KRAUSES FURNITURE INC, S-1, 1997-01-09

KRAUSES FURNITURE INC
S-1, 1997-01-09
HOUSEHOLD FURNITURE

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<PAGE> 1

AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 9, 1997

REGISTRATION NO. 33-
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

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

FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
------------------------

KRAUSE'S FURNITURE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN GOVERNING INSTRUMENTS)

<TABLE>
<S> <C> <C>
DELAWARE 5710 77-0310773
(STATE OR OTHER JURISDICTION OF (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) CLASSIFICATION CODE NUMBER) IDENTIFICATION NUMBER)
</TABLE>

200 NORTH BERRY STREET
BREA, CALIFORNIA 92821-3903
(714) 990-3100
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE OF
REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)

PHILIP M. HAWLEY
CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER
KRAUSE'S FURNITURE, INC.
200 NORTH BERRY STREET
BREA, CALIFORNIA 92821-3903
(714) 990-3100 (TELEPHONE)
(714) 990-3561 (FACSIMILE)
(NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE OF
AGENT FOR SERVICE)
------------------------

COPIES TO:
WILLIAM E. HORWICH, ESQ.
WENDEL, ROSEN, BLACK & DEAN, LLP
1111 BROADWAY, 24TH FLOOR
OAKLAND, CALIFORNIA 94607
(510) 834-6600 (TELEPHONE)
(510) 834-1928 (FACSIMILE)
------------------------

APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as
practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box [X]

If this form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act Registration Statement Number of the earlier
effective Registration Statement for the same offering. [ ]

If this form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
Registration Statement Number of the earlier effective Registration Statement
for the same offering. [ ]

If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]
------------------------

CALCULATION OF REGISTRATION FEE
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- --------------------------------------------------------------------------------

<TABLE>
<CAPTION>
TITLE OF EACH CLASS PROPOSED MAXIMUM PROPOSED MAXIMUM AMOUNT OF
OF SECURITIES TO BE AMOUNT TO BE OFFERING PRICE AGGREGATE REGISTRATION
REGISTERED REGISTERED PER SHARE(1) OFFERING PRICE(1) FEE
<S> <C> <C> <C> <C>
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Common Stock (par value $0.001)..... 4,394,528 Shares $1.32 $5,800,777 $2,000.27
- -----------------------------------------------------------------------------------------------------------------
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</TABLE>

(1) Estimated solely for the purpose of calculating the registration fee.
Pursuant to Rule 457(c), the computation of fees is based upon the average
of the high and low sales prices on the Nasdaq System on January 6, 1997, of
$1.32.

------------------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A),
MAY DETERMINE.
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<PAGE> 2

KRAUSE'S FURNITURE, INC.
------------------------

CROSS-REFERENCE SHEET PURSUANT
TO ITEM 501(B) OF REGULATION S-K
SHOWING LOCATION IN THE PROSPECTUS OF INFORMATION
REQUIRED BY ITEMS OF FORM S-1

<TABLE>
<CAPTION>
REGISTRATION STATEMENT ITEM
NUMBER AND HEADING PROSPECTUS LOCATION IN PROSPECTUS
----------------------------------------- -----------------------------------------
<C> <S> <C>
1. Forepart of the Registration Statement
and Outside Front Cover Page of
Prospectus............................. Outside Front Cover Page
2. Inside Front and Outside Back Cover Pages
of Prospectus.......................... Inside Front and Additional Information
3. Summary Information, Risk Factors and
Ratio of Earnings to Fixed Charges..... Prospectus Summary; Risk Factors
4. Use of Proceeds.......................... Use of Proceeds
5. Determination of Offering Price.......... Inapplicable
6. Dilution................................. Inapplicable
7. Selling Security Holders................. Principal and Selling Stockholders
8. Plan of Distribution..................... Outside Front Cover Page; Plan of
Distribution
9. Description of Securities to be
Registered............................. Description of Capital Stock
10. Interests of Named Experts and Counsel... Legal Matters; Experts
11. Information with Respect to the
Registrant............................. Outside Front and Inside Front Cover
Pages; Prospectus Summary; Risk Factors;
Dividends; Capitalization; Selected
Financial Data; Management's Discussion
and Analysis of Financial Condition and
Results of Operations; Business;
Management; Certain Transactions;
Principal and Selling Stockholders;
Description of Capital Stock;
Consolidated Financial Statements
12. Disclosure of Commission Position on
Indemnification for Securities Act
Liabilities............................ Inapplicable
</TABLE>
<PAGE> 3

INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A
REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR
MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT
BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR
THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE
SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE
UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS
OF ANY SUCH STATE.

SUBJECT TO COMPLETION, DATED JANUARY 9, 1997

PROSPECTUS

4,394,528 SHARES

KRAUSE'S FURNITURE, INC.
COMMON STOCK

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

All of the shares of Common Stock, par value $0.001 per share (the "Common
Stock"), of Krause's Furniture, Inc., a Delaware corporation (the "Company" or
"KFI"), offered hereby are being offered on a continuous or delayed basis in the
future by certain stockholders of the Company (the "Selling Stockholders"). All
of the shares which may be offered by the Selling Stockholders are presently
"restricted securities" currently salable under Rule 144 of the Securities Act
of 1933, as amended (the "Securities Act"), subject to certain minimum holding
period and/or volume limitations. See "Principal and Selling Stockholders."

The Company will not receive any of the proceeds from the sale of shares by
the Selling Stockholders.

The Common Stock of the Company is reported and traded on the Nasdaq Small
Cap Market ("Nasdaq") under the symbol "SOFA." On , 1997, the last
sale price of the Common Stock as reported by Nasdaq was $ per share.
See "Market Price Data."

SEE "RISK FACTORS" AT PAGE 6 FOR INFORMATION THAT SHOULD BE CONSIDERED BY
PROSPECTIVE INVESTORS.

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

THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.

<TABLE>
<CAPTION>
UNDERWRITING
PRICE TO DISCOUNTS AND PROCEEDS TO PROCEEDS TO SELLING
PUBLIC(1) COMMISSIONS COMPANY STOCKHOLDERS(2)
<S> <C> <C> <C> <C>
- ------------------------------------------------------------------------------------------------
Per Share....... $ $0 $0 $
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Total........... $ $0 $0 $
- ------------------------------------------------------------------------------------------------
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</TABLE>

(1) The price stated is an estimate based upon the average of the high and low
sales prices on the Nasdaq System on , 1997 of $ .

(2) Before deducting brokers' commissions.

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

, 1997
<PAGE> 4

NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS IN CONNECTION WITH THIS OFFERING OTHER THAN THOSE CONTAINED IN
THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST
NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY SELLING
STOCKHOLDER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A
SOLICITATION OF AN OFFER TO BUY, ANY SECURITIES OTHER THAN THE REGISTERED
SECURITIES TO WHICH IT RELATES OR AN OFFER TO, OR A SOLICITATION OF, ANY PERSON
IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD BE UNLAWFUL.
NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER
ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE
AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED
HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF.
------------------------

UNTIL , 1997 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL
DEALERS EFFECTING TRANSACTIONS IN THE REGISTERED SECURITIES, WHETHER OR NOT
PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS.
THIS DELIVERY REQUIREMENT IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER
A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD
ALLOTMENTS OR SUBSCRIPTIONS.

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

TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary.................... 3
Risk Factors.......................... 6
Use of Proceeds....................... 9
Dividends............................. 9
Capitalization........................ 9
Selected Financial Data............... 10
Management's Discussions and Analysis
of Financial Condition and Results
of Operations....................... 11
Business.............................. 16

<CAPTION>
PAGE
----
<S> <C>
Management............................ 21
Certain Transactions.................. 28
Principal and Selling Stockholders.... 30
Plan of Distribution.................. 32
Description of Capital Stock.......... 32
Legal Matters......................... 34
Experts............................... 34
Additional Information................ 35
Index to Consolidated Financial
Statements.......................... 36
</TABLE>

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

The Company furnishes its stockholders with annual reports containing
consolidated financial statements audited by its independent auditors, and
intends to furnish quarterly reports containing unaudited consolidated financial
data for the first three quarters of each fiscal year.
------------------------

Krause's Sofa Factory(R) and Castro Convertibles(R) are registered
trademarks of the Company, and the Company claims trademark rights in
Foreverflex(TM). All other trademarks or trade names referred to in this
Prospectus are the property of their respective owners.

2
<PAGE> 5

PROSPECTUS SUMMARY

The following summary is qualified in its entirety by the more detailed
information and Consolidated Financial Statements and Notes thereto appearing
elsewhere in this Prospectus. Unless otherwise indicated, references to the
"Company" or "KFI" shall include Krause's Furniture, Inc. and its wholly-owned
subsidiaries.

This Prospectus contains certain forward-looking statements that are based
on current expectations. In light of the important factors that can materially
affect results, including those set forth in this Prospectus, the inclusion of
forward-looking information herein should not be regarded as a representation by
the Company or any other person that the objectives or plans of the Company will
be achieved. The Company may encounter competitive, financial and business
challenges making it more difficult than expected to continue to develop,
market, manufacture and ship products on a timely basis; competitive conditions
may change adversely; demand for the Company's products may weaken; the market
may not accept the Company's merchandising strategies and products; the Company
may be unable to retain existing key management personnel; the Company's
forecasts may not accurately anticipate customer demand; and there may be other
material adverse changes in the Company's operations or business. Certain
important factors affecting the forward-looking statements made herein include,
but are not limited to (1) timely identifying, designing and delivering new
products as well as enhancing existing products, (2) implementing current
strategic plans, (3) accurately forecasting capital expenditures, and (4)
obtaining new sources of external financing. Assumptions relating to budgeting,
marketing, advertising, product development and other management decisions are
subjective in many respects and thus susceptible to interpretations and periodic
revisions based on actual experiences and business developments, the impact of
which may cause the Company to alter its marketing, advertising, capital
expenditure or other budgets, which may in turn affect the Company's financial
position and results of operations.

Prospective investors should carefully consider the matters set forth in
"Risk Factors."

THE COMPANY

The Company, through its wholly-owned subsidiary, Krause's Sofa Factory, a
California corporation ("Krause's Sofa Factory"), is the leading
vertically-integrated U.S. manufacturer, distributor and retailer of
made-to-order upholstered furniture and accessories. Headquartered in Brea,
California, the Company operates 82 furniture showrooms in the Western U.S. and
East Coast markets under the names Krause's Sofa Factory (67 stores) and Castro
Convertibles (15 stores). The Company believes that these two retail chains are
among the most established in their respective markets. Krause's Sofa Factory
opened its first showroom 22 years ago and Castro Convertibles has operated
furniture showrooms for 63 years. Showrooms are located in 12 states: New York,
New Jersey, Connecticut, Florida and Illinois in the East; California, Texas,
Washington, Arizona, Colorado, New Mexico and Nevada in the West. Twelve
distribution centers service these stores.

The Company offers customers an extensive selection of more than 60 styles
using more than 800 fabrics and 50 leathers, giving customers an unparalleled
choice. KFI offers customers the selection usually associated with custom-made
furniture combined with the satisfaction of delivery in two to four weeks. KFI
manufactures 85% of the products sold in its stores in a 250,000 square foot
facility located in Brea.

The Company's management team has recently undergone a substantial
restructuring and is now headed by Philip M. Hawley, the former Chairman and
Chief Executive Officer of The Broadway Stores, Inc. (formerly Carter Hawley
Hale Stores, Inc.) The Company has also appointed Robert A. Burton as Senior
Vice President and Chief Financial Officer. Mr. Burton was formerly Senior Vice
President and Chief Financial Officer of John Breuner Company.

KFI has experienced operating losses during each of the past five years,
partially due to inefficiencies within its operation and largely due to
depressed economic conditions in its principal markets.

3
<PAGE> 6

KFI is a Delaware corporation which is publicly traded on the Nasdaq Small
Cap Market (Nasdaq trading symbol "SOFA"). The Company changed its name to
Krause's Furniture, Inc., in December 1994. Its former corporate name was Worth
Corporation, which had a Nasdaq trading symbol of "WRTH" until December 12,
1994. References herein to the Company and to KFI include Krause's Furniture,
Inc. and its wholly-owned subsidiaries. The Company's principal office is
located at 200 North Berry Street, Brea, California 92821-3903, its telephone
number is 714/990-3100 and its facsimile number is 714/990-3561.

THE OFFERING

<TABLE>
<S> <C>
Common Stock offered by the Selling Shareholders................... 4,394,528 Shares
Common Stock outstanding before and after the offering............. 19,020,539 Shares(1)
NASDAQ Symbol...................................................... SOFA
</TABLE>

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

(1) Based on the number of shares outstanding on December 31, 1996, excluding
1,395,457 shares of Common Stock issuable upon exercise of options and
1,754,956 shares of Common Stock issuable upon exercise of warrants.

4
<PAGE> 7

SUMMARY CONSOLIDATED FINANCIAL DATA

The following data for each of the five years in the period ended January
28, 1996, has been derived from consolidated financial statements that have been
audited by Ernst & Young LLP, independent auditors. The information set forth
below for the nine-month periods ended October 27, 1996 and October 29, 1995 is
unaudited. Results for the period ended October 27, 1996 are not necessarily
indicative of the results of operations for future periods. This summary data
should be read in conjunction with the consolidated financial statements and
notes thereto appearing elsewhere in this Prospectus.

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
FISCAL YEAR ENDED
------------------------- -----------------------------------------------------------------------
OCTOBER 27, OCTOBER 29, JANUARY 28, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1996 1995 1996(2) 1994 1993 1992 1991(1)
----------- ----------- ----------- ------------ ------------ ------------ ------------
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS:
Net furniture sales..... $ 82,738 $92,465 $ 122,319 $116,471 $ 96,984 $ 87,045 $ 54,753
Gross profit............ 40,374 47,845 62,467 62,949 50,792 45,688 29,790
Loss from operations.... (11,799) (5,545) (9,388) (2,398) (7,852) (5,982) (4,091)
Gain from sale of Mr.
Coffee stock(3)....... -- -- -- 12,115 -- -- --
Income (loss) before
extraordinary items... (12,374) (4,487) (8,715) 5,831 (9,751) (3,641) (3,391)
Extraordinary items..... -- -- -- (436) (221) 3,330 (86)
Net income (loss)....... (12,374) (4,487) (8,715) 5,395 (9,972) (311) (3,477)
Income (loss) per share(4):
Income (loss) before
extraordinary
items............... (1.62) (1.15) (2.21) 1.08 (3.88) (1.84) (1.93)
Extraordinary items... -- -- -- (0.08) (0.09) 1.68 (0.05)
Net income (loss)..... $ (1.62) $ (1.15) $ (2.21) $ 1.00 $ (3.97) $ (0.16) $ (1.98)
Weighted average common
and common equivalent
shares
outstanding(4)........ 7,661 3,905 3,950 5,394 2,510 1,982 1,761
</TABLE>

<TABLE>
<CAPTION>
OCTOBER 27, OCTOBER 29, JANUARY 28, JANUARY 29, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1996 1995 1996 1995 1993 1992 1991
----------- ----------- ----------- ----------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets.............. $47,402 $49,445 $46,866 $53,750 $ 64,749 $ 47,730 $ 46,187
Working capital
deficiency.............. (3,796) (4,621) (6,878) (3,751) (1,404) (3,603) (3,862)
Long-term debt(3)......... 5,260 4,219 5,584 2,181 17,700 15,500 12,376
Stockholders' equity...... 16,265 18,213 13,985 22,700 20,626 11,170 9,485
</TABLE>

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

(1) The Company acquired Krause's Sofa Factory on April 28, 1991, therefore,
operations for 1991 are for a period of eight months.
(2) In April 1995 the Company changed from a calendar year-end to a fiscal year
ending on the last Sunday of January as determined by the 52/53 week retail
fiscal year. In connection with the change in fiscal periods, the Company
reported a net loss of $3,221,000 for the month ended January 29, 1995.
(3) In August 1994 the Company sold its ownership of 1,500,548 shares of Mr.
Coffee, inc. common stock for cash of $23,258,000. Proceeds from this sale
were used to retire debt of $18,317,000 and pay income taxes of $2,100,000
with the remainder used for working capital.
(4) Previously reported share and per share amounts have been restated to
reflect a one-for-three reverse stock split effective August 1, 1995.

5
<PAGE> 8

RISK FACTORS

In addition to the other information contained in this Prospectus, the
following factors should be considered carefully in evaluating the Company and
its business before purchasing any of the shares of Common Stock offered hereby.

HISTORY OF LOSSES

The Company has reported losses from continuing operations in each of the
past five years and for the thirty-nine week period ended October 27, 1996. As a
result of such losses from operations, the Company had an accumulated deficit of
$33.3 million at October 27, 1996, which amount is expected to increase as a
result of losses expected at least through the second quarter of 1997. The
continuation of losses from operations could adversely affect the market price
for the Common Stock and the Company's ability to obtain financing and increases
the risks of owning shares of Common Stock.

WORKING CAPITAL DEFICIENCY

At October 27, 1996, the Company had a working capital deficiency of
approximately $3.8 million and current liabilities at October 27, 1996, were
$24.1 million. In future periods a substantial portion of the Company's net cash
provided by operations will be dedicated to these working capital deficiencies.
Substantially all of the Company's assets are pledged as collateral for
repayment of existing indebtedness. The Company's working capital deficiency and
collateral pledge make it more difficult for the Company to obtain additional
financing on advantageous terms, if at all.

COMPETITION

The home furnishings industry is highly competitive and fragmented, and
includes competition from traditional furniture retailers, department stores and
discount and warehouse outlets. Certain companies which compete directly with
the Company have greater financial and other resources than the Company. The
Company competes on a national level with Ethan Allen Inc., Levitz Furniture,
Leather Center, Inc., Expressions and traditional department stores, among
others. The Company also competes on a regional basis. In New York, New Jersey
and Chicago, the Company's primary competitor is Jennifer Convertibles, Inc.,
and in the Western United States the Company's primary regional competitors
include Homestead House, Inc., The Leather Factory and Norwalk Furniture
Corporation (the latter of which also competes in the Midwest market). In
Houston, Texas, the Company's primary regional competitor is Star Furniture
Company. Expressions, Norwalk Furniture Corporation and Ethan Allen Inc., like
the Company, manufacture their own upholstered products and offer
"made-to-order" customization similar to that provided by the Company. Levitz
Furniture primarily addresses the low to middle end "as shown" market, whereas
traditional department stores typically focus on the middle to upper end "as
shown" market.

CYCLICAL NATURE OF THE FURNITURE INDUSTRY

The home furnishings industry historically has been cyclical, fluctuating
significantly with general economic cycles. Following economic downturns,
recovery in the home furnishings industry tends to lag recovery in the general
economy. The Company believes that the industry is significantly influenced by
economic conditions generally and particularly by consumer behavior and
confidence, the level of personal discretionary spending, housing activity,
interest rates and credit availability. A prolonged economic downturn would have
a material adverse effect on the Company.

DEPENDENCE ON REGIONAL ECONOMIES

The Company's markets are concentrated in the States of California and New
York, where 48% and 16%, respectively, of the Company's showrooms are located.
Consequently, an economic downturn in either of those states would likely have a
disproportionate and negative impact on the financial condition of the Company.

6
<PAGE> 9

DEPENDENCE ON SUPPLIERS

The Company obtains its raw materials and some products from a variety of
sources and generally has not experienced difficulty in obtaining these items.
The Company is, however, dependent on the continued supply from relatively few
suppliers of certain products, components and raw materials including fabrics,
leather, foam, and sleeper and motion mechanisms. Inability to develop
alternative sources of supply if and as required, or to obtain sufficient single
source products, components and raw materials as required, would adversely
affect the Company's net revenues and net income.

CONTROL BY PRINCIPAL STOCKHOLDERS

The current management, directors and other principal stockholders of the
Company own in the aggregate approximately 65.4% of the issued and outstanding
capital stock of the Company on a fully-diluted basis. Such concentration of
ownership may have the effect of delaying, deferring or preventing a change in
control of the Company. These stockholders, if acting together, may have
sufficient voting power to elect the entire Board of Directors of the Company
and to influence the outcome of any corporate transactions or other matters
submitted to stockholders for approval. Furthermore, as of August 26, 1996, in
connection with the GECC financing described under "Certain Transactions" below,
the Company entered into a Stockholders Agreement with several of the investors
in the GECC financing, including General Electric Capital Corporation as well as
certain existing stockholders. The terms of the Stockholders Agreement are
described under "Description of Capital Stock" below. One effect of the
Stockholders Agreement is that certain of the major stockholders have agreed to
vote their shares with respect to the election of directors in a manner that
assures the election of directors designated by them. Also the Company is
prohibited from taking certain actions unless the member of the Board of
Directors designated by General Electric Capital Corporation approves such
action. Such actions include, among others, mergers, liquidations and
dissolutions and certain other major corporate events. Additionally, under
Section 382 of the Internal Revenue Code of 1986, as amended, utilization of the
Company's operating loss carryforwards is subject to limitations if the
cumulative ownership change during any three year period exceeds 50%. As a
result of transactions occurring through October 27, 1996, the Company has
experienced a cumulative ownership change of approximately 44% as defined in
Section 382 of the Internal Revenue Code. These factors may have the effect of
delaying, deferring or preventing a change in control of the Company.

MARKET FOR THE COMPANY'S COMMON STOCK

The Company's Common Stock is reported and traded on the Nasdaq Small Cap
Market but is not a Nasdaq National Market System security, and there can be no
assurances as to the extent or nature of the market for the Company's Common
Stock (which is presently thinly traded) or as to the price at which the
Company's Common Stock will trade, which will depend on a number of factors
including, but not limited to, market conditions and the business and prospects
of the Company. Further, there have been periods of extreme volatility in the
stock market that, in many cases, were unrelated to the operating performance
of, or announcements concerning, the issuers of the affected securities. General
market declines or volatility in the future could adversely affect the price of
the Common Stock. There can be no assurance that the Common Stock will maintain
its current market price. Short-term trading strategies of certain investors can
have a significant effect on the price of specific securities. Due to sporadic
trading, the Company does not believe that an established trading market exists
for its Common Stock.

PROPOSED CHANGES TO MAINTENANCE CRITERIA FOR NASDAQ SECURITIES

On November 6, 1996, the Board of Directors of The Nasdaq Stock Market,
Inc. approved changes to both the quantitative and qualitative standards which
issuers would be required to satisfy to continue to be included on the Nasdaq
Small Cap Market. A proposal to adopt such changes may be submitted to the
Securities and Exchange Commission as early as February 1997. Among the proposed
changes, Nasdaq Small Cap companies, including the Company, will be required to
maintain (1) a $1.00 per share minimum bid price; (2) net tangible assets of
$2,000,000, or a market capitalization of at least $35,000,000, or net income in
two of the issuer's last three years of at least $500,000; (3) a public float of
at least 500,000 shares with an

7
<PAGE> 10

aggregate market value of at least $1,000,000; and (4) at least two market
makers. In addition, such companies would be required to meet certain corporate
governance standards, including (1) distribution of annual reports with audited
financial statements to stockholders; (2) making available to stockholders
copies of quarterly reports; (3) maintaining at least two independent directors;
(4) maintaining an audit committee, a majority of the members of which are
independent directors; (5) holding annual stockholder meetings; (6) soliciting
proxies for any meeting of stockholders; and (7) obtaining stockholder approval
for certain corporate actions such as the adoption of stock option or purchase
plans meeting certain requirements and the issuance of securities when such
issuance will result in a change in control of the issuer or, in certain cases,
where the voting power of the shares issued would equal or exceed 20% of the
voting power outstanding before the issuance.

If the proposed rules were in effect at the date of this Prospectus, the
Company would fail to meet certain of the listing maintenance criteria. Further,
there can be no assurance that if and when the proposed rules go into effect,
the Company will satisfy all of the listing maintenance requirements at that
time or thereafter. The failure to meet these maintenance criteria in the future
may result in the Company's Common Stock no longer being included on the Nasdaq
Small Cap Market. In such event, trading, if any, in the Common Stock may then
continue to be conducted in the non-Nasdaq over-the-counter market in what are
commonly referred to as the "pink sheets" or on the OTC Electronic Bulletin
Board. As a result, an investor may find it more difficult to dispose of, or to
obtain accurate quotations as to the market value of, the Common Stock. In
addition, sales of the Company's securities would be subject to a rule
promulgated by the SEC that would impose various sales practice requirements on
broker-dealers who sell securities governed by the rule to persons other than
established customers and accredited investors if the Company or its securities
fail to meet certain criteria set forth in such rule. For these types of
transactions, the broker-dealer must make a special suitability determination
for the purchaser and have received the purchaser's written consent to the
transactions prior to sale. Consequently, the rule may have an adverse effect on
the ability of broker-dealers to sell the Company's Common Stock, which may
affect the ability of purchasers in this offering to sell the Common Stock in
the secondary market.

MARKET OVERHANG; SHARES AVAILABLE FOR FUTURE SALE

As of December 1, 1996, there were 5,285,288 shares of the Company's Common
Stock outstanding and freely tradeable under applicable securities laws. Upon
the effective date of this Prospectus, up to 4,394,528 additional outstanding
shares of the Common Stock will become registered for public sale. The sale at
any time or over a relatively compressed period of time of any significant
portion of the total number of shares of Common Stock which are the subject of
this Prospectus would substantially increase the total number of shares
available for public trading, and could depress the market price of the
Company's Common Stock.

BLANK CHECK PREFERRED STOCK

The Company's Certificate of Incorporation, as amended, authorizes the
issuance of up to 666,667 shares of Preferred Stock, none of which are
outstanding. The Board of Directors has the authority to fix and determine the
relative rights and preferences of preferred shares, as well as the authority to
issue such shares, without further stockholder approval. As a result, the Board
of Directors could authorize the issuance of a series of Preferred Stock which
would grant to holders preferred rights to the assets of the Company upon
liquidation, the right to receive dividends before dividends would be declared
to holders of Common Stock, and the right to the redemption of such shares,
together with a premium, prior to the redemption of the Common Stock, or such
other preferred provisions as the Board of Directors may in its sole discretion
deem appropriate. Holders of Common Stock have no redemption rights or other
preferences. In addition, the Board of Directors could issue large blocks of
Preferred Stock to fend against unwanted tender offers or hostile takeovers
without further stockholder approval.

ABSENCE OF DIVIDENDS

The Company has not paid cash dividends on its Common Stock and does not
anticipate that it will do so in the foreseeable future.

8
<PAGE> 11

USE OF PROCEEDS

All shares of Common Stock covered by this Prospectus are being offered by
the Selling Stockholders. Consequently, the Company will not receive any of the
proceeds from the sale of securities covered by this Prospectus.

DIVIDENDS

The Company has never declared or paid dividends on its Common Stock and
anticipates that all earnings will be retained for use in its business. The
payment of any future dividends will be at the discretion of the Board of
Directors and will continue to be subject to certain limitations and
restrictions under the terms of the Company's indebtedness to various
institutional lenders, including a prohibition on the payment of dividends
without the prior written consent of such lenders.

CAPITALIZATION

The following table sets forth the capitalization of KFI as of October 27,
1996. The table should be read in conjunction with the consolidated financial
statements and notes thereto included elsewhere in this Prospectus. (Dollars in
thousands.)

<TABLE>
<S> <C>
Current portion of notes payable.......................................... $ 8
Long-term notes payable:
Secured revolving credit notes.......................................... 1,540
Subordinated note, net of $1,346 of unamortized debt discount........... 3,654
Other notes, excluding current portion.................................. 66
--------
Total long-term notes payable................................... 5,260
--------
Stockholders' equity:
Common stock............................................................ 19
Capital in excess of par value.......................................... 49,581
Accumulated deficit..................................................... (33,335)
--------
Total stockholders' equity...................................... 16,265
--------
Total capitalization............................................ $ 21,533
========
</TABLE>

9
<PAGE> 12

SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
FISCAL YEAR ENDED
------------------------ -------------------------------------------------------------------
OCTOBER 27, OCTOBER 29, JANUARY 28, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1996 1995 1996(2) 1994 1993 1992 1991(1)
----------- ----------- ----------- ------------ ------------ ------------ ------------
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS:
Net furniture sales........ $ 82,738 $92,465 $ 122,319 $116,471 $ 96,984 $ 87,045 $ 54,753
Gross profit............... 40,374 47,845 62,467 62,949 50,792 45,688 29,790
Loss from operations....... (11,799) (5,545) (9,388) (2,398) (7,852) (5,982) (4,091)
Gain from sale of Mr.
Coffee stock(3).......... -- -- -- 12,115 -- -- --
Income (loss) before
extraordinary items...... (12,374) (4,487) (8,715) 5,831 (9,751) (3,641) (3,391)
Extraordinary items........ -- -- -- (436) (221) 3,330 (86)
Net income (loss).......... (12,374) (4,487) (8,715) 5,395 (9,972) (311) (3,477)
Income (loss) per share(4):
Income (loss) before
extraordinary items.... (1.62) (1.15) (2.21) 1.08 (3.88) (1.84) (1.93)
Extraordinary items...... -- -- -- (0.08) (0.09) 1.68 (0.05)
Net income (loss)........ $ (1.62) $ (1.15) $ (2.21) $ 1.00 $ (3.97) $ (0.16) $ (1.98)
Weighted average common and
common equivalent shares
outstanding(4)........... 7,661 3,905 3,950 5,394 2,510 1,982 1,761
</TABLE>

<TABLE>
<CAPTION>
OCTOBER 27, OCTOBER 29, JANUARY 28, JANUARY 29, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1996 1995 1996 1995 1993 1992 1991
----------- ----------- ----------- ----------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets................ $47,402 $49,445 $46,866 $53,750 $ 64,749 $ 47,730 $ 46,187
Inventories................. 12,621 15,359 14,627 18,016 14,690 11,468 12,790
Working capital
deficiency................ (3,796) (4,621) (6,878) (3,751) (1,404) (3,603) (3,862)
Intangible assets........... 17,223 18,867 18,236 19,910 22,826 16,425 12,943
Short-term debt(3).......... 8 18 19 17 1,147 458 3,693
Long-term debt(3)........... 5,260 4,219 5,584 2,181 17,700 15,500 12,376
Stockholders' equity........ 16,265 18,213 13,985 22,700 20,626 11,170 9,485
</TABLE>

- ---------------
(1) The Company acquired Krause's Sofa Factory on April 28, 1991, therefore,
operations for 1991 are for a period of eight months.

(2) In April 1995 the Company changed from a calendar year-end to a fiscal year
ending on the last Sunday of January as determined by the 52/53 week retail
fiscal year. In connection with the change in fiscal periods, the Company
reported a net loss of $3,221,000 for the month ended January 29, 1995.

(3) In August 1994 the Company sold its ownership of 1,500,548 shares of Mr.
Coffee, inc. common stock for cash of $23,258,000. Proceeds from this sale
were used to retire debt of $18,317,000 and pay income taxes of $2,100,000
with the remainder used for working capital.

(4) Previously reported share and per share amounts have been restated to
reflect a one-for-three reverse stock split effective August 1, 1995.

10
<PAGE> 13

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the
consolidated financial statements and notes thereto included elsewhere herein.

RESULTS OF OPERATIONS

The following table sets forth for the periods indicated certain items from
the Company's Consolidated Statement of Operations as a percentage of net sales.

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED FISCAL YEAR ENDED
--------------------------- ---------------------------------------------
OCTOBER 27, OCTOBER 29, JANUARY 28, DECEMBER 31, DECEMBER 31,
1996 1995 1996 1994 1993
----------- ----------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Net sales.................... 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales................ 51.2 48.3 48.9 46.0 47.6
------- ------ ------ ------ ------ -
Gross profit................. 48.8 51.7 51.1 54.0 52.4
Operating expenses:
Selling...................... 52.6 48.2 49.3 45.9 49.8
General and administrative... 9.5 8.7 8.7 9.3 9.9
Amortization of goodwill..... 1.0 .8 .8 .9 .8
------- ------ ------ ------ ------ -
63.1 57.7 58.8 56.1 60.5
------- ------ ------ ------ ------ -
Loss from operations......... (14.3) (6.0) (7.7) (2.1) (8.1)
Interest expense............. (1.0) (.6) (.6) (1.8) (3.5)
Other income................. .3 .3 .1 10.8 1.5
------- ------ ------ ------ ------ -
Income (loss) before income
taxes and extraordinary
items...................... (15.0) (6.3) (8.2) 6.9 (10.1)
Provision (credit) for income
taxes...................... -- (1.4) (1.1) 1.9 --
------- ------ ------ ------ ------ -
Income (loss) before
extraordinary items........ (15.0) (4.9) (7.1) 5.0 (10.1)
Extraordinary items.......... -- -- -- (.4) (.2)
------- ------ ------ ------ ------ -
Net income (loss)............ (15.0)% (4.9)% (7.1)% 4.6% (10.3)%
======= ====== ====== ====== =======
</TABLE>

THIRTY-NINE WEEKS ENDED OCTOBER 27, 1996 COMPARED TO THIRTY-NINE WEEKS ENDED
OCTOBER 29, 1995

Net furniture sales for the first thirty-nine weeks of 1996 were
$82,738,000 compared to $92,465,000 for the same period in fiscal 1995. The
sales decrease was due principally to a same-store sales decrease of 9.9% in the
1996 nine-month period compared to the same period in 1995 and the fact that the
Company operated an average of approximately 3.6 fewer stores in 1996. The
same-store sales decrease was the result, among other things, of an
industry-wide softness in retail sales and the shortage of raw materials due to
insufficient cash available for purchases of raw materials required for
production and shipments. Raw material shortages began to improve in September
1996.

Gross margin was 48.8% of net sales in the 1996 period compared to 51.7% in
the 1995 period. Lower gross margins in 1996 resulted from extensive promotional
pricing during the first half of the 1996 period and changes in mix of products
sold.

Selling expenses were $43,556,000, a decrease of $976,000 from the same
period last year. Selling expenses were 52.6% of net furniture sales in 1996
compared to 48.2% in the 1995 period. Selling expenses increased as a percentage
of sales primarily due to fixed showroom expenses applied to lower sales volume.
Also, commissions, delivery expenses and advertising expenses were higher as a
percentage of sales, offset in part by certain expenses which were lower as a
result of having fewer stores operating in 1996.

11
<PAGE> 14

General and administrative expenses increased as a percentage of sales due
to the 10.5% decrease in net sales; however, in total dollar amounts general and
administrative expenses decreased by $242,000, due principally to general cost
reductions offset somewhat by higher employee termination expenses and
professional fees. Due to expected termination of employment of certain officers
and employees, the Company expects to record approximately $800,000 of severance
benefits in the fourth quarter of fiscal 1996.

Interest expense in the 1996 period increased by $254,000, due principally
to higher average debt outstanding compared to the prior year.

Income tax benefits of $1,327,000 in the first nine months of 1995
represent refundable income taxes available from the carryback of 1995 losses.
There were no carryback benefits recorded in 1996 and none are available in
future periods.

YEAR ENDED JANUARY 28, 1996 (FISCAL 1995) AS COMPARED TO YEAR ENDED DECEMBER 31,
1994

Net Sales. Furniture sales were $122,319,000 in the 1995 fiscal year, an
increase of 5% from sales in 1994. The sales increase was primarily attributable
to sales in stores opened in late 1994 and early 1995, which were offset
somewhat by a decrease in sales in stores open less than one year. During fiscal
1995 the Company opened five new stores, relocated four stores and closed nine
underperforming stores. A comparable store sales decline of 2.9% was primarily
the result of general economic conditions in fiscal year 1995 compared to 1994.

Cost of Sales and Gross Margins. Cost of sales was higher by approximately
11.8% in fiscal year 1995 compared to 1994. Gross margins in fiscal year 1995
were 51.1% compared to 54.0% in 1994. Lower gross margins in 1995 were due to
price discounting and clearance merchandise sales necessary to generate sales
due to increased competition and generally poor economic conditions in the
Company's two major markets, California and New York. In addition, the Company
provided approximately $760,000 to reduce certain showroom inventory to its
estimated net realizable value in fiscal year 1995. During the fourth quarter of
fiscal 1995 Krause's Sofa Factory experienced a shortage of fabric for expected
production. This fabric out-of-stock position caused a disruption in operations,
which had the effect of increasing labor costs per unit and thereby reducing
margins. Margin erosion also occurred since additional discounts were given to
customers due to delivery delays. The out-of-stock position returned to normal
levels in early fiscal 1996.

Operating Costs and Expenses. Selling expenses were $60,257,000 in fiscal
year 1995, an increase of approximately 12.7% from 1994. Selling expenses were
49.3% of sales compared to 45.9% in 1994. The increase in total selling expenses
was principally attributable to higher sales incentives and operating costs
associated with new stores. Variable selling expenses and advertising expenses
as a percentage of sales are expected to decline in future periods.

General and administrative expenses declined by $289,000 and as a
percentage of sales declined to 8.7% from 9.3%. Exclusive of employee severance
costs in fiscal year 1995 of approximately $800,000, general and administrative
expenses were 8% of sales. General and administrative expenses, exclusive of
employee severance costs, declined by over $1 million principally from
reductions in payroll and related expenses.

Interest Expense. Interest expense decreased by $1,419,000 in fiscal 1995
due to significantly less debt outstanding. In August and September 1994 the
Company paid off approximately $18.3 million of debt with proceeds from the sale
of its investment in Mr. Coffee, inc. ("Mr. Coffee").

The Company's investment in Mr. Coffee was accounted for by the equity
method which resulted in equity in earnings of $316,000 in 1994. The Company
sold its investment in Mr. Coffee in August 1994.

Income Taxes. Income tax benefits of $1,327,000 represent refundable
income taxes available from the carryback of fiscal year 1995 losses.

YEAR ENDED DECEMBER 31, 1994 AS COMPARED TO YEAR ENDED DECEMBER 31, 1993

Net Sales. Furniture sales were $116,471,000 in 1994, an increase of
approximately 20% from sales in 1993. This sales increase was principally the
result of an increase in same-store sales of 11.7% and sales generated from new
stores in 1994. Management believes comparable store sales increases were
primarily the

12
<PAGE> 15

result of increased consumer confidence from general improvements in economic
conditions. Also contributing to the sales increase in 1994 was a full year of
sales from Castro Convertibles showrooms, which were acquired in May 1993.

Cost of Sales and Gross Margins. Cost of sales in 1994 increased by about
15.9% from the prior year and gross margins increased to 54.0% from 52.4% in the
prior year. Lower gross margins in 1993 were due to higher promotional pricing
and the inventory liquidation sale conducted at the Castro Convertibles
locations following their acquisition in May 1993. Also in 1994 Krause's
restructured the lease of its Brea, California factory and office resulting in
approximately one-fourth of the gross margin percentage increase in 1994.

Operating Costs and Expenses. Selling expenses in 1994 were $53,460,000 or
45.9% of sales, a reduction from 49.8% of sales in 1993. Advertising expenses
were 8.6% of sales versus 8.9% of sales in the prior year due to better
utilization of ads through new stores added in major advertising areas of
Chicago and New York. The increase in selling expenses was principally due to
higher payroll costs associated with more stores and higher sales volume.

General and administrative expenses increased 13.5% in 1994 compared to
1993. During 1994 approximately $240,000 of expense was incurred for legal
claims and expenses and the write-down of assets related to former business
operations. Also, additional costs were incurred for payroll, travel and
relocation associated with opening new stores in existing and new markets. As a
percentage of net sales, general and administrative expenses declined to 9.3% in
1994 compared to 9.9% in 1993. During 1994 the Company recorded a $400,000
provision for closed store representing the estimated remaining net liability on
a building lease relating to a closed Krause's showroom.

The increase in amortization of goodwill of $280,000 resulted from
additional goodwill associated with the merger of Krause's in October 1993.

Mr. Coffee, inc. In August 1994 the Company sold its 18% ownership in the
common stock of Mr. Coffee for $23,258,000 resulting in a pre-tax gain of
$12,115,000. Equity in earnings of Mr. Coffee in 1994 through the date of sale
was $316,000 compared to $1,208,000 for the full year 1993. See Note 3 of Notes
to Consolidated Financial Statements.

Interest Expense. Interest costs were substantially less in 1994 as
compared with 1993 due to the payoff of $18,317,000 of debt subsequent to the
sale of Mr. Coffee.

Income Taxes. The provision for income taxes in 1994 was approximately 27%
of income before taxes. The 1994 effective tax rate differs from the federal
statutory rate due to the benefit of utilization of net operating loss
carryforwards and the realization of $920,000 of deferred tax assets, offset by
state income taxes and the impact of nondeductible goodwill amortization. No tax
benefits were available for operating losses incurred in 1993.

Statement of Financial Accounting Standards No. 109 provides for the
recognition of deferred tax assets if realization of such assets is more likely
than not. The Company's valuation allowance reduces the deferred tax asset to
the amount available through the carryback of temporary differences expected to
reverse within the carryback period.

Extraordinary Loss. Extraordinary losses, net of income tax benefits,
amounted to $436,000 and $221,000 in 1994 and 1993, respectively, and were from
expensing unamortized deferred debt costs and prepaid interest due to the
retirement of debt of the Company in 1994 and of Mr. Coffee in 1993.

LIQUIDITY AND CAPITAL RESOURCES

As of October 27, 1996, the Company had $6,341,000 in cash and cash
equivalents compared to $1,336,000 as of January 28, 1996. Cash flow activity
for the periods described below are presented in the Consolidated Statement of
Cash Flows included elsewhere herein.

Cash Flow -- Thirty-Nine Weeks Ended October 27, 1996. Cash and cash
equivalents increased by $5,005,000 during the period. Operating activities used
net cash of $8,581,000, principally from a $10,521,000

13
<PAGE> 16

cash loss from operations and decreases in accounts payable and other
liabilities of $1,293,000 offset by a decrease in inventories of $2,006,000 and
collections of income tax refund receivables of $1,467,000. Investing activities
during the period included capital expenditures of $563,000, principally for
additions to leasehold improvements at retail showrooms. Financing activities
during the period were comprised principally of proceeds from issuances of
Common Stock of $10,669,000 less expenses of $448,000, proceeds from issuances
of $2,950,000 of convertible and demand notes (subsequently converted into
Common Stock, together with interest of $116,000) and issuance of a subordinated
note of $5,000,000, offset by net payments of $3,975,000 under the Company's
revolving credit facility.

1995 Cash Flow. During 1995 cash and cash equivalents decreased by
$616,000. Operating activities used net cash of $3,177,000, principally from a
cash loss from operations of $4,752,000 offset by a net change in operating
assets and liabilities of $1,575,000. Inventories and other operating assets
were reduced by $3,389,000 and $147,000, respectively, while accounts payable
and accrued liabilities were reduced by $1,961,000. Investing activities during
the year included capital expenditures of $1,883,000, primarily related to
Krause's opening of five new showrooms and remodeling of four showrooms,
partially offset by $1,039,000 of proceeds from the sale-leaseback of a showroom
in Texas. Financing activities in fiscal 1995 of $3,405,000 were principally net
borrowings under Krause's revolving credit agreement which was entered into in
January 1995.

1994 Cash Flow. In August 1994 the Company sold its ownership of 1,500,548
shares of Mr. Coffee common stock for cash of $23,258,000. Proceeds from this
sale were used to retire debt of $18,317,000 and pay income taxes of $2,100,000,
with the remainder used for working capital.

During 1994 cash and cash equivalents decreased by $4,685,000. Operating
activities used net cash of $6,877,000, principally from a cash loss from
operations of $2,986,000 and a change in operating assets and liabilities of
$3,891,000. Inventories and other operating assets increased by $2,567,000 and
$813,000, respectively, while accounts payable and accrued liabilities were
reduced by $511,000. Investing activities provided cash of $20,935,000 in 1994
including the Mr. Coffee sale proceeds mentioned above, offset by capital
expenditures of $2,323,000, primarily related to Krause's opening of 15 new
showrooms and remodeling of three showrooms during the year. Financing
activities used net cash of $18,743,000 and were comprised primarily of debt
repayments to related parties.

1993 Cash Flow. In late 1993 the Company completed the private placement
of approximately $12,200,000 of convertible preferred stock. Proceeds from the
issuance were used to retire debt of $3,000,000 and prepay interest on senior
secured term notes of $896,000, with the balance used for growth and working
capital.

During 1993 cash and cash equivalents increased by $2,608,000. Operating
activities used net cash of $7,917,000, including a $7,770,000 cash loss from
operations. Net cash used in operations also included an increase in current
liabilities of $5,048,000 and additions of $3,222,000 to inventories and
$1,973,000 to other operating assets. Investing activities during the year
included capital expenditures of $1,841,000, principally for additions to
leasehold improvements to retail showrooms, and $1,790,000, principally for the
purchase of leasehold interests in showrooms acquired from Castro Convertibles.
During the years financing activities provided $14,114,000, principally from the
preferred stock issuances noted above and from a revolving credit arrangement
with related parties.

OUTLOOK

On August 26, 1996 and September 10, 1996 the Company completed
transactions with investors in which the Company received aggregate gross cash
proceeds of $15,669,000 from private placements of $10,669,000 of Common Stock
(at a price of $1.00 per share) and a $5,000,000 subordinated note. Also,
Krause's revolving credit agreement was amended to extend the expiration date of
the agreement to January 2000 and provide for an increase in borrowing
availability.

The proceeds from these transactions allow the Company to accelerate its
strategic objectives and initiatives including downsizing showroom square
footage to reduce occupancy expenses, upgrading and

14
<PAGE> 17

remodeling showrooms to provide a more appealing setting for customers,
remerchandising, refocusing advertising expenditures, improving manufacturing
processes, and reducing corporate expenses. These objectives and initiatives are
expected to contribute significantly to reducing losses and ultimately returning
the Company to profitability. The Company's long-term success is dependent upon
its ability to execute successfully management's strategic plan and, ultimately,
to achieve sustained profitable operations. Operating losses are expected to
continue at least through the second quarter of 1997. Other than as attendant to
the strategic objectives described above, the Company has no significant
long-term capital expenditure requirements or commitments.

15
<PAGE> 18

BUSINESS

CORPORATE HISTORY

KFI is a Delaware corporation which is publicly traded on the Nasdaq Small
Cap Market ("Nasdaq trading symbol "SOFA"). The Company changed its name to
Krause's Furniture, Inc. in December 1994. The former name was Worth
Corporation, which had a Nasdaq trading symbol of "WRTH" until December 12,
1994. References herein to the Company and to KFI include Krause's Furniture,
Inc. and its wholly owned subsidiaries. The Company's principal office is
located at 200 North Berry Street, Brea, California 92821-2902, its telephone
number is 714/990-3100 and its facsimile number is 714/990-3561.

The Company's business is primarily conducted through its wholly-owned
subsidiary, Krause's Sofa Factory ("Krause's Sofa Factory"), a manufacturer and
retailer of made-to-order upholstered furniture. In April 1991 the Company
acquired a controlling interest in Krause's Sofa Factory for approximately $6.2
million. On October 31, 1993, the Company acquired by merger the then
outstanding minority interest in Krause's Sofa Factory through an exchange of
stock. Each of the minority shareholders of Krause's Sofa Factory received 3.24
shares of the Company's Common Stock for each share of Krause's Sofa Factory
capital stock. Krause's Sofa Factory was started in San Diego, California in
1973. Originally incorporated as The Sofa Factory, it changed its name to
Krause's Sofa Factory in 1984.

In May 1993 Krause's Sofa Factory acquired certain assets principally
related to the retail operations of Castro Convertible Corporation, including
the "Castro Convertibles" tradename and trademark and retail store locations.
Castro Convertibles, which was started in 1931, has been known throughout the
East Coast for its quality sofabed products and was an early pioneer in
developing the tri-fold sofabed mechanism. Krause's Sofa Factory manufactures
products for sale through the Castro stores and dealerships. Descriptions of the
businesses, products, manufacturing and other information of Krause's Sofa
Factory are outlined in the following sections of this Prospectus.

In August 1994 the Company sold its 18% ownership interest in Mr. Coffee to
Health o meter Products, Inc. for cash totaling $23.3 million. The Company had
purchased its equity position in Mr. Coffee through various stock purchases and
exchanges commencing in February 1988. Mr. Coffee is the leading producer of
automatic drip coffeemakers in the United States and also manufactures other
small kitchen appliances.

In April 1995 the Company changed from a calendar year-end to a fiscal year
ending on the last Sunday of January as determined by the 52/53 week retail
fiscal year. The Company's 1995 fiscal year ended January 28, 1996.

BUSINESS

The Company, through Krause's Sofa Factory, manufactures made-to-order
sofas, sofabeds, loveseats and chairs, and retails these products (as well as
externally-sourced furniture and home furnishing products) through its own chain
of retail showrooms as well as licensed dealerships. As of December 1, 1996,
there were 82 Company-owned showrooms and two dealer stores in 12 states. The
Company believes it is the largest combined manufacturer and retailer of
made-to-order upholstered furniture in the United States. The distinctive
competitive characteristic of Krause's Sofa Factory is its ability to
manufacture and supply competitively priced made-to-order upholstered furniture
in two to four weeks from the date ordered by the customer.

PRODUCTS

Krause's Sofa Factory's focus is the manufacture and sale of high-quality,
affordably-priced made-to-order upholstered furniture. Its product line consists
primarily of upholstered (woven fabric and leather) sofas, sofabeds, chairs and
sectionals, in a wide variety of styles and sizes. Except for a few styles of
occasional and reclining chairs, Krause's Sofa Factory manufactures virtually
all of its upholstered furniture, which accounts for approximately 85% of its
net sales. Krause's Sofa Factory manufactured upholstered furniture is currently
sold exclusively through its own leased retail showrooms and licensed dealers.
In addition to its exclusive

16
<PAGE> 19

upholstered furniture line, Krause's Sofa Factory retails an assortment of
tables, occasional chairs, dining sets, area rugs, lamps and other fashion
accessories. Merchandise purchased from other suppliers accounts for
approximately 15% of net sales.

Customers of Krause's Sofa Factory may choose from approximately 60
different styles, 40 sizes, 800 fabrics, 50 leather choices, and various
weltings. The upholstered furniture product line consists of the following:

SOFAS. Stationary upholstery accounts for the largest proportion of
Krause's Sofa Factory sales. Sofa styles range from classic traditional, to
contemporary, to country, to Eurostyles.

INCLINERS. Krause's Sofa Factory manufactures its own design of incliners,
which are sofas, loveseats or chairs which include a modified incliner
footrest mechanism built directly into the unit. The Company believes
Krause's Sofa Factory is the only retailer which offers an incliner option
in the customer's choice of style, size and fabric.

RECLINERS. Fully reclining sofas and chairs are offered as an option in a
number of sofas and chairs manufactured by Krause's Sofa Factory. It offers
not only fully reclining sofas but a complete line of reclining chairs. The
Company believes Krause's Sofa Factory offers more reclining options in the
customer's choice of style, size and fabrics than most competitors.

SECTIONALS. Sectionals are modular units of upholstered furniture which
can be combined or separated to form any variety of seating arrangements
desired. Krause's Sofa Factory offers and manufactures a sectional option
for most styles of its sofas.

SOFABEDS. Prior to the acquisition of the operating assets of Castro
Convertibles, approximately 15% of the sofas sold by Krause's Sofa Factory
were sofabeds. Since the reputation of Castro Convertibles is that of a
sofabed specialist, the percentage of total sofabed sales has nearly
doubled since the assets acquisition. Working with a third party vendor,
Krause's Sofa Factory has developed an enhanced sofabed mechanism to take
advantage of its unique position in sofabed retailing. Krause's Sofa
Factory offers a super-queen mattress, which the Company believes is wider
than most other sofabed mattresses offered in the United States. Although
producing only for its own retail outlets and licensed dealers, the Company
believes it is one of the top 10 retailers of sofabeds in the U.S.

CHAIRS. Krause's Sofa Factory manufactures a complementary line of
upholstered chairs, which coordinate or match with most of the sofa styles
it offers. Usually these chairs are sold in sets with a sofa, loveseat,
incliner, recliner and/or sofabed. Krause's Sofa Factory also manufactures
occasional chairs for customers who desire a chair which coordinates with
but does not match the style or fabric of their primary furnishings.

In order to respond to customer needs and desires as well as to display its
own sofas and upholstered products in room settings, Krause's Sofa Factory
showrooms offer a variety of complementary products purchased from outside
vendors. Some of these products may not be customized. Because of its
made-to-order strategy, Krause's Sofa Factory does not require a substantial
amount of finished goods, whether they are manufactured by it or purchased from
outside sources.

RETAIL OPERATIONS

Krause's Sofa Factory sells its products through Company-owned and licensed
retail showrooms in 12 states. Retail showrooms located in California, Colorado,
Arizona, Nevada, Texas, New Mexico, Washington and Illinois are operated under
the name Krause's Sofa Factory(R) or Krause's Sofas. Retail showrooms in New
York, New Jersey, Connecticut and Florida are operated under the name Castro
Convertibles(R). Showroom locations are selected on the basis of strictly
defined criteria, including expected population growth, desirable target
consumer demographics and psychographics, high visibility with easy access from
major thoroughfares, adequate parking facilities and proximity to other
furniture retailers.

17
<PAGE> 20

Retail showrooms vary in size from 1,700 square feet to 24,000 square feet,
with an average size of 13,500 square feet. The typical showroom displays
approximately 50 to 60 styles in coordinated furniture groupings to illustrate
the diversity and availability of contemporary and traditional upholstered
furniture.

When a customer makes a selection, a down payment is collected and the
order is immediately entered in the computer system at Krause's Sofa Factory by
means of an on-line terminal at the showroom. The order, reflecting the
customer's exact specifications as to style, color, size, configuration and
fabric, is then registered and scheduled at the Company's manufacturing facility
and the manufacturing or outside purchasing process begins.

When an order has completed the manufacturing and/or outside purchasing
process, it is shipped to a regional warehouse. The manager at this warehouse
has responsibility for the final preparation and delivery of the order to the
customer. Outside delivery services, as well as Company personnel in certain
areas, are utilized for this process.

MANUFACTURING

The Company's manufacturing facilities, located in Brea, California,
produce upholstered furniture for sale through Krause's Sofa Factory and Castro
Convertibles showrooms. Manufacturing begins with the purchase of lumber
(hardwood and softwood), which is kiln dried for extra strength and
straightness. Mill workers cut the component pieces for each different style,
working to precise standards. Craftsmen, using pneumatic and power tools, take
the wooden parts and assemble them into frames for different furniture models.
All corners are blocked and glued for added strength and proper distribution of
weight and stress.

Krause's Sofa Factory primarily uses a one-piece frame method in which the
entire frame is built before any upholstering occurs. This method results in
superior frame strength for a finer tailored appearance. Frame construction is
completed with the installation of metal springs, which contributes to the
continued comfort, durability and appearance of the upholstered furniture.

While the frame is being built, the chosen fabric or leather for that
particular customer order is cut and sewn. The Company employs quilters as well
as special seamstresses for sewing zippers, bolster covers, ruffles, skirts and
pleats. The pillow back, chair back and ottoman cushions are assembled prior to
proceeding to the upholstery stage.

Upholstery is performed using an assembly line technique. Several
individuals work on each frame, each specializing in an area of
responsibility-springs, outside body, seat, arm, inside body and so on. As the
frame is being upholstered, seat cushions are filled with a Foreverflex(TM)
insert (the Company's proprietary seating material). The Foreverflex(TM) cushion
insert is a high-density foam cushion which is injection molded with springs
suspended within the foam. The Foreverflex(TM) cushion insert is manufactured by
an outside supplier to strict specifications set by Krause's Sofa Factory and
carries a lifetime guarantee.

Placement of the upholstered cushions on the furniture completes the
manufacturing process. Every piece of finished upholstered furniture undergoes a
quality control inspection during production and again prior to shipment from
the factory to the local distribution center or retail showroom.

Krause's Sofa Factory builds approximately 600 pieces of upholstered
furniture per day in a single shift. This represents approximately 75% of single
shift manufacturing capacity. The level of production is primarily determined by
customer orders, since Krause's Sofa Factory builds only minor amounts of units
for inventory. Krause's Sofa Factory turns its manufacturing backlog
approximately every 23 to 28 days. Backlog as of January 28, 1996 was
approximately $12.8 million compared to $13.9 million at the end of January
1995. Backlog at October 27, 1996 was approximately $12.1 million.

Many suppliers currently provide the Company with the materials used in the
manufacture of its upholstered furniture products. One such supplier provided
approximately 25% and another 13% of the Company's raw materials purchased
during the year ended January 28, 1996. Krause's Sofa Factory is dependent on
the continued supply of components and raw materials, including fabrics,
leather, foam and sofabed and motion mechanisms. Management constantly seeks new
suppliers and better prices through

18
<PAGE> 21

competitive bidding and the qualification of alternative sources of supply.
Inability to develop alternative sources of supply if and as required or to
obtain sufficient single source products, components and raw materials would
adversely affect the Company's sales and operating results.

TRADEMARKS AND PATENTS

The Company holds trademarks and patents registered in the United States
for various products and processes. Krause's Sofa Factory has a registered
trademark in the United States for the Krause's Sofa Factory(R) and Castro
Convertibles(R) names and logos. The Company considers these trademarks
important to its business.

GOVERNMENT REGULATIONS

The Company's facilities are subject to numerous federal, state and local
laws and regulations designed to protect the environment from waste emissions
and from hazardous substances. The Company is also subject to the federal
Occupational Safety and Health Act and other laws and regulations affecting the
safety and health of employees in the production areas of its facilities.
Company management believes that it is in compliance in all material respects
with all applicable environmental and occupational safety regulations.

EMPLOYEES

The majority of Krause's Sofa Factory employees are not unionized and many
have been with the Company for over 10 years. Approximately 50 retail employees
in the greater New York area are covered by a union contract which was
negotiated in connection with the acquisition of Castro Convertibles, and which
expires in May 1998. As of December 31, 1996, the total work force numbers
approximately 960 with approximately 355 engaged in manufacturing activities,
535 in the Company's retail/warehousing operations and 70 in administration.

COMPETITION

Krause's Sofa Factory competes in retail furniture markets where both
national, regional and strong local competitors are well represented. Other
furniture retailers with which Krause's Sofa Factory competes include major
department store chains, as well as independent furniture stores and discount
and warehouse chains. Levitz Furniture, one of the largest U.S. furniture
retailers, competes throughout most of the geographic locations where the
Company's showrooms are located, and offers mass-produced furniture in the
moderate price range.

INSURANCE

The Company purchases occurrence-based product liability insurance in the
aggregate amount of $17 million. Company management believes that based upon its
historical liability experience, the amount of insurance it carries is adequate.

PROPERTIES

The Company maintains its administrative offices and manufacturing plant in
a leased 250,000 sq. ft. facility at 200 North Berry Street, Brea, California.
The lease has a remaining term of 13 years with four five-year renewal options
and grants to the Company certain options to purchase the facility. Krause's
Sofa Factory also leases approximately 275,000 sq. ft. for warehouse and
distribution facilities. Retail showrooms are all leased with rents either fixed
or with fixed minimums coupled with contingent rents based on the Consumer Price
Index or a percentage of sales. The 82 Company-operated showrooms occupy
approximately one million sq. ft. of space.

19
<PAGE> 22

LEGAL PROCEEDINGS

On May 27, 1994, the Company was served with a complaint in the case
captioned Miriam Brown v. Mr. Coffee, inc. et al. (Civil Action No. 13531), in
the Delaware Court of Chancery, New Castle County. The complaint names the
Company, Mr. Coffee and certain individuals including Jean R. Perrette, then
Chairman of the Board, and Kenneth W. Keegan, a former director of the Company,
as defendants in a purported class action lawsuit. The complaint alleges that
the individuals named as co-defendants breached their fiduciary duties as
directors of Mr. Coffee by, among other things, their alleged efforts to
entrench themselves in office and prevent Mr. Coffee's public shareholders from
maximizing the value of their holdings, engaging in plans and schemes unlawfully
to thwart offers and proposals from third parties, and approving or causing the
Company and others to agree to vote in favor of a merger with Health o meter
Products, Inc. The Company is alleged to have participated in and advanced the
alleged breaches. The plaintiff originally sought to enjoin the merger; however,
plaintiff withdrew such action and the merger was completed in August 1994. The
Company and the Mr. Coffee directors filed motions to dismiss the complaint on
August 11, 1994. On October 9, 1996, the plaintiff filed a second amended
complaint. All defendants subsequently joined in filing a motion to dismiss the
complaint. The plaintiff seeks compensatory damages and costs and disbursements
in connection with the action, including attorneys' and experts' fees, and such
other further relief as the court deems just and proper.

For a number of reasons, including the extensive solicitation and
negotiation process which preceded the acceptance by Mr. Coffee's Board of
Directors of the Health o meter offer, the Company believes that the plaintiff's
allegations are without merit. Management believes that any liability in the
event of final adverse determination of any of this matter would not be material
to the Company's consolidated financial position or results of operations.

MARKET PRICE DATA

The Company's Common Stock trades on the Nasdaq Small Cap Market under the
ticker symbol SOFA. The following table sets forth the high and low per share
sales prices for the Company's Common Stock for each of the first three fiscal
quarters in 1996 and for each quarter during the 1995 (52 weeks ended January
28, 1996) and 1994 (calendar year) fiscal years. For the month of January 1995
the high and low per share sales prices were $7.12 and $5.62, respectively.
Quotations are as reported by Nasdaq, adjusted for periods prior to August 1,
1995, to reflect a one for three reverse stock split, effective on that date.

<TABLE>
<CAPTION>
1996 1995 1994
------------ ------------- -------------
QUARTER HIGH LOW HIGH LOW HIGH LOW
------------------------------------------ ----- ---- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C>
First..................................... $2.56 $.88 $6.75 $4.87 $8.63 $6.00
Second.................................... 1.63 .69 6.37 3.00 8.25 5.25
Third..................................... 2.19 .50 4.37 2.00 7.50 5.63
Fourth.................................... 3.00 1.63 7.88 4.50
</TABLE>

The high and low prices for the Company's Common Stock from the end of the
third quarter 1996 to January 6, 1997, were $1.56 and $1.00, respectively. On
January 6, 1997, the closing price of the Company's Common Stock was $1.38. As
of December 31, 1996, there were approximately 400 holders of record of the
Company's Common Stock.

20
<PAGE> 23

MANAGEMENT

DIRECTORS AND EXECUTIVE OFFICERS

The names, ages and positions of the Company's directors and officers are
as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
- ------------------------------ --- ------------------------------------
<S> <C> <C>
Philip M. Hawley.............. 71 Chairman of the Board and Chief
Executive Officer
Thomas M. DeLitto............. 43 Vice Chairman of the Board
Stephen P. Anderson........... 45 President
Robert G. Sharpe.............. 61 Executive Vice President and
Treasurer
Robert A. Burton.............. 56 Senior Vice President and Chief
Financial Officer
Kamal G. Abdelnour............ 60 Director
Jeffrey H. Coats.............. 39 Director
Peter H. Dailey............... 66 Director
John A. Gavin................. 65 Director
</TABLE>

Philip M. Hawley has been Chairman of the Board and Chief Executive Officer
since August 1996. He served as Chairman and Chief Executive Officer of The
Broadway Stores, Inc. (formerly Carter Hawley Hale Stores, Inc.) from 1977 to
1993. Mr. Hawley is also a director of Atlantic Richfield Company, Johnson &
Johnson and Weyerhauser Company.

Thomas M. DeLitto has been Vice Chairman of the Board since December 1994
and a director since June 1991. He was Chief Executive from April 1995 to August
1996, President and Chief Executive Officer from July 1992 to December 1994, and
Executive Vice President and Chief Operating Officer from June 1991 to July
1992. Mr. DeLitto has been President of Permal Capital Management, Inc., a
wholly-owned subsidiary of Worms & Co., Inc., since October 1990; in this
capacity he oversees operations of that company's direct investment activities.

Kamal G. Abdelnour has been a director since September 1996. He had been a
director from February 1993 to August 1996 when he resigned in connection with
the Company's recapitalization. Mr. Abdelnour has been President and Chief
Executive Officer of ATCO Development, Inc. ("ATCO") since 1980. ATCO is engaged
in the business of investments, real estate ownership and management, and export
sales. Mr. Abdelnour currently serves as a director of First National
Bankshares, Inc. Mr. Abdelnour has been elected as a director of the Company in
accordance with a contractual undertaking by the Company to nominate him.

Stephen P. Anderson has served as President of the Company since April 1995
and was Chief Operating Officer from April 1995 to August 1996. He has been
President and Chief Executive Officer of Krause's Sofa Factory since April 1995.
Previously, he was President and Chief Operating Officer of Krause's Sofa
Factory from November 1994 to April 1995. Prior to his association with the
Company and Krause's Sofa Factory, Mr. Anderson held various executive positions
with The Stanley Works. He was President and General Manager of Stanley Door
Systems Division from January 1991 until February 1994 and Vice President of the
Garage Door Division from August 1989 to January 1991. Mr. Anderson will
terminate as an officer and employee of the Company by the end of January 1997.

Robert G. Sharpe has been Executive Vice President, Corporate Development
and Treasurer since April 1995. He was Chief Financial Officer and Treasurer
from July 1987 to April 1995, and served as a director from July 1987 to May
1993. Mr. Sharpe will terminate as an officer and employee of the Company
effective January 31, 1997.

Robert A. Burton has been Senior Vice President and Chief Financial Officer
since December 1996. Mr. Burton was an independent financial consultant from
January 1995 to November 1996, and from

21
<PAGE> 24

November 1987 to December 1994 he was Senior Vice President and Chief Financial
Officer of John Breuner Company, a home furnishings company. In October 1993,
John Breuner Company filed for bankruptcy and emerged in July 1994.

Jeffrey H. Coats has been a Director since August 1996. He has been a
Managing Director of GE Capital Equity Capital Group, Inc., a wholly-owned
subsidiary of General Electric Capital Corporation, since April 1996. He was
also a Managing Director of GE Capital Corporate Finance Group, Inc., a
wholly-owned subsidiary of General Electric Capital Corporation, from June 1987
to April 1993. From March 1994 to April 1996, Mr. Coats was President of
Maverick Capital Equity Partners, LLC and from April 1993 to January 1994, he
was Managing Director and a Partner of Veritas Capital, Inc., both of which are
investment firms. Mr. Coats is the Chairman of the Board of The Hastings Group,
Inc., a clothing retailer, which filed for bankruptcy in October 1995. The
Hastings Group, Inc. currently is in the process of formulating a plan of
liquidation under Chapter 11.

Hon. Peter H. Dailey has been a director since September 1996. He is also
the Chairman of the Board and Chief Executive Officer of Memorex Telex, NV, a
world-wide technology company headquartered in Amsterdam, the Netherlands and
has served in those roles since April 1996. He served as Ambassador to Ireland
from 1982 to 1984, and was special Presidential envoy to NATO countries. From
1985 to 1988, Mr. Daily served as counselor to the Director of the Central
Intelligence Agency. From 1985 to 1992 he was a member of President's Advisory
Committee on Arms Control and Disarmament. He also serves as founder and
Chairman of the Board of Enniskerry Financial, Inc., a private investment
company founded in 1968, and has been a principal of Gavin, Dailey and Partners,
an international capital and consulting firm, since 1991. Mr. Dailey is a member
of the Board of Directors of Chicago Title and Trust Company, Sizzler, Inc.,
Pinkerton's, Inc., and Jacobs Engineering Group, Inc. Prior to returning to
government service he served as a director of the Walt Disney Co. and the
Interpublic Group of Companies. Memorex Telex Corp., the U.S. Subsidiary of
Memorex Telex, NV, filed for bankruptcy in 1996 and is in the process of
liquidation. Sizzler, Inc. a family style restaurant chain, filed for bankruptcy
in 1996 and is in the process of formulating a plan of reorganization.

Hon. John A. Gavin has been a director since September 1996. He has been
the founder and Chairman of Gamma Services Corporation and a principal of Gavin,
Dailey and Partners, both international capital and consulting firms, since 1968
and 1991, respectively. He has also been affiliated with Hicks, Muse, Tate and
Furst (Latin America) as Managing Director since 1995. Mr. Gavin is a member of
the Board of Directors of Atlantic Richfield Company, Dresser Industries,
Pinkerton's, Inc., International Wire Group and KAP Resources.

All Directors are elected annually and serve until the next annual meeting
of stockholders or until the election and qualification of their successors. All
executive officers serve at the discretion of the Board of Directors and, in
some cases, pursuant to their written employment agreements. There are no family
relationships between any of the directors or executive officers of the Company.

The Board of Directors has created an Executive Committee, an Audit
Committee, a Compensation Committee and a Nominating Committee. The Executive
Committee is composed of Philip M. Hawley, Thomas M. DeLitto and Jeffrey H.
Coats, and has all of the powers and authority in the management of the business
and affairs of the Company, except to the extent prohibited by law, to take
action on behalf of the Board of Directors as may be necessary between regular
meetings of the Board. The Audit Committee is composed of John A. Gavin, Peter
H. Dailey and Kamal G. Abdelnour, and is charged with reviewing the Company's
annual audit and meeting with the Company's independent accountants to review
the Company's internal controls and financial management practices. The
Compensation Committee, which is composed of Kamal G. Abdelnour, John A. Gavin
and Peter H. Dailey, recommends to the Board of Directors compensation for the
Company's key employees and administers certain employee benefit plans. The
Nominating Committee is composed of Philip M. Hawley, Thomas M. DeLitto, Jeffrey
H. Coats and Kamal G. Abdelnour, and is charged with reviewing the
qualifications of and recommending candidates to the Board of Directors for
election as directors of the Company. The Nominating Committee also acts on
other matters pertaining to membership on the Board of Directors, including
terms of tenure and compensation for Directors and issues involving potential
conflict of interests. It also reviews the qualifications of, and recommends to
the Board of Directors individuals for senior management positions with the
Company.

22
<PAGE> 25

DIRECTOR COMPENSATION

During fiscal year 1996 no fees were paid to directors, although directors
were reimbursed for travel and other expenses related to their activities as
directors. The Board is currently reconsidering the entire fee structure. Prior
to fiscal year 1996 directors received annual retainers and fees in various
amounts both for serving as a director and as a member of a committee and for
each Board meeting attended. Each director is granted an option to purchase
5,000 shares of Common Stock upon such director's election to the Board and an
option to purchase an additional 5,000 shares on each anniversary of such
director's election to the Board. Such options are granted pursuant to the
Company's 1994 Directors Stock Option Plan described under "Stock Plans" below.

COMPENSATION OF EXECUTIVE OFFICERS

The following table discloses compensation received by the Company's two
former Chief Executive Officers and two other executive officers whose annual
compensation exceeded $100,000 and who were executive officers at the end of
fiscal year 1995. Information presented for 1995 is for the Company's fiscal
year ended January 28, 1996. Information presented for 1994 and 1993 is for the
prior fiscal calendar years. Philip M. Hawley became Chairman of the Board and
Chief Executive Officer of the Company in August 1996. Mr. Hawley's base salary
is at the rate of $225,000 per year. Robert A. Burton became Senior Vice
President and Chief Financial Officer in December 1996. His base salary is at
the rate of $150,000 per year.

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
ANNUAL ---------------
COMPENSATION SECURITIES ALL OTHER
------------------------------- UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS/SARS(#) ($)(3)
- ----------------------------------- ----- --------- -------- --------------- ------------
<S> <C> <C> <C> <C> <C>
Thomas M. DeLitto(1)............... 1995 1,666 9,375
President, Chief Executive 1994 1,666 15,000
Officer
and Director 1993 833 14,500
Stephen P. Anderson................ 1995 203,846 36,667
President and Chief Executive 1994 50,000 16,667
Officer of Krause's Sofa Factory
Michael W. Gibbons(2).............. 1995 229,427 138,713
Director, President and Chief 1994 222,237 14,125
Executive Officer of Krause's 1993 217,767 59,400 14,500
Sofa
Factory
Robert G. Sharpe................... 1995 157,278 30,000 6,666
Executive Vice President 1994 149,187 30,000 3,333
1993 136,083 30,000 8,333 5,300
</TABLE>

- ---------------
(1) Permal Capital Management, Inc. ("PCMI"), of which Mr. DeLitto is President,
performed certain executive management services on behalf of the Company
(Mr. DeLitto is currently Vice Chairman, until August 1996 he was also Chief
Executive Officer and he was President and Chief Executive Officer of the
Company until December 1994) during 1995 and received $100,000 for such
services. See "Certain Transactions."

(2) Mr. Gibbons entered into a three year employment agreement with Krause's
Sofa Factory on April 29, 1991. The agreement provided an annual salary of
$198,000, $208,000, and $218,000 in the first, second and third years,
respectively. The agreement also provided for an annual bonus based on the
pre-tax income of Krause's Sofa Factory. Effective April 29, 1994 Mr.
Gibbons and Krause's Sofa Factory entered into a new employment agreement,
which provided for a base annual salary of $225,000 in the first year and
discretionary bonus. No annual bonus was paid or accrued under the
employment agreements. Mr. Gibbons resigned as President and Chief Executive
Officer in April 1995 and as a director in February 1996. See "Certain
Transactions."

23
<PAGE> 26

(3) Other annual compensation represents directors' fees, except in the case of
Mr. Gibbons, where other compensation includes $8,800 of directors' fees and
$129,913 of accrued vacation paid upon termination of employment.

OPTION/SAR GRANTS IN LAST FISCAL YEAR

<TABLE>
<CAPTION>
POTENTIAL
REALIZABLE
VALUE AT ASSUMED
ANNUAL RATES OF
NUMBER OF % OF TOTAL STOCK PRICE
SECURITIES OPTIONS/SARS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OR OPTION TERM
OPTIONS/SARS EMPLOYEES IN BASE PRICE EXPIRATION ------------------
NAME GRANTED(#) FISCAL YEAR(1) ($/SH) DATE 5%($) 10%($)
- --------------------------- ------------ -------------- ----------- ---------- ------ --------
<S> <C> <C> <C> <C> <C> <C>
1,666 1.3% 3.66 07/31/05 9,932 15,816
Thomas M. DeLitto..........
10,000 7.5% 3.18 06/20/05 51,799 82,481
Stephen P. Anderson........
26,667 20.1% 2.19 09/20/05 95,129 151,476
None
Michael W. Gibbons.........
3,333 2.5% 6.00 04/18/05 32,575 51,870
Robert G. Sharpe...........
3,333 2.5% 3.18 06/20/05 17,265 27,491
</TABLE>

- ---------------
(1) The Company granted options for a total of 11,662 shares of Common Stock to
directors and 121,166 shares of Common Stock to employees of the Company and
Krause's Sofa Factory during 1995.

AGGREGATED OPTION/SAR EXERCISES IN 1995
AND YEAR-END OPTION/SAR VALUES(1)

<TABLE>
<CAPTION>
NUMBER OF SECURITIES UNDERLYING VALUE OF UNEXERCISED
UNEXERCISED OPTIONS/SARS IN-THE-MONEY OPTIONS/SARS
AT FISCAL YEAR-END AT FISCAL YEAR-END(2)
------------------------------- -------------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- --------------------------------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Thomas M. DeLitto................ 3,332 1,666 $ -- $ --
Stephen P. Anderson.............. 21,112 32,222 3,867 7,733
Michael W. Gibbons............... 140,940 17,820 -- --
Robert G. Sharpe................. 17,332 4,333 -- --
</TABLE>

- ---------------
(1) No options or SARs were exercised by the above-named executives in 1995.

(2) Based on closing price of Common Stock as quoted on Nasdaq of $2.625 on
January 26, 1996.

STOCK PLANS

1990 Employees Stock Option Plan

The 1990 Employees Stock Option Plan (the "Employees Plan") was adopted by
the Board of Directors and approved by the stockholders in 1990. Originally,
250,000 shares of the Company's Common Stock were reserved for issuance upon
exercise of options granted under the Employees Plan. A subsequent 1-for-3 share
reverse stock split followed by an amendment to the Employees Plan have resulted
in a net increase in the number of shares reserved for issuance upon exercise of
options granted under the Employees Plan to 500,000. Under the Employees Plan,
incentive stock options ("ISOs") and nonstatutory stock options ("NSOs") may be
granted only to employees, including officers, of the Company and its
subsidiaries. The Employees Plan terminates on the last day of December, 1999,
and no options may be granted under the Employees Plan thereafter.

The exercise price of options granted under the Employees Plan must equal
100% of the fair market value of the Company's Common Stock on the date of
grant, provided that options granted to any person who owns more than 10% of the
voting power of all classes of capital stock of the Company at the date of grant
shall provide for an exercise price of not less than 110% of the fair market
value of the Company's Common Stock on the date of grant. Options shall be
exercisable in amounts and over specified periods of time as determined by the
Compensation Committee at the time of grant. The foregoing notwithstanding, all
options shall vest

24
<PAGE> 27

and be exercisable over a period not exceeding 10 years, provided that for
persons owning more than 10% of the total combined voting power of all classes
of capital stock of the Company, the maximum term shall be not more than five
years from the date of grant. During his or her lifetime, only the employee or
officer who is the recipient of the option grant may exercise the option. If an
employee or officer is terminated with cause, as defined in the Employees Plan,
his or her option ceases to be exercisable and terminates upon the effective
date of termination. If an employee's or officer's employment terminates and
such termination is not for cause, as defined, the option is exercisable for a
period of 90 days following the date when the termination occurs, but in no
event later than the date of expiration of the option in accordance with the
terms of the Employees Plan. In the event an employee's or officer's employment
terminates as a result of disability, as defined in the Employees Plan, or if
the employee's or officer's death occurs while employed or within 90 following
the date when he or she ceases to be so employed, the option must be exercised
within 12 months following the date when the employee or officer becomes
disabled or dies, subject to earlier expiration in accordance with the terms of
the Employees Plan.

If any change, such as a stock split or dividend, is made in the Company's
capitalization which results in an exchange of Common Stock for a greater or
lesser number of shares without receipt of consideration, an appropriate
adjustment will be made in the exercise price of, and the number of shares
subject to, all outstanding options under the Employees Plan, and an appropriate
adjustment will be made in the total number of shares reserved for issuance
under the Employees Plan. In the event of a merger or a consolidation of the
Company with any other corporation in which the Company is not the surviving
corporation and in which the surviving corporation does not assume the
obligations of the Company under the Employees Plan, all options outstanding
under the Employees Plan will be automatically accelerated and become
exercisable. Any options not exercised prior to the merger or consolidation will
lapse.

In the event of a proposed dissolution or liquidation of the Company, each
option outstanding under the Employees Plan will terminate immediately prior to
consummation of such proposed action. In the event of a sale of all or
substantially all of the assets of the Company or subsidiary of the Company or
the merger of the Company or one of its subsidiaries with or into another
corporation, unless each outstanding option will be assumed or an equivalent
option will be substituted by the successor corporation in the transaction or by
a parent or subsidiary of such successor corporation, the optionee shall have
the right to exercise the option as to all of the shares subject thereto,
including shares as to which the option would not otherwise be exercisable. In
this case, the option will be fully exercisable for a period of 30 days from the
date of such notice, and the option will terminate upon the expiration of such
period.

The Plan is administered by the Compensation Committee of the Board of
Directors. Subject to the terms of the Employees Plan, the Compensation
Committee has the authority to interpret the Employees Plan and all decisions,
determinations and interpretations of the Compensation Committee shall be final
and binding on the employees participating in the Employees Plan.

1994 Directors Stock Option Plan

The 1994 Directors Stock Option Plan (the "Directors Plan") was adopted by
the Board of Directors and approved by the shareholders in 1994. Originally,
200,000 shares of the Company's Common Stock were reserved for issuance upon
exercise of options granted under the Directors Plan. A subsequent 1-for-3 share
reverse stock split in 1995 followed by an Amendment to the Directors Plan have
resulted in the number of shares reserved for issuance upon exercise of options
granted under the Directors Plan remaining at 200,000. The Directors Plan
terminates on the last day of February, 2004, and no options may be granted
under the Directors Plan thereafter.

The Directors Plan provides for the automatic grant of an option to each
nonemployee director upon his or her election to the Board, entitling the
optionee to purchase up to a total of 5,000 shares of Common Stock, at an
exercise price equal to the fair market value for such shares as of the date of
grant. On each anniversary of such first election, provided that the individual
continues to serve as a director, he or she will automatically receive an
additional grant of an option for the same number of shares, exercisable again
at the fair market value as of the date of the grant.

25
<PAGE> 28

Each option granted under the Directors Plan may be exercised in whole or
in part at any time beginning upon conclusion of one year following the date of
grant until the expiration or earlier termination of the option. During his or
her lifetime, only the director who is the recipient of the option grant may
exercise the option. If a director is terminated with cause, as defined in the
Directors Plan, his or her option ceases to be exercisable and terminates upon
the effective date of termination. If a director ceases to serve on the Board
and his or her departure from the Board is not for cause, as defined, the option
is exercisable for a period of 90 days following the date when the director's
tenure on the Board ceases, but in no event later than the date of expiration of
the option in accordance with the terms of the Directors Plan. In the event a
director ceases to serve on the Board as a result of disability, as defined in
the Directors Plan, or if the director's death occurs while serving on the Board
or within 90 days following the date when he or she ceases to so serve, the
option must be exercised within 12 months following the date when the director
no longer is serving on the Board, subject to earlier expiration in accordance
with the terms of the Directors Plan. Options under the Directors Plan expire 10
years from their respective date of grant, unless subject to earlier
termination.

In the event of a proposed dissolution or liquidation of the Company, each
option outstanding under the Directors Plan will terminate immediately prior to
consummation of such proposed action. In the event of a sale of all or
substantially all of the assets of the Company or subsidiary of the Company or
the merger of the Company or one of its subsidiaries with or into another
corporation, unless each outstanding option will be assumed or an equivalent
option will be substituted by the successor corporation in the transaction or by
a parent or subsidiary of such successor corporation, the optionee shall have
the right to exercise the option as to all of the shares subject thereto,
including shares as to which the option would not otherwise be exercisable. In
this case, the option will be fully exercisable for a period of 30 days from the
date of such notice, and the option will terminate upon the expiration of such
period.

The Plan is administered by the Board of Directors. Subject to the terms of
the Directors Plan, the Board has the authority to interpret the Directors Plan
and all decisions, determinations and interpretations of the Board shall be
final and binding on the directors participating in the Directors Plan.

Krause's Sofa Factory Stock Option Plans

Krause's Sofa Factory also has in effect several stock option plans which
were established prior to the time it was acquired by merger by the Company.
Those plans are inactive and the Company has no intention of granting any
options under any of them. Nonetheless, there are currently options to purchase
an aggregate of 11,880 shares of the Company's Common Stock outstanding under
the plans to two employees. The options were originally granted for the purchase
of Krause's Sofa Factory stock, but were converted into options to purchase the
Company's Common Stock in connection with the merger.

EMPLOYMENT AGREEMENTS

In August 1996, the Company entered into an Employment Agreement with
Philip M. Hawley pursuant to which the Company agreed to pay Mr. Hawley a base
salary at the rate of $225,000 per year and provide benefits for a period of
three years upon his termination by the Company without cause (as defined in the
Employment Agreement) or upon his resignation from the Company upon a change in
control (as defined in the Employment Agreement). Furthermore, the Company
agreed to grant Mr. Hawley an option to purchase 1,234,000 shares of Common
Stock at an exercise of price of $1.00 per share with vesting over three years.
In the event of a change in control, the right to exercise the options would
accelerate.

Several of the officers and employees of the Company are subject to
employment agreements that provide for the payment of severance benefits equal
to such officers' or employees' monthly salary plus benefits for up to 12 months
if terminated without cause. Steven P. Anderson, whose employment will terminate
by the end

26
<PAGE> 29

of January 1997, is among the officers of the Company subject to such an
employment agreement. The aggregate amount of severance payments to Mr. Anderson
will be approximately $250,000.

Robert G. Sharpe will terminate his employment with the Company effective
January 31, 1997. In connection with the termination of his employment, Mr.
Sharpe is entitled to severance equal to his monthly salary plus benefits
through January 1999. The aggregate amount of such payments will be
approximately $360,000.

27
<PAGE> 30

CERTAIN TRANSACTIONS

During 1996 and 1995 a number of transactions occurred between the Company
and its subsidiaries and certain directors and their affiliates. The Company
believes that each such arrangement was as fair as could have been obtained from
unaffiliated persons.

Corporate Recapitalization. On August 26 and September 10, 1996, the
Company received $18,735,000 in equity and debt financing from existing
stockholders of the Company and from new investors including General Electric
Capital Corporation ("GECC"), Mr. Philip M. Hawley and certain trusts for the
benefit of relatives of Mr. Hawley. Mr. Hawley also became the Company's
Chairman and Chief Executive Officer. Mr. Hawley is the former Chairman and
Chief Executive Officer of The Broadway Stores, Inc. (formerly Carter Hawley
Hale Stores, Inc.) Also in connection with the transactions, Mr. Jeffrey H.
Coats became a member of the Company's Board of Directors. Mr. Coats is a
Managing Director of GE Capital Equity Capital Group, Inc., a wholly-owned
subsidiary of General Electric Capital Corporation.

The financing (the "GECC financing") consisted of equity and subordinated
debt, including:

- The purchase by GECC of (1) 5,000,000 newly issued shares of Common Stock
at a purchase price of $1.00 per share and (2) a 10% Subordinated Note in
the amount of $5,000,000. As part of this transaction, GECC also received
warrants to purchase an additional 1,400,000 shares of Common Stock at a
purchase price of $.001 per share, exercisable in whole or in part at any
time or from time to time until August 31, 2006.

- The purchase by new investors, including Mr. Hawley, and certain of the
Company's existing stockholders, including the Permal Group, of 5,669,000
new shares of Common Stock at $1.00 per share.

- The cancellation of $2,950,000 principal amount of existing promissory
notes in the Company, plus accrued interest of $116,251, in consideration
for the issuance to the noteholders of 3,066,251 shares of Common Stock.

In addition, substantially all of the Company's outstanding shares of
Series A Preferred Stock were converted into approximately 1,176,950 shares of
Common Stock.

The shares of Common Stock acquired by GECC represent approximately 26.3%
of the outstanding shares of the Common Stock of the Company, or 28.9% on a
fully-diluted basis. In addition, as part of the GECC financing, certain of the
Company's stockholders have given GECC the right while indebtedness remains
payable by the Company to GECC, to direct the voting of their shares under the
circumstances set forth in a Stockholders Agreement dated August 26, 1996. In
effect, GECC may exercise voting control of the Company pursuant to these
arrangements. (See "Description of Capital Stock" below.)

As part of the GECC financing, the Company has entered into a Registration
Rights Agreement permitting GECC and the other new and existing stockholders who
participated in the GECC financing to demand the registration of their shares
under the Securities Act of 1933 and to participate in registered offerings made
by the Company of its shares, under the circumstances and subject to the
conditions set forth in the Registration Rights Agreement. (See "Description of
Capital Stock" below.)

In conjunction with the GECC financing, Krause's Sofa Factory amended its
revolving credit agreement with Congress Financial Corporation. Under the
revised facility, the term of the loan was extended to January 20, 2000, the
interest rate was reduced to prime plus 1%, and the borrowing capacity was
increased.

Transactions with Michael W. Gibbons. Mr. Gibbons resigned as Chief
Executive Officer of the Company and Krause's Sofa Factory in April 1995.
Pursuant to a severance agreement with the Company, Mr. Gibbons is to receive
certain severance payments. The severance arrangements also confer a put option
on Mr. Gibbons entitling him, at his option, over a period expiring April 30,
2002, to sell his shares to the Company at a price of $1.60 per share, with
downward adjustments in certain instances. The Company must accept an exercise
of the put option in a minimum aggregate purchase price for the shares being put
in any month of $25,000. The Company's obligation to purchase shares in excess
of the minimum, up to a maximum

28
<PAGE> 31

of $80,000 in any given month, is tied to a formula of available cash. The
Company purchased 7,619 shares for $20,000 in 1995 upon exercise by Mr. Gibbons
of his put right with respect to such shares. The balance of shares owned by Mr.
Gibbons were sold in the open market and the Company paid $4,500 to Mr. Gibbons
in 1996, thereby completing the Company's obligation to purchase shares in
future periods.

Transactions with Bernadette Castro. Krause's Sofa Factory leases five
showrooms and a distribution center from Bernadette Castro, her family and
various entities controlled by the Castro family. During 1995 Krause's Sofa
Factory paid approximately $824,669 for rents under these leases. Ms. Castro was
a member of the Board of Directors of the Company from September 1993 until she
resigned in March 1996.

Transactions with PCMI. In 1996 and 1995, PCMI provided various management
services for the Company and its subsidiaries, for which PCMI received $58,333
and $100,000, respectively. PCMI's executive management services for the Company
included assistance with regard to executive management, financial consulting
and strategic planning during the year. Thomas M. DeLitto, President of PCMI,
served as President and Chief Executive Officer of the Company from January to
December 1994, served as Chief Executive Officer from April 1995 to August 1996
and is currently Vice Chairman of the Board of Directors.

29
<PAGE> 32

PRINCIPAL AND SELLING STOCKHOLDERS

The following table sets forth certain information with respect to
beneficial ownership of the Company's Common Stock as of December 31, 1996, and
as adjusted to reflect this offering (1) by each person (or group of affiliated
persons) who is known by the Company to own beneficially more than 5% of the
Company's Common Stock, (2) by each of the Company's directors, (3) by all
executive officers and directors as a group and (4) by each of the Selling
Stockholders.

<TABLE>
<CAPTION>
SHARES BENEFICIALLY
OWNED NUMBER OF SHARES SHARES BENEFICIALLY
PRIOR TO OFFERING(1) BEING OFFERED OWNED AFTER OFFERING
----------------------- ---------------- --------------------
NAME AND ADDRESS OF BENEFICIAL OWNER NUMBER PERCENT NUMBER PERCENT
- ------------------------------------ ---------- ------- ---------- -------
<S> <C> <C> <C> <C> <C>
5% STOCKHOLDERS, EXECUTIVE OFFICERS
AND DIRECTORS
General Electric Capital
Corporation....................... 6,400,000(2) 31.3% -- 6,400,000 31.3%
260 Long Ridge Road
Stamford, CT 06927
Worms & Cie......................... 5,428,656(3) 28.4 -- 5,428,656 28.4
c/o Worms & Co., Inc.
900 Third Avenue
New York, NY 10022
Edson Investments, Inc.............. 2,096,111(4) 11.0 -- 2,096,111 11.0
Tropic Isle Building
Road Town, Tortola
British Virgin Islands
ATCO Holdings Limited............... 1,115,923 5.9 -- 1,115,923 5.9
c/o ATCO Development, Inc.
11777 Katy Freeway
Houston, TX 77079
John F. Hawley and Barbara H.
Hawley, as Trustees............... 1,050,000(5) 5.5 1,050,000(5) -- --
515 South Figueroa Street
Los Angeles, CA 90071
Philip M. Hawley.................... 338,500(6) 1.8 -- 338,500 1.8
Thomas M. DeLitto................... 94,199(7) * -- 94,199 *
Kamal G. Abdelnour.................. 32,325(8) * -- 32,325 *
Jeffrey H. Coats.................... -- -- -- -- --
Peter H. Dailey..................... -- -- -- -- --
John A. Gavin....................... -- -- -- -- --
Stephen P. Anderson................. 35,557(9) * -- 30,001 *
Robert G. Sharpe.................... 87,096(10) * 25,528 65,905 *
All directors and executive officers
as a group (9 persons)............ 13,532,256(11) 64.6 25,528 13,506,728 64.6
OTHER SELLING STOCKHOLDERS
Permal Noscal Ltd................... 624,616 3.3 405,000 219,616 1.2
Zaxis Partners, L.P................. 46,667 * 40,000 6,667 *
Sidney Kimmel....................... 60,464 * 50,000 10,464 *
Pollat, Evans & Co., Inc............ 17,737 * 15,000 2,737 *
Quadra Appreciation Fund, Inc....... 5,000 * 5,000 -- --
Branagh Revocable Trust............. 8,710 * 5,000 3,710 *
Sanford J. Colen.................... 36,764 * 20,000 16,764 *
C. Redington Barrett, III........... 7,126 * 5,000 2,126 *
Hurley & Co.(12).................... 66,666 * 35,000 31,666 *
</TABLE>

30
<PAGE> 33

<TABLE>
<CAPTION>
SHARES BENEFICIALLY
OWNED SHARES BENEFICIALLY
PRIOR TO OFFERING(1) OWNED AFTER OFFERING
----------------------- NUMBER OF SHARES --------------------
NAME AND ADDRESS OF BENEFICIAL OWNER PERCENT BEING OFFERED NUMBER PERCENT
- ------------------------------------ ------- ---------------- ---------- -------
NUMBER
----------
<S> <C> <C> <C> <C> <C>
G(2) Investment Partners............ 110,190 * 90,000 20,190 *
Fairmont Services Ltd............... 429,009 2.3 400,000 29,009 *
Carlton Securities N.V.............. 108,822 * 100,000 8,822 *
Emmanual Bagdjian................... 210,000 1.1 210,000 -- --
Heliopolis Inc...................... 100,000 * 100,000 -- --
T. Michael Wallace.................. 400,000 2.1 400,000 -- --
Gary S. Gladstein................... 212,668 1.1 200,000 12,668 *
Peter L. Rhulen..................... 100,000 * 100,000 -- --
Maureen Erin Hawley Trust I(5)...... 112,500 * 112,500 -- --
Allison Booth Hawley Trust I(5)..... 112,500 * 112,500 -- --
Caitlin Hale Hawley Trust I(5)...... 112,500 * 112,500 -- --
Shannon Follen Hawley Trust I(5).... 112,500 * 112,500 -- --
Maureen Erin Hawley Trust II(5)..... 25,000 * 25,000 -- --
Allison Booth Hawley Trust II(5).... 25,000 * 25,000 -- --
Caitlan Hale Hawley Trust II(5)..... 25,000 * 25,000 -- --
Shannon Follen Hawley Trust II(5)... 25,000 * 25,000 -- --
Hawley Family Trust(5).............. 500,000 2.6 500,000 -- --
H.D. Investment Group, Inc.......... 117,000 * 25,000 92,000 *
Morgan Adams, Inc................... 120,000 * 50,000 70,000 *
Theodore D. Konopisos............... 32,333(13) * 22,000 10,333 *
William A. MacLaughlin IRA.......... 25,000 * 25,000 -- --
Gregory M. Simon.................... 20,000 * 20,000 -- --
Hugh H. Wilson, Jr.................. 15,000 * 15,000 -- --
Codell Holdings Ltd................. 100,000 * 100,000 -- --
J. Stephen Emerson IRA.............. 100,000 * 100,000 -- --
J. Stephen Emerson.................. 100,000 * 100,000 -- --
Paul Marciano Trust................. 100,000 * 100,000 -- --
G. Tyler Runnels.................... 76,063 * 50,000 26,063 *
Charles Perez....................... 100,000 * 100,000 -- --
JMG Capital Partners L.P............ 50,000 * 50,000 -- --
William C. Miller, IV............... 42,000(14) * 25,000 17,000 *
Tendencia Investments Overseas...... 250,000 1.3 250,000 -- --
Lawrence S. Black................... 50,000 * 50,000 -- --
Ian and Francine Jack............... 10,000 * 10,000 -- --
Keith and Tanya Jacobs.............. 10,000 * 10,000 -- --
J. Richard Cordsen.................. 47,000 * 27,000 20,000 *
J.D. Yates.......................... 10,000 * 10,000 -- --
</TABLE>

- ---------------
* Less than one percent

(1) Outstanding warrants and options held by each of the principal
stockholders, directors and executive officers which are exercisable
currently or within 60 days of the date of this table are deemed to be
outstanding shares of Common Stock for their respective calculations.

(2) Includes a warrant to purchase 1,400,000 shares of Common Stock.

(3) Worms & Cie, through its affiliates, is deemed to be the beneficial owner
of 5,288,240 shares of Common Stock and warrants to purchase 122,518 shares
of Common Stock.

31
<PAGE> 34

(4) Edson Investments, Inc. is an affiliate of Worms & Cie. Therefore, shares
beneficially owned by Edson Investments, Inc. are also included above as
shares beneficially owned by Worms & Cie.

(5) As trustees for various Hawley Trusts, John F. Hawley and Barbara H. Hawley
are deemed to be beneficial owners of such shares. The shares owned by each
of the various trusts is reflected below in the same Table under "Other
Selling Stockholders."

(6) Includes options to purchase 308,500 shares of Common Stock.

(7) Includes options to purchase 4,998 shares of Common Stock and a warrant to
purchase 14,163 shares of Common Stock.

(8) Includes a warrant to purchase 32,325 shares of Common Stock.

(9) Represents options to purchase 30,001 shares of Common Stock.

(10) Includes options to purchase 17,332 shares of Common Stock.

(11) Includes shares deemed beneficially owned by General Electric Capital
Corporation, Worms & Cie and ATCO Holdings Limited since directors of the
Company are affiliated with those entities.

(12) Nominee for Banque Cantonale Valdoise.

(13) Includes 10,333 shares owned by the Konopisos Family Trust.

(14) Includes 17,000 shares owned by minor children of Mr. Miller, who is deemed
to be the beneficial owner of such shares.

PLAN OF DISTRIBUTION

The Selling Stockholders, directly or through agents designated by them,
may sell from time to time all or part of the Common Stock in amounts and on
terms to be determined at the time of sale or in the open market at the market
price on each date of sale. The Selling Stockholders may also pledge such shares
as collateral, and such shares could be sold pursuant to the terms of such
pledges. The Selling Stockholders reserve the sole right to accept and, together
with the agents retained by them from time to time, to reject in whole or in
part any proposed purchase of the Common Stock to be made directly or through
agents. The Selling Stockholders and brokers who execute orders on their behalf
may be deemed underwriters as that term is used in Section 2(11) of the
Securities Act, and a portion of the proceeds of sales and commissions may
therefore be deemed underwriting compensation for purposes of the Securities
Act.

DESCRIPTION OF CAPITAL STOCK

The authorized capital stock of the Company consists of 35,000,000 shares
of Common Stock, par value $0.001 per share (the "Common Stock") and 666,667
shares of Preferred Stock, par value $0.001 per share (the "Preferred Stock").

COMMON STOCK

As of December 31, 1996, there were issued and outstanding 19,020,539
shares of Common Stock, warrants to purchase an additional 1,754,956 shares of
Common Stock and options to purchase an additional 1,395,457 shares of Common
Stock. The holders of Common Stock (but not warrant holders or optionees) are
entitled to dividends and distributions, if any, with respect to the Common
Stock when, as and if declared by the Board of Directors from funds legally
available therefor. Holders of Common Stock are entitled to one vote per share
and are not entitled to cumulative voting in the election of directors. The
holders of Common Stock have no preemptive, subscription, redemption or
conversion rights. In the event of the liquidation, dissolution or winding up of
the Company, the holders of Common Stock are entitled to share rateably in all
assets remaining after payment of all debts and other liabilities, subject to
prior distribution rights of holders of Preferred Stock, if any, then
outstanding.

32
<PAGE> 35

PREFERRED STOCK

The Company's Board of Directors is authorized to divide the Preferred
Stock into series and, with respect to each series, to determine the
preferences, rights, qualifications, limitations and restrictions thereof,
including the dividend rights, conversion rights, voting rights, redemption
rights and terms, liquidation preferences, sinking fund provisions, number of
shares constituting a series and the designation of such series. Although the
Company currently does not have any plans to issue shares of Preferred Stock or
to designate any new series of Preferred Stock, there can be no assurance that
the Company will not do so in the future. The Board of Directors could, without
stockholder approval, issue Preferred Stock with voting and other rights that
could adversely affect the voting power of the holders of Common Stock and could
have certain anti-takeover effects.

The Company's Board of Directors has designated two series of Preferred
Stock, Series A Preferred Stock and Series B Preferred Stock, and has authorized
the issuance of up to a total of 200,000 shares of Series A Preferred Stock and
44,444 shares of Series B Preferred Stock. All previously issued shares of
Series A Preferred Stock and Series B Preferred Stock have been converted into
Common Stock.

WARRANTS

As of the date of this Prospectus, the Company has warrants outstanding to
purchase an aggregate of 1,754,956 shares of its Common Stock. One million four
hundred thousand of such shares are subject to a warrant issued to GECC at a
exercise price of $0.001 per share exercisable in whole or in part at any time
or from time to time until August 31, 2006. Warrants to purchase an additional
354,956 shares of Common Stock at exercise prices ranging from $1.33 to $15.00
per share with expiration dates ranging from May 1998 to June 2005 are also
outstanding. The warrants generally provide for certain antidilution
adjustments.

REGISTRATION RIGHTS

After this Offering, holders of 9,340,723 shares of Common Stock will be
entitled to certain rights with respect to the registration of such shares under
the Securities Act, pursuant to a certain Registration Rights Agreement dated as
of August 26, 1996, as amended, among such holders and the Company (the
"Registration Rights Agreement"). Under the terms of the Registration Rights
Agreement, if the Company hereafter proposes to register any of its securities
under the Securities Act, either for its own account or for the account of other
security holders exercising registration rights, such holders are entitled to
notice of such registration and are entitled to include shares of Common Stock
therein. Stockholders benefiting from these rights may also require the Company
to file a registration statement under the Securities Act with respect to their
shares of Common Stock, and the Company is required to use best efforts to
effect up to two such registrations during any 12-month period. This right is
not exercisable prior to August 31, 1999, unless certain conditions are
satisfied. Further, these rights are subject to certain conditions and
limitations, among them the right of the underwriter of an offering to limit the
number of shares included in such registration and the right of the Company not
to effect a requested registration within 180 days following the offering of the
Company's securities in another public offering.

STOCKHOLDERS AGREEMENT

As of August 26, 1996, in connection with the GECC financing described
under "Certain Transactions" above, the Company entered into a stockholders
agreement (the "Stockholders Agreement") with several of the investors in the
GECC financing, including General Electric Capital Corporation as well as
certain existing stockholders. The Stockholders Agreement provides, among other
things, for certain restrictions on the transfer of shares by those stockholders
who are parties to the Stockholders Agreement and confers rights of first offer
to GECC in the event certain of the stockholders wish to sell their shares.
Furthermore, the Stockholders Agreement allows for GECC to name one director to
the Board of Directors of the Company, allows the Permal Group (as defined in
the Stockholders Agreement) to designate another director, provides that Philip
M. Hawley will be a third director, and provides that the three remaining
directors (the "Joint Designees") will be selected by Mr. Hawley and the
directors who are designated by GECC and the Permal

33
<PAGE> 36

Group. At each meeting of the stockholders of the Company held for the purpose
of electing directors, the stockholders who are parties to the Stockholders
Agreement (with the exception of certain trusts) are required to vote to cause
the GECC designee, the Permal Group designee, Mr. Hawley and the Joint Designees
to be elected as directors. In addition, the Company is prohibited from taking
certain actions unless the GECC designee on the Board of Directors approves such
action. Such restricted actions include mergers; liquidations and dissolutions;
acquisitions of all or a substantial portion of the business or the assets of
another person; the entering into of a joint venture or partnership arrangement;
expansion into new lines of business; the sale, lease or transfer of any assets
of the Company or any of its subsidiaries except for sales of inventory in the
ordinary course of business and the subleasing of vacant retail space; the
adoption or change of any material accounting policy; the creation of any
additional indebtedness (with certain exceptions); the granting of liens against
the Company's assets; the payment of dividends or the redemption of capital
stock; the making or commitment to make of any capital expenditure in any year
in excess of $50,000; the issuance or sale of any shares of capital stock or
rights to purchase capital stock; the entering into, adoption, amendment or
termination of any employment or consulting agreement or the hiring of any
person who will report directly to the Chief Executive Officer or to whom total
compensation would be in the excess of $110,000 per year; the adoption or
amendment of any employment benefit plan; the amendment of the Company's charter
documents; a change in independent certified accountants or actuaries; the
registration of any security under the Securities Act or the granting of any
registration rights therefor; certain related party transactions; changes to the
Company's annual business plan; and any action which is required by law to be
approved by the Board of Directors.

The Stockholders Agreement further provides that each member of the Permal
Group will vote all of its shares in the same manner that GECC votes its shares
with respect to each matter subject to the vote or consent of stockholders of
the Company. In the event GECC or any member of the Permal Group, pursuant to a
common plan, were to enter into any agreement to sell to any person or group in
one transaction or series of related transactions in which such group would sell
in excess of 3,000,000 shares, then each of the other stockholders party to the
Stockholders Agreement would have the right to participate in such sale. The
Stockholders Agreement will terminate at such time as GECC is no longer the
beneficial owner of at least 2,000,000 of the outstanding shares of Common
Stock, or at such earlier time as may be agreed by GECC and the Permal Group.
Furthermore, the Stockholders Agreement will terminate as to any member of the
Hawley Group on the later of (1) six months after Mr. Hawley ceases to be a
Director of the Company and (2) August 31, 1999.

TRANSFER AGENT AND REGISTRAR

The Transfer Agent and Registrar for the Common Stock is First National
Bank of Boston.

LEGAL MATTERS

The validity of the Common Stock offered hereby will be passed upon by
Wendel, Rosen, Black & Dean, LLP, Oakland, California.

EXPERTS

The consolidated financial statements of Krause's Furniture, Inc. as of
January 28, 1996 and January 29, 1995, and for the fiscal years ended January
28, 1996, December 31, 1994 and December 31, 1993, and for the month ended
January 29, 1995, appearing in this Prospectus and Registration Statement have
been audited by Ernst & Young LLP, independent auditors, as set forth in their
report thereon appearing elsewhere herein which, as to the year ended December
31, 1993, is based in part on the report of KPMG Peat Marwick LLP, independent
auditors. The consolidated financial statements referred to above are included
in reliance upon such reports, given upon the authority of such firms as experts
in accounting and auditing.

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<PAGE> 37

ADDITIONAL INFORMATION

The Company has filed with the Securities and Exchange Commission (the
"Commission") a Registration Statement on Form S-1 (together with all amendments
and exhibits thereto, the "Registration Statement") under the Securities Act
with respect to the shares of Common Stock offered hereby. This Prospectus does
not contain all of the information set forth in the Registration Statement,
certain parts of which are omitted in accordance with the rules and regulations
of the Commission. For further information with respect to the Company and the
shares of Common Stock offered hereby, reference is made to the Registration
Statement. Statements contained in this Prospectus as to the contents of any
contract or other document are not necessarily complete, and in each instance
reference is made to the copy of such contract or other document filed as an
exhibit to the Registration Statement, each such statement being qualified in
all respects by such reference. Copies of such materials may be examined without
charge at, or obtained upon payment of prescribed fees from, the Public
Reference Section of the Commission at Room 1024 Judiciary Plaza, 450 Fifth
Street, N.W., Washington, D.C. 20549, and at the Commission's regional offices
located at 500 West Madison Street, Suite 1400, Chicago, Illinois 60661 and at 7
World Trade Center, 13th Floor, New York, New York 10048. The Commission
maintains a World Wide Web site that contains reports, proxy and information
statements and other information regarding registrants that file electronically
with the Commission. The address of the site is http://www.sec.gov.

35
<PAGE> 38

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Ernst & Young LLP, Independent Auditors..................................... F-1
Report of KPMG Peat Marwick LLP....................................................... F-2
Consolidated Balance Sheet at January 28, 1996 and January 29, 1995................... F-3
Consolidated Statement of Operations for the fiscal years ended January 28, 1996,
December 31, 1994 and December 31, 1993............................................. F-4
Consolidated Statement of Stockholders' Equity for the period from January 1, 1993 to
January 28, 1996.................................................................... F-5
Consolidated Statement of Cash Flows for the fiscal years ended January 28, 1996,
December 31, 1994 and December 31, 1993............................................. F-6
Consolidated Statement of Operations for the months ended January 29, 1995, and
January 30, 1994.................................................................... F-7
Consolidated Statement of Cash Flows for the months ended January 29, 1995, and
January 30, 1994.................................................................... F-8
Notes to Consolidated Financial Statements............................................ F-9
Unaudited Consolidated Balance Sheet at October 27, 1996.............................. F-18
Unaudited Consolidated Statement of Operations for the thirty-nine weeks ended October
27, 1996 and October 29, 1995....................................................... F-19
Unaudited Consolidated Statement of Stockholders' Equity for the thirty-nine weeks
ended October 27, 1996.............................................................. F-20
Unaudited Consolidated Statement of Cash Flows for the thirty-nine weeks ended October
27, 1996 and October 29, 1995....................................................... F-21
Notes to Unaudited Consolidated Financial Statements.................................. F-22
</TABLE>

36
<PAGE> 39

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Krause's Furniture, Inc.

We have audited the consolidated balance sheets of Krause's Furniture, Inc.
as of January 28, 1996 and January 29, 1995, and the related consolidated
statements of operations, stockholders' equity, and cash flows for the fiscal
years ended January 28, 1996, December 31, 1994 and December 31, 1993 and for
the month ended January 29, 1995. 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. The financial
statements of Mr. Coffee, inc. (a corporation in which the Company had an 18%
interest) for the year ended December 26, 1993 have been audited by other
auditors whose report has been furnished to us; insofar as our opinion on the
consolidated financial statements for the year ended December 31, 1993 relates
to data included for Mr. Coffee, inc., it is based solely on their report.

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 and the report of other auditors provide a reasonable
basis for our opinion.

In our opinion, based on our audits and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Krause's Furniture,
Inc. at January 28, 1996 and January 29, 1995, and the consolidated results of
its operations and its cash flows for the fiscal years ended January 28, 1996,
December 31, 1994 and December 31, 1993 and for the month ended January 29,
1995, in conformity with generally accepted accounting principles.

/s/ ERNST & YOUNG LLP

Orange County, California
April 26, 1996, except for Notes 1 and 4,
as to which the date is May 10, 1996

F-1
<PAGE> 40

REPORT OF KPMG PEAT MARWICK LLP

The Board of Directors
Mr. Coffee, inc.

We have audited the statement of operations of Mr. Coffee, inc. for the year
ended December 26, 1993. This financial statement (not presented separately
herein) is the responsibility of the Company's management. Our responsibility is
to express an opinion on this financial statement based on our audit.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, the financial statement referred to above presents fairly, in
all material respects, the results of Mr. Coffee, inc.'s operations for the year
ended December 26, 1993 in conformity with generally accepted accounting
principles.

/s/ KPMG Peat Marwick LLP
Cleveland, Ohio
February 18, 1994

F-2
<PAGE> 41

KRAUSE'S FURNITURE, INC.

CONSOLIDATED BALANCE SHEET
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
JANUARY 28, JANUARY 29,
1996 1995
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents........................................... $ 1,336 $ 1,952
Accounts receivable, net of allowance for doubtful accounts of $291
($616 at January 29, 1995)....................................... 786 1,190
Inventories......................................................... 14,627 18,016
Income tax refund receivable........................................ 1,467 --
Deferred income taxes............................................... -- 920
Prepaid expenses.................................................... 386 1,450
-------- --------
Total current assets........................................ 18,602 23,528
Property, equipment, and leasehold improvements, net.................. 6,738 6,519
Goodwill, net......................................................... 16,406 17,425
Leasehold interests, net.............................................. 1,830 2,485
Other assets.......................................................... 3,290 3,793
-------- --------
$ 46,866 $ 53,750
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses............................... $ 16,176 $ 17,542
Accrued payroll and related expenses................................ 1,696 1,704
Customer deposits................................................... 7,014 6,809
Notes payable....................................................... 19 17
Income taxes payable................................................ 575 1,207
-------- --------
Total current liabilities................................... 25,480 27,279
Long-term liabilities:
Note payable........................................................ 5,584 2,181
Other liabilities................................................... 1,817 1,590
-------- --------
Total long-term liabilities................................. 7,401 3,771

Commitments and contingencies
Stockholders' equity:
Convertible preferred stock, $.001 par value; 666,667 shares
authorized (2,000,000 at January 29, 1995) 117,694 shares
outstanding (483,780 at January 29, 1995) at stated value
(liquidation preference $67.50 per share)........................ 7,523 10,455
Common stock, $.001 par value; 8,333,333 shares authorized
(25,000,000 at January 29, 1995), 4,120,810 shares outstanding
(11,054,953 at January 29, 1995)................................. 4 11
Capital in excess of par value...................................... 27,419 24,480
Accumulated deficit................................................. (20,961) (12,246)
-------- --------
Total stockholders' equity.................................. 13,985 22,700
-------- --------
$ 46,866 $ 53,750
======== ========
</TABLE>

See accompanying notes.

F-3
<PAGE> 42

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
FISCAL YEARS ENDED
---------------------------------------------
JANUARY 28, DECEMBER 31, DECEMBER 31,
1996 1994 1993
----------- ------------ ------------
<S> <C> <C> <C>
Net furniture sales.................................... $ 122,319 $116,471 $ 96,984
Cost of sales.......................................... 59,852 53,522 46,192
-------- -------- -------
Gross profit........................................... 62,467 62,949 50,792
Operating expenses:
Selling.............................................. 60,257 53,460 48,330
General and administrative........................... 10,578 10,867 9,574
Amortization of goodwill............................. 1,020 1,020 740
-------- -------- -------
71,855 65,347 58,644
-------- -------- -------
Loss from operations................................... (9,388) (2,398) (7,852)
Gain from sale of Mr. Coffee stock..................... -- 12,115 --
Equity in earnings of Mr. Coffee....................... -- 316 1,208
Interest expense....................................... (721) (2,140) (3,399)
Other income........................................... 67 109 292
-------- -------- -------
Income (loss) before income taxes and extraordinary
item................................................. (10,042) 8,002 (9,751)
Provision (benefit) for income taxes................... (1,327) 2,171 --
-------- -------- -------
Income (loss) before extraordinary item................ (8,715) 5,831 (9,751)
Extraordinary loss from debt retirement, net of income
tax.................................................. -- (436) (221)
-------- -------- -------
Net income (loss)...................................... $ (8,715) $ 5,395 $ (9,972)
======== ======== =======
Income (loss) per share:
Income (loss) before extraordinary item.............. $ (2.21) $ 1.08 $ (3.88)
Extraordinary loss................................... -- (0.08) (0.09)
-------- -------- -------
Net income (loss).................................... $ (2.21) $ 1.00 $ (3.97)
======== ======== =======
Average number of common and common equivalent shares
outstanding.......................................... 3,950 5,394 2,510
</TABLE>

See accompanying notes.

F-4
<PAGE> 43

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)

<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK CAPITAL IN TOTAL
---------------- --------------- EXCESS OF ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT PAR VALUE DEFICIT EQUITY
------ ------- ------ ------ ---------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1992... -- $ -- 6,939 $ 7 $ 15,611 $ (4,448) $11,170
Issuance of common stock by
subsidiary................... -- -- -- -- 50 -- 50
Proceeds from issuance of
preferred stock, net of
expenses of $364............. 547 11,856 -- -- -- -- 11,856
Purchase of warrants........... -- -- -- -- (75) -- (75)
Issuance of common stock
related to exercise of stock
options...................... -- -- 8 -- 8 -- 8
Issuance of common stock and
options in merger of
subsidiary, net of expenses
of $200...................... -- -- 3,522 3 7,586 -- 7,589
Net loss....................... -- -- -- -- -- (9,972) (9,972)
---- ------- ------ --- ------- -------- -------
Balance at December 31, 1993... 547 11,856 10,469 10 23,180 (14,420) 20,626
Conversion of Series A
preferred stock.............. (63) (1,401) 636 1 1,400 -- --
Repurchase of common stock..... -- -- (55) -- (105) -- (105)
Issuance of common stock
related to exercise of stock
options...................... -- -- 5 -- 5 -- 5
Net income..................... -- -- -- -- -- 5,395 5,395
---- ------- ------ --- ------- -------- -------
Balance at December 31, 1994... 484 10,455 11,055 11 24,480 (9,025) 25,921
Net loss January 1995.......... -- -- -- -- -- (3,221) (3,221)
---- ------- ------ --- ------- -------- -------
Balance at January 29, 1995.... 484 10,455 11,055 11 24,480 (12,246) 22,700
Conversion of Series B
preferred stock.............. (119) (2,674) 1,190 1 2,673 -- --
Reverse stock split............ (235) -- (8,163) (8) 8 -- --
Conversion of Series A
preferred stock.............. (12) (258) 39 -- 258 -- --
Net loss....................... -- -- -- -- -- (8,715) (8,715)
---- ------- ------ --- ------- -------- -------
Balance at January 28, 1996.... 118 $ 7,523 4,121 $ 4 $ 27,419 $ (20,961) $13,985
==== ======= ====== === ======= ======== =======
</TABLE>

See accompanying notes.

F-5
<PAGE> 44

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FISCAL YEARS ENDED
---------------------------------------------
JANUARY 28, DECEMBER 31, DECEMBER 31,
1996 1994 1993
----------- ------------ ------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss).................................... $(8,715) $ 5,395 $ (9,972)
Adjustments to reconcile net income (loss) to net cash
used by operating activities:
Depreciation and amortization........................ 2,760 3,501 3,189
Deferred income taxes................................ 920 (920) --
Write off of leasehold interests and improvements.... 283 342 --
Gain from sale of Mr. Coffee stock................... -- (12,115) --
Equity in earnings of Mr. Coffee..................... -- (316) (987)
Gain from debt retirement............................ -- 727 --
Provision for closed stores.......................... -- 400 --
Change in assets and liabilities:
Accounts receivable.................................. 404 340 (828)
Inventories.......................................... 3,389 (2,567) (3,222)
Income tax refund receivable......................... (1,467) -- --
Prepaid expenses and other assets.................... 1,210 (1,153) (1,145)
Accounts payable and accrued liabilities............. (1,534) (736) 3,883
Customer deposits.................................... 205 (517) 1,165
Income taxes payable................................. (632) 742 --
----------- ------------ ------------
Net cash used by operating activities........ (3,177) (6,877) (7,917)
----------- ------------ ------------
Cash flows from investing activities:
Capital expenditures................................. (1,883) (2,323) (1,841)
Proceeds from sale-leaseback......................... 1,039 -- --
Proceeds from sale of Mr. Coffee stock............... -- 23,258 --
Purchases of leasehold interests..................... -- -- (1,790)
Other................................................ -- -- 42
----------- ------------ ------------
Net cash provided (used) by investing
activities................................. (844) 20,935 (3,589)
----------- ------------ ------------
Cash flows from financing activities:
Net borrowings-line of credit........................ 3,423 100 5,665
Net borrowings (payments) on short-term notes........ (18) (1,093) 689
Principal payments on long-term debt................. -- (17,700) (2,965)
Issuance of preferred stock, net of expenses......... -- -- 10,967
Other................................................ -- (50) (242)
----------- ------------ ------------
Net cash provided (used) by financing
activities................................. 3,405 (18,743) 14,114
----------- ------------ ------------
Net increase (decrease) in cash and cash equivalents... (616) (4,685) 2,608
Cash and cash equivalents at beginning of year......... 1,952 6,302 3,694
----------- ------------ ------------
Cash and cash equivalents at end of year............... $ 1,336 $ 1,617 $ 6,302
======== ========== ==========
Supplemental disclosures of cash flow information --
Cash paid during the year for:
Interest............................................. $ 543 $ 915 $ 1,768
Income taxes......................................... -- 2,100 5
Noncash investing and financing activities:
Common stock and options issued in merger............ -- -- 7,789
Conversion of preferred stock and other stock
issuances....................................... 2,932 1,401 1,081
</TABLE>

See accompanying notes.

F-6
<PAGE> 45

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
MONTH ENDED
JANUARY 30,
MONTH ENDED 1994
JANUARY 29, ------------
1995
------------ (UNAUDITED)
<S> <C> <C>
Net furniture sales............................................... $ 7,179 $ 7,326
Cost of sales..................................................... 3,647 3,519
------- -------
Gross profit...................................................... 3,532 3,807
Operating expenses:
Selling......................................................... 5,446 4,935
General and administrative...................................... 1,317 913
------- -------
6,763 5,848
------- -------
Loss from operations.............................................. (3,231) (2,041)
Equity in earnings of Mr. Coffee.................................. -- 93
Interest expense.................................................. (12) (258)
Other income...................................................... 22 21
------- -------
Net loss.......................................................... $ (3,221) $ (2,185)
======= =======
Net loss per share................................................ $ (0.87) $ (0.63)
Average number of common shares outstanding....................... 3,685 3,490
</TABLE>

See accompanying notes.

F-7
<PAGE> 46

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
MONTH ENDED
JANUARY 30,
MONTH ENDED 1994
JANUARY 29, -----------
1995
----------- (UNAUDITED)
<S> <C> <C>
Cash flows from operating activities:
Net loss......................................................... $(3,221) $(2,185)
Adjustments to reconcile net loss to net cash used by operating
activities:
Depreciation and amortization.................................... 217 321
Equity in earnings of Mr. Coffee................................. -- (93)
Change in assets and liabilities:
Accounts receivable.............................................. 81 (160)
Inventories...................................................... (759) (1,396)
Prepaid expenses and other assets................................ (719) (196)
Accounts payable and accrued liabilities......................... 343 (1,899)
Customer deposits................................................ 3,113 2,349
Income taxes payable............................................. -- 42
------- -------
Net cash used by operating activities.................... (945) (3,217)
Cash flows from investing activities --
Capital expenditures............................................. (764) (60)
Cash flows from financing activities:
Proceeds from issuance of long-term debt......................... 2,092 --
Principal payments on long-term debt............................. (48) --
------- -------
Net cash provided by financing activities................ 2,044 --
Net increase (decrease) in cash and cash equivalents............... 335 (3,277)
Cash and cash equivalents at beginning of period................... 1,617 6,302
------- -------
Cash and cash equivalents at end of period......................... $ 1,952 $ 3,025
======= =======
Supplemental disclosures of cash flow information --
Cash paid during the period for:
Interest...................................................... $ -- $ 351
Noncash investing and financing activities --
Note receivable reduction in exchange for common stock and
warrants..................................................... -- 50
</TABLE>

See accompanying notes.

F-8
<PAGE> 47

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation

The consolidated financial statements include the accounts of Krause's
Furniture, Inc., (the "Company") and its wholly owned subsidiaries, including
the Company's principal subsidiary, Krause's Sofa Factory ("Krause's") and the
principal subsidiary of Krause's, Castro Convertible Corporation. In April 1995
the Company changed its fiscal year from a calendar year-end to a fiscal year
ending on the last Sunday of January as determined by the 52/53 retail fiscal
year. The Company's 1995 fiscal year ended January 28, 1996. All significant
intercompany transactions and balances have been eliminated. Certain
reclassifications of previously reported financial information were made to
conform to the 1995 presentation.

On August 1, 1995 the Company effected a one-for-three reverse split of its
common and preferred stock. Except for share amounts prior to August 1, 1995
appearing in the accompanying consolidated balance sheet and statement of
stockholders' equity, all share and per share data in this report have been
restated to reflect the reverse split.

The preparation of 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
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the reported
periods. Actual results could differ from those estimates.

Business

Krause's manufactures made-to-order sofas, sofabeds, loveseats and chairs,
and sells these products (as well as externally-sourced products) through its
own chain of retail showrooms, as well as licensed dealerships. As of January
28, 1996 there were 83 company-owned showrooms in 12 states.

Operations

During fiscal 1995 the Company incurred an operating loss of $9,388,000,
and as of January 28, 1996 the Company has a working capital deficiency of
$6,878,000 and an accumulated deficit of $20,961,000. Management has identified
certain initiatives and taken steps to return to profitability. Principal
planned strategic objectives and initiatives include a downsizing of showroom
size to reduce occupancy expenses, upgrading and remodeling showrooms to provide
a more appealing setting for customers, remerchandising, refocusing and reducing
advertising expenditures, improving manufacturing processes, and a corporate
expense reduction with tight budgeting controls. Some of these initiatives can
be undertaken presently while others will require capital expenditures and,
therefore, additional financing.

To provide necessary financing for current operations as well as to begin
to obtain necessary funding for the capital expenditures contemplated by
management's strategic initiatives, the Company has amended the terms of the
credit agreement for its revolving credit notes to modify the covenants and
conditions, extend the expiration date of the credit facility to January 1998,
and provide, subject to obtaining certain additional junior debt or equity
financing, additional borrowing availability (Note 4). Additionally, the Company
has received a commitment from an investor that will assure it of receiving at
least $2 million from a planned convertible debt offering during the fiscal year
ending January 1997. As a result, management believes the Company has sufficient
sources of financing to continue operations throughout fiscal 1996. However, the
Company will need to obtain further financing to implement all of the strategic
objectives and initiatives contemplated by the strategic plan. The Company's
long-term success is dependent upon its ability to obtain necessary financing,
the successful execution of management's strategic plan and, ultimately, the
achievement of sustained profitable operations.

F-9
<PAGE> 48

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Cash and cash equivalents

Cash and cash equivalents include U.S. Treasury bills, government agency
securities and commercial paper with original maturities of less than three
months, carried at cost, which approximates fair market value.

Fair values of financial instruments

Fair values of cash and cash equivalents approximate cost due to the short
period of time to maturity. The fair value of the secured revolving credit note
is based on borrowing rates currently available to the Company for loans with
similar terms or maturity and approximates the carrying amount reflected in the
accompanying consolidated financial statements.

Inventories

Inventories are carried at the lower of cost or market using the first-in,
first-out method and are comprised of the following:

<TABLE>
<CAPTION>
JANUARY 28, JANUARY 29,
1996 1995
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Finished goods................................................ $12,345 $13,161
Work in progress.............................................. 297 479
Raw materials................................................. 1,985 4,376
------- -------
$14,627 $18,016
======= =======
</TABLE>

Showroom pre-opening expenses

Showroom pre-opening expenses are capitalized and amortized over periods
ranging from 12 to 24 months subsequent to opening of the unit. Pre-opening
expenses are included in prepaid expenses and were $113,000 and $398,000 at
January 28, 1996 and January 29, 1995, respectively.

Closed store expenses

Future expenses, such as rent and real estate taxes, net of estimated
sublease recovery, relating to closed showrooms are charged to operations upon a
formal decision to close the showroom.

Property, equipment and leasehold improvements

Property, equipment and leasehold improvements are stated at cost less
accumulated depreciation and amortization. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets which range
from three to five years. Leasehold improvements are amortized on a straight
line basis

F-10
<PAGE> 49

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

over the shorter of the estimated useful life or the term of the lease.
Property, equipment and leasehold improvements are summarized as follows:

<TABLE>
<CAPTION>
JANUARY 28, JANUARY 29,
1996 1995
----------- -----------
<S> <C> <C>
Leasehold improvements........................................ $ 8,985 $ 7,862
Construction in progress...................................... 214 493
Machinery and equipment....................................... 2,855 2,738
Office and store furniture.................................... 923 931
------- -------
12,977 12,024
Less accumulated depreciation and amortization................ (6,239) (5,505)
------- -------
$ 6,738 $ 6,519
======= =======
</TABLE>

Goodwill

Goodwill, which represents the excess of purchase price over the fair value
of net assets acquired, is being amortized on a straight-line basis over 20
years (Note 2). Accumulated amortization amounted to $3,920,000 as of January
28, 1996 and $2,900,000 as of January 29, 1995.

Long-lived assets and certain identifiable intangibles held and used by the
Company are reviewed for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. Based upon
its analysis, management believes that no impairment of the carrying value of
its long-lived assets inclusive of goodwill exists at January 28, 1996. The
Company's analysis at January 28, 1996 is based on an estimate of future
undiscounted cash flows using forecasts contained in the Company's operating
plan. Should the results of the operating plan not be achieved, future analyses
may indicate insufficient future undiscounted net cash flows to recover the
carrying value of the Company's long-lived assets, in which case the carrying
value of such assets should be written down to fair value if lower than the
carrying value. The Company would then be required to make a determination of
the fair value of its long-lived assets. Management is unable to predict whether
any write-down would be required in such circumstances. The Company's historical
results of operations and its cash flows in fiscal years 1995, 1994, and 1993
indicate that it is at least reasonably possible that such circumstances could
arise in the fiscal year 1996.

Leasehold interests

Leasehold interests represent the present value of the excess of fair
market value lease rates on certain retail facility leases as compared to the
stated lease rates contained in the leases as determined at the date the leases
were acquired. Amortization of leasehold interests is on a straight-line basis
over the remaining lease terms. Accumulated amortization amounted to $1,493,000
as of January 28, 1996 and $1,224,000 as of January 29, 1995.

Revenue recognition

Sales are recorded when goods are delivered to the customer. The Company
provides for estimated customer returns and allowances by reducing sales or by a
charge to operations, as appropriate, in the period of the sale.

Advertising expenses

Advertising costs, which are principally newspaper printads, mail inserts
and radio spots, are charged to expense as incurred. Advertising expenses in the
fiscal years ended January 28, 1996, December 31, 1994, and December 31, 1993
were $11,181,000, $10,029,000 and $8,628,000, respectively.

F-11
<PAGE> 50

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Warranty costs

Estimated amounts for future warranty obligations for furniture sold are
charged to operations in the year the products are sold.

Income taxes

Effective January 1, 1993, the Company adopted Statement of Financial
Accounting Standards No. 109 ("FAS 109"), "Accounting for Income Taxes." Under
FAS 109, the liability method is used in accounting for income taxes. Under this
method, deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities, and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. Prior to the adoption of FAS 109, income
tax expense was determined using the deferred method. Deferred tax expense was
based on items of income and expense that were reported in different years in
the financial statements and tax returns and were measured at a tax rate in
effect in the year the difference originated.

As permitted by FAS 109, the Company has elected not to restate the
financial statements of any prior years. The effect of the change on income
taxes for the year ended December 31, 1993 and the cumulative effect of the
change were not material.

Income (loss) per share

Income (loss) per share amounts for 1994 were computed based on the
weighted average number of common and common equivalent shares outstanding.
Common equivalent shares arise from dilutive stock options and warrants and
convertibility of preferred stock into common stock. Loss per share for 1995 and
1993 were computed based on the weighted average number of common shares
outstanding during each period since common stock equivalents were antidilutive.
If the conversions of preferred stock during the year ended January 28, 1996 had
occurred at the beginning of the year, the net loss per share for the fiscal
year 1995 would have been $2.11.

Stock option plans

The Company follows Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees," ("APB 25"), and related Interpretations in
accounting for its employee stock options. Under APB 25, because the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.

The Company follows the practice of recording amounts received upon the
exercise of options by crediting common stock and additional capital. The
Company realizes an income tax benefit from the exercise or early disposition of
certain stock options. This benefit results in a decrease in current income
taxes payable and an increase in additional capital.

Credit risk

Finance options are offered to consumers through non-affiliated third
parties, at no material risk to the Company. Non-financed retail consumer
receivables are collected during the normal course of operations. There is no
significant concentration of credit risk and credit losses have been minimal.

2. ACQUISITION OF KRAUSE'S SOFA FACTORY

On April 29, 1991, the Company acquired a controlling interest in the
outstanding common stock of Krause's, a manufacturer and retailer of
made-to-order upholstered furniture, for a cash investment of $6,143,000. This
acquisition was accounted for by the purchase method and the results of
operations of

F-12
<PAGE> 51

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Krause's have been consolidated since the date of acquisition. The initial
purchase of Krause's resulted in $12,354,000 of excess of purchase price over
the fair value of net assets acquired, which was equal to the purchase price
plus Krause's stockholders' deficit at acquisition. Since Krause's did not have
positive stockholders' equity, no income or loss has been allocated to minority
interest in the consolidated statement of operations.

Effective October 31, 1993, Krause's became a wholly owned subsidiary of
the Company through a merger accomplished by an exchange of stock. The minority
shareholders of Krause's each received three and twenty- four one-hundredths
(3.24) shares of the Company's common stock for each share of Krause's capital
stock held by them. A total of 3,522,506 shares were issued to the Krause's
minority shareholders in the transaction. This acquisition resulted in
$6,892,000 of excess purchase price over the fair value of net assets acquired,
which was equal to the purchase price.

The following summary presents the unaudited pro forma results of
operations of the Company for the year ended December 31, 1993 as if the
acquisition of Krause's had taken place on January 1, 1993. The summary does not
necessarily reflect the results of operations as they would have been if the
Company and Krause's constituted a single entity during the year (in thousands,
except per share amount).

<TABLE>
<CAPTION>
1993
--------
<S> <C>
Revenues from continuing operations....................................... $ 97,276
========
Loss from continuing operations........................................... $(10,076)
Extraordinary loss........................................................ (221)
--------
Net loss.................................................................. $(10,297)
========
Net loss per share........................................................ $ (2.94)
========
</TABLE>

3. INVESTMENT -- MR. COFFEE, INC.

On August 17, 1994 the Company sold all of its Mr. Coffee common stock
(1,500,548 shares) for $15.50 per share for a total cash consideration of
$23,258,000. The sale was completed pursuant to a merger of Mr. Coffee with
Health o meter Products, Inc. and resulted in a pre-tax gain to the Company of
$12,115,000 as reported in the consolidated statement of operations. Since the
Company and Mr. Coffee had certain members of the Board of Directors in common,
the investment in Mr. Coffee was accounted for on the equity method.

Summarized below (in thousands, except per share amount) is certain
financial information of Mr. Coffee for the fiscal year ended December 1993:

<TABLE>
<S> <C>
Net sales................................................................. $175,045
Operating income.......................................................... 14,625
Interest expense.......................................................... 2,782
Extraordinary loss........................................................ 1,224
Net income applicable to common........................................... 5,453
Net income per share...................................................... .66
</TABLE>

In connection with a refinancing in 1993 Mr. Coffee wrote off certain
unamortized deferred financing costs and discounts resulting in an extraordinary
loss after tax of $1,224,000. The Company's equity share of such loss of
$221,000 has been recorded as an extraordinary loss in the 1993 consolidated
statement of operations.

F-13
<PAGE> 52

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

4. NOTES PAYABLE

Notes payable consists of the following:

<TABLE>
<CAPTION>
JANUARY 28, JANUARY 29,
1996 1995
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Secured revolving credit notes................................ $ 5,515 $ 2,092
Other notes................................................... 88 106
------ ------
5,603 2,198
Less current portion.......................................... 19 17
------ ------
$ 5,584 $ 2,181
====== ======
</TABLE>

The secured revolving credit notes were issued under a two-year revolving
credit arrangement entered into with a financial institution on January 28,
1995. The credit agreement provides for revolving loans of up to $10 million
based on the value of inventories. As of January 28, 1996, borrowing under the
revolving credit facility was limited to approximately $6.9 million as defined
in the agreement. Substantially all of Krause's assets are pledged as collateral
for the loans which are guaranteed by the Company. Interest on the loans is
payable monthly at the rate of 1.5% in excess of the prime rate (8.5% at January
28, 1996).

Krause's is required to satisfy certain financial covenants for working
capital and stockholders' equity. As of January 28, 1996 the Company did not
comply with these covenants. On May 10, 1996 the Company's revolving credit
agreement was amended to provide for a waiver by the lender of the technical
noncompliance with financial covenants and to amend those covenants, to extend
the credit agreement to January 1998 and to provide, subject to the Company
obtaining certain additional equity financing, for additional borrowing
availability under the revolving credit facility (Note 1).

5. INCOME TAXES

The provision (benefit) for income taxes consists of:

<TABLE>
<CAPTION>
FIDCAL YEAR ENDED
------------------------------
JANUARY 28, DECEMBER 31,
1996 1994
------------ -------------
(IN THOUSANDS)
<S> <C> <C>
Current:
Federal................................................... $ (2,247) $ 2,413
State..................................................... -- 678
------- ------
(2,247) 3,091
Deferred (Federal).......................................... 920 (920)
------- ------
$ (1,327) $ 2,171
======= ======
</TABLE>

F-14
<PAGE> 53

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The provision for income taxes differs from the amounts computed by
applying the federal statutory rate of 34% to income (loss) before income taxes,
as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
-----------------------------------
DECEMBER 31,
JANUARY 28, ------------------
1996 1994 1993
------------ ------ -------
(IN THOUSANDS)
<S> <C> <C> <C>
Tax at federal statutory rate..................... $ (3,414) $2,721 $(3,726)
Goodwill amortization............................. 346 350 252
Adjustment of valuation allowance................. 2,144 (920) --
Benefit of net operating loss carryforwards....... -- (752) --
State income tax, net of federal benefit.......... -- 630 --
Losses for which no tax benefits are currently
recognizable.................................... -- -- 3,474
Other............................................. (403) 142 --
------- ------ -------
$ (1,327) $2,171 $ --
======= ====== =======
</TABLE>

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities are as follows:

<TABLE>
<CAPTION>
JANUARY 28, JANUARY 29,
1996 1995
------------ ------------
<S> <C> <C>
Deferred tax liabilities.............................. $ 200 $ 215
Deferred tax assets:
Net operating loss carryforwards.................... 7,510 5,425
Reserves and accruals not currently deductible for
tax purposes..................................... 900 1,362
Deferred gain on asset sales........................ -- 297
Other............................................... 100 217
------- -------
Total deferred tax assets........................... 8,510 7,301
Valuation allowance for deferred tax assets........... (8,310) (6,166)
------- -------
Net deferred tax assets............................. 200 1,135
------- -------
Net deferred tax.................................... $ -- $ 920
======= =======
</TABLE>

The change in the valuation allowance was a net increase of $2,144,000 for
the fiscal year ended January 28, 1996, a net decrease of $485,000 for 1994 and
a net increase of $3,400,000 for 1993. The valuation allowance was increased
since the realization of net deferred tax assets is uncertain.

As of January 28, 1996 the Company has federal net operating loss
carryforwards of approximately $18 million which begin to expire in 2003, if not
utilized. In addition, the Company had state net operating loss carryforwards of
approximately $11.5 million which begin to expire in the year 1997, if not
utilized. As a result of various equity transactions, the Company and its
subsidiaries have experienced changes of ownership as defined in the Internal
Revenue Code. As a result of these ownership changes and other provisions of the
Internal Revenue Code, utilization of these net operating loss carryforwards is
limited to the future income of Krause's and is further limited to approximately
$1 million per year.

6. STOCKHOLDERS' EQUITY

At January 28, 1996 there were outstanding warrants to purchase 199,480
shares of the Company's common stock at prices from $3.18 to $15.00 per share,
which prices were not less than the market value of common stock on the dates
the warrants were issued. The warrants expire between April 1996 and June 2005.

F-15
<PAGE> 54

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

In late 1993 the Company sold, principally to related parties in private
placements, a total of 182,451 shares of preferred stock for gross proceeds of
$12,219,707. Of the preferred shares issued, 142,784 shares were Series A and
39,667 shares were Series B. In 1994 21,191 shares of Series A preferred stock
were converted into 211,907 shares of common stock. In 1995 3,899 shares of
Series A and 39,667 shares of Series B preferred stock were converted into
38,994 and 396,667 shares of common stock, respectively. At January 28, 1996
there were 117,694 shares of Series A preferred stock issued and outstanding.

Each share of Series A preferred stock is convertible into 10 shares of
common stock, has a liquidation value of $67.50 per share and has voting rights
equal to the equivalent number of shares of common stock into which it would
from time to time be convertible. The preferred stock has dividend rights to the
extent dividends are paid on common stock.

At January 28, 1996 the Company had 1,376,420 shares of common stock
reserved for issuance upon exercise of outstanding warrants and for conversion
of outstanding preferred stock.

7. STOCK OPTION PLANS

The Company has stock option plans for employees and directors. Options
granted under the plans have exercise prices equal to the fair market value of
the common stock on the date of grant.

Option grants under the employee stock option plan are made at the
discretion of the Compensation Committee of the Board of Directors and 83,333
shares of common stock have been reserved for issuance under the plan. Options
granted under the directors plan are exercisable after nine months from the date
of the grant. Under the directors plan, 66,667 shares of common stock are
reserved for issuance. Employee and director options generally have a term of 10
years and vest over one to five years.

In connection with the merger of the Company and Krause's (Note 2)
employees of Krause's received the right to purchase, upon exercise of their
outstanding Krause's stock options, an aggregate of 172,800 shares of the
Company's common stock at an exercise price of $4.62 per share. The difference
between the fair value of the Company's common stock and the option exercise
price resulted in additional acquisition cost of $303,264. Also on November 1,
1993, certain Krause's employees were granted options for the right to purchase
131,220 shares of the Company's common stock at $6.375 per share, the market
price of common stock at time of grant. These options are exercisable at various
times through 1999 and expire December 1, 2000.

The following table reflects exercise prices and activity under all stock
option plans from January 1, 1993 through January 28, 1996.

<TABLE>
<CAPTION>
PRICE RANGE
NUMBER OF OF SHARES
OPTIONS UNDER OPTION
--------- -------------
<S> <C> <C>
Outstanding December 31, 1994............................ 359,843 $3.09 - $8.34
Granted.................................................. 140,828 $2.16 - $6.48
Forfeited................................................ (140,298) $3.09 - $6.38
--------
Outstanding January 28, 1996............................. 360,373 $2.16 - $8.34
========
</TABLE>

As of January 28, 1996, under all options and option plans, a total of
449,854 shares of common stock are reserved for future issuance, options to
purchase 360,373 shares of common stock were outstanding, options to purchase
236,642 shares were exercisable and options for 89,481 shares were available for
future grants.

8. RETIREMENT PLAN

Krause's has a 401(k) retirement plan (effective January 1, 1994) to which
eligible employees may contribute up to 18% of their annual earnings. At its
discretion Krause's matches employees' contributions.

F-16
<PAGE> 55

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

During the fiscal years ended January 28, 1996 and December 31, 1994, Krause's
matched employee contributions up to $75 and $50 per participant, respectively,
which amounted to a total of $7,500 and $10,000, respectively.

9. COMMITMENTS AND CONTINGENCIES

The Company and its subsidiaries lease production, office and retail
facilities and equipment under operating leases. Lease terms range from three to
25 years and most leases contain renewal options and certain leases contain
purchase options. Krause's administrative offices and manufacturing facilities
lease has a remaining term of 13 years with four five-year options. Retail
showrooms are all leased with rents either fixed or with fixed minimums coupled
with contingent rents based on the Consumer Price Index or a percentage of
sales. Certain facilities were leased from a director of the Company and the
director's family. Commitments as of January 28, 1996 under operating leases
require approximate future minimum annual rental payments as follows:

<TABLE>
<CAPTION>
RELATED
FISCAL YEAR PARTIES OTHER TOTAL
----------------------------------------------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
1996........................................... $ 858 $14,349 $15,207
1997........................................... 857 13,247 14,104
1998........................................... 857 11,874 12,731
1999........................................... 735 10,138 10,873
2000........................................... 710 8,014 8,724
Thereafter..................................... 701 29,350 30,051
------ ------- -------
$ 4,718 $86,972 $91,690
====== ======= =======
</TABLE>

Total rent expense under all operating leases was approximately
$15,631,000, $14,965,000, and $15,031,000 for the fiscal years ended January 28,
1996, December 31, 1994 and December 31, 1993, respectively, including $802,000,
$846,000 and $1,166,000, respectively, to related parties.

During 1994 Krause's negotiated a restructuring of its administrative
offices and manufacturing facilities lease resulting in a lower rental rate and
the addition of a purchase option. In connection with the restructuring a bank
issued, on behalf of Krause's, a $1,000,000 letter of credit to the landlord.
This letter of credit is supported by a bank certificate of deposit in the same
amount which is included in other assets in the consolidated balance sheet.

The Company and its subsidiaries are also parties to various legal actions
and proceedings incident to normal business activity. Management believes that
any liability in the event of final adverse determination of any of these
matters would not be material to the Company's financial position, liquidity or
results of operations.

10. OTHER RELATED PARTY TRANSACTIONS

The Company has an agreement with an affiliate (Permal Capital Management,
Inc.) to provide executive management, financial consulting and other services
to the Company (the Company's Vice Chairman and Chief Executive Officer is
President of Permal Capital Management, Inc.). Charges for services under this
agreement were $100,000 in the fiscal year ended January 28, 1996 and $200,000
in each of 1994 and 1993. In 1993 Permal Capital Management, Inc. also received
$200,000 cash, 2,370 shares (at $67.50 per share) of the Company's Series A
preferred stock and warrants to purchase 16,667 shares of the Company's common
stock (at $7.13 per share) for services in connection with the Company's private
placement of $12,220,000 of preferred stock (Note 6).

F-17
<PAGE> 56

KRAUSE'S FURNITURE, INC.

CONSOLIDATED BALANCE SHEET
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
OCTOBER 27,
1996
-----------
<S> <C>
ASSETS
Current assets:
Cash and cash equivalents....................................................... $ 6,341
Accounts receivable, net of allowance for doubtful accounts of $318............. 735
Inventories..................................................................... 12,621
Prepaid expenses................................................................ 642
--------
Total current assets.................................................... 20,339
Property, equipment, and leasehold improvements, net.............................. 6,515
Goodwill, net..................................................................... 15,641
Leasehold interest, net........................................................... 1,582
Other assets...................................................................... 3,325
--------
$ 47,402
========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses........................................... $ 15,588
Accrued payroll and related expenses............................................ 1,593
Customer deposits............................................................... 6,364
Current portion of notes payable................................................ 8
Income taxes payable............................................................ 582
--------
Total current liabilities............................................... 24,135
Long-term liabilities:
Notes payable................................................................... 5,260
Other liabilities............................................................... 1,742
--------
Total long-term liabilities............................................. 7,002
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock, $.001 par value; 666,667 shares authorized,
no shares outstanding........................................................ --
Common stock, $.001 par value; 35,000,000 shares authorized,
19,020,539 shares outstanding................................................ 19
Capital in excess of par value.................................................. 49,581
Accumulated deficit............................................................. (33,335)
--------
Total stockholders' equity.............................................. 16,265
--------
$ 47,402
========
</TABLE>

See accompanying notes.

F-18
<PAGE> 57

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
---------------------------
OCTOBER 27, OCTOBER 29,
1996 1995
----------- -----------
<S> <C> <C>
Net furniture sales................................................... $ 82,738 $92,465
Cost of sales......................................................... 42,364 44,620
-------- -------
Gross profit.......................................................... 40,374 47,845
-------- -------
Operating expenses:
Selling............................................................. 43,556 44,532
General and administrative.......................................... 7,852 8,094
Amortization of goodwill............................................ 765 764
-------- -------
52,173 53,390
-------- -------
Loss from operations.................................................. (11,799) (5,545)
Interest expense...................................................... (782) (528)
Other income.......................................................... 207 259
-------- -------
Loss before income taxes.............................................. (12,374) (5,814)
Income tax benefit.................................................... -- (1,327)
-------- -------
Net loss.............................................................. $ (12,374) $(4,487)
======== =======
Net loss per share.................................................... $ (1.62) $ (1.15)
======== =======
Average number of common shares outstanding........................... 7,661 3,905
</TABLE>

See accompanying notes.

F-19
<PAGE> 58

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(UNAUDITED)
(IN THOUSANDS)

<TABLE>
<CAPTION>
CONVERTIBLE CAPITAL
PREFERRED STOCK COMMON STOCK IN TOTAL
---------------- --------------- EXCESS OF ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT PAR VALUE DEFICIT EQUITY
------ ------- ------ ------ --------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance January 28, 1996....... 118 $ 7,523 4,121 $ 4 $27,419 $ (20,961) $ 13,985
Conversion of Series A
preferred stock.............. (118) (7,523) 1,177 1 7,522 -- --
Exchange of notes payable and
related interest for common
stock........................ -- -- 3,066 3 3,063 -- 3,066
Issuance of common stock for
cash, net of expenses of
$448......................... -- -- 10,669 11 10,210 -- 10,221
Issuance of common stock
purchase warrant............. -- -- -- -- 1,400 -- 1,400
Repurchase of common stock..... -- -- (12) -- (33) -- (33)
Net loss....................... -- -- -- -- -- (12,374) (12,374)
------ ------ ------ ---- -- -------- - ---------- - ---------- ---
Balance October 27, 1996....... -- $ -- 19,021 $ 19 $49,581 $ (33,335) $ 16,265
====== ====== ====== ====== ========= =========== =============
</TABLE>

See accompanying notes.

F-20
<PAGE> 59

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
-----------------------------
OCTOBER 27, OCTOBER 29,
1996 1995
------------ ------------
<S> <C> <C>
Cash flows from operating activities:
Net loss.......................................................... $(12,374) $ (4,487)
Adjustments to reconcile net loss to net cash used by operating
activities:

Depreciation and amortization..................................... 1,853 1,851
Change in assets and liabilities:
Accounts receivable............................................ 51 315
Deferred income taxes.......................................... -- 920
Income tax refund receivable................................... 1,467 (1,503)
Inventories.................................................... 2,006 2,657
Prepaid expenses and other assets.............................. (291) 581
Accounts payable and accrued liabilities....................... (650) (595)
Customer deposits.............................................. (650) (399)
Income taxes payable........................................... 7 (632)
--------- --------
Net cash used by operating activities..................... (8,581) (1,292)
--------- --------
Cash flows from investing activities:
Capital expenditures.............................................. (563) (955)
--------- --------
Net cash used by investing activities..................... (563) (955)
--------- --------
Cash flows from financing activities:
Net borrowings (payments) under revolving credit.................. (3,975) 2,052
Proceeds from issuance of subordinated note....................... 5,000 --
Proceeds from issuance of notes................................... 2,950 --
Net proceeds from issuance of common stock........................ 10,221 --
Other............................................................. (47) (13)
--------- --------
Net cash provided by financing activities................. 14,149 2,039
--------- --------
Net increase (decrease) in cash and cash equivalents................ 5,005 (208)
Cash and cash equivalents at beginning of period.................... 1,336 1,952
--------- --------
Cash and cash equivalents at end of period.......................... $ 6,341 $ 1,744
========= ========
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest.......................................................... $ 431 $ 248
Income taxes...................................................... -- 200
Noncash investing and financing activities
Preferred stock converted into common stock....................... 7,523 2,674
Exchange of notes payable and related accrued interest for common
stock.......................................................... 3,066 --
Issuance of common stock purchase warrant......................... 1,400 --
</TABLE>

See accompanying notes.

F-21
<PAGE> 60

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. The accompanying consolidated financial statements of Krause's
Furniture, Inc. (the "Company") and its wholly owned subsidiaries, including the
Company's principal subsidiary, Krause's Sofa Factory ("Krause's"), have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission and reflect all adjustments which are, in the opinion of management,
necessary for a fair presentation for the periods reported. Certain information
and note disclosures normally included in annual financial statements prepared
in accordance with generally accepted accounting principles have been condensed
or omitted pursuant to those rules or regulations, although management believes
that the disclosures made are adequate to make the information presented not
misleading.

These financial statements should be read in conjunction with the
consolidated financial statements and the notes thereto for the year ended
January 28, 1996 included elsewhere herein. The results of operations for the
thirty-nine weeks ended October 27, 1996 are not necessarily indicative of
results to be expected in future periods.

The preparation of 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
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reported
periods. Actual results could differ from those estimates.

2. On August 26, 1996 and September 10, 1996 the Company completed
transactions with investors in which the Company received cash proceeds of
$15,669,000 from financings through issuances of $10,669,000 of common stock, at
$1 per share, and a $5 million subordinated note with a warrant to purchase
1,400,000 shares of common stock at $.001 per share. In addition $2,950,000 of
existing notes together with accrued interest of $116,251 were exchanged for
3,066,251 shares of common stock and outstanding Series A preferred stock was
converted into 1,176,950 shares of common stock.

The proceeds from these transactions allow the Company to accelerate its
strategic objectives and initiatives including downsizing showroom square
footage to reduce occupancy expenses, upgrading and remodeling showrooms to
provide a more appealing setting for customers, remerchandising, refocusing
advertising expenditures, improving manufacturing processes, and reducing
corporate expenses. These objectives and initiatives are expected to contribute
significantly to reducing losses and ultimately returning the Company to
profitability. The Company's long-term success is dependent upon its ability to
successfully execute management's strategic plan and, ultimately, to achieve
sustained profitable operations.

3. Inventories are carried at the lower of cost or market using the
first-in, first-out method and are comprised of the following:

<TABLE>
<CAPTION>
OCTOBER 27,
1996
-----------
<S> <C>
Finished goods.......................................................... $ 9,653,000
Work-in-process......................................................... 368,000
Raw materials........................................................... 2,600,000
-----------
$12,621,000
===========
</TABLE>

F-22
<PAGE> 61

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

4. Notes payable consist of the following:

<TABLE>
<CAPTION>
OCTOBER 27,
1996
-----------
<S> <C>
Secured revolving credit notes.......................................... $ 1,540,000
Subordinated note....................................................... 5,000,000
Unamortized debt discount, net of accumulated amortization of $54,000... (1,346,000)
Other notes............................................................. 74,000
-----------
5,268,000
Less current portion.................................................... 8,000
-----------
$ 5,260,000
===========
</TABLE>

The secured revolving credit notes were issued under a revolving credit
facility with a financial institution that expires in January 2000. Borrowings
under the revolving credit facility are based on the value of eligible
inventory, as defined, and as of October 27, 1996 were limited to approximately
$6.8 million. Interest on the loans as of October 27, 1996 was payable monthly
at the rate of 1% in excess of the prime rate (8.25%). Substantially all of
Krause's assets are pledged as collateral for the notes.

The subordinated note was issued August 26, 1996 (Note 2) and bears
interest at 10% per annum, payable in additional subordinated notes for the
first two years. Semiannual mandatory redemptions of $1,015,336 are required
beginning February 28, 1999 through final maturity on August 31, 2001. The
subordinated note was issued with a warrant to purchase 1,400,000 shares of
common stock at $.001 per share at any time through August 31, 2006. The fair
value of the warrant of $1,400,000 was reflected in the consolidated financial
statements as a discount on the subordinated note and an increase in capital in
excess of par value. This discount is being amortized to interest expense using
the effective interest method over the term of the subordinated note.

5. Net loss per share amounts were computed based on the weighted average
number of common shares outstanding during the periods reported. Common
equivalent shares are not included in the computation since such share
equivalents are antidilutive.

F-23
<PAGE> 62

PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.

The following table sets forth expenses in connection with the issuance and
distribution of the securities being registered. All amounts shown are
estimated, except the SEC Registration fee and the NASD fees.

<TABLE>
<S> <C>
SEC Registration Fees...................................................... $ 2,000
Legal Fees and Expenses.................................................... $ *
Accounting Fees and Expenses............................................... $ *
NASD Fees.................................................................. $ 0
Blue Sky Fees and Expenses (Including Legal Fees).......................... $ *
Printing and Engraving Fees................................................ $ *
Total............................................................ $ *
</TABLE>

- ---------------
* To be filed by amendment.

ITEM 14. INDEMNIFICATION OF OFFICERS AND DIRECTORS.

Section 145 of the General Corporation Law of the State of Delaware (the
"DGCL") grants each corporation organized thereunder, such as the Registrant,
the power to indemnify its directors and officers against liabilities for
officers of the Registrant to the fullest extent permitted by applicable law.
Section 102(a)(7) of the DGCL permits a provision in the certificate of
incorporation of each corporation organized thereunder, such as the Registrant,
eliminating or limiting, with certain exceptions, the personal liability of a
director of the corporation or its stockholders for monetary damages for breach
of fiduciary duty as a director. The Registrant's Certificate of Incorporation
eliminates the liability of each of its directors to its stockholders or to the
Registrant itself for monetary damages for breach of fiduciary duty as a
director, to the extent permitted by the DGCL. The foregoing statements are
subject to the detailed provisions of Section 102(a)(7) of the DGCL and the
Certificate of Incorporation of Registrant, as applicable. The Registrant
maintains a directors and officers liability and reimbursement insurance policy
intended to reimburse the Registrant for any payments made by it pursuant to its
indemnification obligations.

ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES.

1. Within the past three years the Company sold an aggregate of 1,667
shares of Common Stock to one employee for consideration in the aggregate amount
of $5,150 pursuant to the Company's 1990 Employees Stock Option Plan.

2. From May 13, 1996, through June 19, 1996, the Company sold an aggregate
principal amount of $950,000 of its Series 1996-I and Series 1996-II Convertible
Promissory Notes to certain directors, officers and 5% stockholders of the
Company and parties related to them. In connection with the GECC financing, the
holders of the Notes converted the principal amount and accrued interest due
under the Notes into an

II-1
<PAGE> 63

aggregate of 970,140 shares of Common Stock at a conversion price of $1.00 per
share. The purchasers of these Notes are as follows:

<TABLE>
<CAPTION>
SERIES NO. OF SHARES
1996-I SERIES 1996-II ACCRUED RECEIVED
NAME NOTE AMOUNT NOTE AMOUNT INTEREST UPON CONVERSION
--------------------------------------- ----------- -------------- ------ ---------------
<S> <C> <C> <C> <C>
The Vulture Fund, Ltd.................. $ 50,000 $1,472 51,472
Jean R. Perrette....................... $ 250,000 $5,278 255,278
Permal Capital Management, Inc......... $ 50,000 $1,056 51,056
Isaac Robert Souede.................... $ 250,000 $5,278 255,278
Thomas M. DeLitto...................... $ 25,000 $ 528 25,528
ATCO Development, Inc.................. $ 150,000 $3,167 153,167
Robert G. Sharpe....................... $ 25,000 $ 528 25,528
United Gulf Bank (B.S.C.) E.C.......... $150,000 $2,833 152,833
</TABLE>

3. On May 21, 1996, the Company issued its Demand Promissory Note in the
principal amount of $1,500,000 to Edson Investments, Inc. ("Edson"). On July 2,
1996, the Company issued a second Demand Promissory Note in the principal amount
of $500,000 to Edson. In connection with the GECC financing, Edson acquired
2,096,111 shares of Common Stock at a price of $1.00 per share in consideration
for its cancellation of the Company's obligation to repay the principal and
accrued interest of $96,111 owed under these Notes.

4. On August 26, 1996, and September 10, 1996, the Company completed a
private placement of 10,669,000 shares of Common Stock to 55 investors, some of
whom are related to each other, at the price of $1.00 per share. In addition,
the Company issued its subordinated note in the aggregate principal amount of
$5,000,000 and a warrant to purchase 1,400,000 additional shares of Common Stock
at a purchase price of $.001 per share to General Electric Capital Corporation.
The purchasers of shares in this private placement and the number of shares
purchased are as follows:

<TABLE>
<CAPTION>
NO. OF SHARES NO. OF SHARES
NAME ON 8/26/96 ON 9/10/96
------------------------------------------------------------- ------------- -------------
<S> <C> <C>
General Electric Capital Corporation......................... 5,000,000
Permal Noscal Ltd. .......................................... 405,000
Zaxis Partners, L.P. ........................................ 40,000
Sidney Kimmel................................................ 50,000
Pollat, Evans & Co., Inc. ................................... 15,000
Quadra Appreciation Fund, Inc. .............................. 5,000
Branagh Revocable Trust...................................... 5,000
Sanford J. Colen............................................. 20,000
Jean R. Perrette............................................. 250,000
Isaac Robert Souede.......................................... 250,000
Thomas M. DeLitto............................................ 25,000
C. Redington Barrett, III.................................... 5,000
Hurley & Co. ................................................ 35,000
United Gulf Bank............................................. 225,000
ATCO Holdings Ltd. .......................................... 400,000
ATCO Development, Inc. ...................................... 100,000
G(2) Investment Partners..................................... 60,000 30,000
Fairmont Services Ltd. ...................................... 400,000
Carlton Securities N.V. ..................................... 100,000
Emmanual Bagdjian............................................ 210,000
Heliopolis Inc. ............................................. 100,000
T. Michael Wallace........................................... 100,000 300,000
</TABLE>

II-2
<PAGE> 64

<TABLE>
<CAPTION>
NO. OF SHARES NO. OF SHARES
NAME ON 8/26/96 ON 9/10/96
------------------------------------------------------------- --------- ---------
<S> <C> <C>
Gary S. Gladstein............................................ 100,000 100,000
Peter L. Rhulen.............................................. 100,000
Maureen Erin Hawley Trust I.................................. 112,500
Allison Booth Hawley Trust I................................. 112,500
Caitlin Hale Hawley Trust I.................................. 112,500
Shannon Follen Hawley Trust I................................ 112,500
Hawley Family Trust.......................................... 500,000
Philip M. Hawley............................................. 30,000
Philip M. Hawley, Jr. ....................................... 20,000
H.D. Investment Group, Inc. ................................. 25,000
Morgan Adams, Inc. .......................................... 50,000
Theodore D. Konopisos........................................ 22,000
William A. MacLaughlin IRA................................... 25,000
Gregory M. Simon............................................. 20,000
Hugh H. Wilson, Jr. ......................................... 15,000
Codell Holdings Ltd. ........................................ 100,000
J. Stephen Emerson IRA....................................... 100,000
J. Stephen Emerson........................................... 100,000
Paul Marciano Trust.......................................... 100,000
G. Tyler Runnels............................................. 50,000
Charles Perez................................................ 100,000
JMG Capital Partners L.P. ................................... 50,000
William C. Miller, IV........................................ 25,000
Tendencia Investments Overseas............................... 250,000
Lawrence S. Black............................................ 50,000
Maureen Erin Hawley Trust II................................. 25,000
Allison Booth Hawley Trust II................................ 25,000
Caitlan Hale Hawley Trust II................................. 25,000
Shannon Follen Hawley Trust II............................... 25,000
Ian and Francine Jack........................................ 10,000
Keith and Tanya Jacobs....................................... 10,000
J. Richard Cordsen........................................... 27,000
J.D. Yates................................................... 10,000
</TABLE>

Except for the issuance of the Series 1996-II Convertible Promissory Notes
and the shares of Common Stock acquired upon conversion thereof described in
item 2, the issuances of securities in the above-transactions were deemed to be
exempt from registration under the Securities Act in reliance on Section 4.2
thereof or Regulation D promulgated thereunder as transactions not involving any
public offering. The issuance of the Series 1996-II Convertible Promissory Notes
and the shares of Common Stock acquired upon conversion thereof described in
item 2 above, were deemed exempt from registration under the Act in reliance un
Regulation S promulgated thereunder.

ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

(a) EXHIBITS

<TABLE>
<S> <C>
3.1 Certificate of Incorporation.(1)
3.1(a) Certificate of Amendment of Certificate of Incorporation dated November 28, 1994.(5)
3.1(b) Certificate of Amendment of Certificate of Incorporation dated August 1, 1995.(6)
3.1(c) Certificate of Amendment of Certificate of Incorporation dated June 7, 1996.(7)
</TABLE>

II-3
<PAGE> 65

<TABLE>
<S> <C>
3.1(d) Certificate of Amendment of Certificate of Incorporation dated August 1, 1996.(7)
3.2 By-Laws.(1)
4.1 Loan and Security Agreement dated January 20, 1995 by and between Congress Financial
Corporation (Western) and Krause's Sofa Factory and Castro Convertible
Corporation.(3)
4.1(a) First Amendment to Loan and Security Agreement dated May 10, 1996 by and between
Congress Financial Corporation (Western) and Krause's Sofa Factory and Castro
Convertibles Corporation.(6)
4.2 Guarantee dated January 20, 1995 by Krause's Furniture, Inc. to Congress Financial
Corporation (Western).(3)
4.5 Certificate of Designations of Preferred Stock.(4)
5 Opinion of counsel as to the legality of the Securities being registered.*
10.1 1994 Directors Stock Option Plan.(5)
10.2 1990 Employees Stock Option Plan.(2)
10.3 Form of Securities Purchase Agreement between the Company and GECC dated as of
August 26, 1996.(8)
10.4 form of $5,000,000 10% Subordinated Pay-In-Kind Note due August 31, 2001.(8)
10.5 Form of Warrant to Purchase 1,400,000 Shares of Common Stock.(8)
10.6 Form of Securities Purchase Agreement between the Company and Certain Stockholders
dated as of August 26, 1996.(8)
10.7 Form of Stockholders Agreement among the Company, GECC and certain other
stockholders of the Company dated as of August 26, 1996.(8)
10.8 Form of Registration Rights Agreement among the Company and GECC and certain other
stockholders of the Company dated as of August 26, 1996.(8)
10.9 Employment Agreement with Philip M. Hawley.(8)
11 Statement regarding computation of per share earnings.
21 Subsidiaries.
23.1 Consent of Ernst & Young LLP, Independent Auditors.
23.2 Consent of KPMG Peat Marwick LLP.
23.3 Consent of Counsel Reference is made to Exhibit 5.1.*
24 Power of Attorney. Reference is made to page II-7.
</TABLE>

- ---------------
(1) Incorporated herein by reference to Exhibits to Registrant's Form S-4 dated
June 19, 1992 (File No. 33-48725).

(2) Incorporated herein by reference to Exhibit 10.2 to Registrant's Form 10-K
for the year ended December 31, 1990 (File No. 0-17868).

(3) Incorporated herein by reference to Exhibit to Registrant's Form 8-K dated
as of January 20, 1995 (File No. 0-17868).

(4) Incorporated herein by reference to Exhibit 4.3 to Registrant's Form 8-K
dated as of October 7, 1993 (File No. 0-17868).

(5) Incorporated herein by reference to Exhibit 10.1 to Registrant's Form 10-K
dated as of December 31, 1994 (File No. 0-17868).

(6) Incorporated herein by reference to Exhibits to Registrant's Form 10-K dated
as of January 28, 1996 (File No. 0-17868).

(7) Incorporated herein by reference to Exhibits to Registrant's Form 10-Q dated
as of July 28, 1996 (File No. 0-17868).

(8) Incorporated herein by reference to Exhibits to Registrant's Form 8-K dated
as of August 26, 1996 (File No. 0-17868).

* To be filed by amendment.

II-4
<PAGE> 66

(b) FINANCIAL STATEMENT SCHEDULES.
Report of Ernst & Young LLP, Independent Auditors
Schedule II -- Valuation and Qualifying Accounts

ITEM 17. UNDERTAKINGS.

The undersigned Registrant hereby undertakes:

(a) (1) To file during any period in which offers or sales are being
made, a post-effective amendment to this registration statement:

(i) To include any prospectus required by section 10(a)(3) of the
Securities Act of 1933;

(ii) To reflect in the prospectus any facts or events arising after
the effective date of the registration statement (or the most recent
post-effective amendment thereof) which, individually or in the
aggregate, represent a fundamental change in the information set forth
in the registration statement. Notwithstanding the foregoing, any
increase or decrease in volume of securities offered (if the total
dollar value of securities offered would not exceed that which was
registered) and any deviation from the low or high end of the estimated
maximum offering range may be reflected in the form of Prospectus filed
with the Commission pursuant to Rule 424(b) if, in the aggregate, the
changes in volume and price represent no more than 20% change in the
maximum aggregate offering price set forth in the "Calculation of
Registration Fee" table in the effective registration statement;

(iii) To include any material information with respect to the plan
of distribution not previously disclosed in the registration statement
or any material change to such information in the registration
statement;

provided, however, that paragraphs (a)(1)(i) and (a)(1)(ii) do not apply if
the registration statement is on Form S-3, Form S-8 or Form F-3, and the
and the information required to be included in a post-effective amendment
by those paragraphs is contained in periodic reports filed with or
furnished to the Commission by the Registrant pursuant to Section 13 or
15(d) of the Securities Exchange Act of 1934 that are incorporated by
reference in the registration statement.

(2) That, for the purpose of determining any liability under the
Securities Act of 1933, each such post-effective amendment shall be deemed
to be a new registration statement relating to the securities offered
therein, and the offering of such securities at that time shall be deemed
to be the initial bona fide offering thereof.

(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.

(h) Insofar as indemnification for liabilities arising under the Securities
Act of 1933 may be permitted to directors, officers and controlling persons of
the Registrant pursuant to the provisions, or otherwise, the Registrant has been
advised that in the opinion of the Securities and Exchange Commission, such
indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification against
such liabilities (other than the payment by the Registrant of expenses incurred
or paid by a director, officer or controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, the Registrant will, unless in the opinion of its counsel the matter
has been settled by controlling precedent, submit to a court of appropriate
jurisdiction the question whether such indemnification by it is against public
policy as expressed in the Act and will be governed by the final adjudication of
such issue.

II-5
<PAGE> 67

SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Brea, County of Orange,
State of California, on January 8, 1997.

KRAUSE'S FURNITURE, INC.

By /s/ PHILIP M. HAWLEY
------------------------------------
PHILIP M. HAWLEY
Chairman of the Board and Chief Executive Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints, Philip M. Hawley, Robert G. Sharpe and
Robert A. Burton, and each of them, as his true and lawful attorneys-in-fact and
agents, with full power of substitution and resubstitution, for him and in his
name, place and stead, in any and all capacities, to sign any and all amendments
(including post-effective amendments) to this Registration Statement, and to
file the same, with all exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
connection therewith, as fully to all intents and purposes as he might or could
do in person, hereby ratifying and confirming all that said attorneys-in-fact
and agents, or any of them, or their or his substitute or substitutes, may
lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed by the following persons in the
capacities indicated, as of January 8, 1997.

<TABLE>
<CAPTION>
SIGNATURE TITLE
- ------------------------------------------ -----------------------------------------------
<S> <C>
/s/ PHILIP M. HAWLEY Chairman of the Board and Chief Executive
---------------------------------------- Officer (Principal Executive Officer)
Philip M. Hawley
/s/ STEPHEN P. ANDERSON President
----------------------------------------
Stephen P. Anderson
/s/ ROBERT G. SHARPE Executive Vice President and Treasurer
----------------------------------------
Robert G. Sharpe
/s/ ROBERT A. BURTON Senior Vice President and Chief Financial
---------------------------------------- Officer (Principal Financial Officer and
Robert A. Burton Principal Accounting Officer)
/s/ THOMAS M. DELITTO Vice Chairman of the Board
----------------------------------------
Thomas M. DeLitto
/s/ KAMAL G. ABDELNOUR Director
----------------------------------------
Kamal G. Abdelnour
/s/ JEFFREY H. COATS Director
----------------------------------------
Jeffrey H. Coats
/s/ PETER H. DAILEY Director
----------------------------------------
Peter H. Dailey
/s/ JOHN A. GAVIN Director
----------------------------------------
John A. Gavin
</TABLE>

II-6
<PAGE> 68

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Krause's Furniture, Inc.

We have audited the consolidated financial statements of Krause's
Furniture, Inc., as of January 28, 1996 and January 29, 1995, and the related
consolidated statements of operations for the fiscal years ended January 28,
1996, December 31, 1994 and December 31, 1993, and for the month ended January
29, 1995, and have issued our report thereon dated April 26, 1996, except for
Notes 1 and 4, as to which the date is May 10, 1996 (included elsewhere in this
Registration Statement). Our audits also included the financial statement
schedule listed in Item 16(b) of this Registration Statement. This schedule is
the responsibility of the Company's management. Our responsibility is to express
an opinion on this schedule based on our audits.

In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP

Orange County, California
April 26, 1996, except for Notes 1 and 4,
as to which the date is May 10, 1996

II-7
<PAGE> 69

KRAUSE'S FURNITURE, INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FISCAL YEAR ENDED JANUARY 28, 1996, MONTH ENDED JANUARY 29, 1995 AND
YEARS ENDED DECEMBER 31, 1994 AND DECEMBER 31, 1993

<TABLE>
<CAPTION>
ADDITIONS
----------------------
BALANCE CHARGED TO CHARGED BALANCE
ALLOWANCES FOR BEGINNING COST AND TO OTHER END
DOUBTFUL ACCOUNTS OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS(A) OF PERIOD
- ------------------------------------- --------- ---------- --------- ------------- ---------
<S> <C> <C> <C> <C> <C>
1995(c).............................. $ 616,148 $218,414 $ -- $ 543,075 $ 291,487
Month ended January 29, 1995......... 591,744 24,404 -- -- 616,148
1994................................. 395,322 566,000 (320,000)(b) 49,578 591,744
1993................................. 250,441 265,000 -- 120,119 395,322
</TABLE>

- ---------------
(a) Represents accounts written off.

(b) Represents allowance for sales returns reclassified to accrued liabilities
to conform to the presentation for the fiscal year ended January 28, 1996.

II-8
<PAGE> 70

EXHIBIT INDEX

<TABLE>
<CAPTION>
SEQUENTIALLY
NUMBERED
PAGES
------------
<S> <C> <C>
3.1 Certificate of Incorporation.(1)
3.1(a) Certificate of Amendment of Certificate of Incorporation dated November
28, 1994.(5)
3.1(b) Certificate of Amendment of Certificate of Incorporation dated August 1,
1995.(6)
3.1(c) Certificate of Amendment of Certificate of Incorporation dated June 7,
1996.(7)
3.1(d) Certificate of Amendment of Certificate of Incorporation dated August 1,
1996.(7)
3.2 By-Laws.(1)
4.1 Loan and Security Agreement dated January 20, 1995 by and between Congress
Financial Corporation (Western) and Krause's Sofa Factory and Castro
Convertible Corporation.(3)
4.1(a) First Amendment to Loan and Security Agreement dated May 10, 1996 by and
between Congress Financial Corporation (Western) and Krause's Sofa Factory
and Castro Convertibles Corporation.(6)
4.2 Guarantee dated January 20, 1995 by Krause's Furniture, Inc. to Congress
Financial Corporation (Western).(3)
4.5 Certificate of Designations of Preferred Stock.(4)
5 Opinion of counsel as to the legality of the Securities being registered.*
10.1 1994 Directors Stock Option Plan.(5)
10.2 1990 Employees Stock Option Plan.(2)
10.3 Form of Securities Purchase Agreement between the Company and GECC dated
as of August 26, 1996.(8)
10.4 form of $5,000,000 10% Subordinated Pay-In-Kind Note due August 31,
2001.(8)
10.5 Form of Warrant to Purchase 1,400,000 Shares of Common Stock.(8)
10.6 Form of Securities Purchase Agreement between the Company and Certain
Stockholders dated as of August 26, 1996.(8)
10.7 Form of Stockholders Agreement among the Company, GECC and certain other
stockholders of the Company dated as of August 26, 1996.(8)
10.8 Form of Registration Rights Agreement among the Company and GECC and
certain other stockholders of the Company dated as of August 26, 1996.(8)
10.9 Employment Agreement with Philip M. Hawley.(8)
11 Statement regarding computation of per share earnings.
21 Subsidiaries.
23.1 Consent of Ernst & Young LLP, Independent Auditors.
23.2 Consent of KPMG Peat Marwick LLP.
23.3 Consent of Counsel Reference is made to Exhibit 5.1.*
24 Power of Attorney. Reference is made to page II-7.
</TABLE>

- ---------------
(1) Incorporated herein by reference to Exhibits to Registrant's Form S-4 dated
June 19, 1992 (File No. 33-48725).

(2) Incorporated herein by reference to Exhibit 10.2 to Registrant's Form 10-K
for the year ended December 31, 1990 (File No. 0-17868).
<PAGE> 71

(3) Incorporated herein by reference to Exhibit to Registrant's Form 8-K dated
as of January 20, 1995 (File No. 0-17868).

(4) Incorporated herein by reference to Exhibit 4.3 to Registrant's Form 8-K
dated as of October 7, 1993 (File No. 0-17868).

(5) Incorporated herein by reference to Exhibit 10.1 to Registrant's Form 10-K
dated as of December 31, 1994 (File No. 0-17868).

(6) Incorporated herein by reference to Exhibits to Registrant's Form 10-K dated
as of January 28, 1996 (File No. 0-17868).

(7) Incorporated herein by reference to Exhibits to Registrant's Form 10-Q dated
as of July 28, 1996 (File No. 0-17868).

(8) Incorporated herein by reference to Exhibits to Registrant's Form 8-K dated
as of August 26, 1996 (File No. 0-17868).

* To be filed by amendment.

<PAGE> 1

EXHIBIT 11

KRAUSE'S FURNITURE, INC.

COMPUTATION OF NET INCOME (LOSS) PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
THIRTY-NINE THIRTY-NINE -----------------------------------------
WEEKS ENDED WEEKS ENDED JANUARY 28, DECEMBER 31, DECEMBER 31,
OCTOBER 27, 1996 OCTOBER 29, 1995 1996 1994 1993
---------------- ---------------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Income (loss) before extraordinary
items........................... $(12,374) $ (4,487) $(8,715) $ 5,831 $ (9,751)
Extraordinary items............... -- -- -- (436) (221)
-------- ------- ------- ------ -------
Net income (loss)................. $(12,374) $ (4,487) $(8,715) $ 5,395 $ (9,972)
======== ======= ======= ====== =======
Weighted average number of shares
outstanding(C)
Common stock.................... 7,661 3,905 3,950 3,523 2,510
Common stock equivalents(A):
Convertible preferred
stock...................... -- -- -- 1,778 --
Stock options(B)............. -- -- -- 80 --
Warrants(B).................. -- -- -- 13 --
-------- ------- ------- ------ -------
Total................... 7,661 3,905 3,950 5,394 2,510
======== ======= ======= ====== =======
Income (loss) per share:
Income (loss) before
extraordinary items.......... $ (1.62) $ (1.15) $ (2.21) $ 1.08 $ (3.88)
Extraordinary items............. -- -- -- (.08) (.09)
-------- ------- ------- ------ -------
Net income (loss)............... $ (1.62) $ (1.15) $ (2.21) $ 1.00 $ (3.97)
======== ======= ======= ====== =======
</TABLE>

- ---------------
(A) Common stock equivalents are excluded from the calculation in loss years
since they are anti-dilutive.

(B) Computations of dilutive stock options and warrants is based on the treasury
stock method using the average market price.

(C) All share and per share amounts have been restated to reflect a
one-for-three reverse stock split effected August 1, 1995.

<PAGE> 1

EXHIBIT 21

SUBSIDIARIES OF REGISTRANT

<TABLE>
<CAPTION>
NAME OF SUBSIDIARY STATE OF INCORPORATION
---------------------------------------------------------- ----------------------
<S> <C>
Krause's Sofa Factory..................................... California
(business operated under the names "Krause's Sofa
Factory"
and "Castro Convertibles")
KMC Enterprises, Inc...................................... Delaware
</TABLE>

<PAGE> 1

EXHIBIT 23.1

CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the reference to our firm under the captions "Summary
Consolidated Financial Data", "Selected Financial Data", and "Experts" and to
the use of our reports dated April 26, 1996 (except Notes 1 and 4, as to which
the date is May 10, 1996) in the Registration Statement (Form S-1) and the
related Prospectus of Krause's Furniture, Inc. for the registration of 4,394,528
shares of its common stock.

/s/ ERNST & YOUNG LLP

Orange County, California
January 3, 1997

<PAGE> 1

EXHIBIT 23.2

CONSENT OF KPMG PEAT MARWICK LLP

We consent to the use of our report dated February 18, 1994 included herein
and to the reference to our firm under the heading "Experts" in the prospectus
of Krause's Furniture, Inc. for the registration of 4,394,528 shares of its
common stock.

Cleveland, Ohio
January 7, 1997