, 1999, respectively. The present
value of the minimum lease payments is as follows (in thousands):
<TABLE>
<CAPTION>
As of
January
30, As of
1999 May 1, 1999
------- -----------
<S> <C> <C>
(unaudited)
Total minimum lease payments.............................. $5,100 $ 4,511
Less-- Amount representing interest....................... (558) (464)
------ -----------
Present value of minimum lease payments................... $4,542 $ 4,047
====== ===========
</TABLE>
Future minimum lease payments under the Company's operating and capital
leases, including leases for stores, a distribution facility and office space
opening in fiscal 1999 which were entered into before the period indicated, are
as follows (in thousands):
<TABLE>
<CAPTION>
As of As of
January 30, 1999 May 1, 1999
----------------- -----------------
<S> <C> <C> <C> <C>
(unaudited)
<CAPTION>
Fiscal Operating Capital Operating Capital
- ------ --------- ------- --------- -------
<S> <C> <C> <C> <C>
1999........................................ $ 19,168 $2,075 $ 15,766 $1,349
2000........................................ 21,288 1,598 22,561 1,775
2001........................................ 21,688 1,022 22,943 1,025
2002........................................ 22,021 405 23,263 362
2003........................................ 22,400 -- 23,642 --
2004 and thereafter......................... 58,904 -- 78,398 --
-------- ------ -------- ------
$165,469 $5,100 $186,573 $4,511
======== ====== ======== ======
</TABLE>
F-17
<PAGE>
ZANY BRAINY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of May 1, 1999 and for the 13 weeks ended May 2, 1998 and May
1, 1999 is unaudited)
401(k) Plan
On October 1, 1996, the Company adopted a 401(k) plan for its employees (the
"Plan"). The Plan, as amended, allows participants to contribute up to 15% of
their compensation and permits a discretionary employer match, subject to
certain defined limitations. Employer contributions vest 20% per year. No
employer contributions were made in fiscal 1996, 1997, 1998, and for the 13
weeks ended May 1, 1999.
General
From time to time, the Company is named as a defendant in legal actions
arising from its normal business activities. Although the amount of any
liability that could arise with respect to currently pending actions cannot be
estimated, in the opinion of the Company, any such liability will not have a
material adverse effect on its financial position, operating results or
liquidity.
F-18
<PAGE>
[Depicted on the inside back cover page is a picture of a smiling child. The
text reads as follows: "Our Product Mission: The Best Stuff for Kids! Zany
Brainy will provide the best merchandise for children at the right price. We
seek interactive products that encourage a sense of wonder and stimulate
creativity. We believe that learning should be fun!"]
[Depicted on the outside back cover is a collage of icons representing our
major product categories and corresponding category names]
<PAGE>
June 2, 1999
6,100,000 Shares of Common Stock
----------------
PROSPECTUS
----------------
Donaldson, Lufkin & Jenrette
BT Alex. Brown
William Blair & Company
U.S. Bancorp Piper Jaffray
DLJdirect Inc.
- --------------------------------------------------------------------------------
Until June 27, 1999 (25 days after the date of this prospectus), all dealers,
whether or not participating in this offering, that affect transactions in
these securities may be required to deliver a prospectus. This is in addition
to the dealer's obligation to deliver a prospectus when acting as an
underwriter in this offering and when selling previously unsold allotments or
subscriptions.
- --------------------------------------------------------------------------------
