KRAUSES FURNITURE INC, 424B1, 1997-03-14

KRAUSES FURNITURE INC
424B1, 1997-03-14
HOUSEHOLD FURNITURE

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Filed Pursuant to Rule 424(b)(1).
Registration Number 333-19485.

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 March 12, 1997, the last sale price of
the Common Stock as reported by the Nasdaq Small Cap Market was $1.69 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.

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================================================================================================
UNDERWRITING
PRICE TO DISCOUNTS AND PROCEEDS TO PROCEEDS TO SELLING
PUBLIC(1) COMMISSIONS COMPANY STOCKHOLDERS(2)
- ------------------------------------------------------------------------------------------------
Per Share....... $1.72 $0 $0 $1.72
- ------------------------------------------------------------------------------------------------
Total........... $7,644,588 $0 $0 $7,644,588
================================================================================================
</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 March 12, 1997 of
$1.72.

(2) Before deducting brokers' commissions.

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

MARCH 14, 1997

<PAGE> 2

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 APRIL 8, 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
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PAGE
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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

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PAGE
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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.

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<PAGE> 3

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 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.

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

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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

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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>

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(1) Based on the number of shares outstanding on January 31, 1997, excluding
1,722,457 shares of Common Stock issuable upon exercise of options, 24,616
deferred stock units 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
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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.
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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)
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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)
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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>

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OCTOBER 27, OCTOBER 29, JANUARY 28, JANUARY 29, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1996 1995 1996 1995 1993 1992 1991
----------- ----------- ----------- ----------- ------------ ------------ ------------
(IN THOUSANDS)
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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>

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(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.

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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

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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

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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.

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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> 10

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> 11

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> 12

SELECTED 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,
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.

(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.

12
<PAGE> 13

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

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

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
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> 14

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. Showroom pre-opening expenses
are a component of the Company's selling expenses. The Company has historically
capitalized these expenses and amortized them over periods ranging from 12 to 24
months subsequent to opening of the showroom. In future periods the Company
intends to amortize these expenses for new showrooms over a period of not more
than 12 months subsequent to opening of the showroom. Management believes that
had it reduced the amortization period to a maximum of 12 months in any of the
periods presented in the consolidated financial statements, such reduction would
not have had a material effect on the Company's consolidated financial position
or results of operations.

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.

14
<PAGE> 15

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.

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.

15
<PAGE> 16

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 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.

16
<PAGE> 17

LIQUIDITY AND CAPITAL RESOURCES

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

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

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<PAGE> 18

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 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> 19

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

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<PAGE> 20

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> 21

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

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<PAGE> 22

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> 23

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> 24

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> 25

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.

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<PAGE> 26

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 11,154 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> 27

OPTION/SAR GRANTS IN LAST FISCAL YEAR

<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
VALUE AT ASSUMED
ANNUAL RATES OF
NUMBER OF % OF TOTAL STOCK PRICE
SECURITIES OPTIONS/SARS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OR OPTION TERM
OPTIONS/SARS EMPLOYEES IN BASE PRICE EXPIRATION -----------------------
NAME GRANTED(#) FISCAL YEAR(1) ($/SH) DATE 5%($) 10%($)
- ----------------------- ------------ -------------- ----------- ---------- --------- ----------
<S> <C> <C> <C> <C> <C> <C>
1,234,000 74.9% 1.00 08/26/06 2,010,056 3,200,678
Philip M. Hawley.......
5,000 .3% .78 07/31/06 6,353 10,116
Thomas M. DeLitto......
6,154 .4% 1.62 01/20/07 16,239 25,858
50,000 3.0% 1.62 01/20/07 131,940 210,093
Klaus Tabar............
50,000 3.0% 1.62 01/20/07 131,940 210,093
Herbert J. Friedman....
5,000 .3% 1.06 03/11/06 8,633 13,747
K. James McTaggart.....
40,000 2.4% 1.62 01/20/07 105,552 168,074
</TABLE>

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

(1) The Company granted options for a total of 50,000 shares of Common Stock and
24,616 deferred stock units 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....... -- -- 11,152 5,000 2,308 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> 28

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> 29

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> 30

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> 31

$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> 32

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> 33

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> 34

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> 35

<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> 36

(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, 24,616 shares of Common Stock issuable upon payment of deferred stock
units and options to purchase an additional 1,722,457 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> 37

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> 38

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> 39

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> 40

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> 41

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> 42

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> 43

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> 44

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> 45

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> 46

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> 47

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> 48

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> 49

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> 50

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> 51

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> 52

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> 53

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> 54

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> 55

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> 56

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> 57

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> 58

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> 59

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> 60

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> 61

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> 62

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> 63

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