KRAUSES FURNITURE INC, S-1/A, 1997-02-28

KRAUSES FURNITURE INC
S-1/A, 1997-02-28
HOUSEHOLD FURNITURE

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<PAGE> 1

AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON FEBRUARY 28, 1997

REGISTRATION NO. 333-19485

================================================================================

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

AMENDMENT NO. 1

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
================================================================================

<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>
- -----------------------------------------------------------------------------------------------------------------
Common Stock (par value $0.001)..... 50,000 Shares $1.84 $92,000 $27.88
=================================================================================================================
</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 Small Cap Market System on
February 25, 1997, of $1.84.

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

THIS REGISTRATION STATEMENT SHALL HEREAFTER BECOME EFFECTIVE IN ACCORDANCE
WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933.

================================================================================
<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 FEBRUARY 28, 1997

PROSPECTUS

4,444,528 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 under the symbol "SOFA." On , 1997, the last sale price
of the Common Stock as reported by the Nasdaq Small Cap Market 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>
<S> <C> <C> <C> <C>
================================================================================================
UNDERWRITING
PRICE TO DISCOUNTS AND PROCEEDS TO PROCEEDS TO SELLING
PUBLIC(1) COMMISSIONS COMPANY STOCKHOLDERS(2)
- ------------------------------------------------------------------------------------------------
Per Share....... $ $0 $0 $
- ------------------------------------------------------------------------------------------------
Total........... $ $0 $0 $
================================================================================================
</TABLE>

(1) The price stated is an estimate based upon the average of the high and low
sales prices on the Nasdaq Small Cap Market 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....................... 10
Dividends............................. 10
Capitalization........................ 11
Selected Financial Data............... 12
Management's Discussions and Analysis
of Financial Condition and Results
of Operations....................... 13
Business.............................. 19

<CAPTION>
PAGE
----
<S> <C>
Management............................ 24
Certain Transactions.................. 32
Principal and Selling Stockholders.... 34
Plan of Distribution.................. 36
Description of Capital Stock.......... 36
Legal Matters......................... 38
Experts............................... 38
Additional Information................ 39
Index to Consolidated Financial
Statements.......................... 40
</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 a 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). 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 ranks 41st among all U.S. furniture retailers in terms of furniture
sales volume according to an August 1996 survey published by Furniture Today/HFN
Magazine and based on information included in the survey, the Company believes
that it ranks third among vertically-integrated U.S. furniture retailers.

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 from operations during each of the
past five years, due to inefficiencies within its operation and due to depressed
economic conditions in its principal markets. As a

3
<PAGE> 6

result of such losses, 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 in the fourth quarter 1996 and in fiscal year 1997 that will end on
February 1, 1998. At October 27, 1996, the Company also had a working capital
deficiency of approximately $3.8 million and current liabilities of $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.

KFI is a Delaware corporation which is publicly traded on the Nasdaq Small
Cap Market (Nasdaq Small Cap Market 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 Small Cap Market 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................... 4,444,528 Shares
Common Stock outstanding before and after the offering............. 19,020,539 Shares(1)
Nasdaq Small Cap Symbol............................................ SOFA
</TABLE>

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

(1) Based on the number of shares outstanding on January 31, 1997, excluding
1,762,457 shares of Common Stock issuable upon exercise of options and
1,754,956 shares of Common Stock issuable upon exercise of warrants.

RISK FACTORS

There are substantial risks associated with an investment in the Common
Stock of the Company, including, among others, lack of profitable operations and
a history of losses, a substantial working capital deficiency, the dependence to
a significant degree on two raw materials suppliers, control of the Company by
its principal stockholders and the attendant potential for conflicts of interest
between those stockholders and the public stockholders, volatility generally in
the stock market, and the potential failure of the Company to continue to
satisfy the minimum listing maintenance requirements of the Nasdaq Small Cap
Market which could result in the Company's Common Stock no longer being included
on the Nasdaq Small Cap Market. See "Risk Factors."

4
<PAGE> 7

SUMMARY CONSOLIDATED FINANCIAL DATA

The following data for each of the five years in the period ended January
28, 1996 and for the month ended January 29, 1995, has been derived from
consolidated financial statements that have been audited by Ernst & Young LLP,
independent auditors. The information set forth below for the month ended
January 30, 1994 and 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 FIVE WEEKS ENDED FISCAL YEAR ENDED
------------------------ ------------------------ ---------------------------------------
OCTOBER 27, OCTOBER 29, JANUARY 29, JANUARY 30, JANUARY 28, DECEMBER 31, DECEMBER 31,
1996 1995 1995(3) 1994(3) 1996(2) 1994 1993
----------- ----------- ----------- ----------- ----------- ------------ ------------
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS:
Net furniture sales..................... $ 82,738 $ 92,465 $ 7,179 $ 7,326 $ 122,319 $116,471 $ 96,984
Gross profit............................ 40,374 47,845 3,532 3,807 62,467 62,949 50,792
Loss from operations.................... (11,799) (5,545) (3,231) (2,041) (9,388) (2,398) (7,852)
Gain from sale of Mr. Coffee stock(4)... -- -- -- -- -- 12,115 --
Income (loss) before extraordinary
items.................................. (12,374) (4,487) (3,221) (2,185) (8,715) 5,831 (9,751)
Extraordinary items(5).................. -- -- -- -- -- (436) (221)
Net income (loss)....................... (12,374) (4,487) (3,221) (2,185) (8,715) 5,395 (9,972)
Income (loss) per share(6):
Income (loss) before extraordinary
items................................ (1.62) (1.15) (.87) (.63) (2.21) 1.08 (3.88)
Extraordinary items.................... -- -- -- -- -- (0.08) (0.09)
Net income (loss)...................... $ (1.62) $ (1.15) $ (.87) $ (.63) $ (2.21) $ 1.00 $ (3.97)
Weighted average common and common
equivalent shares outstanding(6)....... 7,661 3,905 3,685 3,490 3,950 5,394 2,510

DECEMBER 31, DECEMBER 31,
1992 1991(1)
------------ ------------

<S> <<C> <C>
RESULTS OF OPERATIONS:
Net furniture sales..................... $ 87,045 $ 54,753
Gross profit............................ 45,688 29,790
Loss from operations.................... (5,982) (4,091)
Gain from sale of Mr. Coffee stock(4)... -- --
Income (loss) before extraordinary
items.................................. (3,641) (3,391)
Extraordinary items(5).................. 3,330 (86)
Net income (loss)....................... (311) (3,477)
Income (loss) per share(6):
Income (loss) before extraordinary
items................................ (1.84) (1.93)
Extraordinary items.................... 1.68 (0.05)
Net income (loss)...................... $ (0.16) $ (1.98)
Weighted average common and common
equivalent shares outstanding(6)....... 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
----------- ----------- ----------- ----------- ------------ ------------ ------------
(IN THOUSANDS)
<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(4).................... 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) Average weekly sales (shipments) in January are lower than other months due
to seasonally low order rates in the last three weeks of December.
Therefore, the operating loss reported in January is higher than other
months in the fiscal years presented.

(4) 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.

(5) Represents gain or loss from early debt retirement.

(6) 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 in the fourth quarter 1996 and in fiscal year 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.

CAPITAL REQUIREMENTS; RESTRICTIONS ON COMPANY'S ABILITY TO OBTAIN ADDITIONAL
CAPITAL

Although the Company has raised approximately $18,619,000 in private
offerings of convertible debt and equity since May 1996, the Company may require
additional capital in the future to finance its strategic objectives (see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations") in the event borrowings under Krause's Sofa Factory's revolving
credit facility and internally generated cash are insufficient for this purpose.
This offering is a secondary offering; consequently, the Company will receive
none of the proceeds from the offering. See "Use of Proceeds." The Company
anticipates that its existing capital resources, including borrowings under
Krause's Sofa Factory's revolving credit facility and internally generated cash,
will enable it to fund its plan to remodel and upgrade 25 showrooms during
fiscal 1997 at a projected cost of approximately $1,500,000. However, if this is
not the case, the Company will need to obtain additional capital. Such
additional capital, if raised through the issuance of addtional equity, may
result in additional dilution to investors. There can be no assurance that any
additional equity or debt financing will be available when needed or that, if
available, such financing will be obtained on terms favorable to the Company or
the stockholders.

Krause's Sofa Factory's existing revolving credit facility provides for
borrowings of up to $10,000,000, subject to borrowing base limitations, and
restricts it from incurring additional indebtedness from third parties in an
amount in excess of $5,000,000. Consequently, any significant requirement for
infusions of capital into this operating subsidiary may require the Company to
issue additional equity. The revolving credit agreement further requires
Krause's Sofa Factory to maintain working capital of not less than negative
$8,000,000 and to maintain adjusted net worth of not less than negative
$1,500,000.

In connection with the GECC financing described under "Certain
Transactions" below, the Company entered into a Securities Purchase Agreement
with General Electric Capital Corporation ("GECC"), pursuant to which the
Company issued and sold to GECC 5,000,000 shares of Common Stock, a Warrant to
purchase an additional 1,400,000 shares of Common Stock and a Subordinated
Promissory Note in the principal amount of $5,000,000 (the "Note"). So long as
any portion of the Note remains unpaid, the Company is required to maintain
certain financial covenants and is prohibited from issuing any securities
ranking senior as to dividends or liquidation to the Common Stock. The financial
covenants require that the Company (1) maintain a consolidated net worth of not
less than $14,000,000 in fiscal 1997, $14,500,000 in fiscal 1998, $17,000,000 in
fiscal 1999, $24,000,000 in fiscal 2000 and $35,000,000 in fiscal 2001; (2)
maintain

6
<PAGE> 9

a ratio of consolidated indebtedness to consolidated net worth of not greater
than 1.0 in fiscal 1997, 0.8 in fiscal 1998, 0.6 in fiscal 1999 and 0.35 in
fiscal 2000; (3) maintain a fixed charge ratio of not less than 0.7 in fiscal
1997, 1.0 in fiscal 1998, 1.3 in fiscal 1999 and 1.6 in fiscal 2000; and (4)
limit capital expenditures to not more than $7,500,000 in fiscal 1997,
$7,000,000 in fiscal 1998, $4,000,000 in fiscal 1999 and $4,000,000 in fiscal
2000, provided that any amount not spent in any one fiscal year may be added to
the amount permissible in any succeeding fiscal year.

The above-described restrictions imposed on the Company and on Krause's
Sofa Factory could serve significantly to impair the Company's ability to raise
additional capital either through the issuance of additional equity or debt.

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.
Management believes the economic indicator most relevant to its operations is
consumer confidence. In December 1996 the consumer confidence index, as reported
by the Conference Board, for the Middle Atlantic Region, which includes New
York, was 76.6, while the index for the Pacific Region, which includes
California, was 113.9, both of which are lower than the average index for the
United States as a whole, which was 114.2.

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. Specifically, approximately
70% of aggregate purchases are made from the Company's 10 largest suppliers.
This includes approximately 18% of such purchases consisting of leather
purchased from Lackawanna Leather, constituting most of the leather purchases
made by the Company, and approximately 9% of such purchases consisting of
pre-cut wood components purchased from

7
<PAGE> 10

Montclair Wood, constituting nearly all of the pre-cut wood component purchases
made by the Company. The Company has no supply contract with either Lackawanna
Leather or Montclair Wood, but instead makes each purchase pursuant to a
separate purchase order. Both leather and pre-cut wood components are
commodities the Company believes are readily available from alternative sources
and the Company has, on prior occasions, purchased such commodities from
alternative sources. Nonetheless, inability to develop alternative sources of
supply of leather, pre-cut wood components or certain other products, components
and raw materials 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 66% 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 GECC 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 GECC 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.

POTENTIAL CONFLICTS OF INTEREST BETWEEN PRINCIPAL STOCKHOLDERS AND PUBLIC
STOCKHOLDERS

The potential for conflicts of interest exists between the principal
stockholders of the Company, particularly GECC, and the public stockholders.
Current management, directors and other principal stockholders of the Company
own in the aggregate approximately 66% of the issued and outstanding capital
stock of the Company on a fully-diluted basis. As a result, these stockholders,
if acting together, may have sufficient voting power to elect the entire Board
of Directors of the Company and to determine the outcome of any corporate
transactions or other matters submitted to stockholders for approval. Further,
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 GECC as well as certain existing
stockholders pursuant to which, among other things, 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
and prohibits the Company from taking certain actions unless the member of the
Board of Directors designated by GECC approves such action, all as summarized
under "Control by Principal Stockholders" above and under "Certain Transactions"
below. As a result of the foregoing, it is unlikely that any public stockholder
or group of public stockholders acting in concert would be in the position to
influence corporate policy, particularly where any such policy could have a
detrimental effect on GECC or others of the principal stockholders, even if such
policy would clearly be in the best interest of the public stockholders. These
factors may, for example, have the effect of delaying, deferring or preventing a
change in control of the Company.

8
<PAGE> 11

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 SMALL CAP MARKET 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 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 January 31, 1997, 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 4,444,528

9
<PAGE> 12

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.

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.

10
<PAGE> 13

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>

11
<PAGE> 14

SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
FIVE WEEKS ENDED FISCAL YEAR ENDED
------------------------- ------------------------- --------------------------
OCTOBER 27, OCTOBER 29, JANUARY 29, JANUARY 30, JANUARY 28, DECEMBER 31,
1996 1995 1995(3) 1994(3) 1996(2) 1994
----------- ----------- ----------- ----------- ----------- ------------
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS:
Net furniture sales................. $ 82,738 $92,465 $ 7,179 $ 7,326 $ 122,319 $116,471
Gross profit........................ 40,374 47,845 3,532 3,807 62,467 62,949
Loss from operations................ (11,799) (5,545) (3,231) (2,041) (9,388) (2,398)
Gain from sale of Mr. Coffee
stock(4).......................... -- -- -- -- -- 12,115
Income (loss) before extraordinary
items............................. (12,374) (4,487) (3,221) (2,185) (8,715) 5,831
Extraordinary items(5).............. -- -- -- -- -- (436)
Net income (loss)................... (12,374) (4,487) (3,221) (2,185) (8,715) 5,395
Income (loss) per share(6):
Income (loss) before extraordinary
items........................... (1.62) (1.15) (.87) (.63) (2.21) 1.08
Extraordinary items............... -- -- -- -- -- (0.08)
Net income (loss)................. $ (1.62) $ (1.15) $ (.87) $ (.63) $ (2.21) $ 1.00
Weighted average common and common
equivalent shares
outstanding(6).................... 7,661 3,905 3,685 3,490 3,950 5,394

DECEMBER 31, DECEMBER 31, DECEMBER 31,
1993 1992 1991(1)
------------ ------------ ------------

<S> <C> <C> <C>
RESULTS OF OPERATIONS:
Net furniture sales................. $ 96,984 $ 87,045 $ 54,753
Gross profit........................ 50,792 45,688 29,790
Loss from operations................ (7,852) (5,982) (4,091)
Gain from sale of Mr. Coffee
stock(4).......................... -- -- --
Income (loss) before extraordinary
items............................. (9,751) (3,641) (3,391)
Extraordinary items(5).............. (221) 3,330 (86)
Net income (loss)................... (9,972) (311) (3,477)
Income (loss) per share(6):
Income (loss) before extraordinary
items........................... (3.88) (1.84) (1.93)
Extraordinary items............... (0.09) 1.68 (0.05)
Net income (loss)................. $ (3.97) $ (0.16) $ (1.98)
Weighted average common and common
equivalent shares
outstanding(6).................... 2,510 1,982 1,761
</TABLE>

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

<CAPTION>
DECEMBER 31, DECEMBER 31,
1992 1991
------------ ------------

<S> <C> <C>
BALANCE SHEET DATA:
Total assets............................................ $ 47,730 $ 46,187
Inventories............................................. 11,468 12,790
Working capital deficiency.............................. (3,603) (3,862)
Intangible assets....................................... 16,425 12,943
Short-term debt(4)...................................... 458 3,693
Long-term debt(4)....................................... 15,500 12,376
Stockholders' equity.................................... 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.

(5) Represents gain or loss from early debt retirement.

(6) Previously reported share and per share amounts have been restated to

reflect a one-for-three reverse stock split effective August 1, 1995.

12
<PAGE> 15

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
FIVE WEEKS ENDED FISCAL YEAR ENDED
------------------------- ------------------------- -----------------------------------------
OCTOBER 27, OCTOBER 29, JANUARY 29, JANUARY 30, JANUARY 28, DECEMBER 31, DECEMBER 31,
1996 1995 1995 1994 1996 1994 1993
----------- ----------- ----------- ----------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Net sales.......... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales...... 51.2 48.3 50.8 48.0 48.9 46.0 47.6
------- ------ ----- ----- ------ ------ ------ -
Gross profit....... 48.8 51.7 49.2 52.0 51.1 54.0 52.4
Operating expenses:
Selling............ 52.6 48.2 75.9 67.4 49.3 45.9 49.8
General and
administrative... 9.5 8.7 17.1 11.3 8.7 9.3 9.9
Amortization of
goodwill......... 1.0 .8 1.2 1.2 .8 .9 .8
------- ------ ----- ----- ------ ------ ------ -
63.1 57.7 94.2 79.9 58.8 56.1 60.5
------- ------ ----- ----- ------ ------ ------ -
Loss from
operations....... (14.3) (6.0) (45.0) (27.9) (7.7) (2.1) (8.1)
Interest expense... (1.0) (.6) (.2) (3.5) (.6) (1.8) (3.5)
Other income....... .3 .3 .3 1.6 .1 10.8 1.5
------- ------ ----- ----- ------ ------ ------ -
Income (loss)
before income
taxes and
extraordinary
items............ (15.0) (6.3) (44.9) (29.8) (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) (44.9) (29.8) (7.1) 5.0 (10.1)
Extraordinary
items............ -- -- -- -- -- (.4) (.2)
------- ------ ----- ----- ------ ------ ------ -
Net income
(loss)........... (15.0)% (4.9)% (44.9)% (29.8)% (7.1)% 4.6% (10.3)%
======= ====== ===== ===== ====== ====== =======
</TABLE>

STORE (SHOWROOM) DATA

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

(1) Based upon the weighted average number of stores open during the period
indicated.

(2) Comparable store sales are calculated by excluding the net sales of any
store for any month of the period if the store was not open during the same
month of the prior period. In addition, a store opened at any time during a
month is deemed to have been open for the entire month.

13
<PAGE> 16

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.

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.

FIVE WEEKS ENDED JANUARY 29, 1995 COMPARED TO FIVE WEEKS ENDED JANUARY 30, 1994

Results of operations for the month of January are not indicative of
results for the full year since January has the lowest average weekly shipments
of any month due to seasonally low orders during the last three weeks of
December. The late December orders are normally shipped in January when the sale
is recorded. The low January sales and margins are not sufficient to cover
certain fixed selling expenses and general and administrative expenses, which
resulted in substantial operating losses during the respective periods.

Net furniture sales for January 1995 were $7,179,000 which was a decrease
of approximately 2.0% from net sales in January 1994. The decrease was primarily
attributable to lower backlog position in the 1995 period.

Gross margin was 49.2% of net sales in January 1995 compared to 52.0% in
January 1994. The lower gross margins resulted from more product discounting and
higher freight costs associated with proportionately higher sales in the East
and a higher level of customer credits.

Selling expenses were $5,446,000 in January 1995 and $4,935,000 in January
1994. The increase was principally due to higher advertising expenses in 1995
offset by lower variable selling expenses attributable to lower sales volume.

General and administrative expenses increased by $404,000 to $1,317,000 in
January 1995 from the prior year. General administrative expenses were higher in
the 1995 period principally because of higher personnel costs and employee
termination expenses.

Interest expense decreased by $246,000 in January 1995 compared to January
1994 due principally to significantly less debt outstanding in 1995.

14
<PAGE> 17

The Company's investment in Mr. Coffee, inc. ("Mr. Coffee") was accounted
for by the equity method and the Company recorded equity in earnings from Mr.
Coffee of $93,000 in January 1994. The Company sold its investment in Mr. Coffee
in August 1994.

As a result of the above factors, net loss was $3,221,000 in January 1995
compared to a net loss of $2,185,000 in January 1994. Net loss per share in
January 1995 was $.87 based on 3,685,000 average shares outstanding. In the
comparable 1994 period the net loss per share was $.63 on 3,490,000 average
shares outstanding.

No tax benefits are available for January 1995 or 1994 operating losses.

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. Management
believes that the sales increase is not significantly attributable to increases
in prices or increases in sales volumes for goods being sold in existing stores
or to the introduction of new products. 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.

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 result of increased consumer confidence from general improvements
in economic conditions. Also contributing

15
<PAGE> 18

to the sales increase in 1994 was a full year of sales from Castro Convertibles
showrooms, which were acquired in May 1993. Management believes that the sales
increase is not significantly attributable to increases in prices or to the
introduction of new products in existing stores, but, rather, primarily to
increases in sales volumes of goods being sold in new and existing stores.

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.

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<PAGE> 19

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 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
and a $5,000,000 subordinated note. In addition, $950,000 of convertible notes
and $2,000,000 of demand notes (issued between May 13, 1996 and July 2, 1996 to
related parties) together with accrued interest of $116,251 were exchanged for
3,066,251 shares of Common Stock. See "Certain

17
<PAGE> 20

Transactions." Also, Krause's Sofa Factory'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 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; however, there can be no assurance that the Company will achieve
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 in the fourth
quarter 1996 and in fiscal year 1997.

In fiscal 1997 management plans to remodel and upgrade 25 showrooms at a
cost of approximately $1,500,000. Such capital expenditures are expected to be
funded by internally generated cash and borrowings under Krause's Sofa Factory's
revolving credit facility. The Company has no other significant long-term
capital expenditure requirements or commitments.

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<PAGE> 21

BUSINESS

CORPORATE HISTORY

KFI is a Delaware corporation which is publicly traded on the Nasdaq Small
Cap Market (Nasdaq Small Cap Market 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 Small Cap Market 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 January 31, 1997,
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

19
<PAGE> 22

sold exclusively through its own leased retail showrooms and licensed dealers.
In addition to its exclusive 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.

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<PAGE> 23

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. The Company's 10 largest
suppliers provide the Company with 70% of the raw materials it purchased during
the year ended January 28, 1996, including one such supplier that provided
approximately 18% and another that provided approximately 9% of such raw
materials. Krause's Sofa Factory is dependent on the continued supply of
components and raw materials, including fabrics, leather, foam and

21
<PAGE> 24

sofabed and motion mechanisms. Management constantly seeks new suppliers and
better prices through 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. The Company does not believe any of its
patents is material to its ongoing product lines. 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. These trademarks, which the Company
considers important to its business, have expiration dates ranging from May 13,
2002 to November 30, 2004, but are each renewable in perpetuity. Krause's Sofa
Factory also has other trademarks, both registered and unregistered, that the
Company believes are not material to its business or to any ongoing product
lines.

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 January 31, 1997, 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.

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<PAGE> 25

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 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 the Nasdaq Small Cap Market, 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.................................... 2.13 1.00 3.00 1.63 7.88 4.50
</TABLE>

On February 25, 1997, the closing price of the Company's Common Stock was
$1.81. As of January 31, 1997, there were approximately 400 holders of record of
the Company's Common Stock.

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<PAGE> 26

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
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.

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 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

24
<PAGE> 27

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.
Pursuant to the Stockholders Agreement described in detail under "Description of
Capital Stock", GECC is allowed to designate one director for nomination to be
elected to the Board of Directors of the Company, the Permal Group (as defined
in the Stockholders Agreement) is allowed to designate another director, Philip
M. Hawley is to be designated as a third director, and the three remaining
directors (the "Joint Designees") are to be designated by Mr. Hawley and the
directors who are designated by GECC and the Permal 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.
At present, all directors have been elected pursuant to the Stockholders
Agreement. In this regard, Jeffrey H. Coats is the GECC designee, Thomas M.
DeLitto is the Permal designee and Kamal G. Abdelnour, Peter H. Dailey and John
A. Gavin are the Joint Designees. Mr. Abdelnour has also been elected as a
director of the Company in accordance with a contractual undertaking by the
Company to nominate him. This contract was entered into at the time the Company
issued and sold shares of capital stock to ATCO Holdings Limited (See "Principal
and Selling Stockholders").

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.

25
<PAGE> 28

DIRECTOR COMPENSATION

All directors were reimbursed for travel and other expenses related to
their activities as directors during fiscal year 1996, and will continue to be
so reimbursed in fiscal year 1997 and beyond. The four non-employee directors
other than Jeffrey H. Coats were each paid a fee of $3,333 and were each granted
deferred stock units valued at $10,000 under the Company's 1997 Stock Incentive
Plan (see "Stock Plans" below) for services rendered as directors during fiscal
year 1996. Each non-employee director (other than Mr. Coats) will also be paid a
fee of $10,000 for his services during fiscal year 1997. Also, additional
deferred stock units valued at $10,000 will be granted to each non-employee
director (other than Mr. Coats) in office on December 31, 1997 and on December
31 of each year thereafter during the term of the 1997 Stock Incentive Plan.

COMPENSATION OF EXECUTIVE OFFICERS

The following table discloses compensation received by the Company's
current and former Chief Executive Officers and three other executive officers
whose annual compensation exceeded $100,000 and who were executive officers at
the end of fiscal year 1996. Information presented for 1995 is for the Company's
fiscal year ended January 28, 1996. Information presented for 1994 is for the
prior fiscal calendar year. 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(#) ($)(2)
- ----------------------------------- ----- --------- -------- --------------- ------------
<S> <C> <C> <C> <C> <C>
Philip M. Hawley................... 1996 101,959 1,234,000
Chairman of the Board and
Chief Executive Officer
Thomas M. DeLitto(1)............... 1996 15,000 3,333
President, Chief Executive 1995 1,666 9,375
Officer
and Director 1994 1,666 15,000
Klaus Tabar........................ 1996 141,645 34,030 50,000
Senior Vice President Real Estate 1995 117,899 13,505 1,000
of Krause's Sofa Factory 1994 98,461 12,750
Herbert J. Friedman................ 1996 152,301 50,000
Senior Vice President 1995 136,770 1,200 1,000
Merchandising
and Sales of Krause's Sofa 1994 130,192
Factory
K. James McTaggart................. 1996 121,953 45,000
Senior Vice President
Manufacturing
and Distribution of Krause's Sofa
Factory
</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) Other annual compensation represents directors' fees.

26
<PAGE> 29

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>
Philip M. Hawley....... 1,234,000 74.2% 1.00 08/26/06 2,010,056 3,200,678
Thomas M. DeLitto...... 5,000 .3% .78 07/31/06 6,353 10,116
10,000 .6% 1.62 01/20/07 26,388 42,019
Klaus Tabar............ 50,000 3.0% 1.62 01/20/07 131,940 210,093
Herbert J. Friedman.... 50,000 3.0% 1.62 01/20/07 131,940 210,093
K. James McTaggart..... 5,000 .3% 1.06 03/11/06 8,633 13,747
40,000 2.4% 1.62 01/20/07 105,552 168,074
</TABLE>

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

(1) The Company granted options for a total of 90,000 shares of Common Stock to
directors and 1,572,000 shares of Common Stock to employees of the Company
and Krause's Sofa Factory during 1996.

AGGREGATED OPTION/SAR EXERCISES IN 1996

AND YEAR-END OPTION/SAR VALUES(1)

<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING VALUE OF UNEXERCISED
UNEXERCISED OPTIONS/SARS IN-THE-MONEY OPTIONS/SARS
NUMBER OF AT FISCAL YEAR-END AT FISCAL YEAR-END(2)
SHARES ACQUIRED VALUE ----------------------------- -----------------------------
NAME ON EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------ --------------- -------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Philip M. Hawley........ -- -- 308,500 925,500 $ 308,500 $ 925,500
Thomas M. DeLitto....... -- -- 14,998 5,000 3,800 6,100
Klaus Tabar............. -- -- 16,111 51,089 -- 19,000
Herbert J. Friedman..... -- -- 10,387 50,873 -- 19,000
K. James McTaggart...... -- -- 1,667 43,333 1,567 18,333
</TABLE>

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

(1) No options or SARs were exercised by the above-named executives in 1996.

(2) Based on closing price of Common Stock as quoted on the Nasdaq Small Cap
Market of $2.00 on January 31, 1997.

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 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,
the Company was able to grant incentive stock options ("ISOs") and nonstatutory
stock options ("NSOs") only to employees, including officers, of the Company and
its subsidiaries. The

27
<PAGE> 30

Employees Plan was terminated by the Board of Directors in January 1997, and no
more options may be granted under the Employees Plan. Options outstanding under
the Employees Plan remain in full force and effect.

The exercise price of all options granted under the Employees Plan is equal
to 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 owned more than 10% of
the voting power of all classes of capital stock of the Company at the date of
grant provided 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 are
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 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 is 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. 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 has been 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
resulted in the number of shares reserved for issuance upon exercise of options
granted under the Directors Plan remaining at 200,000.

28
<PAGE> 31

The Directors Plan was terminated by the Board of Directors in January 1997, and
no more options may be granted under the Directors Plan. Options outstanding
under the Directors Plan remain in full force and effect.

The Directors Plan provided 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
continued to serve as a director, he or she automatically received 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.

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 was 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 were terminated by the Board of Directors in January 1997, and no
more options may be granted under them. There are currently options to purchase
an aggregate of 11,880 shares of the Company's Common Stock outstanding to two
employees which will continue in full force and effect. 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.

29
<PAGE> 32

1997 Stock Incentive Plan

The 1997 Stock Incentive Plan (the "1997 Plan") was approved by the Board
of Directors in January 1997 and is scheduled to be presented to stockholders at
the next annual meeting of stockholders for their approval. The 1997 Plan
extends for 10 years, but may be terminated at an earlier date. Until
stockholder approval is obtained all awards under the 1997 Plan are specifically
conditioned upon obtaining stockholder approval and, if the approval is not
obtained, will be canceled. The 1997 Plan provides for the issuance of awards
covering up to 800,000 shares to employees, officers, directors and consultants.

Awards under the 1997 Plan can consist of options, stock appreciation
rights, dividend equivalent rights, restricted stock, performance shares,
deferred stock units or other stock based awards. The Compensation Committee of
the Board of Directors, which includes only non-employee directors as its
members, has been designated to administer the 1997 Plan. The administrator has
the power to select employees, officers, directors and consultants to receive
awards, to make awards, to determine the terms upon which awards are made, to
approve agreements with recipients of awards, to amend awards, to interpret the
1997 Plan and to take other actions not inconsistent with the express terms of
the 1997 Plan.

Directors who are not employees of the Company, other than one non-employee
director who has indicated that he cannot accept an award because of his current
employment by a stockholder, receive automatic grants of deferred stock units
covering shares having a fair market value of $10,000 for each year of service
as a director. These awards provide deferred compensation to directors
equivalent to an investment in an equivalent amount of the Company's Common
Stock, based upon the fair market value of the Company's shares on the date the
award is effective. Payout of the award is made in stock following a director's
retirement from the Board of Directors or death. Normally the payment occurs in
five annual installments, but a director may elect to receive a single payment.
If a change in control of the Company occurs, the director's deferred stock unit
account will be paid in cash.

The Compensation Committee in its capacity as administrator of the 1997
Plan has broad authority to determine the type and amount of all other awards.
All awards must be set forth in an agreement. If awards are intended to qualify
as ISO's, they must conform to the requirements of the Internal Revenue Code of
1986, as amended (the "Code"). The committee may establish award exchange
programs or permit early exercise of awards. In general, awards may not have a
term of more than 10 years, and in some cases must have shorter terms. ISO's may
not be transferable except upon death or disability and then only to a limited
extent. Other awards can be transferable to the extend provided in the award
agreement. All option and other awards intended to qualify as performance based
compensation under the Code must be issued at fair market value on the date of
grant or award. The Committee is permitted to issue other awards at prices it
finds appropriate. The Company is permitted to withhold shares or other awards
to compensate it for withholding or other taxes. The Committee also can issue
new options to replace options canceled for this purpose. The Committee
determines the vesting or other timing of the exercise of an award and the
extent to which a recipient of an award or his or her successor can exercise an
award following termination of employment.

The 1997 Plan provides for adjustments in the case of stock splits, reverse
stock splits, stock dividends and other similar events. In the event of a merger
or sale of substantially all of the Company's assets in connection with a
dissolution of the Company, awards under the 1997 Plan will become fully vested,
unless they are assumed by a successor or are otherwise replaced as is provided
in the 1997 Plan. The Committee has authority to authorize full vesting if a
change of control occurs, although this may be conditioned, among other things,
upon a termination of employment following a change of control

1997 MANAGEMENT COMMITTEE INCENTIVE AWARD PROGRAM

The 1997 Management Committee Incentive Award Program (the "Management
Plan") was adopted by the Board of Directors in January 1997, to provide a means
by which certain management level employees of the Company are entitled to
receive bonuses if the Company meets certain financial objectives. The
Management Plan provides that such employees will earn up to one percent of
their respective base salaries for each $100,000 that the Company's earnings
before interest, taxes, depreciation and amortization exceed

30
<PAGE> 33

$500,000 during fiscal year 1997. The Management Plan will be administered by
the Compensation Committee.

EMPLOYMENT AGREEMENTS

In August 1996, the Company entered into an Employment Agreement with
Philip M. Hawley pursuant to which the Company agreed to employ Mr. Hawley for a
term ending on August 25, 1999, and to pay Mr. Hawley a base salary at the rate
of $225,000 per year and provide benefits. If Mr. Hawley's employment is
terminated by the Company without cause (as defined in the Employment Agreement)
he is entitled to receive his full base salary and benefits for the remaining
term of the Employment Agreement. If Mr. Hawley resigns from the Company upon a
change in control (as defined in the Employment Agreement) he is entitled to a
lump sum payment equal to the greater of (1) the remaining amounts that would be
payable to him under the Employment Agreement and (2) $225,000. 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. Mr. Hawley is also entitled to all other benefits of
employment available to executive officers of the Company generally, including
bonuses, retirement, vacation, deferred compensation, employee discount, and
various health related benefits.

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, former President and Chief
Executive Officer of Krause's Sofa Factory, whose employment terminated at the
end of January 1997, was 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, former Executive Vice President and Treasurer of the
Company, terminated 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.

31
<PAGE> 34

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 issued in connection with the GECC financing
were sold at a price of $1.00 per share. This price was negotiated at arms'
length between the Company and GECC, the lead investor, prior to August 19,
1996, the date of the public announcement regarding the proposed GECC financing,
and reflects, among other things, the Company's prospects, a slight discount
from market value reflecting the quantity of shares involved in the transaction
and the fact that the shares were restricted securities when issued. The average
high and low sales prices on the Nasdaq Small Cap Market for the Company's
Common Stock during the two weeks prior to August 19, 1996, was $0.91 per share.
The average of the high and low sales prices on the Nasdaq Small Cap Market for
the Company's Common Stock on August 26, 1996, and on September 10, 1996, the
closing dates of the transactions, was $1.66 and $1.47, respectively.

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.)

32
<PAGE> 35

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. Michael W. 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 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.

Private Label Credit Card Program with Monogram Credit Card Bank of Georgia
(an Affiliate of GECC). The Company has accepted a proposal from Monogram Credit
Card Bank of Georgia ("Monogram"), an affiliate of GECC, pursuant to which, and
subject to execution of definitive agreements, Monogram will provide a
customized credit program to the Company. Pursuant to the program, approved
customers of Krause's Sofa Factory will be able to purchase products on credit
through a credit card issued by Monogram. Monogram will purchase each credit
from the Company and will bear the risk of loss on such credit purchases. The
program will be for an initial term of five years and will automatically renew
for consecutive five year terms unless terminated by either party at least six
months prior to the end of any such five year term.

33
<PAGE> 36

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 30,000 308,500 1.6
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>

34
<PAGE> 37

<TABLE>
<CAPTION>
SHARES BENEFICIALLY
OWNED SHARES BENEFICIALLY
PRIOR TO OFFERING(1) NUMBER OF SHARES OWNED AFTER OFFERING
NAME AND ADDRESS OF BENEFICIAL OWNER PERCENT BEING OFFERED NUMBER PERCENT
- ------------------------------------ ---- ---------- ----
NUMBER
---------
<S> <C> <C> <C> <C> <C>
G(2) Investment Partners............ 123,333 * 90,000 33,333 *
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 -- --
Dr. Philip M. Hawley, Jr. .......... 20,000 * 20,000 -- --
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.................... 78,386 * 50,000 28,386 *
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.

35
<PAGE> 38

(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. Mr. Anderson
terminated as an officer and employee of the Company at the end of January
1997.

(10) Includes options to purchase 17,332 shares of Common Stock. Mr. Sharpe
terminated as an officer and employee of the Company effective January 31,
1997.

(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 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 January 31, 1997, 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 1,762,457 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.

36
<PAGE> 39

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 January 31, 1997, the Company had 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

37
<PAGE> 40

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 and financial statement schedule 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 reports 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.

38
<PAGE> 41

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.

39
<PAGE> 42

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>

40
<PAGE> 43

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> 44

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> 45

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.................................................... $ 12,036 $ 14,285
Accrued payroll and related expenses................................ 1,696 1,704
Other accrued liabilities........................................... 4,140 3,257
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> 46

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 benefit of $291 in 1994 and $144 in 1993......... -- (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> 47

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> 48

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 (payments) on short-term notes......... (18) (1,093) 689
Proceeds from long-term borrowings.................... 141,371 100 5,665
Principal payments on long-term debt.................. (137,948) (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> 49

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> 50

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> 51

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> 52

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> 53

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>

During late 1994 and early 1995 the Company constructed a showroom in
Dallas, Texas on leased land. The building was sold in May 1995 for $1,039,000
to an unrelated party and leased back for a period of 250 months. The sale
resulted in a gain of $364,000, which was deferred and is being amortized over
the term of the lease.

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.

F-11
<PAGE> 54

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

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.

F-12
<PAGE> 55

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 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

F-13
<PAGE> 56

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

such loss of $221,000 has been recorded as an extraordinary loss in the 1993
consolidated statement of operations.

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> 57

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> 58

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> 59

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> 60

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................................................................ $ 9,011
Accrued payroll and related expenses............................................ 1,593
Other accrued liabilities....................................................... 6,577
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> 61

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> 62

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> 63

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:
Proceeds from revolving credit borrowings......................... 97,053 105,935
Payments on revolving credit...................................... (101,028) (103,883)
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> 64

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 $950,000 of
convertible notes and $2,000,000 of demand notes (issued between May 13, 1996
and July 2, 1996 to related parties) 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> 65

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> 66

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................................................... $ 50,000
Accounting Fees and Expenses.............................................. $ 35,000
NASD Fees................................................................. $ 0
Blue Sky Fees and Expenses (Including Legal Fees)......................... $ 10,000
Printing and Engraving Fees............................................... $ 20,000
Total........................................................... $117,000
</TABLE>

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 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>

II-1
<PAGE> 67

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
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
Dr. 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
</TABLE>

II-2
<PAGE> 68

<TABLE>
<CAPTION>
NO. OF SHARES NO. OF SHARES
NAME ON 8/26/96 ON 9/10/96
------------------------------------------------------------- --------- ---------
<S> <C> <C>
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)
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)
</TABLE>

II-3
<PAGE> 69

<TABLE>
<S> <C>
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)
10.10 1997 Stock Incentive Plan.
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).

(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

II-4
<PAGE> 70

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> 71

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 February 28, 1997.

KRAUSE'S FURNITURE, INC.

By /s/ ROBERT A. BURTON
------------------------------------

Robert A. Burton, Senior Vice
President

and Chief Financial Officer

Pursuant to the requirements of the Securities Act of 1933, this Amendment
No. 1 to Registration Statement has been signed by the following persons in the
capacities indicated, as of February 28, 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/ 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
*By /s/ ROBERT A. BURTON
- ------------------------------------------
Robert A. Burton, Attorney-in-Fact
</TABLE>

II-6
<PAGE> 72

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> 73

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> 74

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)
10.10 1997 Stock Incentive Plan.
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> 75

(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).

<PAGE> 1
EXHIBIT 5

[WENDEL, ROSEN, BLACK & DEAN, LLP LETTERHEAD]

February 28, 1997

Krause's Furniture, Inc.
5980 Stoneridge Dr., Suite 109
Pleasanton, CA 94588

RE: REGISTRATION OF SECURITIES ON FORM S-1 REGISTRATION STATEMENT
OF KRAUSE'S FURNITURE, INC.

Ladies and Gentlemen:

You have requested our opinion in connection with the above-referenced
Registration Statement, as amended (the "Registration Statement"), under which
Krause's Furniture, Inc., a Delaware corporation (the "Company"), is
registering for sale certain shares of the Company's Common Stock, par value
$.001 per share (the "Common Stock"), which are presently issued and
outstanding. The shares of Common Stock being registered for sale pursuant to
the Registration Statement are referred to herein as the "Shares."

We have examined, among other things, originals or copies identified to
our satisfaction as being true copies of the above-referenced Registration
Statement, the Certificate of Incorporation and Bylaws of the Company, various
corporate resolutions adopted by the Board of Directors of the Company relating
to the authorization and issuance of the Shares, and other pertinent documents
and instruments of the Company. In addition to such examination, we have
obtained from officers of the Company other such information and advice as we
have deemed necessary for purposes of this opinion.

On the basis of the foregoing and our examination and consideration of
such other factual and legal matters as we have deemed appropriate in the
premises, we are of the opinion as follows:

1. All of the Shares are duly authorized.

2. The Shares have been legally issued and are fully paid and
nonassessable.

We consent to the use of our name under the caption "Legal Matters" in
the Registration Statement and to the filing of this opinion as an exhibit to
the Registration Statement. In giving this consent, we do not hereby admit that
we come within the category of persons whose consent is required under Section
7 of the Securities Act of 1933, as amended, or the rules and regulations of
the Securities and Exchange Commission thereunder.

Very truly yours,

WENDEL, ROSEN, BLACK & DEAN, LLP

/s/ William E. Horwich
---------------------------------
William E. Horwich

WEH:JGP:Isc

<PAGE> 1

EXHIBIT 10.10

KRAUSES'S FURNITURE, INC.

1997 STOCK INCENTIVE PLAN

1. Purposes of the Plan. The purposes of this Stock Incentive Plan are to
attract and retain the best available personnel for positions of substantial
responsibility, to provide additional incentive to Employees, Officers,
Directors and Consultants of the Company and its Subsidiaries and to promote the
success of the Company's business.

2. Definitions. As used herein, the following definitions shall apply:

(a) "Account" means a bookkeeping account established for a
Participant under Section 6.

(b) "Administrator" means the Board or any of the Committees appointed
to administer the Plan.

(c) "Affiliate" and "Associate" shall have the respective meanings
ascribed to such terms in Rule 12b-2 promulgated under the Exchange Act.

(d) "Applicable Laws" means the legal requirements relating to the
administration of stock incentive plans, if any, under applicable
provisions of federal securities laws, state corporate and securities laws,
the Code, the rules of any applicable stock exchange or national market
system, and the rules of any foreign jurisdiction applicable to Awards
granted to residents therein.

(e) "Award" means the grant of an Option, SAR, Dividend Equivalent
Right, Restricted Stock, Performance Unit, Performance Share, Deferred
Stock Unit or other right or benefit under the Plan.

(f) "Award Agreement" means the written agreement evidencing the grant
of an Award executed by the Company and the Grantee, including any
amendments thereto.

(g) "Beneficiary" mean's a Grantee's beneficiary, designated in
writing and in a form and manner satisfactory to the Administrator, or if a
Grantee fails to designate a beneficiary, or if the Grantee's designated
Beneficiary predeceases the Grantee, the Grantee's estate.

(h) "Board" means the Board of Directors of the Company.

(i) "Change in Control" means a change in ownership or control of the
Company effected through either of the following transactions:

(1) the direct or indirect acquisition by any person or related
group of persons (other than an acquisition from or by the Company or by
a Company-sponsored employee benefit plan or by a person that directly
or indirectly controls, is controlled by, or is under common control
with, the Company) of beneficial ownership (within the meaning of Rule
13d-3 of the Exchange Act) of securities possessing more than fifty
percent (50%) of the total combined voting power of the Company's
outstanding securities pursuant to a tender or exchange offer made
directly to the Company's stockholders which a majority of the
Continuing Directors who are not Affiliates or Associates of the offeror
do not recommend such stockholders accept, or

(2) a change in the composition of the Board over a period of
thirty-six (36) months or less such that a majority of the Board members
ceases, by reason of one or more contested elections for Board
membership, to be comprised of individuals who are Continuing Directors.

(j) "Closing Price" shall mean, for any trading day, the closing price
of a Share on the market then used to determine Fair Market Value.

(k) "Code" means the Internal Revenue Code of 1986, as amended.

(l) "Committee" means any committee appointed by the Board to
administer the Plan.

(m) "Common Stock" means the common stock of the Company.

1
<PAGE> 2

(n) "Company" means Krause's Furniture, Inc., a Delaware corporation.

(o) "Consultant" means any person who is engaged by the Company or any
Parent or Subsidiary to render consulting or advisory services as an
independent contractor and is compensated for such services.

(p) "Continuing Directors" means members of the Board who either (i)
have been Board members continuously for a period of at least thirty-six
(36) months or (ii) have been Board members for less than thirty-six (36)
months and were elected or nominated for election as Board members by at
least a majority of the Board members described in clause (i) who were
still in office at the time such election or nomination was approved by the
Board.

(q) "Continuous Status as an Employee, Officer, Director or
Consultant"means that the employment, officer, director or consulting
relationship with the Company, any Parent, or Subsidiary, is not
interrupted or terminated. Continuous Status as an Employee, Director or
Consultant shall not be considered interrupted in the case of (i) any leave
of absence approved by the Company or (ii) transfers between locations of
the Company or between the Company, its Parent, any Subsidiary, or any
successor. A leave of absence approved by the Company shall include sick
leave, military leave, or any other personal leave approved by an
authorized representative of the Company. For purposes of Incentive Stock
Options, no such leave may exceed the time permitted in the Company's
personnel policies published from time to time, unless reemployment upon
expiration of such leave is guaranteed by statute or contract.

(r) "Corporate Transaction" means any of the following
stockholder-approved transactions to which the Company is a party:

(1) a merger or consolidation in which the Company is not the
surviving entity, except for a transaction the principal purpose of
which is to change the state in which the Company is incorporated;

(2) the sale, transfer or other disposition of all or substantially
all of the assets of the Company (including the capital stock of the
Company's subsidiary corporations) in connection with the complete
liquidation or dissolution of the Company; or

(3) any reverse merger in which the Company is the surviving entity
but in which securities possessing more than fifty percent (50%) of the
total combined voting power of the Company's outstanding securities are
transferred to a person or persons different from those who held such
securities immediately prior to such merger.

(s) "Covered Employee" means an Employee who is a "covered employee"
under Section 162(m)(3) of the Code.

(t) "Deferred Stock Unit" means a hypothetical share of Common Stock
as described in Section 6.

(u) "Director" means a member of the Board.

(v) "Dividend Equivalent Right" means a right entitling the Grantee to
compensation measured by dividends paid with respect to Common Stock.

(w) "Effective Date" means the date when this Plan has been adopted by
the Board.

(x) "Employee" means any person, including an Officer or Director, who
is an employee of the Company or any Parent or Subsidiary of the Company
for purposes of Section 422 of the Code. The payment of a director's fee by
the Company shall not be sufficient to constitute "employment" by the
Company.

(y) "Exchange Act" means the Securities Exchange Act of 1934, as
amended.

(z) "Fair Market Value" means, as of any date, the value of Common
Stock determined as follows:

(1) Where there exists a public market for the Common Stock, the
Fair Market Value shall be (A) the closing price for a Share for the
last market trading day prior to the time of the

2
<PAGE> 3

determination (or, if no closing price was reported on that date, on the
last trading date on which a closing price was reported) on the stock
exchange determined by the Administrator to be the primary market for
the Common Stock or the NASDAQ National Market, whichever is applicable
or (B) if the Common Stock is not traded on any such exchange or
national market system, the average of the closing prices of a Share on
the NASDAQ Small Cap Market for the three trading days prior to the time
of the determination (or, if no such prices were reported on one or more
of such days, on the last three days on which such prices were
reported), in each case, as reported in The Wall Street Journal or such
other source as the Administrator deems reliable; or

(2) In the absence of an established market of the type described
in (1), above, for the Common Stock, the Fair Market Value thereof shall
be determined by the Administrator in good faith.

(aa) "Grantee" means an Employee, Director or Consultant who receives
an Award under the Plan.

(bb) "Incentive Stock Option" means an option intended to qualify as
an Incentive Stock Option under Section 422 of the Code.

(cc) "Non-Qualified Stock Option" means an Option not intended to
qualify as an Incentive Stock Option.

(dd) "Officer" means a person who is an officer of the Company within
the meaning of Section 16 of the Exchange Act and the rules and regulations
promulgated thereunder.

(ee) "Option" means a stock option granted pursuant to the Plan.

(ff) "Outside Director" means a Director who is not the beneficial
owner of ten percent (10%) or more of the Company's stock of any class or
an employee of the Company or of any Subsidiary.

(gg) "Parent" means a "parent corporation," whether now or hereafter
existing, as defined in Section 424(e) of the Code.

(hh) "Participating Outside Director" means an Outside Director who
has not indicated in writing to the Company prior to the date of an Award
under Section 6 the he or she cannot or does not wish to participate in the
deferred stock program described in Section 6.

(ii) "Payment Commencement Date" means the first business day of the
Plan Year immediately following the Plan Year in which the Outside Director
terminates service as a member of the Board.

(jj) "Performance-Based Compensation" means compensation qualifying as
"performance-based compensation" under Section 162(m) of the Code.

(kk) "Performance Shares" means Shares or an award denominated in
Shares which may be earned in whole or in part upon attainment of
performance criteria established by the Administrator.

(ll) "Performance Units" means an award which may be earned in whole
or in part upon attainment of performance criteria established by the
Administrator and which may be settled for cash, Shares or other securities
or a combination of cash, Shares or other securities as established by the
Administrator.

(mm) "Plan" means this 1997 Stock Incentive Plan.

(nn) "Plan Year" means the calendar year.

(oo) "Restricted Stock" means Shares issued under the Plan to the
Grantee for such consideration, if any, and subject to such restrictions on
transfer, rights of first refusal, repurchase provisions, forfeiture
provisions, and other terms and conditions as established by the
Administrator.

(pp) "Rule 16b-3" means Rule 16b-3 promulgated under the Exchange Act
or any successor thereto.

(qq) "SAR" means a stock appreciation right entitling the Grantee to
Shares or cash compensation, as established by the Administrator, measured
by appreciation in the value of Common Stock.

3
<PAGE> 4

(rr) "Share" means a share of the Common Stock.

(ss) "Subsidiary" means a "subsidiary corporation," whether now or
hereafter existing, as defined in Section 424(f) of the Code.

(tt) "Subsidiary Disposition" means the disposition by the Company of
its equity holdings in any subsidiary corporation effected by a merger or
consolidation involving that subsidiary corporation, the sale of all or
substantially all of the assets of that subsidiary corporation or the
Company's sale or distribution of substantially all of the outstanding
capital stock of such subsidiary corporation.

3. Stock Subject to the Plan.

(a) Subject to the provisions of Section 10, below, the maximum
aggregate number of Shares which may be issued pursuant to all Awards is
eight hundred thousand (800,000). The Shares to be issued pursuant to
Awards may be authorized, but unissued, or reacquired Common Stock.

(b) If an Award expires or becomes unexercisable without having been
exercised in full, or is surrendered pursuant to an Award exchange program,
or if any unissued Shares are retained by the Company upon exercise of an
Award in order to satisfy the exercise price for such Award or any
withholding taxes due with respect to such Award, such unissued or retained
Shares shall become available for future grant or sale under the Plan
(unless the Plan has terminated). Shares that actually have been issued
under the Plan pursuant to an Award shall not be returned to the Plan and
shall not become available for future distribution under the Plan, except
that if unvested Shares are forfeited, or repurchased by the Company at
their original purchase price, such Shares shall become available for
future grant under the Plan.

4. Administration of the Plan.

(a) Plan Administrator.

(1) Administration with Respect to Directors and Officers. With
respect to grants of Awards to Officers, Directors or Employees who are
also Officers or Directors of the Company, the Plan shall be
administered by (A) the Board or (B) a Committee designated by the Board
to serve at the pleasure of the Board, which Committee shall be
constituted in such a manner as to satisfy the Applicable Laws and to
permit such grants and related transactions under the Plan to be exempt
from Section 16(b) of the Exchange Act in accordance with Rule 16b-3.
Once appointed, such Committee shall continue to serve in its designated
capacity until otherwise directed by the Board. The Committee shall
select one of its members as chairman, and shall hold meetings at such
times and places as it may determine. A majority of the Committee shall
constitute a quorum and acts of the Committee at which a quorum is
present, or acts reduced to or approved in writing by all members of the
Committee, shall be the valid acts of the Committee.

(2) Administration With Respect to Consultants and Other
Employees. With respect to grants of Awards to Employees or Consultants
who are neither Directors nor Officers of the Company, the Plan shall be
administered by (A) the Board or (B) a Committee designated by the
Board, which Committee shall be constituted in such a manner as to
satisfy the Applicable Laws. Once appointed, such Committee shall
continue to serve in its designated capacity until otherwise directed by
the Board. The Board may authorize one or more Officers to grant such
Awards and may limit such authority by requiring that such Awards must
be reported to and ratified by the Board or a Committee within six (6)
months of the grant date, and if so ratified, shall be effective as of
the grant date.

(3) Administration With Respect to Covered
Employees. Notwithstanding the foregoing, grants of Awards to any
Covered Employee intended to qualify as Performance-Based Compensation
shall be made only by a Committee (or subcommittee of a Committee) which
is comprised solely of two or more Directors eligible to serve on a
committee making Awards qualifying as Performance-Based Compensation. In
the case of such Awards granted to Covered Employees,

4
<PAGE> 5

references to the "Administrator" or to a "Committee" shall be deemed to
be references to such Committee or subcommittee.

(4) Administration Errors. In the event an Award is granted in a
manner inconsistent with the provisions of this subsection (a), such
Award shall be presumptively valid as of its grant date to the extent
permitted by the Applicable Laws.

(5) Notwithstanding the foregoing and any designation of the
Administrator by the Board, Awards made under Section 6 shall be
administered exclusively by the Board, except as is specifically
otherwise provided in Section 6.

(b) Powers of the Administrator. Subject to Applicable Laws and the
provisions of the Plan (including any other powers given to the
Administrator hereunder), and except as otherwise provided by the Board,
the Administrator shall have the authority, in its discretion:

(1) to select the Employees, Officers, Directors and Consultants to
whom Awards may be granted from time to time hereunder;

(2) to determine whether and to what extent Awards are granted
hereunder;

(3) to determine the number of Shares or the amount of other
consideration to be covered by each Award granted hereunder;

(4) to approve forms of Award Agreement for use under the Plan;

(5) to determine the terms and conditions of any Award granted
hereunder;

(6) to amend the terms of any outstanding Award granted under the
Plan, including a reduction in the exercise price (or base amount on
which appreciation is measured) of any Award to reflect a reduction in
the Fair Market Value of the Common Stock since the grant date of the
Award, provided that any amendment that would adversely affect the
Grantee's rights under an outstanding Award shall not be made without
the Grantee's written consent; provided, however, that the Administrator
may not amend the terms of any outstanding option to reduce the purchase
price of the Shares covered by such option without the consent of the
stockholders then sufficient to approve the Plan in the first instance.
The Administrator may, with the Optionee's written consent, cancel any
outstanding stock option or accept any outstanding stock option in
exchange for a new option; provided, however, that the Administrator may
not cancel any outstanding option and replace such canceled option with
any option or options having a purchase price of the Shares covered by
such option or options which is lower than that of the canceled option
without the consent of the stockholders then sufficient to approve the
Plan in the first instance.

(7) to construe and interpret the terms of the Plan and Awards
granted pursuant to the Plan;

(8) to establish additional terms, conditions, rules or procedures
to accommodate the rules or laws of applicable foreign jurisdictions and
to afford Grantees favorable treatment under such laws; provided,
however, that no Award shall be granted under any such additional terms,
conditions, rules or procedures with terms or conditions which are
inconsistent with the provisions of the Plan; and

(9) to take such other action, not inconsistent with the terms of
the Plan, as the Administrator deems appropriate.

(c) Effect of Administrator's Decision. All decisions, determinations
and interpretations of the Administrator shall be conclusive and binding on
all persons.

5. Eligibility. Awards, other than Incentive Stock Options, may be granted
to Employees, Officers, Directors and Consultants. Incentive Stock Options may
be granted only to Employees. An Employee, Officer, Director or Consultant who
has been granted an Award may, if otherwise eligible, be granted additional
Awards; provided, however, Outside Directors shall not be eligible for any award
under this plan other than those provided for in Section 6. Awards may be
granted to such Employees of the Company and its subsidiaries who are residing
in foreign jurisdictions as the Administrator may determine from time to time.

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6. Automatic Awards of Deferred Stock Units to Outside Directors.

(a) As of the Effective Date and as of the last day of each Plan Year,
the Company shall credit Deferred Stock Units to each participating Outside
Director's Deferred Stock Unit Account equal to the number of Deferred
Stock Units determined by dividing Ten Thousand Dollars ($10,000) by the
Fair Market Value of a Share on the date of the Award. In the case of a
Participating Outside Director whose service as an Outside Director
terminates during the Plan Year, the applicable dollar amount shall be
determined by multiplying Ten Thousand Dollars ($10,000) by a fraction, the
numerator of which shall be the number of full calendar quarters of service
as an Outside Director completed by the Participating Outside Director
during the Plan Year and the denominator of which shall be four.

(b) A separate Account under the Plan shall be established for each
Participating Outside Director. Such Account shall be (i) credited with the
amounts credited in accordance with paragraph (a), (ii) credited (or
charged, as the case may be) with the investment results determined in
accordance with paragraph (c) and (iii) charged with the amounts paid by
the Plan to or on behalf of the Participating Outside Director in
accordance with paragraph (e). Within each Participating Outside Director's
Account, separate subaccounts shall be maintained to the extent the
Administrator determines them to be necessary or useful in the
administration of the Plan.

(c) A Participating Outside Director's Deferred Stock Unit Account
shall be treated as if it were invested in Deferred Stock Units that are
equivalent in value to the fair market value of shares of Company Common
Stock in accordance with the following rules:

(1) Deemed Reinvestment Of Dividends. The number of Deferred Stock
Units credited to a Participating Outside Director's Deferred Stock Unit
Account shall be increased on each date on which a dividend is paid on
Company Common Stock. The number of additional Deferred Stock Units
credited to a Participating Outside Director's Deferred Stock Unit
Account as a result of such increase shall be determined by (i)
multiplying the total number of Deferred Stock Units (excluding
fractional Deferred Stock Units) credited to the Participating Outside
Director's Deferred Stock Unit Account immediately before such increase
by the amount of the dividend paid per share of Company Common Stock on
the dividend payment date, and (ii) dividing the product so determined
by the Fair Market Value of a Share on the dividend payment date.

(2) Conversion Out of Deferred Stock Units. The dollar value of the
Deferred Stock Units credited to a Participating Outside Director's
Deferred Stock Unit Account on any date shall be determined by
multiplying the number of Deferred Stock Units (including fractional
Deferred Stock Units) credited to the Participating Outside Director's
Deferred Stock Unit Account by the Fair Market Value of a Share on that
date.

(3) Effect of Recapitalization. In the event of a transaction or
event described in this subparagraph (3), the number of Deferred Stock
Units credited to a Participating Outside Director's Deferred Stock Unit
Account shall be adjusted in such manner as the Board, in its sole
discretion, deems equitable. A transaction or event is described in this
subparagraph (3) if (x) it is a dividend (other than regular quarterly
dividends) or other distribution (whether in the form of cash, shares,
other securities, or other property), extraordinary cash dividend,
recapitalization, stock split, reverse stock split, reorganization,
merger, consolidation, split-up, spin-off, repurchase, or exchange of
shares or other securities, the issuance or exercisability of stock
purchase rights, the issuance of warrants or other rights to purchase
shares or other securities, or other similar corporate transaction or
event and (y) the Board determines that such transaction or event
affects the shares of Company Common Stock, such that an adjustment
pursuant to this paragraph (3) is appropriate to prevent dilution or
enlargement of the benefits or potential benefits intended to be made
available under the Plan.

(4) Change in Deemed Investment Election. A Participating Outside
Director who elects to receive distribution of his or her Accounts in
annual installments will continue to have his or her Deferred Stock Unit
Account credited with Deferred Stock Units during the installment
period.

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<PAGE> 7

(d) Each Account established under this Section 6 shall be maintained
for bookkeeping purposes only. Neither the Plan nor any of the Accounts
established under the Plan shall hold any actual funds or assets. The
Deferred Stock Units established hereunder shall be used solely to
determine the amounts to be paid hereunder, shall not be or represent an
equity security of the Company, shall not be convertible into or otherwise
entitle a Participating Outside Director to acquire an equity security of
the Company and shall not carry any voting or dividend rights.

(e) Payments shall be made as follows:

(1) Amounts credited to a Participating Outside Director's Deferred
Stock Unit Account shall be paid in shares of Company Common Stock,
except that a cash payment will be made with any final installment for
any fraction of a Deferred Stock Unit remaining in the Participating
Outside Director's Account. Such fractional Deferred Stock Unit shall be
valued at the Closing Price on the date of settlement. The right of any
person to receive one or more payments under this Section 6 shall be an
unsecured claim against the general assets of the Company.

(2) Payments to a Participating Outside Director with respect to
the Participating Outside Director's Account shall begin as of the
Participating Outside Director's Payment Commencement Date; provided
that if a Participating Outside Director dies before the Participating
Outside Director's Payment Commencement Date, payment of the entire
value of the Participating Outside Director's Account shall be made to
the Participating Outside Director's Beneficiary in accordance with the
provisions of subparagraphs (3) or (4), whichever is applicable, after
the Administrator receives all documents and other information that it
requests in connection with the payment.

(3) Five Annual Installments. A Participating Outside Director
shall receive his or her Account in five annual installments unless the
Participating Outside Director elects to receive his or her benefits
under the Plan in the form of a lump-sum payment in accordance with
subparagraph (4), below. Annual installments shall be payable to the
Participating Outside Director beginning as of the Payment Commencement
Date and continuing as of each Payment Anniversary Date thereafter until
all installments have been paid. The first annual installment shall
equal one-fifth ( 1/5th) of the value of the Participating Outside
Director's Account(s), determined as of the Payment Commencement Date.
Each successive annual installment shall equal the value of the
Participating Outside Director's Account(s), determined as of the
Payment Anniversary Date, multiplied by a fraction, the numerator of
which is one, and the denominator of which is the excess of five over
the number of installment payments previously made (i.e., 1/4th,
1/3rd, etc.). If the Participating Outside Director dies before the
Participating Outside Director's Payment Commencement Date, or after the
Participating Outside Director's Payment Commencement Date but before
all five installments have been paid, the remaining installments shall
be paid to the Participating Outside Director's Beneficiary in
accordance with the schedule in this subparagraph (3).

(4) Lump Sum. A Participating Outside Director may elect to receive
his or her Account under the Plan in the form of a lump-sum payment in
lieu of the five installment payments determined under subparagraph (3),
above. The lump sum shall be payable to the Participating Outside
Director in shares of Company Common Stock on the Payment Commencement
Date. An election under this subparagraph (4) shall be made in a form
and manner satisfactory to the Board and shall be effective as to the
Participating Outside Director only if made prior to termination of
service with the Board of Directors. If the Participating Outside
Director dies before his or her Payment Commencement Date having elected
to receive benefits in the form of a lump sum, a lump sum payment shall
be made to the Participating Outside Director's Beneficiary on the
Payment Commencement Date.

(f) Notwithstanding any other provision in this Section 6 or in any
other Section of the Plan to the contrary, the value of a Participating
Outside Director's Account shall be paid to the Participating Outside
Director in a lump-sum cash payment on the occurrence of a Change in
Control or as soon thereafter as practicable, but in no event later than
five days after a Change in Control. For purposes of payments under this
paragraph (f), the value of a Deferred Stock Unit shall be computed as the
greater

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<PAGE> 8

of (1) the Closing Price of a Share on or nearest the date on which the
Change of Control is deemed to occur, or (2) the highest per Share price
for Shares actually paid in connection with the Change of Control.

(g) The Board may amend, suspend, or terminate the provisions of this
Section 6 at any time; provided that no amendment, suspension, or
termination of this Section 6 shall, without a Participating Outside
Director's consent, reduce the Participating Outside Director's benefits
accrued under this Section 6 before the date of such amendment, suspension,
or termination. If this Section 6 is terminated in accordance with this
paragraph (g), the terms of the Plan as in effect immediately before
termination shall determine the right to payment in respect of any amounts
that remain credited to a Participating Outside Director's Account upon
termination.

(h) The Board shall furnish an annual statement to each Participating
Outside Director or, if the Participating Outside Director is deceased, the
Participating Outside Director's Beneficiary, reporting the value of the
Participating Outside Director's Account as of the end of the most recent
Plan Year.

(i) The Board may delegate to officers of the Company any and all
authority with which it is vested under this Section 6, and the Board may
allocate its responsibilities under this Section 6 among its members.

(j) No payment due under this Section 6 shall be subject in any manner
to anticipation, alienation, sale, transfer, assignment, pledge,
encumbrance, or charge in any other way. Any attempt to anticipate,
alienate, sell, transfer, assign, pledge, encumber, or charge such payment
in any other way shall be void. No such payment or interest therein shall
be liable for or subject to the debts, contracts, liabilities, or torts of
any Participating Outside Director or Beneficiary. If any Participating
Outside Director or Beneficiary becomes bankrupt or attempts to anticipate,
alienate, sell, transfer, assign, pledge, encumber, or charge in any other
way any payment under the Plan, the Board may direct that such payment be
suspended and that all future payments to which such Participating Outside
Director or Beneficiary otherwise would be entitled be held and applied for
the benefit of such person, the person's children or other dependents, or
any of them, in such manner and in such proportions as the Board may deem
proper.

(k) Nothing in this Section 6 shall confer upon any person the right
to continue to serve as a member of the Board or to participate in the
Plan, including this Section 6, other than in accordance with its terms.

(l) The Board may make any appropriate arrangements to deduct from all
credits and payments under this Section 6 any taxes that the Board
reasonably determines to be required by law to be withheld from such
credits and payments.

(m) If the Board determines, upon evidence satisfactory to the Board,
that any Participating Outside Director or Beneficiary to whom a benefit is
payable under this Section 6 is unable to care for his or her affairs
because of illness or accident or otherwise, any payment due under this
Section 6 (unless prior claim therefor shall have been made by a duly
authorized guardian or other legal representative) may be paid, upon
appropriate indemnification of the Board and the Company, to the spouse of
the Participating Outside Director or Beneficiary or other person deemed by
the Board to have incurred expenses for the benefit of and on behalf of
such Participating Outside Director or Beneficiary. Any such payment shall
be a complete discharge of any liability under this Section 6 with respect
to the amount so paid.

(n) Each Participating Outside Director and Beneficiary entitled to
receive a payment under this Section 6 shall keep the Board advised of his
or her current address. If the Board is unable for a period of 36 months to
locate a Participating Outside Director or Beneficiary to whom a payment is
due under the Plan, commencing with the first day of the month as of which
such payment first comes due, the total amount payable to such
Participating Outside Director or Beneficiary shall be forfeited. Should
such a Participating Outside Director or Beneficiary subsequently contact
the Board requesting payment, the Board shall, upon receipt of all
documents and other information that it might request in connection with

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<PAGE> 9

the payment, restore and pay the forfeited payment in a lump sum, the value
of which shall not be adjusted to reflect any interest or other type of
investment earnings or gains for the period of forfeiture.

(o) NOTWITHSTANDING ANY OTHER PROVISIONS OF THIS SECTION 6, THE
PROVISIONS OF THIS SECTION 6 SHALL NOT BE EFFECTIVE IF A MAJORITY OF THE
SHAREHOLDERS PRESENT IN PERSON OR BY PROXY AT A DULY CONVENED MEETING OF
SHAREHOLDERS OF THE COMPANY DO NOT APPROVE THE PLAN. IF SUCH APPROVAL IS
NOT OBTAINED WITHIN TWELVE MONTHS FOLLOWING THE EFFECTIVE DATE
PARTICIPATING OUTSIDE DIRECTORS SHALL HAVE NO RIGHTS HEREUNDER AND ALL
GRANTS SHALL BE OF NO FORCE OR EFFECT WHATSOEVER.

7. Terms and Conditions of Awards.

(a) Type of Awards. The Administrator is authorized under the Plan to
award any type of arrangement to an Employee, Officer, Director (other than
an Outside Director) or Consultant that is not inconsistent with the
provisions of the Plan and that by its terms involves or might involve the
issuance of (i) Shares, (ii) an Option, a SAR or similar right with an
exercise or conversion privilege at a fixed or variable price related to
the Common Stock and/or the passage of time, the occurrence of one or more
events, or the satisfaction of performance criteria or other conditions, or
(iii) any other security with the value derived from the value of the
Common Stock. Such awards include, without limitation, Options, SARs, sales
or bonuses of Restricted Stock, Dividend Equivalent Rights, Performance
Units or Performance Shares, and an Award may consist of one such security
or benefit, or two or more of them in any combination or alternative.

(b) Designation of Award. Each Award shall be designated in the Award
Agreement. In the case of an Option, the Option shall be designated as
either an Incentive Stock Option or a Non-Qualified Stock Option. However,
notwithstanding such designation, to the extent that the aggregate Fair
Market Value of Shares subject to Options designated as Incentive Stock
Options which become exercisable for the first time by a Grantee during any
calendar year (under all plans of the Company or any Parent or Subsidiary)
exceeds $100,000, such excess Options, to the extent of the Shares covered
thereby in excess of the foregoing limitation, shall be treated as
Non-Qualified Stock Options. For this purpose, Incentive Stock Options
shall be taken into account in the order in which they were granted, and
the Fair Market Value of the Shares shall be determined as of the date the
Option with respect to such Shares is granted.

(c) Conditions of Award. Subject to the terms of the Plan, the
Administrator shall determine the provisions, terms, and conditions of each
Award including, but not limited to, the Award vesting schedule, repurchase
provisions, rights of first refusal, forfeiture provisions, form of payment
(cash, Shares, or other consideration) upon settlement of the Award,
payment contingencies, and satisfaction of any performance criteria. The
performance criteria established by the Administrator may be based on any
one of, or combination of, increase in share price, earnings per share,
total stockholder return, return on equity, return on assets, return on
investment, net operating income, cash flow, revenue, economic value added,
personal management objectives, or other measure of performance selected by
the Administrator. Partial achievement of the specified criteria may result
in a payment or vesting corresponding to the degree of achievement as
specified in the Award Agreement.

(d) Deferral of Award Payment. The Administrator may establish one or
more programs under the Plan to permit selected Grantees the opportunity to
elect to defer receipt of consideration upon exercise of an Award,
satisfaction of performance criteria, or other event that absent the
election would entitle the Grantee to payment or receipt of Shares or other
consideration under an Award. The Administrator may establish the election
procedures, the timing of such elections, the mechanisms for payments of,
and accrual of interest or other earnings, if any, on amounts or Shares so
deferred, and such other terms, conditions, rules and procedures that the
Administrator deems advisable for the administration of any such deferral
program.

(e) Award Exchange Programs. The Administrator may establish one or
more programs under the Plan to permit selected Grantees to exchange an
Award under the Plan for one or more other types of

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<PAGE> 10

Awards under the Plan on such terms and conditions as established by the
Administrator from time to time.

(f) Individual Option and SAR Limit. The maximum number of Shares with
respect to which Options and SARs may be granted to any Employee in any
fiscal year of the Company shall be two hundred thousand (200,000) Shares.
The foregoing limitation shall be adjusted proportionately in connection
with any change in the Company's capitalization pursuant to Section 11,
below. To the extent required by Section 162(m) of the Code or the
regulations thereunder, in applying the foregoing limitation with respect
to an Employee, if any Option or SAR is canceled, the canceled Option or
SAR shall continue to count against the maximum number of Shares with
respect to which Options and SARs may be granted to the Employee. For this
purpose, the repricing of an Option (or in the case of a SAR, the reduction
of the base amount on which the stock appreciation is calculated to reflect
a reduction in the Fair Market Value of the Common Stock) shall be treated
as the cancellation of the existing Option or SAR and the grant of a new
Option or SAR.

(g) Early Exercise. The Award may, but need not, include a provision
whereby the Grantee may elect at any time while an Employee, Officer,
Director or Consultant to exercise any part or all of the Award prior to
full vesting of the Award. Any unvested Shares received pursuant to such
exercise may be subject to a repurchase right in favor of the Company or to
any other restriction the Administrator determines to be appropriate.

(h) Term of Award. The term of each Award shall be the term stated in
the Award Agreement, provided, however, that the term of an Incentive Stock
Option shall be no more than ten (10) years from the date of grant thereof.
However, in the case of an Incentive Stock Option granted to a Grantee who,
at the time the Option is granted, owns stock representing more than ten
percent (10%) of the voting power of all classes of stock of the Company or
any Parent or Subsidiary, the term of the Incentive Stock Option shall be
five (5) years from the date of grant thereof or such shorter term as may
be provided in the Award Agreement.

(i) Transferability of Awards. Incentive Stock Options may not be
sold, pledged, assigned, hypothecated, transferred, or disposed of in any
manner other than by will or by the laws of descent or distribution and may
be exercised, during the lifetime of the Grantee, only by the Grantee.
Other Awards shall be transferable to the extent provided in the Award
Agreement.

(j) Time of Granting Awards. The date of grant of an Award shall for
all purposes be the date on which the Administrator makes the determination
to grant such Award, or such other date as is determined by the
Administrator. Notice of the grant determination shall be given to each
Employee, Officer, Director or Consultant to whom an Award is so granted
within a reasonable time after the date of such grant.

8. Award Exercise or Purchase Price, Consideration, Taxes and Reload
Options.

(a) Exercise or Purchase Price. The exercise or purchase price, if
any, for an Award shall be as follows:

(1) In the case of an Incentive Stock Option:

(A) granted to an Employee who, at the time of the grant of such
Incentive Stock Option owns stock representing more than ten percent
(10%) of the voting power of all classes of stock of the Company or
any Parent or Subsidiary, the per Share exercise price shall be not
less than one hundred ten percent (110%) of the Fair Market Value per
Share on the date of grant.

(B) granted to any Employee other than an Employee described in
the preceding paragraph, the per Share exercise price shall be not
less than one hundred percent (100%) of the Fair Market Value per
Share on the date of grant.

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<PAGE> 11

(2) In the case of a Non-Qualified Stock Option, the per Share
exercise price shall be not less than one hundred percent (100%) of the
Fair Market Value per Share on the date of grant unless otherwise
determined by the Administrator.

(3) In the case of Awards intended to qualify as Performance-Based
Compensation, the exercise or purchase price, if any, shall be not less
than one hundred percent (100%) of the Fair Market Value per Share on
the date of grant.

(4) In the case of other Awards, such price as is determined by the
Administrator.

(b) Consideration. Subject to Applicable Laws, the consideration to be
paid for the Shares to be issued upon exercise or purchase of an Award
including the method of payment, shall be determined by the Administrator.
In addition to any other types of consideration the Administrator may
determine, the Administrator is authorized to accept as consideration for
Shares issued under the Plan the following:

(1) cash;

(2) check;

(3) delivery of Grantee's promissory note with such recourse,
interest, security, and redemption provisions as the Administrator
determines is appropriate;

(4) surrender of Shares (including withholding of Shares otherwise
deliverable upon exercise of the Award) which have a Fair Market Value
on the date of surrender equal to the aggregate exercise price of the
Shares as to which said Award shall be exercised (but only to the extent
that such exercise of the Award would not result in an accounting
compensation charge with respect to the Shares used to pay the exercise
price unless otherwise determined by the Administrator);

(5) delivery of a properly executed exercise notice together with
such other documentation as the Administrator and the broker, if
applicable, shall require to effect an exercise of the Award and
delivery to the Company of the sale or loan proceeds required to pay the
exercise price; or

(6) any combination of the foregoing methods of payment.

(c) Taxes. No Shares shall be delivered under the Plan to any Grantee
or other person until such Grantee or other person has made arrangements
acceptable to the Administrator for the satisfaction of any foreign,
federal, state, or local income and employment tax withholding obligations.
Upon exercise of an Award, the Company shall withhold or collect from
Grantee an amount sufficient to satisfy such tax obligations. Upon an
Optionee's exercise of a stock option, the Company may satisfy its
withholding by withholding from such Optionee or requiring the Optionee to
surrender Shares sufficient to satisfy federal, state and local income and
employment tax withholding obligations.

(d) Reload Options. In the event the exercise price or tax withholding
of an Option is satisfied by the Company or the Grantee's employer
withholding Shares otherwise deliverable to the Grantee, the Administrator
may issue the Grantee an additional Option, with terms identical to the
Award Agreement under which the Option was exercised, but at an exercise
price as determined by the Administrator in accordance with the Plan.

9. Exercise of Award.

(a) Procedure for Exercise; Rights as a Stockholder.

(1) Any Award granted hereunder shall be exercisable at such times
and under such conditions as determined by the Administrator under the
terms of the Plan and specified in the Award Agreement.

(2) An Award shall be deemed to be exercised when written notice of
such exercise has been given to the Company in accordance with the terms
of the Award by the person entitled to exercise the Award and full
payment for the Shares with respect to which the Award is exercised has
been received by the Company. Until the issuance (as evidenced by the
appropriate entry on the books of

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<PAGE> 12

the Company or of a duly authorized transfer agent of the Company) of
the stock certificate evidencing such Shares, no right to vote or
receive dividends or any other rights as a stockholder shall exist with
respect to Shares subject to an Award, notwithstanding the exercise of
an Option or other Award. The Company shall issue (or cause to be
issued) such stock certificate promptly upon exercise of the Award. No
adjustment will be made for a dividend or other right for which the
record date is prior to the date the stock certificate is issued, except
as provided in the Award Agreement or Section 11, below.

(b) Exercise of Award Following Termination of Employment, Officer,
Director or Consulting Relationship.

(1) An Award may not be exercised after the termination date of
such Award set forth in the Award Agreement and may be exercised
following the termination of a Grantee's Continuous Status as an
Employee, Officer, Director or Consultant only to the extent provided in
the Award Agreement.

(2) Where the Award Agreement permits a Grantee to exercise an
Award following the termination of the Grantee's Continuous Status as an
Employee, Officer, Director or Consultant for a specified period, the
Award shall terminate to the extent not exercised on the last day of the
specified period or the last day of the original term of the Award,
whichever occurs first.

(c) Buyout Provisions. The Administrator may at any time offer to buy
out for a payment in cash or Shares, an Award previously granted, based on
such terms and conditions as the Administrator shall establish and
communicate to the Grantee at the time that such offer is made.

10. Conditions Upon Issuance of Shares.

(a) Shares shall not be issued pursuant to the exercise of an Award
unless the exercise of such Award and the issuance and delivery of such
Shares pursuant thereto shall comply with all Applicable Laws, and shall be
further subject to the approval of counsel for the Company with respect to
such compliance.

(b) As a condition to the exercise of an Award, the Company may
require the person exercising such Award to represent and warrant at the
time of any such exercise that the Shares are being purchased only for
investment and without any present intention to sell or distribute such
Shares if, in the opinion of counsel for the Company, such a representation
is required by any Applicable Laws.

11. Adjustments Upon Changes in Capitalization. Subject to any required
action by the stockholders of the Company, the number of Shares covered by each
outstanding Award, and the number of Shares which have been authorized for
issuance under the Plan but as to which no Awards have yet been granted or which
have been returned to the Plan, as well as the price per share of Common Stock
covered by each such outstanding Award, shall be proportionately adjusted for
any increase or decrease in the number of issued shares of Common Stock
resulting from a stock split, reverse stock split, stock dividend, combination
or reclassification of the Common Stock, or any other similar event resulting in
an increase or decrease in the number of issued shares of Common Stock. Except
as expressly provided herein, no issuance by the Company of shares of stock of
any class, or securities convertible into shares of stock of any class, shall
affect, and no adjustment by reason hereof shall be made with respect to, the
number or price of Shares subject to an Award.

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<PAGE> 13

12. Corporate Transactions/Changes in Control/Subsidiary Dispositions.

(a) In the event of any Corporate Transaction, each Award which is at
the time outstanding under the Plan automatically shall become fully vested
and exercisable and be released from any restrictions on transfer and
repurchase or forfeiture rights, immediately prior to the specified
effective date of such Corporate Transaction, for all of the Shares at the
time represented by such Award. However, an outstanding Award under the
Plan shall not so fully vest and be exercisable and released from such
limitations if and to the extent: (i) such Award is, in connection with the
Corporate Transaction, either to be assumed by the successor corporation or
Parent thereof or to be replaced with a comparable Award with respect to
shares of the capital stock of the successor corporation or Parent thereof,
(ii) such Award is to be replaced with a cash incentive program of the
successor corporation which preserves the compensation element of such
Award existing at the time of the Corporate Transaction and provides for
subsequent payout in accordance with the same vesting schedule applicable
to such Award or (iii) the vesting, exercisability and release from such
limitations of such Award is subject to other limitations imposed by the
Administrator at the time of the grant of the Award. The determination of
Award comparability under clause (i) above shall be made by the
Administrator, and its determination shall be final, binding and
conclusive. The Administrator also shall have the authority to grant Awards
under the Plan that are to automatically vest and be fully exercisable and
released from such limitations in whole or in part immediately prior to the
Corporate Transaction or upon the subsequent termination of the Continuous
Status as an Employee or Consultant of the Grantee, whether or not the
Award is otherwise to be assumed or replaced in connection with the
consummation of such Corporate Transaction.

(b) Effective upon the consummation of the Corporate Transaction, all
outstanding Awards under the Plan shall terminate and cease to remain
outstanding, except to the extent assumed by the successor company or its
Parent. Notwithstanding the foregoing, the Administrator, in its
discretion, may prevent the acceleration of vesting and release from any
restrictions on transfer and repurchase or forfeiture rights of any
outstanding Award with respect to any Corporate Transaction.

(c) The Administrator shall have the authority, exercisable either in
advance of any actual or anticipated Change in Control (other than a Change
in Control which is also a Corporate Transaction) or at the time of an
actual Change in Control and either at the time of the grant of an Award or
at any time while an Award remains outstanding, to provide for the
automatic full vesting and exercisability of one or more outstanding
unvested Awards under the Plan and the termination of restrictions on
transfer and repurchase or forfeiture rights on such Awards, in connection
with a Change in Control. The Administrator also shall have the authority
to condition any such Award vesting and exercisability or release from such
limitations upon the subsequent termination of the Continuous Status as an
Employee or Consultant of the Grantee within a specified period following
the effective date of the Change in Control. The Administrator may provide
that any Awards so vested or released from such limitations in connection
with a Change in Control, shall remain fully exercisable until the
expiration or sooner termination of the Award.

(d) The Administrator shall have the authority, exercisable either in
advance of any actual or anticipated Subsidiary Disposition or at the time
of an actual Subsidiary Disposition and either at the time of the grant of
an Award or at any time while an Award remains outstanding, to provide for
the automatic full vesting and exercisability of one or more outstanding
unvested Awards under the Plan and the termination of restrictions on
transfer and repurchase or forfeiture rights on such Awards, in connection
with a Subsidiary Disposition, but only with respect to those Grantees who
are at the time engaged primarily in Continuous Service as an Employee or
Consultant with the subsidiary corporation involved in such Subsidiary
Disposition. The Administrator also shall have the authority to condition
any such Award vesting and exercisability or release from such limitations
upon the subsequent termination of the affected Grantee's Continuous
Service as an Employee or Consultant with that subsidiary corporation
within a specified period following the effective date of the Subsidiary
Disposition. The Administrator may provide that any Awards so vested or
released from such limitations in connection with a Subsidiary Disposition,
shall remain fully exercisable until the expiration or sooner termination
of the Award.

13
<PAGE> 14

13. Term of Plan. Subject to approval of the Plan by the stockholders of
the Company within twelve months of the date of its adoption by the Board, the
Plan shall become effective immediately upon its adoption by the Board. The Plan
shall continue in effect for a term of ten (10) years unless sooner terminated.

14. Amendment, Suspension or Termination of the Plan.

(a) The Board may at any time amend, suspend or terminate the Plan. To
the extent necessary to comply with Applicable Laws, the Company shall
obtain stockholder approval of any Plan amendment in such a manner and to
such a degree as required.

(b) No Award may be granted during any suspension of the Plan or after
termination of the Plan.

(c) Any amendment, suspension or termination of the Plan shall not
affect Awards already granted, and such Awards shall remain in full force
and effect as if the Plan had not been amended, suspended or terminated,
unless mutually agreed otherwise between the Grantee and the Administrator,
which agreement must be in writing and signed by the Grantee and the
Company.

15. Reservation of Shares.

(a) The Company, during the term of the Plan, will at all times
reserve and keep available such number of Shares as shall be sufficient to
satisfy the requirements of the Plan.

(b) The inability of the Company to obtain authority from any
regulatory body having jurisdiction, which authority is deemed by the
Company's counsel to be necessary to the lawful issuance and sale of any
Shares hereunder, shall relieve the Company of any liability in respect of
the failure to issue or sell such Shares as to which such requisite
authority shall not have been obtained.

16. No Effect on Terms of Employment. The Plan shall not confer upon any
Grantee any right with respect to continuation of employment or consulting
relationship with the Company, nor shall it interfere in any way with his or her
right or the Company's right to terminate his or her employment or consulting
relationship at any time, with or without cause.

17. Stockholder Approval. The grant of Incentive Stock Options under the
Plan shall be subject to approval of the Plan by the stockholders of the Company
within twelve (12) months before or after the date the Plan is adopted by the
Board. Such stockholder approval shall be obtained in the degree and manner
required under Applicable Laws. The Administrator may grant Incentive Stock
Options under the Plan prior to approval by the stockholders, but until such
approval is obtained, no such Incentive Stock Option shall be exercisable. In
the event that stockholder approval is not obtained within the twelve (12) month
period provided above, all Incentive Stock Options previously granted under the
Plan shall terminate.

<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 FIVE WEEKS FIVE WEEKS ---------------------------------------
WEEKS ENDED WEEKS ENDED ENDED ENDED JANUARY 28, DECEMBER 31, DECEMBER 31,
OCTOBER 27, 1996 OCTOBER 29, 1995 JANUARY 29, 1995 JANUARY 30, 1994 1996 1994 1993
---------------- ---------------- ---------------- ---------------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Income (loss)
before
extraordinary
items......... $(12,374) $ (4,487) $ (3,221) $ (2,185) $(8,715) $ 5,831 $ (9,751)
Extraordinary
items......... -- -- -- -- -- (436) (221)
-------- -------- -------- -------- -------- ------- -------
Net income
(loss)........ $(12,374) $ (4,487) $ (3,221) $ (2,185) $(8,715) $ 5,395 $ (9,972)
======== ======== ======== ======== ======== ======= =======
Weighted average
number of
shares
outstanding(C)
Common
stock....... 7,661 3,905 3,685 3,490 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 3,685 3,490 3,950 5,394 2,510
======== ======== ======== ======== ======== ======= =======
Income (loss)
per share:
Income (loss)
before
extraordinary
items....... $ (1.62) $ (1.15) $ (.87) $ (.63) $ (2.21) $ 1.08 $ (3.88)
Extraordinary
items....... -- -- -- -- -- (.08) (.09)
-------- -------- -------- -------- -------- ------- -------
Net income
(loss)...... $ (1.62) $ (1.15) $ (.87) $ (.63) $ (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 Amendment No. 1 to the Registration Statement (Form
S-1) and the related Prospectus of Krause's Furniture, Inc. for the registration
of 4,444,528 shares of its common stock.

/s/ ERNST & YOUNG LLP

Orange County, California

February 26, 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 4,444,528 shares of its
common stock.

/s/ KPMG Peat Marwick

Cleveland, Ohio

February 26, 1997