KRAUSES FURNITURE INC, S-1, 1997-12-23

KRAUSES FURNITURE INC
S-1, 1997-12-23
HOUSEHOLD FURNITURE

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<PAGE> 1

AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON DECEMBER 23, 1997
REGISTRATION NO. 333-
================================================================================

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

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

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

<TABLE>
<S> <C> <C>
DELAWARE 5710 77-0310773
(STATE OR OTHER JURISDICTION OF (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYEE
INCORPORATION OR ORGANIZATION) CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.)
</TABLE>

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

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

COPIES OF ALL COMMUNICATIONS TO BE SENT TO:

<TABLE>
<S> <C>
JUDITH OLSON LASKER, ESQ. STEVEN D. PIDGEON, ESQ.
KRAUSE'S FURNITURE, INC. MICHAEL B. MALEDON, ESQ.
200 NORTH BERRY STREET, SNELL & WILMER LLP
BREA, CALIFORNIA 92821-3903 ONE ARIZONA CENTER
714-990-3100 PHOENIX, ARIZONA 85004-0000
AND 602-382-6000
MICHAEL J. CONNELL, ESQ.
MORRISON & FOERSTER LLP
555 WEST FIFTH STREET
LOS ANGELES, CALIFORNIA 90013-1024
213-892-5200
</TABLE>

APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC:
As soon as practicable after the effective date of this registration statement.

If any of the securities being registered on this form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [ ]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]

CALCULATION OF REGISTRATION FEE

<TABLE>
<S> <C> <C> <C> <C>
=========================================================================================================================
TITLE OF EACH CLASS OF AMOUNT OF
SECURITIES AMOUNT TO BE PROPOSED MAXIMUM OFFERING PROPOSED MAXIMUM AGGREGATE REGISTRATION
TO BE REGISTERED REGISTERED(1) PRICE PER UNIT(1) OFFERING PRICE(1) FEE(1)
- -------------------------------------------------------------------------------------------------------------------------
Common Stock, par value
$.001..................... 4,000,000 shares $3.00 $12,000,000 $3,540
=========================================================================================================================
</TABLE>

(1) Estimated solely for purpose of calculating the amount of the registration
fee, based on the average of the high and low prices for the Common Stock as
reported on the Nasdaq SmallCap Market on December 18, 1997 in accordance
with Rule 457(c) under the Securities Act of 1933.
------------------------

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

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

SUBJECT TO COMPLETION DATED DECEMBER , 1997
PROSPECTUS

4,000,000 SHARES

[KRAUSE'S LOGO]

COMMON STOCK
------------------------

Of the 4,000,000 shares of common stock, par value $.001 per share (the
"Common Stock"), offered hereby, 1,903,889 shares are being offered by Krause's
Furniture, Inc. (the "Company") and 2,096,111 shares are being offered by a
stockholder of the Company (the "Selling Stockholder"). The Company will not
receive any of the proceeds from the sale of shares by the Selling Stockholder.
See "Principal and Selling Stockholders." The Common Stock is quoted on the
Nasdaq SmallCap Market under the symbol "SOFA." On December , 1997, the last
reported sale price of the Common Stock, as quoted on the Nasdaq SmallCap Market
was $ . See "Price Range of Common Stock." The Company has applied to
list the Common Stock on the American Stock Exchange under the symbol "KFI."
This listing is expected to be effective prior to completion of the offering, at
which time the Common Stock will be withdrawn from the Nasdaq SmallCap Market.
THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK.
SEE "RISK FACTORS," BEGINNING ON PAGE 9.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION, NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
================================================================================

<TABLE>
<CAPTION>
PROCEEDS TO
SELLING
PRICE TO PLACEMENT AGENT PROCEEDS TO STOCKHOLDER
PUBLIC FEES(1) COMPANY(2)(3) (2)(3)
<S> <C> <C> <C> <C>
- ------------------------------------------------------------------------------------------------------
Per Share.................... $ $ $ $
- ------------------------------------------------------------------------------------------------------
Total........................ $ $ $ $
======================================================================================================
</TABLE>

(1) The Common Stock is being offered on an all or none basis by the Company and
the Selling Stockholder primarily to selected institutional investors.
Cruttenden Roth Incorporated (the "Placement Agent") has been retained to
act, on a best efforts basis, as exclusive agent for the Company and the
Selling Stockholder in connection with the arrangement of this transaction.
The Company and the Selling Stockholder have agreed to pay the Placement
Agent a fee in connection with the arrangement of this transaction and the
Company has agreed to reimburse the Placement Agent for certain
out-of-pocket expenses. The Company and the Selling Stockholder have agreed
to indemnify the Placement Agent against certain liabilities, including
liabilities under the Securities Act of 1933, as amended (the "Securities
Act"). See "Plan of Distribution."

(2) The termination date of the offering is January , 1998, subject to
extension by mutual agreement of the Company, the Selling Stockholder and
the Placement Agent. Prior to the closing date of this best efforts, all or
nothing offering, all investor funds will promptly be placed in escrow with
, as escrow agent for funds collected in connection with the
offering (the "Escrow Agent"), in an escrow account established for the
benefit of the investors. Upon receipt of notice from the Escrow Agent that
investors have affirmed purchase of the Common Stock and deposited the
requisite funds in the escrow account, the Company and the Selling
Stockholder will deliver the shares of Common Stock to be credited to the
accounts of the investors and will collect the investor funds from the
Escrow Agent. In the event that investor funds are not received in the full
amount necessary to satisfy the requirements of the offering, all funds
deposited with the Escrow Agent will promptly be returned to the investors.
See "Plan of Distribution."

(3) Before deducting expenses payable by the Company estimated at $ .

CRUTTENDEN ROTH
INCORPORATED

THE DATE OF THIS PROSPECTUS IS DECEMBER , 1997
<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" are to Krause's Furniture, Inc. and its wholly owned subsidiaries.

This Prospectus contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, including statements
regarding (i) the anticipated performance of the Company's new management team,
(ii) the effect of the Company's remodeling and expansion program, (iii) the
Company's efforts to improve efficiency, (iv) the Company's intention to
capitalize on its brand names to increase sales and market share, and (v) the
Company's efforts to improve its financial performance. These statements involve
risks and uncertainties and actual results could differ materially from those
discussed in the forward-looking statements as a result of certain of the
factors set forth in "Risk Factors" and for the reasons described elsewhere in
this Prospectus. All forward-looking statements and reasons why results may
differ included in this Prospectus are made as of the date hereof, and the
Company assumes no obligation to update any such forward-looking statement or
reason why actual results might differ.

THE COMPANY

The Company is a leading vertically integrated manufacturer and retailer of
custom-crafted upholstered furniture and accessories. The Company operates 81
furniture showrooms under the Krause's (67 showrooms) and Castro Convertibles
(14 showrooms) brand names in 12 states, with 41 of those showrooms in
California and 13 in the New York City metropolitan area, including New Jersey
and Connecticut. Customers can choose from more than 60 styles and 40 sizes of
sofas, incliners, recliners, sectionals, sofabeds and chairs, which they can
customize with 800 fabrics and 50 leathers. The Company believes it has
developed a reputation for delivering high quality, custom-crafted upholstered
furniture at prices comparable to those of mass-produced, sold-as-shown
furniture. In recent periods, the Company has undergone significant changes,
raising substantial new capital, hiring a new management team with extensive
expertise in retailing, and changing the Company's business strategy from a
factory-direct orientation to a retail-oriented approach with updated styles and
fabrics offering greater appeal to its customer base.

RECENT DEVELOPMENTS

In the spring of 1996, General Electric Capital Corporation ("GECC") and
Philip M. Hawley, the former Chairman and Chief Executive Officer of The
Broadway Stores, Inc. (formerly Carter Hawley Hale Stores, Inc.), undertook an
evaluation of the Company and determined that it had strong brand name
recognition, good retail locations in strong markets, a demonstrated
manufacturing capability and a unique niche. They perceived that the Company
presented an opportunity for growth by remodeling existing showrooms, opening
new showrooms in existing markets and penetrating new markets. Beginning in
August 1996, GECC and certain other investors led by Mr. Hawley invested
approximately $22 million in debt and equity in the Company. The Company hired
new executives with retail experience and Mr. Hawley became its Chairman and
Chief Executive Officer.

Under the leadership of Mr. Hawley, the Company has embarked on a major
remodeling and expansion program, and has developed a marketing and
merchandising strategy designed to increase its appeal to its existing broad
customer base by promoting the Company's wide selection of products, styles and
fabrics, as well as quality and value. Under this program, the Company has
remodeled 14 existing showrooms, established design centers in prominent
locations within showrooms to highlight fabric selection, created decorated room
settings, added new lighting and carpeting and integrated the Castro
Convertibles brand name and products into its Krause's showrooms. The Company
expects to complete the remodeling of an additional four showrooms by the end of
this fiscal year (February 1, 1998), and plans to remodel approximately 24
additional showrooms in fiscal 1998. The Company has also taken significant
steps to improve margins by increasing prices to competitive levels, reducing
promotional discounting and improving manufacturing

2
<PAGE> 4

efficiencies and to reduce expenses by implementing budgetary controls,
consolidating selling, general and administrative expenses and cutting costs,
including revising its sales commission structure. Although results are
preliminary, these new strategies, combined with improved economies in selected
regions where the Company operates, are beginning to show positive financial
results. For the nine months ended November 2, 1997, same-store sales (for
showrooms opened a year or more) increased 4.3% compared to the nine-month
period ended October 27, 1996, with remodeled store sales exceeding management's
goal of 25%. In addition, gross profit increased from 48.8% to 51.1% of net
sales in the first nine months of fiscal 1997 compared to the same period in
fiscal 1996. Since the management change, the Company has also opened one new
showroom featuring its new store design, expects to open two additional
showrooms by the end of the current fiscal year and has plans to open
approximately 18 showrooms in fiscal 1998.

INDUSTRY OPPORTUNITY AND COMPETITIVE STRENGTHS

The Company believes a number of macroeconomic factors influence furniture
sales, including existing home sales, housing starts, consumer confidence,
availability of credit, interest rates and demographic trends. Management
believes favorable fundamental trends in home building and demography will
continue to drive long-term growth in the furniture industry. The domestic
residential furniture industry is estimated to be $21 billion in shipments in
1997 up from approximately $20 billion in 1996 and is expected to increase 4.2%
to $21.9 billion in 1998 according to the American Furniture Manufacturers
Association. Upholstered furniture accounted for approximately $8.4 billion in
shipments in 1996 according to the American Furniture Manufacturers Association.

The furniture market is large and diversified. Because the market for
custom crafted furniture is highly fragmented, the Company believes that
manufacturers with strong brand name recognition, broad distribution and good
value to price ratios are positioned to increase market share.

The Company believes it possesses a number of strengths that enable it to
compete effectively in its markets and that should help it gain market share,
including the following:

- Reputation for Value and Selection; Brand Names. The Company believes it
has attained a reputation for high quality, custom-crafted furniture at
prices comparable to those of mass-produced, sold-as-shown furniture.
Over 25 and 65 years, respectively, Krause's and Castro Convertibles have
developed a reputation for selection, quality, price and service. The
Company believes that its reputation and strong brand recognition
influence customer purchasing decisions and will help the Company expand
its distribution in existing markets and penetrate new markets.

- New, Experienced Management Team. The Company has recently hired a strong
management team with extensive retailing experience, led by Philip M.
Hawley, the former Chairman and Chief Executive Officer of The Broadway
Stores, Inc. New management has adopted business and marketing strategies
designed to leverage the Company's existing brand name recognition and
distribution system and appeal to its existing broad customer base. The
management team has a substantial equity stake in the Company.

- Vertically Integrated Manufacturer and Distributor of Custom
Furniture. The Company is a leading combined manufacturer and retailer of
made-to-order upholstered furniture. This vertical integration enables
the Company to manufacture high-quality, competitively priced custom
upholstered furniture and deliver it to the customer usually within two
to four weeks from the date ordered. Vertical integration also enables
the Company to control the introduction of new products and to capture
profits at both the manufacturing and retail level, with minimal
inventory risk because the manufacturing process does not begin until a
customer places an order. Further, the Company can use the available
capacity of its manufacturing facility to accommodate planned sales
growth.

- Well Located Retail Distribution Network. As of November 30, 1997, the
Company operated 81 showrooms, primarily in California and the New York
City metropolitan area, and in selected other markets in the Southwest,
Northwest and Midwest. The Company believes that its showrooms are in
many markets that have favorable demographics and upward economic trends,
and that a substantial

3
<PAGE> 5

majority of its showrooms are located in high traffic areas. In addition,
many showrooms are near other furniture retailers, where the Company
believes it can benefit from increased traffic of furniture customers and
from comparison shopping, typically by shoppers who compare Company
products to those of sold-as-shown retailers or premium-priced custom
manufacturers.

- Focus on Gross Margins and Cost Controls. In recent periods, the Company
has taken a number of steps to improve its gross margin and reduce
expenses by reducing discounts and other special pricing programs,
improving its manufacturing processes, introducing budgetary controls,
revising its sales commission structure, consolidating selling, general
and administrative expenses and cutting costs. As a result, the Company
has developed an organization focused on gross margin improvement,
expense control and operating efficiency.

BUSINESS STRATEGY

The Company intends to leverage its competitive strengths in order to
increase its sales volumes, improve its overall financial performance and
enhance its market position. The Company will seek to achieve these objectives
through the following strategies:

- Remodel Existing Showrooms. The Company has embarked upon a major
remodeling program to update its showrooms, imbue a sense of fashion and
excitement, and move away from the Company's traditional factory-direct
orientation. The Company has developed new store layout, design and
visual presentation themes to center attention on fabric selection and
customization options, present merchandise by life style as complete room
environments and enhance lighting and color in order to add drama and
create excitement throughout its showrooms. Plans call for remodeling
approximately 65 showrooms which will incorporate the new layout, design
and visual presentation themes. To date, the Company has remodeled 14
showrooms and expects to remodel four additional showrooms by the end of
the current fiscal year and approximately 24 more showrooms by the end of
the 1998 fiscal year.

- Add New Showrooms in Existing Markets. The Company plans to expand its
presence in markets where it has an existing base of showrooms so that it
can leverage its brand name recognition and marketing efforts as well as
its existing distribution network and management. The Company estimates
that it has between 40 to 50 opportunities to open showrooms in existing
markets. To date, the Company has opened one new showroom and expects to
open two additional showrooms by the end of the current fiscal year and
approximately 18 more by the end of the 1998 fiscal year.

- Relocate Under Performing Showrooms. The Company estimates that it has
between 10 and 15 showrooms that are in good market areas but in poor
locations within these market areas. As the leases on these showrooms
expire, the Company plans to seek more suitable locations and incorporate
into the new showrooms the same new layout, design and visual
presentation themes that it has developed in the remodeling program.

- Revamp Marketing and Sales Promotion. The Company has revamped its
marketing and sales promotion with the goal of better defining its market
niche and differentiating it from its competitors. A major focus of this
effort is a shift away from a factory-direct orientation to that of
customization and craftsmanship with emphasis on value rather than price.
To this end, the Company has changed the name it does business under from
Krause's Sofa Factory to Krause's Custom Crafted Furniture and has
developed a new, modern logo. Another focus of this effort has been to
create an advertising format and message and to use larger ads in an
effort to better attract customers.

4
<PAGE> 6

chairs and recliners. During fiscal 1996, accessories, custom-made chairs
and recliners accounted for 2%, 4%, and 8%, respectively, of the
Company's sales compared to the industry average (reported by the October
1997 issue of retail Ideas, a publication of Furniture/Today) of 12%,
10%, and 17%, respectively. These additional merchandise classifications
will broaden the Company's offerings and should increase sales per square
foot.

- Leverage the Castro Franchise. In 1993, the Company 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 started business
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. The Company plans to leverage this strong brand awareness by
adding a Castro Convertibles gallery in all of its Krause's remodeled and
new showrooms.

- Increase Showroom Productivity. For the year ended February 2, 1997, the
Company's sales per square foot of selling space averaged $112. To
further increase showroom productivity, the Company intends gradually to
reduce the average size of its showrooms from approximately 12,100 square
feet of selling space to approximately 10,000 square feet, which it
believes is the optimal size to show and sell the Company's products. In
addition, the Company intends to increase same-store sales by continuing
to (i) roll out its remodeling and expansion program, which has produced
higher same-store sales at the initial group of remodeled showrooms, (ii)
add new products, including accessory products manufactured by third
parties, and (iii) increase the effective sales prices of its products
through reduced promotional discounting.

The Company's executive offices are 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 Company was incorporated in Delaware in
1992. The Company's Common Stock is currently traded in the Nasdaq SmallCap
Market under the symbol "SOFA". The Company has applied to list the Common Stock
on the American Stock Exchange under the symbol "KFI." It is expected that this
listing will be effective prior to completion of this offering.

5
<PAGE> 7

THE OFFERING

<TABLE>
<S> <C>
Common Stock Offered by the Company......................... 1,903,889 shares(1)
Common Stock Offered by the Selling Stockholder............. 2,096,111 shares(1)
Common Stock to be Outstanding After the Offering........... 20,924,428 shares(1)(2)
Use of Proceeds(1).......................................... To remodel showrooms, to open
new showrooms and for working
capital and other general
corporate purposes
American Stock Exchange Symbol.............................. KFI
</TABLE>

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

(1) The Company and the Selling Stockholder have reserved the right to
withdraw any and all of their shares from the offering. If the Company
withdraws its shares from the offering, it intends to use other sources
of capital to complete its remodeling and growth plans and to provide
working capital. The Company expects that its decision will be based on
the relative cost of capital, the availability of internally generated
funds, the desirability of having additional Company shares outstanding
and other factors. The Company currently contemplates that other
sources of capital would be available, although this situation could
change while the offering is pending.

(2) Based upon the number of shares outstanding on November 2, 1997,
excluding 4,570,621 shares of Common Stock issuable upon exercise of
outstanding options, deferred stock units and warrants. See
"Description of Capital Stock."

RISK FACTORS

An investment in the Common Stock involves various risks, and investors
should consider carefully the matters discussed under "Risk Factors." Among the
significant risks are the following: the Company has reported losses from
operations in each of the last five years, expects to incur a loss in the
current fiscal year, and has a significant working capital deficiency; the
Company may violate covenants in its loan agreements and be unable to obtain a
waiver, which could restrict its ability to raise additional capital; the
Company depends on a small number of suppliers, and disruptions in delivery of
supplies could adversely affect the Company; and future performance of the
Company is substantially dependant upon the success of its remodeling and
expansion program.

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SUMMARY CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
NOVEMBER 2, OCTOBER 27, FEBRUARY 2, JANUARY 28, DECEMBER 31,
1997 1996 1997 1996 1994
----------- ----------- ----------- ----------- ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance Sheet Data:
Total assets.......... $43,484 $47,402 $43,087 $46,866 $ 51,240
Current assets........ 18,081 20,339 17,553 18,602 21,784
Current liabilities... 19,262 24,135 19,735 25,480 23,732
Long-term debt(2)..... 11,073 5,260 6,306 5,584 89
Stockholders'
equity.............. 11,012 16,265 15,543 13,985 25,921
</TABLE>

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<PAGE> 9

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

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

(2) In August 1994, the Company sold its ownership of 1,500,548 shares of Mr.
Coffee common stock for cash of $23.3 million. Proceeds from this sale were
used to retire debt of $18.3 million and pay income taxes of $2.1 million
with the remainder used for working capital.

(3) Represents loss from early debt retirement.

(4) In April 1995, the Company changed from a calendar year-end to a fiscal year
ending on the last Sunday in 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. The
fiscal year ended February 2, 1997 is a 53-week period and the fiscal year
ended January 28, 1996 is a 52-week period.

(5) 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.

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<PAGE> 10

RISK FACTORS

In addition to the other information in this Prospectus, investors should
carefully consider the following risk factors in evaluating an investment in the
Common Stock offered hereby. This Prospectus contains certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended,
including statements regarding (i) the anticipated performance of the Company's
new management team, (ii) the effect of the Company's remodeling and expansion
program, (iii) the Company's efforts to improve efficiency, (iv) the Company's
intention to capitalize on its brand name to increase sales and market share,
and (v) the Company's efforts to improve its financial performance. These
statements involve risks and uncertainties and actual results could differ
materially from those discussed in the forward-looking statements as a result of
certain of the risk factors set forth below and for the reasons described
elsewhere in this Prospectus. All forward-looking statements and reasons why
results may differ included in this Prospectus are made as of the date hereof,
and the Company assumes no obligation to update any such forward-looking
statement or reason why actual results might differ.

LACK OF PROFITABLE OPERATIONS; ACCUMULATED AND WORKING CAPITAL DEFICITS

The Company has reported losses from operations in each of the past five
years and for the thirty-nine week period ended November 2, 1997. The Company
had an accumulated deficit of $40.0 million at November 2, 1997. If losses from
operations continue, they could adversely affect the market price for the Common
Stock and the Company's ability to maintain existing financing and obtain new
financing and increase the risks of owning shares of Common Stock. At November
2, 1997, the Company had a working capital deficiency of approximately $1.2
million and current liabilities at November 2, 1997 were $19.3 million. In
future periods the Company will dedicate a substantial portion of the net cash
provided by operations to these working capital deficiencies and to repay
indebtedness. There can be no assurance that the Company will achieve
profitability or overcome its deficits.

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

Although the Company has raised approximately $22 million in private
offerings of subordinated debt and equity since August 1996, it may need more
capital in the future to finance its strategic objectives if borrowings under
the Company's revolving and standby credit facilities and internally generated
cash are insufficient. The Company expects its existing capital resources,
borrowings under its revolving and standby credit facilities, internally
generated cash and proceeds from this offering will enable it to fund its plan
to remodel and upgrade approximately 24 showrooms and open approximately 18 new
showrooms during fiscal 1998 at a projected cost of approximately $6.7 million.
However, if this is not the case, the Company will need to obtain additional
capital. The Company has reserved the right to withdraw any and all of its
shares from the offering; if the Company withdraws its shares from the offering,
it will increase the likelihood that the Company will need to obtain additional
capital to fund its remodeling and expansion plans. 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.

The Company's existing secured revolving credit facility provides for
borrowings of up to $10.0 million, is subject to maturity in January 2000,
imposes borrowing base limitations, and restricts it from incurring future
additional indebtedness from third parties in an amount in excess of $5.0
million. Consequently, if the Company needs any significant additional infusion
of capital, it may have to issue additional equity. Such additional capital, if
raised, is likely to dilute the interest of the Company's stockholders. The
revolving credit agreement further requires the Company to maintain financial
covenants regarding working capital, net worth and earnings before interest,
taxes, depreciation and amortization. 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 may make it more difficult for
the Company to obtain additional financing on advantageous terms, if at all.

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<PAGE> 11

Additionally, the restrictions described above could significantly impair
the Company's ability to raise additional capital by issuing either additional
equity or debt.

LEVERAGE AND ABILITY TO SERVICE FIXED CHARGES

At November 2, 1997, the Company had $11.1 million of long-term debt and
had a negative tangible net worth (stockholders' equity less intangible assets)
of $4.9 million. For the thirty-nine weeks ended November 2, 1997, earnings
before interest, taxes, depreciation and amortization were negative $2.3
million. A high percentage of the Company's operating expenses are relatively
fixed, including approximately $1.6 million per month in lease payments.

The Company's high level of debt and debt service requirements will have
several important effects on its future operations, including the following: (i)
the Company will need to devote significant cash to service debt, reducing funds
available for operations and future business opportunities and increasing the
Company's vulnerability to adverse economic and industry conditions and
competition; (ii) the Company's leveraged position will increase its
vulnerability to competitive pressures; (iii) the financial covenants and other
restrictions contained in certain agreements relating to the Company's
indebtedness will require the Company to meet certain financial performance
tests which increase over time and will restrict its ability to borrow
additional funds, to dispose of assets, to issue preferred stock or to pay cash
dividends on or repurchase Common Stock; and (iv) funds available for working
capital, capital expenditures, acquisitions and general corporate purposes will
be limited.

Any default under the documents governing indebtedness of the Company could
have a significant adverse effect on the market value of the Common Stock. From
time to time the Company has found it necessary to seek waivers and amendments
from its lenders because it could not meet financial covenants or other
restrictions in its credit agreements. The Company's future financial
performance may again fail to keep it in compliance with these covenants and
restrictions, and there can be no assurance that any waivers will be available
in the future. If the Company defaults on its obligations under any of its
indebtedness, the lenders could elect to declare all amounts borrowed, together
with accrued interest, due and payable. If the Company could not pay these
amounts, the lenders could proceed against any collateral securing those
obligations due to them. There can be no assurance that in that event, the
Company's assets securing those obligations would be sufficient to repay the
indebtedness or that there would be any assets in excess of the indebtedness to
benefit other creditors or holders of Common Stock.

NO ASSURANCE OF SUCCESSFUL IMPLEMENTATION OF BUSINESS STRATEGIES

The Company's near-term business strategies include (i) revamping marketing
and sales promotion with the goal of better defining the Company's market niche
and differentiating the Company from its competitors; (ii) developing new
products, which will accomplish a freshening of inventories and see the
introduction of a number of new styles, designed to increase customer appeal;
(iii) remodeling showrooms and adding new showrooms in existing market areas;
and (iv) enhancing and leveraging the strength of its brand names. The Company's
inability to achieve any of these goals could have a material adverse effect on
the Company's business, financial condition, and results of operations. See
"Business -- Business Strategy."

Certain internal and external factors directly affect the Company's
business, including the following: the availability of suitable showroom
locations in existing markets; the capacity of management to complete remodeling
at the planned pace; the availability of financing for expansion and remodeling;
and general economic conditions, including employment levels, business
conditions, interest rates and tax rates in the Company's market areas. While
the Company believes that current economic conditions favor growth in the
markets it serves, various factors, including those listed above, could reduce
sales or increase operating expenses. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations." There can be no assurance
that various factors will not adversely effect the Company's business in the
future or will not prevent the Company from successfully implementing its
business strategies.

10
<PAGE> 12

DEPENDENCE UPON CHIEF EXECUTIVE OFFICER AND KEY PERSONNEL

The Company's future performance will depend to a large extent upon the
efforts of Philip M. Hawley and other members of its executive management team.
The loss of the services of Mr. Hawley or other key members of the team could
have an adverse effect on the Company. In August 1996, the Company entered into
an Employment Agreement with Mr. Hawley, pursuant to which the Company agreed to
employ Mr. Hawley for a term ending on August 25, 1999. See
"Management -- Employment Agreements."

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 custom-crafted
furniture 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. After economic downturns, the home
furnishings industry tends to recover more slowly than 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 California and the New York City
metropolitan area, where 49% and 19%, respectively, of the Company's sales in
the nine-month period ended November 2, 1997 originated. Consequently, an
economic downturn in either of those states would likely have a
disproportionately negative impact on the financial condition of the Company.
Management believes the economic indicator most relevant to its operations is
consumer confidence. In October 1997, the consumer confidence index, as reported
by the Conference Board, for the Middle Atlantic Region, which includes New
York, was 102.1, while the index for the Pacific Region, which includes
California, was 121.9, both of which are lower than the average index for the
United States as a whole, which was 123.4.

DEPENDENCE ON SUPPLIERS

The Company obtains its raw materials and some manufactured products from
various outside sources and generally has had no difficulty obtaining them.
However, the Company is 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, the Company's 10
largest suppliers account for approximately 57.5% of its aggregate purchases in
the nine-month period ended November 2, 1997. During the nine-month period ended
November 2, 1997, approximately 13.3% of certain products and raw materials
purchases consisted of leather purchased from a supplier, constituting
approximately 87.2% of the leather purchases made by the Company during this
period, and approximately 9.3% of these purchases consisted of pre-cut wood
components purchased from a supplier, constituting nearly all of the pre-cut
wood component

11
<PAGE> 13

purchases made by the Company. The Company has no supply contract with either of
these large suppliers, but instead makes each purchase under a separate purchase
order. Both leather and pre-cut wood components are commodities the Company
believes it can readily obtain from alternative sources, and from time to time
the Company has purchased such commodities from alternative sources.
Nevertheless, if the Company could not develop alternative sources of supply of
leather, pre-cut wood components or certain other raw materials and products
when needed, or could not obtain sufficient single-source products, components
and raw materials when needed, the resulting loss of production capability,
would adversely affect the Company's results of operations.

In addition, commodity raw materials are subject to fluctuations in price.
Because raw materials make up a substantial part of the cost of goods sold by
the Company, price fluctuations could have a material adverse effect on the
Company's results of operations. Although the Company has historically absorbed
gradual increases in raw material prices, there can be no assurance that the
Company will continue to be able to do so in the future. In addition, sharp
increases in material prices are more difficult to pass through to the customer
in a short period of time and may negatively impact the short-term financial
performance of the Company. See "Business -- Manufacturing."

RELIANCE ON MANUFACTURING FACILITY AND COMPUTER SYSTEM; VULNERABILITY TO
EARTHQUAKES

The Company's sole manufacturing plant, as well as the central processing
facility for the computer system that contains the Company's business records
and links the showrooms to Company headquarters is located in Southern
California, an area prone to earthquakes. An earthquake or other natural
disaster or work stoppage or other event affecting the normal operations of the
business could seriously impair the Company's capacity to continue its
manufacturing and retail operations. While the Company intends to implement a
disaster recovery system to lessen the impact of such a disaster or other work
stoppage, there can be no assurance that the Company will successfully put such
a system into operation.

In addition, the Company is pursuing replacing its computer system with a
new enterprise resource planning system to improve order configuration,
manufacturing scheduling and distribution processes. In the event that the
Company undertakes to replace its current computer system, failure to promptly
implement and integrate its system could have a material adverse affect on the
Company.

POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS

Because the Company sells most of its products on a made-to-order basis
with a two-to-four week delivery cycle, it typically operates with about 30 days
of backlog. As a result, quarterly sales and operating results generally depend
on the volume and timing of orders and the Company's ability to fulfill orders
within a quarter, which are difficult to forecast. The Company may be unable to
adjust spending in a timely manner to compensate for any unexpected revenue
shortfall. Accordingly, any significant shortfall of demand for the Company's
products in relation to the Company's expectations would have an immediate
adverse impact on the Company's business, operating results and financial
condition. In addition, the Company plans to increase certain cash expenditures
in connection with the remodeling of existing showrooms and the opening of new
showrooms. To the extent that such expenditures precede or are not subsequently
followed by increased revenues, the Company's business, operating results and
financial condition will be materially adversely affected. In addition, because
the Company's operating results are affected by a variety of factors, including
consumer tastes, housing activity, interest rates, credit availability and
general economic conditions in its selected markets, it is likely that in some
future quarter the Company's operating results will be below the expectations of
public market analysts and investors. In that event, the price of the Common
Stock would likely be materially adversely affected.

CONTROL BY PRINCIPAL STOCKHOLDERS

The current management, directors and other principal stockholders of the
Company own in the aggregate approximately 70% of the issued and outstanding
capital stock of the Company on a fully-diluted basis. Furthermore, the Company
has entered into a Stockholders Agreement with certain of its stockholders

12
<PAGE> 14

which provides, in part, that the stockholders who are parties to the
Stockholders Agreement will vote their shares in any election of directors in a
manner that assures the election of directors designated by each of them. The
Stockholders Agreement also prohibits the Company from taking certain actions,
such as mergers, liquidations or dissolutions, without the approval of the
member of the Board of Directors designated by GECC. See "Certain Transactions"
and "Description of Capital Stock -- Stockholders Agreement." It is unlikely
that any principal 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 public
stockholders. These factors may have the effect of delaying, deferring or
preventing a change in control of the Company.

POSSIBLE LIMIT ON USE OF OPERATING LOSS CARRYFORWARDS RESULTING FROM CHANGE IN
CONTROL

As of February 2, 1997, the Company had approximately $30 million of
federal net operating loss carryforwards, which were estimated to be
approximately $32 million prior to filing of the Company's tax return for fiscal
1996, including approximately $10 million which is currently limited by Section
382 of the Internal Revenue Code of 1986, as amended. Also, Section 382 would
further limit the Company's use of its operating loss carryforwards if the
cumulative ownership change during any three-year period exceeds 50%. As a
result of transactions occurring through November 2, 1997 and contemplated by
this offering, the Company will have experienced a cumulative ownership change
of approximately 42% as defined in Section 382. These factors may have the
effect of delaying, deferring or preventing a change in control of the Company.

MARKET FOR THE COMPANY'S COMMON STOCK; POTENTIAL VOLATILITY OF STOCK PRICE

The Company's Common Stock has been reported and traded on the Nasdaq
SmallCap Market, and the Company intends to list its shares on the American
Stock Exchange. Nevertheless, there can be no assurances as to the extent or
nature of the market for the Company's Common Stock (which is currently thinly
traded) or as to the price at which the Company's Common Stock will trade. The
market price of the Company's Common Stock may be significantly affected by
various factors such as quarterly variations in the Company's operating results,
changes in revenue growth rates for the Company as a whole or for specific
geographic areas or products, earnings estimates or changes in estimates by
market analysts, speculation in the press or analyst community, the announcement
of new products or product enhancements by the Company or its competitors and
general market conditions or market conditions specific to particular
industries. 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.

MAINTAINING LISTING ON AMERICAN STOCK EXCHANGE

The Company intends to list its shares for trading on the American Stock
Exchange prior to the consummation of this offering. The American Stock Exchange
may at its discretion suspend or delist the securities of a company without
notice if, in the opinion of the exchange, certain circumstances apply,
including any one of the following: the financial condition and/or operating
results of the company appear to be unsatisfactory; it appears that the extent
of public distribution or the aggregate market value of the security has become
so reduced as to make further dealings on the exchange inadvisable; the company
has sold or otherwise disposed of its principal operating assets, or has ceased
to be an operating company; the company has failed to comply with the listing
requirements of the exchange; or any other event has occurred or condition
exists that makes further trading on the exchange unwarranted. Because many of
these circumstances lie beyond the control of the Company, and because the
American Stock Exchange may determine at its discretion whether cause for
suspension or delisting exists, there is a risk that the Company may no longer
be able to list its shares for trading on the American Stock Exchange or any
other stock exchange or market

13
<PAGE> 15

system. In that event, the price of the Common Stock would be materially,
adversely affected and the ability of investors to sell their shares of the
Common Stock could be seriously impaired.

POTENTIAL ADVERSE MARKET IMPACT OF SHARES ELIGIBLE FOR FUTURE SALE

Sales of a substantial number of shares of Common Stock in the public
market following this offering could adversely affect the market price for the
Common Stock. Upon completion of this offering, the Company will have 20,924,428
shares of Common Stock outstanding. Of these shares, 8,036,154 shares are freely
tradeable without restriction or further registration under the Securities Act
of 1933, as amended (the "Securities Act"). The remaining 12,888,274 shares are
"restricted securities," as that term is defined under Rule 144 under the
Securities Act. In general, under Rule 144 as currently in effect, a person who
has beneficially owned restricted securities for at least one year, including
persons who may be deemed "affiliates" of the Company, would be entitled to sell
within any three-month period a number of securities that does not exceed the
greater of 1% of the number of shares of Common Stock then outstanding or the
average weekly trading volume of the Common Stock during the four calendar weeks
preceding the date of such sale. In addition, a person who has not been an
"affiliate" of the Company at any time during the 90 days preceding a sale and
who has beneficially owned the securities proposed to be sold for at least two
years would be entitled to sell such securities under Rule 144 without regard to
the foregoing limitation. Upon completion of the offering, executive officers,
directors and certain stockholders of the Company, who will beneficially own
4,690,558 shares of Common Stock in the aggregate, have agreed not to offer,
sell, contract to sell, or otherwise dispose of, any shares of Common Stock for
a period of 120 days, after the date of the Prospectus without prior written
consent of Cruttenden Roth Incorporated.

In addition to the shares of Common Stock currently outstanding, the
Company also has outstanding options, warrants, and deferred stock units to
purchase an aggregate of 4,570,621 shares of Common Stock. In connection with
prior financings and subject to future contingencies, warrants to purchase an
additional 1,560,000 shares of Common Stock may become issued by the Company.
See "Description of Capital Stock" and "Certain Transactions."

ANTITAKEOVER EFFECTS OF CERTAIN CHARTER PROVISIONS AND DELAWARE LAW

Certain provisions of the Company's Certificate of Incorporation and of
Delaware law could discourage potential acquisition proposals and could delay or
prevent a change in control of the Company. Such provisions could diminish the
opportunities for stockholders to participate in tender offers, including tender
offers at a price above the then current market value of the Company's Common
Stock. See "Description of Capital Stock -- Section 203 of the Delaware General
Corporation Law." Such provisions may also inhibit fluctuations in the market
price of Company Common Stock that could result from takeover attempts. In
addition, while the Company currently has no plans to issue any preferred stock,
the Company's Certificate of Incorporation, as amended, authorizes the Board of
Directors to issue up to 666,667 shares of Preferred Stock without further
stockholder approval. Issuance of preferred stock could have the effect of
delaying, deterring or preventing a change in control of the Company. The
issuance of additional series of preferred stock could also adversely affect the
voting power of the holders of Common Stock, including the loss of voting
control to others. The Board of Directors also 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.

GOVERNMENTAL REGULATION

The Company's operations must meet federal, state and local regulatory
standards in the areas of safety, health and environmental pollution and waste
control. If the Company fails to comply with these regulations,

14
<PAGE> 16

the Company could be subject to liability ranging from monetary fines and
charges to injunctive actions, any of which would adversely affect the Company.
Future changes in these regulations could also have a material adverse effect on
the Company.

DILUTION

Purchasers of the shares of Common Stock offered hereby will experience
immediate and substantial dilution in the net tangible book value of their
investment from the offering price. Additional dilution will occur upon exercise
of outstanding options or warrants. See "Dilution."

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. Furthermore, dividends
are subject to 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 the lenders.

15
<PAGE> 17

USE OF PROCEEDS

The net proceeds from the sale of the 1,903,889 shares of Common Stock
offered by the Company hereby is estimated to be $ (after deducting the
Placement Agent's fees and the estimated offering expenses). The principal
purpose of this offering is to fund the remodeling of existing showrooms, to
fund the opening of new showrooms and for other general corporate purposes.
Projected capital expenditures in 1998 to remodel approximately 24 existing
showrooms and to open approximately 18 new showrooms, which will be leased, is
$6.7 million. Pending the application of the net proceeds, the Company intends
to pay down its secured revolving credit notes, which bear a current interest
rate of 9.5%.

The Company will not receive any of the net proceeds from the sale of
Common Stock being offered by the Selling Stockholder.

DIVIDEND POLICY

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.

PRICE RANGE OF COMMON STOCK

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 prices for
the Company's Common Stock for the first three quarters during the 1997 fiscal
year and for the fourth quarter through December 17, 1997 and for each quarter
during the 1996 (53 weeks ended February 2, 1997) and 1995 (52 weeks ended
January 28, 1996) fiscal years. Quotations are as reported by Nasdaq, adjusted
for periods prior to August 1, 1995 to reflect a one for three reverse stock
split, effective on that date.

<TABLE>
<CAPTION>
1997 1996 1995
--------------- --------------- ---------------
QUARTER HIGH LOW HIGH LOW HIGH LOW
--------------------------- ----- ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C>
First...................... $2.06 $1.25 $2.56 $ .88 $6.75 $4.87
Second..................... 1.81 1.48 1.63 .69 6.37 3.00
Third...................... 4.19 1.50 2.19 .50 4.37 2.00
Fourth..................... 3.25 2.63 2.13 1.00 3.00 1.63
</TABLE>

As of November 2, 1997, there were approximately 370 holders of record of
the Company's Common Stock.

The Company intends to list its shares on the American Stock Exchange prior
to the consummation of this offering and cease trading of its shares on the
Nasdaq Small-Cap Market.

16
<PAGE> 18

DILUTION

As of November 2, 1997, the net tangible book value per share of the
Company's Common Stock was negative $.26. Net tangible book value per share
represents the amount of the Company's tangible assets, less the amount of its
liabilities, divided by the number of shares of Common Stock outstanding.

After giving effect to the issuance of the 1,903,889 shares of Common Stock
offered hereby at an offering price of $ per share and after deduction
of the Placement Agent's fees and the estimated offering expenses payable by the
Company, and the receipt of the proceeds therefrom and assuming no exercise of
any outstanding stock options or warrants, the net tangible book value per share
of Common Stock as of November 2, 1997 would have been $ . This would
result in dilution to the new investors of $ per share, which is
greater than the public offering price. The following table illustrates the per
share dilution:

<TABLE>
<S> <C> <C>
Public offering price per share(1)................................. $ --
Net tangible book deficit per share as of November 2, 1997......... $(.26)
Increase in net tangible deficit per share attributable to the sale
by the Company of the shares offered hereby...................... --
Pro forma net tangible book deficit per share after the
offering(2)...................................................... --
----
Dilution of net tangible book value per share to new investors..... $ --
====
</TABLE>

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

(1) Before deducting the Placement Agent's fees and estimated offering expenses
to be paid by the Company.

(2) Assumes no exercise of the warrants or options to purchase Common Stock that
were outstanding at November 2, 1997. Outstanding options, all of which were
issued under option plans prior to November 2, 1997, cover the purchase of
an aggregate of shares at a weighted average exercise price of
$ . If these options are exercised, they will be dilutive to the
Company's stockholders, including the new investors. Outstanding warrants
include warrants to purchase an aggregate of shares at an average
exercise price of $ . If these warrants are exercised, they will be
dilutive to the Company's shareholders, including the new investors.

Giving effect to the exercise of all warrants and options referenced, with
the exception of anti-dilutive warrants and options, the adjusted net tangible
book value of the Common Stock as of November 2, 1997 after the offering would
have been $ . This would result in dilution to the new investors of
$ .

17
<PAGE> 19

CAPITALIZATION

The following table sets forth the capitalization of the Company as of
November 2, 1997, and as adjusted to give effect to the sale of 1,903,889 shares
of Common Stock offered by the Company and the application of net proceeds
therefrom. See "Use of Proceeds." The table should be read in conjunction with
the consolidated financial statements and notes thereto included elsewhere in
this Prospectus.

<TABLE>
<CAPTION>
NOVEMBER 2, 1997
------------------------
ACTUAL AS ADJUSTED
-------- -----------
(IN THOUSANDS)
<S> <C> <C>
Current portion of notes payable.............................. $ 41 $ 41
Long-term notes payable:
Secured revolving credit notes.............................. 4,094 --
Subordinated notes payable to stockholders, net of $1,884 of
unamortized debt discount................................ 6,617 6,617
Other notes, excluding current portion...................... 362 362
-------- --------
Total long-term notes payable............................ 11,114 7,020
-------- --------
Stockholders' equity:
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 (20,924,428 shares
outstanding as adjusted)(1).............................. 19 21
Capital in excess of par value.............................. 50,952 --
Accumulated deficit......................................... (39,959) (39,959)
-------- --------
Total stockholders' equity............................... 11,012 --
-------- --------
Total capitalization..................................... $ 22,167 $ --
======== ========
</TABLE>

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

(1) Excludes 2,043,958 shares issuable upon exercise of options, 2,502,047
shares issuable upon exercise of warrants and 24,616 shares issuable
pursuant to deferred stock rights. See "Description of Capital Stock."

BACKGROUND OF THE COMPANY

The Company is a combination of two pre-existing furniture manufacturing
and retailing businesses. Krause's Custom Crafted Furniture Corp., formerly
known as Krause's Sofa Factory ("Krause's"), was started in San Diego,
California in 1973. In April 1991, the Company acquired a controlling interest
in Krause's, and in October 1993, the Company acquired the remaining minority
interest in Krause's.

Castro Convertible Corporation, which was started in 1931, has developed a
reputation throughout the East Coast for its quality sofabed products and was an
early pioneer in developing the tri-fold sofabed mechanism. The Company acquired
certain assets related to the retail operations of Castro Convertible
Corporation including the "Castro Convertibles" tradename and trademark and
retail store locations in May 1993.

18
<PAGE> 20

SELECTED CONSOLIDATED FINANCIAL DATA

The following data as of February 2, 1997 and January 28, 1996 and for each
of the three years in the period ended February 2, 1997 and for the month ended
January 29, 1995 has been derived from consolidated financial statements
appearing elsewhere herein that have been audited by Ernst & Young LLP,
independent auditors. The following data as of December 31, 1994, 1993 and 1992
and for each of the two years in the period ended December 31, 1993 have been
derived from audited consolidated financial statements not included herein. The
following data as of and for the nine-month periods ended November 2, 1997 and
October 27, 1996, and for the month ended January 30, 1994, is unaudited. This
summary data should be read in conjunction with the consolidated financial
statements and notes thereto appearing elsewhere in this Prospectus.
<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
FISCAL YEAR ENDED
------------------------ ------------------------------------------------------------------
NOVEMBER 2, OCTOBER 27, FEBRUARY 2, JANUARY 28, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1997 1996 1997(4) 1996(4) 1994 1993 1992
----------- ----------- ----------- ----------- ------------ ------------ ------------
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
Results of Operations:
Net sales................... $ 85,569 $ 82,738 $ 112,737 $ 122,319 $116,471 $ 96,894 $ 87,045
Gross profit................ 43,729 40,374 56,247 62,467 62,949 50,792 45,688
Selling, general and
administrative expense.... 48,103 52,173 68,694 71,855 65,347 58,644 51,670
Loss from operations........ (4,374) (11,799) (12,447) (9,388) (2,398) (7,852) (5,982)
Gain from sale of Mr. Coffee
stock(2).................. -- -- -- -- 12,115 -- --
Income (loss) before
extraordinary items....... (5,609) (12,374) (13,389) (8,715) 5,831 (9,751) (3,641)
Extraordinary items(3)...... -- -- -- -- (436) (221) 3,330
Net income (loss)........... (5,609) (12,374) (13,389) (8,715) 5,395 (9,972) (311)
Income (loss) per share(1):
Income (loss) before
extraordinary items....... (.30) (1.62) (1.28) (2.21) 1.08 (3.88) (1.84)
Extraordinary items....... -- -- -- -- (0.08) (0.09) 1.68
Net income (loss)......... $ (.30) $ (1.62) $ (1.28) $ (2.21) $ 1.00 $ (3.97) $ (0.16)
Number of shares used in
computing income (loss)
per share(1).............. 19,021 7,661 10,445 3,950 5,394 2,510 1,982

MONTH ENDED
------------------------
JANUARY 29, JANUARY 30,
1995(4)(5) 1994(5)
----------- -----------

<S> <C> <C>
Results of Operations:
Net sales................... $ 7,179 $ 7,326
Gross profit................ 3,532 3,807
Selling, general and
administrative expense.... 6,763 5,848
Loss from operations........ (3,231) (2,041)
Gain from sale of Mr. Coffee
stock(2).................. -- --
Income (loss) before
extraordinary items....... (3,221) (2,185)
Extraordinary items(3)...... -- --
Net income (loss)........... (3,221) (2,185)
Income (loss) per share(1):
Income (loss) before
extraordinary items....... (.87) (.63)
Extraordinary items....... -- --
Net income (loss)......... $ (0.87) $ (.63)
Number of shares used in
computing income (loss)
per share(1).............. 3,685 3,490
</TABLE>

<TABLE>
<CAPTION>
NOVEMBER 2, OCTOBER 27, FEBRUARY 2, JANUARY 28, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1997 1996 1997 1996 1994 1993 1992
----------- ----------- ----------- ----------- ------------ ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance Sheet
Data:
Total assets... $43,484 $47,402 $43,087 $46,866 $ 51,240 $ 64,749 $ 47,730
Current
assets....... 18,081 20,339 17,553 18,602 21,784 24,081 16,405
Current
liabilities... 19,262 24,135 19,735 25,480 23,732 25,485 20,008
Long-term
debt(2)...... 11,073 5,260 6,306 5,584 89 17,700 15,500
Stockholders'
equity....... 11,012 16,265 15,543 13,985 25,921 20,626 11,170
</TABLE>

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

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

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

19
<PAGE> 21

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

The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Consolidated
Financial Statements and the Notes thereto included elsewhere in this
Prospectus. This Prospectus contains certain forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, including
statements regarding (i) the anticipated performance of the Company's new
management team, (ii) the effect of the Company's remodeling and expansion
program, (iii) the Company's efforts to improve efficiency, (iv) the Company's
intention to capitalize on its brand names to increase sales and market share,
and (v) the Company's efforts to improve its financial performance. These
statements involve risks and uncertainties and actual results could differ
materially from those discussed in the forward-looking statements as a result of
certain factors, including but not limited to the reasons discussed in "Risk
Factors" and elsewhere in this Prospectus.

The Company has reported losses from operations in each of the past five
fiscal years and for the thirty-nine weeks ended November 2, 1997 due to
inefficiencies within its operations and due to an industry-wide softness in
retail sales. As a result of such losses, the Company had an accumulated deficit
of $39,959,000 and a working capital deficiency of $1,181,000 at November 2,
1997. The Company expects to incur a net loss in its fourth quarter of 1997.

The Company's management, which underwent a substantial restructuring after
the 1996 financings, discussed below under "Liquidity and Capital Resources,"
has developed a strategic plan for the business which provides, among other
things, for remodeling existing showrooms to provide a more appealing setting
for customers, adding new showrooms in existing markets, increasing product
prices to competitive levels, reducing promotional discounting, reconfiguring
selling commissions, remerchandising, refocusing advertising, improving the
manufacturing processes and reducing expenses through budgetary controls. Many
of these plans were implemented since the latter part of fiscal 1996 and 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.

Management believes that the Company has sufficient sources of financing to
continue operations throughout fiscal 1998. However, the Company's long-term
success is dependent upon management's ability to successfully execute its
strategic plan and, ultimately, to achieve sustained profitable operations.

20
<PAGE> 22

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED FISCAL YEAR ENDED MONTH ENDED
------------------------- ---------------------------------------- -------------------------
NOVEMBER 2, OCTOBER 27, FEBRUARY 2, JANUARY 28, DECEMBER 31, JANUARY 29, JANUARY 30,
1997 1996 1997 1996 1994 1995 1994
----------- ----------- ----------- ----------- ------------ ----------- -----------
<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................... 48.9 51.2 50.1 48.9 46.0 50.8 48.0
------ ------ ------ ------ ------ ------ ------
Gross profit.................... 51.1 48.8 49.9 51.1 54.0 49.2 52.0
Operating expenses:
Selling....................... 47.4 52.7 51.1 49.3 45.9 75.9 67.4
General and administrative.... 7.9 9.5 9.0 8.7 9.3 17.1 11.3
Amortization of goodwill...... 0.9 0.9 0.9 0.8 0.9 1.2 1.2
------ ------ ------ ------ ------ ------ ------
56.2 63.1 61.0 58.8 56.1 94.2 79.9
------ ------ ------ ------ ------ ------ ------
Loss from operations............ (5.1) (14.3) (11.1) (7.7) (2.1) (45.0) (27.9)
Interest expense................ (1.4) (0.9) (1.1) (0.6) (1.8) (0.2) (3.5)
Other income.................... (0.1) 0 .3 0.3 0.1 10.8 0.3 1.6
------ ------ ------ ------ ------ ------ ------
Income (loss) before income
taxes and extraordinary
items......................... (6.6) (14.9) (11.9) (8.2) 6.9 (44.9) (29.8)
Provision (benefit) for income
taxes......................... -- -- -- (1.1) 1.9 -- --
------ ------ ------ ------ ------ ------ ------
Income (loss) before
extraordinary items........... (6.6) (14.9) (11.9) (7.1) 5.0 (44.9) (29.8)
Extraordinary items............. -- -- -- -- (0.4) -- --
------ ------ ------ ------ ------ ------ ------
Net income (loss)............... (6.6)% (14.9)% (11.9)% (7.1)% 4.6% (44.9)% (29.8)%
====== ====== ====== ====== ====== ====== ======
STORE (SHOWROOM) DATA
Stores open at beginning of
period........................ 82 83 83 89 87 89 87
Stores opened during period..... 1 1 1 4 10 -- --
Stores closed during period..... 2 1 2 10 8 1 --
------ ------ ------ ------ ------ ------ ------
Stores open at end of period.... 81 83 82 83 89 88 87
Average sales per showroom(1)... $ 1,063 $ 997 $ 1,361 $ 1,432 $1,373 $ 82 $ 84
Same-store sales increase
(decrease)(2)................. 4.3% (9.9)% (6.0)% (2.9)% 11.7% (8.6)% (1.1)%
</TABLE>

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

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

(2) Same 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. A store opened at any time during the month is deemed to
have been open for the entire month.

THIRTY-NINE WEEKS ENDED NOVEMBER 2, 1997 COMPARED TO THIRTY-NINE WEEKS
ENDED OCTOBER 27, 1996

Net Sales. Net sales for the thirty-nine weeks ended November 2, 1997 were
$85,569,000 versus $82,738,000 for the comparable period of fiscal 1996, an
increase of $2,831,000 or 3.4%. The sales increase was primarily attributable to
an increase in same-store sales of 4.3% partially offset by a decrease
attributable to the operation of two fewer stores in the 1997 period. Sales for
the thirty-nine weeks ended October 27, 1996 were adversely impacted by a
shortage of raw materials, resulting from insufficient cash prior to the August
and September 1996 financings to purchase such raw materials which were required
for production and shipments.

Gross Profit. Gross profit was 51.1% of net sales for the thirty-nine weeks
ended November 2, 1997 and was 48.8% of net sales in the comparable period of
fiscal 1996. The increase in gross profit resulted primarily from increased
product prices and reduced promotional discounting.

Selling Expenses. Selling expenses were $40,558,000 or 47.4% of net sales
for the thirty-nine weeks ended November 2, 1997 and were $43,556,000 or 52.7%
of net sales in the comparable period of fiscal 1996. The decrease of $2,998,000
in selling expenses was primarily due to a decrease of $1,630,000 in variable
selling payroll, resulting from a new commission structure, and decreases of
$1,589,000 and $325,000 in store non-

21
<PAGE> 23

payroll expenses and delivery expenses, respectively, resulting primarily from
tighter cost controls offset by increased advertising costs of $824,000.

General and Administrative Expenses. General and administrative expenses
for the thirty-nine weeks ended November 2, 1997 were $6,780,000 compared to
$7,852,000, for the comparable period of fiscal 1996, a decrease of $1,072,000.
This decrease was primarily as a result of lower professional fees, contract
labor costs and computer rental and maintenance costs offset in part by higher
payroll related costs.

Interest Expense. Interest expense for the thirty-nine weeks ended November
2, 1997 increased by $395,000 over the comparable period of fiscal 1996 due to
higher average debt outstanding.

Income Taxes. The Company paid no taxes and no tax benefits were available
for either of the thirty-nine week periods of fiscal 1997 or 1996.

Net Loss. As a result of the above factors, the net loss was $5,609,000 for
the thirty-nine weeks ended November 2, 1997 as compared to a net loss of
$12,374,000 for the comparable period of fiscal 1996. Net loss per share in the
1997 period was $.30 based on 19,021,000 shares outstanding. In the comparable
1996 period the net loss per share was $1.62 based on 7,661,000 average shares
outstanding.

53 WEEKS ENDED FEBRUARY 2, 1997 (FISCAL 1996) AS COMPARED TO 52 WEEKS ENDED
JANUARY 28, 1996 (FISCAL 1995)

Net Sales. Sales were $112,737,000 in fiscal 1996, a decrease of 7.8% from
sales in fiscal 1995; same store sales decreased 6.0% between years. The sales
decrease was due to a combination of factors including (i) an industrywide
softness in retail sales, (ii) insufficient cash during the first eight months
of fiscal 1996 to timely purchase raw materials needed for the manufacture of
customer orders, and (iii) the Company's decision in the third quarter of fiscal
1996 to raise prices to competitive levels and reduce promotional discounting.

Gross Profit. Gross profit was 49.9% of net sales in fiscal 1996 as
compared to 51.1% in fiscal 1995. Lower gross profit in fiscal 1996 resulted
from extensive promotional discounting during the first half of 1996 and changes
in the mix of products sold. As noted above, the Company increased product
prices and reduced promotional discounting in the second half of fiscal 1996
which contributed to an overall improvement in gross profit from 47.1% for the
26 weeks ended July 28, 1996 to 52.7% for the 27 weeks ended February 2, 1997.

Selling Expenses. Selling expenses for fiscal 1996 were $57,573,000,
representing a decrease of $2,684,000 from fiscal 1995. Selling expenses were
51.1% of net sales in fiscal 1996 as compared to 49.3% in fiscal 1995. 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 fiscal 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 12-24 months subsequent to the 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 minimum 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. General and administrative expenses
increased as a percentage of sales from 8.7% to 9.0% due primarily to a lower
sales base in fiscal 1996; however, in total dollars, general and administrative
expenses decreased by $477,000 due principally to general cost reductions offset
somewhat by higher employee termination expenses and professional fees.

Interest Expense. Interest expense in fiscal 1996 increased by $509,000,
due principally to higher average debt outstanding compared to the prior year.

22
<PAGE> 24

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

As of February 2, 1997, the Company has federal net operating loss
carryforwards of approximately $32 million which begin to expire in 2003, if not
utilized. As a result of various equity transactions, one of the Company's
subsidiaries has experienced change 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 approximately $10 million of these net
operating loss carryforwards is limited to the future income of one of the
Company's subsidiaries and is further limited to approximately $1 million per
year on a cumulative basis. As of February 2, 1997, approximately $3 million of
the limited losses were available. In addition, the Company had state net
operating loss carryforwards of approximately $14 million which begin to expire
in the year 1997, if not utilized.

The valuation allowance for deferred tax assets totaled $8,310,000 at
January 28, 1996 and $13,643,000 at February 2, 1997. The valuation allowance
increased since the realization of net deferred tax assets is uncertain.

Net Loss. Although net loss in fiscal 1996 increased to $13,389,000 from
$8,715,000 in fiscal 1995, an increase of 54%, net loss per share decreased to
$1.28 in fiscal 1996 as compared to $2.21 in fiscal 1995, a decrease of 42%. The
change is due primarily to the increase in the weighted average number of
Company shares outstanding from 3,950,000 in fiscal 1995 to 10,445,000 in fiscal
1996 attributable to the issuance of 14,912,000 shares of the Company's Common
Stock in connection with the August and September 1996 financings discussed
below under Liquidity and Capital Resources.

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

Net Sales. Sales were $122,319,000 in fiscal 1995, an increase of 5.0% from
sales in 1994. The sales increase was primarily from sales of stores opened in
late 1994 and early 1995, which were offset somewhat by a decrease in sales of
stores open more than one year. Management believes that the sales increase was
not significantly attributable to increases in prices or increases in sales
volume for goods sold in existing stores or to the introduction of new products
being sold in comparable stores. During fiscal 1995, the Company opened four new
stores, relocated four stores and closed ten underperforming stores. A
comparable store sales decline of 2.9% was primarily the result of general
economic conditions in fiscal 1995 compared to 1994.

Gross Profit. Gross profits in fiscal 1995 were 51.1% compared to 54.0% in
1994. Lower gross profits in fiscal 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 1995. During the fourth quarter of fiscal 1995, the
Company 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 profits. Profit erosion
also occurred since additional discounts were given to customers due to delivery
delays. The out-of-stock position returned to normal levels in fiscal 1996.

Selling Expenses. Selling expenses were $60,257,000 in fiscal 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. 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 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 $1,000,000
principally from reductions in payroll and related expenses.

23
<PAGE> 25

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 $18,300,000 million of debt with proceeds from
the sale of its investment in Mr. Coffee.

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 1995 losses.

MONTH ENDED JANUARY 29, 1995 COMPARED TO MONTH 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 profits 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 Sales. Net 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 a lower backlog position in the 1995 period.

Gross Profit. Gross profit was 49.2% of net sales in January 1995 compared
to 52.0% in January 1994. The lower gross profits 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. 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 selling expenses attributable to
lower sales volume.

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

Interest Expense. 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 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.

Net Loss. As a result of the above factors, the 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.

Income Taxes. The Company paid no taxes and no tax benefits were available
for the January 1995 or 1994 operating losses.

LIQUIDITY AND CAPITAL RESOURCES

In recent periods, the Company has utilized its working capital to cover
operating deficits and to finance the remodeling and expansion of its showrooms.
In the balance of the fourth quarter of 1997 and in fiscal 1998, management
plans to remodel and upgrade approximately 28 existing showrooms, as well as add
approximately 20 additional showrooms, at an aggregate cost of approximately
$7.7 million. Management expects to fund such capital expenditures by internally
generated cash, by borrowings under the Company's revolving and standby credit
facilities, and by the proceeds to the Company of the sales of its shares, if
any, in this offering.

24
<PAGE> 26

The Company is not contractually committed to make these capital expenditures
and could slow its expansion and remodeling program if the Company experiences
any liquidity shortages.

In May 1996, the Company raised approximately $3 million through the
issuance of convertible notes to certain related party investors. In August and
September 1996, GECC and certain other investors led by Mr. Hawley invested
$15.7 million in the Company. In connection with this financing, the Company (i)
issued approximately $13.7 million of Common Stock, of which $5 million was
purchased by GECC and approximately $3 million was issued to the holders of
convertible notes in cancellation thereof; and (ii) issued to GECC a 10%
promissory note in the principal amount $5 million, together with a warrant to
purchase 1.4 million shares at $.001 per share. Also in connection with this
financing, the holders of shares of the Company's pre-existing Preferred Stock
agreed to convert their shares into approximately 1.2 million shares of Common
Stock. See "Certain Transactions."

In August 1997, the Company raised $3 million through the issuance of 9.5%
promissory notes to GECC and Japan Omnibus Ltd. ("JOL") in the principal amounts
of $2.5 million and $.5 million, respectively, together with warrants to
purchase 600,000 and 140,000 shares of Common Stock, respectively, at a purchase
price of $1.25 per share. In connection with this investment, GECC and JOL also
granted to the Company a standby credit facility under which the Company may, at
its option, subject to the attainment of certain financial covenants, borrow up
to an additional $3.5 million. In the event that the Company borrows funds under
the standby credit facility, the Company will issue to GECC and JOL additional
warrants to purchase 400,000 and 160,000 shares of Common Stock, respectively,
at $1.25 per share. The Company expects to borrow the full $3.5 million of this
standby credit facility in late December 1997. See "Certain Transactions."

Also in August 1997, the Company renegotiated the terms of its existing
revolving line of credit with Congress Financial Corporation (Western) by making
a change in the advance rate that will provide greater borrowing capacity. The
credit facility currently has a maximum commitment of $10 million, subject to
borrowing base limitations. The credit facility expires January 20, 2000,
accrues interest at a rate of prime plus 1%, and is secured by substantially all
of the Company's assets. Under the credit facility, the Company is required to
maintain certain financial covenants and is prohibited from incurring additional
indebtedness from third parties in an amount in excess of $5 million. In
addition, the credit facility requires the Company to maintain certain financial
covenants regarding working capital, net worth and earnings. As of November 2,
1997, the Company was out of compliance with one of these covenants but has
obtained a waiver. The Company may be in violation of one of these covenants as
of February 1, 1998 and anticipates being able to obtain a similar waiver, as
necessary, at that time. However, there can be no assurance that future
financial performance will result in compliance with these restrictions or that
waivers will be obtained if the Company fails to maintain compliance. See "Risk
Factors -- Leverage and Ability to Service Debt." As of November 2, 1997, the
Company had unused borrowing capacity under its credit facility of approximately
$3.6 million.

The Company believes that the net proceeds from this offering, if any,
combined with borrowings under its credit facilities and internally generated
funds, will be sufficient to fund its requirements for working capital and
capital expenditures through the end of fiscal year 1998. However, the Company
may need to raise additional funds to finance its remodeling and expansion
program through either debt or equity financing, and there can be no assurance
that the Company's financial performance will generate significant funds.
Further, the Company has reserved the right to withdraw any and all of its
shares from the offering. If the Company withdraws its shares from the offering,
it intends to use other sources of capital to complete its remodeling and growth
plans and to provide working capital. The Company expects that its decision will
be based on the relative cost of capital, the availability of internally
generated funds, the desirability of having additional Company shares
outstanding and other factors. The Company currently contemplates that other
sources of capital would be available, although this situation could change.

The aggregate annual maturities of long-term debt during each of the five
fiscal years subsequent to February 2, 1997 are approximately as follows:
$41,000 in 1997, $74,000 in 1998, $4,111,000 in 1999, $2,098,000 in 2000, and
$1,286,000 in 2001. Management anticipates such payments will be made out of
operating cash flow.

25
<PAGE> 27

Cash Flow -- Thirty-Nine Weeks Ended November 2, 1997. During the
thirty-nine weeks ended November 2, 1997, cash and cash equivalents decreased by
$977,000. Operating activities used net cash of $4,498,000, principally from a
cash loss from operations of $3,021,000, an increase in inventories of
$2,486,000 and a decrease in customer deposits of $408,000 partially offset by
decreases in prepaid expenses and other assets of $424,000 and accounts
receivable of $340,000 and an increase in Accounts Payable and Other Liabilities
of $653,000. Investing activities during the period included capital
expenditures of $1,498,000, nearly all of which was used to remodel certain
retail showrooms. Financing activities during the period consisted principally
of net borrowings of $2,095,000 under the Company's revolving credit facility
and $3,000,000 borrowed from GECC and JOL. Management plans to continue its
program of remodeling and upgrading showrooms as well as to add new showrooms in
existing markets; the Company expects to incur costs of approximately $3,200,000
related to this program in fiscal 1997 and $6,750,000 in fiscal 1998.

1996 Cash Flow. During fiscal 1996, cash and cash equivalents decreased by
$109,000. Operating activities used net cash of $14,315,000, principally from a
cash loss from operations of $10,210,000 (the cash loss from operations for the
first half of fiscal 1996 was $8,638,000 and $1,572,000 for the second half) and
decreases in accounts payable and other liabilities of $6,081,000, offset
principally by a decrease in inventories of $614,000 and collections of income
tax refund receivables of $1,467,000. Investing activities during the year
included capital expenditures of $806,000, principally for additions to
leasehold improvements at certain retail showrooms. Financing activities during
fiscal 1996 were comprised principally of proceeds from issuances of common
stock of $10,669,000 less expenses of $448,000, proceeds of $2,950,000 from
issuances of convertible and demand notes (subsequently converted into common
stock, together with interest of $116,000) and the issuance of a subordinated
note of $5,000,000, offset by net payments of $3,516,000 under the Company's
revolving credit facility.

1995 Cash Flow. During fiscal 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 the
opening of four 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.

YEAR 2000 ISSUES

During fiscal 1997, the Company initiated a plan to implement new business
information systems, which will address all year 2000 issues, as well as enhance
Company operations. This implementation may result in significant capital
expenditures during fiscal 1998 and 1999. In the event that this implementation
is not completed prior to the year 2000, the Company has a contingency plan,
pursuant to which, existing systems will be modified to eliminate remaining year
2000 issues. Expenditures related to this contingency plan will be expensed as
incurred and are not expected to have a significant impact on the Company's
results of operations.

CHANGE IN AUDITOR

As previously disclosed, the Board of Directors of the Company, upon the
recommendation of the Audit Committee of the Board on September 19, 1997,
terminated the Company's relationship with Ernst & Young LLP and engaged Arthur
Andersen LLP as its new independent accountants to audit the Company's
consolidated financial statements. The reports of Ernst & Young LLP on the
Company's consolidated financial statements for the most recent two years ended
February 2, 1997 did not contain an adverse opinion or a disclaimer of opinion
nor were they qualified or modified as to uncertainty, audit scope or accounting
principles. During this two-year period and thereafter there were no
disagreements between the Company and Ernst & Young LLP on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedure, which disagreements, if not resolved to the satisfaction of
Ernst & Young LLP, would have caused it to make reference to the subject matter
of the disagreements in connection with its

26
<PAGE> 28

report. The Company has authorized Ernst & Young LLP to respond fully to
inquiries from Arthur Andersen LLP concerning all matters relating to prior
audits conducted by Ernst & Young LLP.

The Company interviewed Arthur Andersen LLP before making its decision.
During this interview Company representatives sought information concerning the
potential auditor's familiarity with accounting matters affecting the furniture
manufacturing and furniture retail industries and the Company. No specific
advice was sought. The Company did not perceive that there were any differences
with regard to substantive accounting issues between Arthur Andersen LLP and the
Company's prior auditors.

The Company has supplied a copy of this disclosure to both Ernst & Young
LLP and Arthur Andersen LLP and neither has indicated to the Company that it
objects or disagrees with this disclosure.

RECENT ACCOUNTING PRONOUNCEMENTS

In February 1997, the Financial Accounting Standards Board issued Statement
No. 128, "Earnings per Share," which is required to be adopted on December 31,
1997. At that time, the Company will be required to change the method currently
used to compute earnings per share and to restate all prior periods. Under the
new requirements for calculating primary earnings per share, the dilutive effect
of stock options will be excluded. Equity instruments, such as options and
warrants are excluded if antidilutive in the calculation of diluted earnings per
share. Since the effect of stock options is already excluded in the computation
of net loss per share, the adoption of Statement 128 will not result in any
change in the loss per share amounts reported for the thirty-nine weeks ended
November 2, 1997 or October 27, 1996.

Effective in fiscal 1998, the Company will be required to adopt Statements
of Financial Accounting Standards (SFAS) No. 129 "Capital Structure," SFAS No.
130 "Reporting Comprehensive Income" and SFAS No. 131 "Disclosures about
Segments of an Enterprise and Related Information." The impact of adoption of
these pronouncements is not expected to be material to the Company's financial
position or results of operations.

27
<PAGE> 29

QUARTERLY OPERATING RESULTS

The following tables set forth certain unaudited consolidated financial
information for each of the four quarters in fiscal 1996 and the first three
quarters of fiscal 1997. In management's opinion, this unaudited quarterly
information has been prepared on the same basis as the audited consolidated
financial statements and includes all necessary adjustments, consisting only of
normal recurring adjustments, that management considered necessary for a fair
presentation of the unaudited quarterly results when read in conjunction with
the Consolidated Financial Statements and Notes thereto included elsewhere in
this Prospectus. The Company believes that quarter-to-quarter comparisons of its
financial results are not necessarily meaningful and should not be relied upon
as an indication of future performance.

STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
QUARTER ENDED
-----------------------------------------------------------------------------------------------
NOVEMBER 2, AUGUST 3, MAY 4, FEBRUARY 2, OCTOBER 27, JULY 28, APRIL 28,
1997 1997 1997 1997(1) 1996 1996 1996
------------ ---------- ------- ------------ ----------- --------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Net sales................. $ 30,159 $ 27,768 $27,642 $ 29,999 $26,865 $ 26,236 $ 29,637
Cost of sales............. 14,560 14,005 13,275 14,126 12,781 13,860 15,723
------- ------- ------- ------- ------- ------- -------
Gross profit.............. 15,599 13,763 14,367 15,873 14,084 12,376 13,914
Operating costs and
expenses:
Selling ................ 13,698 13,832 13,028 14,017 14,081 15,006 14,469
General and
administrative........ 2,191 2,293 2,296 2,249 2,084 3,072 2,696
Amortization of
goodwill.............. 255 255 255 255 255 255 255
------- ------- ------- ------- ------- ------- -------
16,144 16,380 15,579 16,521 16,420 18,333 17,420
------- ------- ------- ------- ------- ------- -------
Loss from operations...... (545) (2,617) (1,212) (648) (2,336) (5,957) (3,506)
Interest expense.......... (467) (370) (340) (448) (296) (304) (182)
Other income (expense).... (35) (8) (15) 81 111 45 51
------- ------- ------- ------- ------- ------- -------
Net loss.................. $ (1,047) $ (2,995) $(1,567) $ (1,015) $(2,521) $ (6,216) $ (3,637)
======= ======= ======= ======= ======= ======= =======
</TABLE>

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

(1) All quarters are for a period of 13 weeks except the quarter ended February
2, 1997 which is for a period of 14 weeks.

The Company's operating results are subject to various risks and
uncertainties, including risks and uncertainties related to management's ability
to implement its business strategy, the Company's ability to service fixed
charges and to raise additional capital, economic conditions, competitive
pressures, availability and cost of supplies, the composition, timing and volume
of orders, overhead costs, manufacturing or production difficulties, certain
nonrecurring charges and other factors. Accordingly, the Company's operating
results may vary materially from quarter to quarter. Because a high percentage
of the Company's operating expenses are relatively fixed, if anticipated sales
and shipments in any quarter do not occur as expected, the Company's operating
results may be adversely affected and fall significantly short of expectations.
Any unanticipated decline in growth of the Company's net revenue, without a
corresponding and timely reduction in the growth of operating expenses, could
have an adverse effect on the Company's business, operating results and
financial condition. There can be no assurance that, in the event of any
shortfall of sales or reduction in gross margin in a quarter, the Company will
be able to control expenses sufficiently or promptly to meet profitability
objectives for that quarter. See "Risk Factors" for a discussion of other
factors that may adversely affect the Company's operating results in any given
quarter.

28
<PAGE> 30

BUSINESS

THE COMPANY

The Company is a leading vertically integrated manufacturer and retailer of
made-to-order upholstered furniture and accessories. The Company operates 81
furniture showrooms under the Krause's (67 showrooms) and Castro Convertibles
(14 showrooms) brand names in 12 states, with 41 of those showrooms in
California and 13 in the New York City metropolitan area, including New York,
New Jersey and Connecticut. Customers can choose from more than 60 styles and 40
sizes of sofas, incliners, recliners, sectionals, sofabeds and chairs, which
they can customize with 800 fabrics and 50 leathers. The Company believes that
it has developed a reputation for delivering high quality, custom-crafted
furniture at prices comparable to those of mass-produced sold-as-shown
furniture. In recent periods, the Company has undergone significant changes,
raising substantial new capital, hiring a new management team with extensive
expertise in retailing, and changing the Company's business strategy from a
factory-direct orientation to a retail-oriented, fashion conscious approach.

RECENT DEVELOPMENTS

In the Spring of 1996, GECC and Philip M. Hawley, the former Chairman and
Chief Executive Officer of The Broadway Stores, Inc. (formerly Carter Hawley
Hale Stores, Inc.), undertook an evaluation of the Company and determined that
it had strong brand name recognition, good retail locations in strong markets,
demonstrated manufacturing capability and a unique niche. They perceived that
the Company presented an opportunity for growth by remodeling existing
showrooms, opening new showrooms in existing markets and penetrating new
markets. Beginning in August 1996, GECC and certain other investors led by Mr.
Hawley invested approximately $22 million in equity and debt in the Company. The
Company hired new executives with retail experience and Mr. Hawley became its
Chairman and Chief Executive Officer.

Under the leadership of Mr. Hawley, the Company has adopted a major
expansion and remodeling program, and has developed a marketing and
merchandising strategy that is designed to increase its appeal to its existing
broad customer base by promoting the Company's wide selection of products,
styles and fabrics, as well as quality and value. Under this program, the
Company has remodeled 14 existing showrooms, established design centers in
prominent locations within showrooms to highlight fabric selection, created
decorated room settings, added new lighting and carpeting, and integrated the
Castro Convertibles brand name and products into its remodeled Krause's
showrooms. The Company expects to complete an additional four remodels by the
end of this fiscal year (February 1, 1998), and plans to remodel approximately
24 additional showrooms in fiscal 1998. The Company has also taken significant
steps to improve margins by increasing prices to competitive levels, reducing
promotional discounting and improving manufacturing efficiencies and to reduce
expenses by implementing budgeting controls, consolidating selling, general and
administrative expenses and cutting costs, including revising its sales
commission structure. Although results are preliminary, these new strategies,
combined with improved economies in selected regions where the Company operates,
have begun to show positive financial results. For the nine months ended
November 2, 1997, same-store sales (for showrooms opened a year or more)
increased 4.3% compared to the nine-month period ended October 27, 1996, with
remodeled store sales exceeding management's goal of 25%. In addition, gross
profit increased from 48.8% to 51.1% of net sales in the first nine months of
fiscal 1997 compared to the same period in fiscal 1996. Since the management
change, the Company has also opened one new showroom featuring its new store
design, expects to open two additional showrooms by the end of the current
fiscal year, and has plans to open approximately 18 showrooms in fiscal 1998.

INDUSTRY OPPORTUNITY AND COMPETITIVE STRENGTHS

29
<PAGE> 31

$21.9 billion in 1998 according to the American Furniture Manufacturers
Association. Upholstered furniture accounted for approximately $8.4 billion in
shipments in 1996, according to the American Furniture Manufacturers
Association.

Reputation for Value and Selection; Brand Names. The Company believes that
it has attained a reputation for high quality, custom-crafted furniture at
prices comparable to those of mass-produced, sold-as-shown furniture. Over 25
and 65 years, respectively, Krause's and Castro Convertibles have developed a
reputation for selection, quality, price and service. The Company believes that
its reputation and strong brand recognition influence customer purchasing
decisions and will help the Company expand its distribution in existing markets
and penetrate new markets.

New, Experienced Management Team. The Company recently hired a strong
management team with extensive retailing experience, led by Philip M. Hawley,
the former Chairman and Chief Executive Officer of The Broadway Stores, Inc. New
management has adopted business and marketing strategies designed to leverage
the Company's existing brand name recognition and distribution system and appeal
to its existing broad customer base. The management team has a substantial
equity stake in the Company.

Vertically Integrated Manufacturer and Distributor of Custom Furniture. The
Company is a leading combined manufacturer and retailer of made-to-order
upholstered furniture. This vertical integration enables the Company to
manufacture high-quality, competitively priced custom upholstered furniture and
deliver it to the customer usually within two to four weeks from the date
ordered. Vertical integration also enables the Company to capture profits at
both the manufacturing and retail level, with minimal inventory risk. Further,
the Company can use the available capacity of its manufacturing facility to
accommodate planned sales growth.

Well Located Retail Distribution Network. As of November 30, 1997, the
Company operated 81 showrooms, primarily in California and the New York City
metropolitan area, and in selected other markets in the Southwest, Northwest and
Midwest. The Company believes that its showrooms are in many markets that have
favorable demographics and upward economic trends, and that a substantial
majority of its showrooms are located in high traffic areas. In addition, many
showrooms are near other furniture retailers, where the Company believes it can
benefit from increased traffic of furniture customers and from comparison
shopping, typically by shoppers who compare Company products to those of
sold-as-shown retailers or premium-priced custom manufacturers.

Focus on Gross Margins and Cost Controls. In recent periods, the Company
has taken a number of steps to improve its gross margin and reduce expenses by
reducing discounts and other special pricing programs, improving its
manufacturing processes, introducing budgeting controls, revising its sales
commission structure, consolidating selling, general and administrative expenses
and cutting costs. As a result, the Company has developed an organization
focused on gross margin improvements, expense control and operating efficiency.

BUSINESS STRATEGY

- Remodel Existing Showrooms. The Company has embarked upon a major
remodeling program to update its showrooms, imbue a sense of fashion and
excitement and move away from the Company's traditional factory-direct
orientation. The Company has developed new store layout, design and
visual presentation themes to center attention on fabric selection and
customization options, present merchandise by life style as complete room
environments and enhance lighting and color in order to add drama and
create excitement throughout its showrooms. Plans call for remodeling
approximately 65 showrooms which will incorporate the new layout, design
and visual presentation themes. To date,

30
<PAGE> 32

the Company has remodeled 14 showrooms and expects to remodel four
additional showrooms by the end of the current fiscal year and
approximately 24 more showrooms by the end of the 1998 fiscal year.

- Relocate Under-Performing Showrooms. The Company estimates that it has
between 10 and 15 showrooms that are in good market areas but in poor
locations within these market areas. As the leases on these showrooms
expire, the Company plans to seek more suitable locations and incorporate
into the new showrooms the same new layout, design and visual
presentation themes that it has developed in the remodeling program.

- Develop New Products; Increase Sales of Complementary Products. The
Company has put in place a new product development program, which will
accomplish a freshening of showroom inventories and introduce a number of
new styles designed to increase its appeal to customers; during the
current fiscal year, eight new sofa styles have been introduced. In
addition, although the Company intends to continue to focus on the
manufacture and sale of upholstered products, as a part of its new
merchandising approach it intends to increase the promotion and sale of
other products, including accessories supplied by third parties such as
tables, lamps, area rugs and wall decor, custom-made chairs and
recliners. During fiscal 1996, accessories, custom-made chairs and
recliners accounted for 2%, 4%, and 8%, respectively, of the Company's
sales compared to the industry average (reported by the October 1997
issue of retail Ideas, a publication of Furniture/Today) of 12%, 10%, and
17%, respectively. These additional merchandise classifications will
broaden the Company's offerings and should increase sales per square
foot.

31
<PAGE> 33

SHOWROOMS AND MERCHANDISING

Showrooms. The Company sells its products exclusively through leased retail
showrooms in 12 states. Retail showrooms in California, Colorado, Arizona,
Nevada, Texas, New Mexico, Washington and Illinois operate under the name
KRAUSE'S CUSTOM CRAFTED FURNITURE, KRAUSE'S SOFA FACTORY(R) or KRAUSE'S
SOFAS(R). The Company intends to convert all of these showrooms to operate under
the name KRAUSE'S CUSTOM CRAFTED FURNITURE. 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.

Selling space in retail showrooms varies in size from 1,400 square feet to
23,400 square feet, with an average size of 12,100 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 sales associate collects a down
payment and immediately enters the order in the Company's computer system
through a terminal at the showroom. The order, reflecting the customer's exact
specifications of style, color, size, configuration and fabric, is then sent to
the Company's facility in Brea, California for manufacturing.

Expansion and Remodeling. The Company recently adopted a major expansion
and remodeling program. Key components of this program include establishing
design centers in prominent locations within showrooms to highlight fabric
selection, creating decorated room settings, adding new lighting and carpeting,
developing consistent and highly visible signage, and integrating the Castro
Convertibles brand name and products into its Krause's Custom Crafted Furniture
showrooms. As part of this program, the Company has remodeled 14 showrooms to
date and has plans to remodel approximately 28 additional showrooms by the end
of fiscal 1998. The remodeled showrooms are designed to present a more appealing
environment to the consumer, emphasizing the Company's wide array of styles and
fabric selections, and highlight the consumer's ability to customize furniture
selections to suit individual taste. Remodeled showrooms feature prominently
displayed design centers to highlight fabric selection, decorated room settings,
and new lighting and carpeting. The Company anticipates that it will recover the
cost of remodels in approximately one year through increased sales after the
remodel.

The Company will also seek to expand its presence in existing markets to
increase sales and market share. This will enable the Company to leverage its
brand name recognition and take advantage of the advertising umbrella and
infrastructure that currently exists. It will also focus on areas with strong
demographics and economic performance. The Company has opened one new store
since it began its expansion program, expects to open two additional stores by
the end of the current fiscal year and intends to open approximately 18
additional showrooms during fiscal 1998. In addition, as leases expire on
showrooms that are not located in prime retail areas, but are in favorable
markets, the Company will seek to move those showrooms to more suitable
locations.

Merchandising and Advertising. The Company has begun new merchandising
programs designed to further leverage and enhance the strength of the Krause's
and Castro Convertibles brand names. In addition to implementing its expansion
and remodeling program designed to enhance the Company's appeal to its existing
broad customer base, the Company intends to further enhance and leverage the
strength of the Krause's and Castro Convertibles brand names through new
advertising and merchandising programs that emphasize the selection, features
and value of its products. The Company will seek to use its strong brand
awareness initially to increase its share of existing markets and ultimately to
penetrate new markets. As an integral part of its new and remodeled Krause's
Custom Crafted Furniture showrooms, the Company is adding a section dedicated to
its Castro Convertibles products to further leverage this product line and brand
name.

The Company primarily advertises through print media, both in newspapers
and by direct mail. It also employs targeted radio advertising in selected
markets. The Company has freshened the appearance of its

32
<PAGE> 34

advertising to give more consistent placement of the Krause's and Castro
Convertibles brand names, to play down the Company's previous factory-direct
image, and to appeal to a more fashion-conscious buyer. While the Company plans
to continue to display prices in its advertising, it has reduced the prominence
of promotional pricing in favor of highlighting the selection, style and value
of its products.

PRODUCTS

The Company focuses on manufacturing and retailing high-quality, affordably
priced made-to-order upholstered furniture. Its product line consists primarily
of upholstered (covered in woven fabric or leather) sofas, sofabeds, chairs and
sectionals. Customers of the Company may choose from a selection of
approximately 60 different styles, 40 sizes, 800 fabrics and 50 leather choices.
Except for a few styles of occasional and reclining chairs which the Company
purchases from outside vendors, the Company manufactures virtually all of the
upholstered furniture offered in its showrooms.

In addition to its exclusive upholstered furniture line, the Company
retails an assortment of tables, area rugs, lamps and wall decor, custom-made
chairs and recliners. These furniture products and accessories, which are
supplied to the Company by outside vendors, complement the Company's upholstered
furniture products and help to create the room setting displays. Because the
Company typically views sales of these furniture products and accessories as
incremental to, rather than in lieu of, sales of the Company's own upholstered
furniture products, the Company intends to increase the promotion and sale of
these complimentary furniture products and accessories. Merchandise purchased
from other suppliers currently accounts for approximately 10% of net sales.

In order to be responsive to changing customer demands, the Company will
develop new products more aggressively. Since the 1996 financings, the Company
has introduced eight new sofa styles. In addition, the Company is committed to
periodically update its inventory of 800 fabrics by replacing slow-moving,
out-of-style fabrics with more contemporary designs.

Because of its made-to-order strategy, the Company does not require a
substantial inventory of finished goods, whether they are manufactured by it or
purchased from outside sources.

MANUFACTURING

The Company's manufacturing facilities in Brea, California produce
upholstered furniture for both Krause's and Castro Convertibles showrooms.
Manufacturing generally begins with the purchase of kits containing wooden frame
components. These components are chiefly hardwood, but also include softwood and
some engineered lumber. Outside mills make the components, first kiln-drying the
lumber for extra strength and straightness, then cutting the component pieces to
Company specifications for each different style, working to precise standards.
Company artisans, using pneumatic and power tools, assemble the wooden parts
into frames for different furniture models. All corners are blocked and glued
for added strength and proper distribution of weight and stress.

The Company primarily uses a one-piece frame method in which workers build
the entire frame before any upholstering occurs. This method makes the frame
stronger and leads to a more finely tailored appearance. Workers complete the
frames by installing metal springs, which contribute to the continued comfort,
durability and appearance of the upholstered furniture. Some Castro Convertibles
models have a frame that can be disassembled for delivery through the narrow
doorways and hallways of New York area apartments.

The first step in the upholstering process is cutting and sewing the fabric
chosen by the customer. The sewn fabric is sent to the assembly line where
workers construct the frame and upholster the seats, backs and arms. The Company
employs quilters as well as special seamstresses to sew zippers, bolster covers,
ruffles, skirts and pleats.

Upholstering takes place along an assembly line. Several individuals work
on each frame, each specializing in an area of responsibility -- springs,
outside body, seat, arm, inside body and so on. While the frame is upholstered,
seat cushions are filled with the customer's selection of either down, standard
foam or a

33
<PAGE> 35

Foreverflex(R) insert (the Company's proprietary seating material). The
Foreverflex(R) cushion insert is a high-density foam cushion which is injection
molded with springs suspended within the foam. An outside supplier makes the
Foreverflex(R) cushion insert to strict Company specifications and provides a
lifetime guarantee. 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.

The Company generally has adequate inventories of raw materials and other
supplies on hand to fill customer orders, and expects its suppliers to satisfy
its requirements shortly before materials are used in production.

The Company builds approximately 500 pieces of upholstered furniture per
day in a single shift. This output represents approximately 75% of single shift
manufacturing capacity. The level of production primarily reflects customer
orders, because the Company does not manufacture units for inventory.

When an order has completed the manufacturing or outside purchasing
process, it is shipped to a regional warehouse for the final preparation and
delivery to the customer. The Company uses outside delivery services, as well as
its own personnel in certain areas, for deliveries.

BACKLOG

The Company turns its manufacturing backlog approximately every 23 to 28
days. Backlog as of November 2, 1997 was approximately $10.0 million compared to
$12.1 million at the end of October 1996.

SUPPLIERS AND MATERIALS

Many suppliers currently provide the Company with the materials used in
manufacturing its upholstered furniture products. The Company's ten largest
suppliers provided it with 57.5% of its purchased raw materials during the
nine-month period ended November 2, 1997, including one such supplier that
provided approximately 13.3% and another that provided 9.3% of such purchases.
The Company is dependent on the continued supply of components and raw
materials, including frame components, fabrics, leather, foam and sofabed and
motion mechanisms. Management constantly seeks new suppliers and better prices
through competitive bidding and the qualification of alternative sources of
supply. If the Company could not develop alternative sources of supply when
needed or failed to obtain sufficient single-source products, components and raw
materials, the resulting loss in production capability 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 some of its products and processes. The Company has a registered trademark
in the United States for the Krause's Sofa Factory(R) and Castro
Convertibles(R)names and logos and the name Foreverflex(R). The Company has
applied for a trademark for the name Krause's Custom Crafted Furniture.
Trademarks, which the Company considers important to its business, have
expiration dates ranging from May 13, 2002 to November 30, 2004, but each is
renewable in perpetuity. The Company 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.
Management believes that it is in compliance in all material respects with all
applicable environmental and occupational safety regulations.

EMPLOYEES

The majority of the Company's employees are not unionized and many have
worked for the Company for more than 10 years. A union contract which expires in
May 1998 covers approximately 50 retail employees in

34
<PAGE> 36

the greater New York area. At November 2, 1997, the total work force numbers
approximately 960, with approximately 355 working in manufacturing, 535 in
retail and warehousing operations, and 70 in administration.

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.

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 11 years with four five-year options and
grants the Company certain options to purchase the facility. The Company also
leases approximately 275,000 sq. ft. for warehouse and distribution facilities.
The Company leases all its retail showrooms, with rents either fixed or with
fixed minimums coupled with contingent rents based on the Consumer Price Index
or a percentage of sales. The Company's 81 showrooms occupy approximately
980,000 sq. ft. of selling space.

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 and
Kenneth W. Keegan, both former directors and officers 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.

35
<PAGE> 37

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.................... 72 Chairman of the Board and Chief Executive Officer
Thomas M. DeLitto................... 44 Vice Chairman of the Board
Robert A. Burton.................... 57 Senior Vice President and Chief Financial Officer
Herbert J. Friedman................. 47 Senior Vice President of Merchandising, Product
Development, Marketing and Stores
K. James McTaggart.................. 35 Senior Vice President of Manufacturing and Distribution
Klaus Tabar......................... 44 Senior Vice President of Real Estate and Construction
Kamal G. Abdelnour.................. 61 Director
Jeffrey H. Coats.................... 40 Director
Peter H. Dailey..................... 67 Director
John A. Gavin....................... 66 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 Johnson & Johnson, Weyerhauser Company
and Aeromovel, U.S.A.

Thomas M. DeLitto has been Vice Chairman of the Board since December 1994
and a director since June 1991. He was Chief Executive Officer 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 a Director and President of Permal Capital
Management, Inc., a wholly owned subsidiary of Worms & Co., Inc. (a wholly owned
subsidiary of Worms & Cie., a principal shareholder of the Company), since
October 1990; in this capacity he oversees operations of that company's direct
investment activities. Mr. DeLitto has served as Executive Vice President of
Worms & Co., Inc. since February 1996.

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. John Breuner Company filed for bankruptcy in October
1993 and emerged in July 1994.

Herbert J. Friedman has been Senior Vice President of Merchandising,
Product Development, Marketing and Stores since September 1996. Mr. Friedman was
Senior Vice President of Strategic Planning from April 1995 to September 1996
and Vice President of Merchandising from June 1989 to April 1995.

K. James McTaggart has been Senior Vice President of Manufacturing and
Distribution since April 1996. Mr. McTaggart was Vice President of Distribution
and Logistics from February 1996 to March 1996. Mr. McTaggart was formerly the
Vice President of Distribution/Logistics at Stanley-Works-Door Systems from
March 1995 to February 1996, and served in other positions in Stanley
Works-Door-Systems from November 1985 to March 1995.

Klaus Tabar is Senior Vice President of Real Estate and Construction. Mr.
Tabar was Senior Vice President of Real Estate and Store Construction from
September 1996 to April 1997 and Senior Vice President of Real Estate and
Administration from April 1996 to September 1996. He joined the Company as Vice
President of Real Estate in January 1989.

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.

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<PAGE> 38

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. Since 1989,
Mr. Abdelnour has served as a director of Permal Capital Management, Inc., a
wholly-owned subsidiary of Worms & Co., Inc., which is a wholly owned subsidiary
of Worms & Cie., a principal shareholder of the Company.

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

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

Hon. John A. Gavin has been a director since September 1996. He founded and
has been the 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.
Nomination and election of the Board of Directors of the Company is subject to a
Stockholders Agreement. See "Capital Stock -- Stockholders Agreement." 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
designee of the Permal group of stockholders 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").

In December 1997, a Succession Agreement was entered into by the Company
and the following stockholders: Philip M. Hawley, its Chairman, his sons John F.
Hawley and Dr. Philip M. Hawley, Jr., GECC and Permal Capital Management. The
parties to the Succession Agreement agreed that if Philip M. Hawley ceases to
serve on the Board of Directors, the stockholder parties would take all
necessary action to ensure that John F. Hawley is elected to serve as a
director.

COMMITTEES OF THE BOARD OF DIRECTORS

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 except to the extent prohibited by law has all power and

37
<PAGE> 39

authority to manage the business and affairs of the Company 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.

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, payable quarterly, 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.

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<PAGE> 40

SUMMARY COMPENSATION TABLE

The following table sets forth all compensation paid by the Company during
fiscal 1996, 1995, and 1994 to (i) each of the individuals serving as the
Company's Chief Executive Officer during fiscal 1996, (ii) the four other most
highly compensated executive officers of the Company during fiscal 1996, and
(iii) up to two additional individuals who would have been among the Company's
four most highly compensated executive officers, but for the fact that they were
not serving as executive officers of the Company at the end of fiscal 1996
(collectively referred to as the "Named Executive Officers").

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
ANNUAL ---------------
COMPENSATION SECURITIES ALL OTHER
--------------------------- UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS/SARS(#) ($)(1)
- ------------------------------------- ---- ------- ------ --------------- ------------
<S> <C> <C> <C> <C> <C>
Philip M. Hawley(2).................. 1996 101,959 1,234,000
Chairman of the Board and Chief
Executive Officer
Thomas M. DeLitto(3)................. 1996 11,154 3,333
Vice Chairman; Former Chief 1995 1,666 9,375
Executive Officer 1994 1,666 15,000
Herbert J. Friedman.................. 1996 152,301 50,000
Senior Vice President of 1995 136,770 1,200 1,000
Merchandising,
Product Development, Marketing and 1994 130,192
Stores
Klaus Tabar.......................... 1996 141,645 34,030 50,000
Senior Vice President of 1995 117,899 13,505 1,000
Real Estate and Construction 1994 98,461 12,750
K. James McTaggart................... 1996 121,953 45,000
Senior Vice President of
Manufacturing and Distribution
Stephen P. Anderson(4)............... 1996 266,635 249,000
Former President 1995 203,846
1994 50,000
Robert G. Sharpe(5).................. 1996 166,878 366,068
Former Executive Vice President, 1995 157,278 30,000
Corporate Development and Treasurer 1994 149,187 30,000
</TABLE>

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

(1) Other annual compensation represents directors' fees for Mr. DeLitto and
severance benefits for Messrs. Anderson and Sharpe.

(2) Philip M. Hawley commenced employment with the Company, becoming 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. See "Employment
Agreements."

(3) Mr. DeLitto resigned as Chief Executive Officer of the Company in August
1996. Permal Capital Management, Inc. received payments from the Company in
consideration for the performance of executive management services of Mr.
DeLitto who is President of Permal Capital Management, Inc. See "Certain
Transactions."

(4) Mr. Anderson resigned his employment with the Company effective January 26,
1997.

(5) Mr. Sharpe resigned his employment with the Company effective January 31,
1997.

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<PAGE> 41

OPTION/SAR GRANTS IN LAST FISCAL YEAR

The following table sets forth information regarding stock options and
deferred stock units granted during fiscal 1996 to the Named Executive Officers.

<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
VALUE
% OF TOTAL AT ASSUMED ANNUAL
NUMBER OF OPTIONS/SARS RATES
SECURITIES GRANTED TO OF STOCK PRICE
UNDERLYING EMPLOYEES IN EXERCISE OR APPRECIATION
OPTIONS/SARS FISCAL BASE PRICE EXPIRATION FOR OPTION TERM
NAME GRANTED(#) YEAR(1) ($/SH) DATE 5%($) 10%($)
- ----------------------- ------------ ------------ ----------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Philip M. Hawley....... 1,234,000 74.9% 1.00 08/26/06 2,010,056 3,200,678
Thomas M. DeLitto...... 5,000 .3% .78 07/31/06 6,353 10,116
6,154 .4% 1.62 01/19/07 16,239 25,858
Klaus Tabar............ 50,000 3.0% 1.62 01/19/07 131,940 210,093
Herbert J. Friedman.... 50,000 3.0% 1.62 01/19/07 131,940 210,093
K. James McTaggart..... 5,000 .3% 1.06 03/11/06 8,633 13,747
40,000 2.4% 1.62 01/19/07 105,552 168,074
Stephen P. Anderson.... -- -- -- -- -- --
Robert G. Sharpe....... -- -- -- -- -- --
</TABLE>

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

(1) The Company granted options for a total of 45,000 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 during 1996. Options for 417,000 shares of
Common Stock were granted to employees in fiscal 1997. All of the options
and deferred stock units were granted under the 1997 Stock Incentive Plan.

YEAR-END OPTION/SAR VALUES

The following table sets forth information concerning the value of
unexercised options and deferred stock units held by the Named Executive
Officers as of February 2, 1997, the end of the Company's 1996 fiscal year. No
Named Executive Officers exercised any options during fiscal 1996.

<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING VALUE OF UNEXERCISED
UNEXERCISED OPTIONS/SARS IN-THE-MONEY OPTIONS/SARS
AT FISCAL YEAR-END AT FISCAL YEAR-END(1)
----------------------------- -----------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- --------------------------------------------- ----------- ------------- ----------- -------------
<S> <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
Stephen P. Anderson(2)....................... 35,557 17,777 -- --
Robert G. Sharpe(2).......................... 17,332 4,333 -- --
</TABLE>

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

(1) Based on the closing price of Common Stock as quoted on the Nasdaq SmallCap
Market of $2.00 on January 31, 1997, the last trading day in fiscal 1996.

(2) Options for Messrs. Anderson and Sharpe expired in April 1997.

1997 MANAGEMENT COMMITTEE INCENTIVE AWARD PROGRAM

The 1997 Management Committee Incentive Award Program (the "Management
Plan") was adopted by the Board of Directors to provide bonuses to certain
management employees of the Company if the Company meets certain financial
objectives. The Management Plan currently provides that such employees will earn
eight percent of their respective base salaries if the Company's earnings before
interest, taxes, depreciation and amortization reach $1,100,000 during the last
six months of fiscal year 1997. In addition, such employees will earn an
additional one percent of their respective base salaries for each $100,000 that
such earnings before

40
<PAGE> 42

interest, taxes, depreciation and amortization exceed $1,100,000. Also certain
management employees may receive up to seven percent of their base salaries
based on their personal achievements. The Management Plan is administered by the
Compensation Committee.

STOCK PLANS

1997 Stock Incentive Plan

The 1997 Stock Incentive Plan (the "1997 Plan") was approved by the Board
of Directors in January 1997 and the stockholders in May 1997. The 1997 Plan
extends for 10 years, but may be terminated at an earlier date. The 1997 Plan
provides for the issuance of awards covering up to 1,000,000 shares of Common
Stock 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 principal 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 extent 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.

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. The Directors
Plan was terminated by the Board of Directors in

41
<PAGE> 43

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.

Prior to its termination, the Directors Plan provided for the automatic
grant of an option to each non-employee director upon his or her election to the
Board, entitling the optionee to purchase up to a total of 4,000 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.

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. The 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.

Prior to its termination, 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
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

42
<PAGE> 44

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.

Krause's Stock Option Plans

Krause's 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 stock, but were converted into
options to purchase the Company's Common Stock in connection with the merger.

EMPLOYMENT AGREEMENTS

In August 1996, the Company entered into an Employment Agreement with
Philip M. Hawley pursuant to which the Company agreed to 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 (i) the remaining amounts that would be
payable to him under the Employment Agreement and (ii) $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.

43
<PAGE> 45

The Company has entered into agreements with Messrs. Friedman and Tabar, as
well as several other officers and employees of the Company, providing 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.

CERTAIN TRANSACTIONS

During 1997, 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.

1996 Notes. From May 13, 1996 to June 19, 1996, various investors loaned an
aggregate of $2,950,000 to the Company. Among the investors were Permal Capital
Management, Inc., an indirect subsidiary of Worms & Cie ($50,000 principal
amount), ATCO Development, Inc. ($150,000), Mr. DeLitto, the Company's Vice
Chairman of the Board ($25,000), and Mr. Sharpe ($25,000) and Mr. Perrette
($250,000), each a former officer of the Company. In addition, on May 21, 1996
and July 2, 1996, JOL loaned to the Company $1,500,000 and $500,000,
respectively. All indebtedness pursuant to these loans (collectively, the "1996
Notes") was payable on demand and bore interest at the annual rate of 10% for
the first year only. All amounts outstanding under the 1996 Notes were retired
in connection with the 1996 Securities Purchase Agreement described below.

1996 Securities Purchase Agreement. On August 26, 1996, and September 4,
1996, the Company entered into a securities purchase agreement (the "Securities
Purchase Agreement") whereby the Company raised an aggregate of $18,735,000 in
debt and equity. Pursuant to the Securities Purchase Agreement:

- The Company sold 10,669,000 shares of Common Stock to certain investors,
at a price of $1.00 per share. Purchasers included GECC (5,000,000
shares), ATCO Holdings Ltd. (500,000 shares), certain affiliates of Worms
& Cie (500,000 shares), Mr. Hawley, the Company's Chairman of the Board
and Chief Executive Officer and various trusts established for the
benefit of relatives of Mr. Hawley (1,080,000 shares), and Mr. DeLitto,
the Company's Vice Chairman of the Board (25,000 shares).

- The Company issued 3,066,251 shares of Common Stock to the holders of the
1996 Notes in consideration for retirement of all amounts outstanding
under the 1996 Notes, including accrued interest. Shares were issued at a
rate of one share per $1.00 of debt retired.

- GECC made a loan to the Company in the original principal amount of
$5,000,000. This indebtedness was evidenced by a note (the "Original
Note") bearing interest at the rate of 10% per annum and payable in full
on or before August 31, 2001. Pursuant to the 1997 Supplemental
Securities Agreement (described below), this note was replaced with a
note bearing interest at 9.5% per annum and payable in full on August 31,
2002. In connection with the issuance of the Original Note, the Company
issued to GECC warrants to purchase a total of 1,400,000 shares of Common
Stock at an exercise price of $.001 per share, expiring August 31, 2006.
In the event that the Company fails to meet certain financial covenants,
including failure to repay this loan, the Securities Purchase Agreement
provides, in part, that GECC may take action to appoint additional
members of the Board of Directors such that GECC will control the
majority of the Board.

- The Company converted all outstanding shares of Series A Preferred Stock
into 1,176,950 shares of Common Stock. The holders of the Preferred Stock
who received shares of Common Stock included certain affiliates of Worms
& Cie and JOL.

- The Company entered into a Registration Rights Agreement with all
investors that received shares of Common Stock pursuant to the Securities
Purchase Agreement. See "Description of Capital Stock -- Registration
Rights Agreement."

- The Company entered into a Shareholders Agreement with investors. See
"Description of Capital Stock -- Shareholders Agreement." Pursuant to the
Shareholders Agreement, Mr. Hawley was appointed Chief Executive Officer
and named Chairman of the Board. Also pursuant to the Shareholders
Agreement, (i) Mr. Coats, a managing Director of GE Capital Equity
Capital Group, a wholly-owned subsidiary of GECC, was appointed to the
Board, and (ii) Mr. DeLitto, the President of Permal Capital Management,
Inc., was appointed to the Board.

44
<PAGE> 46

The price of $1.00 per share for shares of Common Stock issued pursuant to
the Securities Purchase Agreement was negotiated at arm's 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. The average of the
high and low sales prices on the Nasdaq SmallCap 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 SmallCap 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.

1997 Supplemental Securities Purchase Agreement. On August 14, 1997, the
Company concluded a supplemental agreement to the Securities Purchase Agreement
(the "Supplemental Agreement"). Pursuant to the Supplemental Agreement:

- The Company sold subordinated notes to GECC and JOL in the principal
amounts of $2,500,000 and $500,000, respectively (together, the "1997
Notes"). The 1997 Notes bear interest at a rate of 9.5%, payable
quarterly. Principal is payable in six semi-annual installments,
commencing February, 2000. In addition, GECC and JOL were issued warrants
to purchase 600,000 shares of Common Stock and 140,000 shares of Common
Stock, respectively, at a purchase price of $1.25 per share. In the event
that the Company fails to meet certain financial covenants, including
failure to repay this loan, the Securities Purchase Agreement provides,
in part, that GECC may take action to appoint additional members of the
Board of Directors such that GECC will control the majority of the Board.

- The Company arranged for a standby credit facility under which the
Company may at its option, subject to attainment of certain financial
covenants, borrow up to an additional $3,500,000 (the "Standby Notes")
from GECC and JOL under the same terms and conditions of the 1997 Notes.
In the event that the Company borrows funds pursuant to the Standby
Notes, the Company will issue to GECC and JOL additional warrants to
purchase 400,000 and 160,000 shares of Common Stock, respectively, at
$1.25 per share.

- The Company issued to GECC and JOL warrants to purchase in the aggregate
up to an additional 1,000,000 shares of Common Stock at a price of $0.01
per share (the "Performance Warrants"). The Performance Warrants first
become exercisable in April 2000 and will be canceled if the Company
meets certain economic performance targets for fiscal 1999.

- The Company issued a new 9.5% Subordinated Note due August 31, 2002 (the
"Replacement Note") in the principal amount of $5,501,091 to replace the
Original Note (which bore interest at 10% per annum and was payable in
full on or before August 31, 2001) in the principal amount of $5 million
and certain additional notes in aggregate principal amount of $501,091
reflecting accrued interest. The Replacement Note is payable semiannually
on a straight line basis over three years beginning February 2000.

Private Label Credit Card Program with Monogram Credit Card Bank of Georgia
(an Affiliate of GECC). In April 1997, the Company entered into an agreement
with Monogram Credit Card Bank of Georgia ("Monogram"), an affiliate of GECC,
pursuant to which Monogram provides a customized credit program to the Company.
Under this program, approved customers of the Company are able to purchase
products on credit through a credit card issued by Monogram. Monogram purchases
each credit from the Company and bears the risk of loss on such credit
purchases. The program is 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.

Transactions with Permal Capital Management, Inc. (a wholly owned
subsidiary of Worms & Co., Inc., since October 1990). In 1996 and 1995, Permal
Capital Management, Inc. ("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.

45
<PAGE> 47

PRINCIPAL AND SELLING STOCKHOLDERS

The following table sets forth certain information with respect to
beneficial ownership of the Company's Common Stock as of November 2, 1997, and
is adjusted to reflect the sale of the shares offered hereby by (i) 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, (ii) each of the Company's
directors, (iii) each of the Named Executive Officers, (iv) the Selling
Stockholder, and (v) all directors and executive officers as a group.

<TABLE>
<CAPTION>
SHARES BENEFICIALLY SHARES BENEFICIALLY
OWNED OWNED AFTER
PRIOR TO OFFERING(1) NUMBER OF OFFERING
--------------------- SHARES -------------------
NAME AND ADDRESS OF BENEFICIAL OWNER NUMBER PERCENT BEING OFFERED NUMBER PERCENT
- ---------------------------------------- --------- ------- ------------- --------- -------
<S> <C> <C> <C> <C> <C>
GECC.................................... 7,000,000(2) 33.3% -- 7,000,000 30.5%
260 Long Ridge Road
Stamford, CT 06927
Worms & Cie............................. 5,120,232(3) 26.5 2,096,111(5) 3,024,121 14.3
c/o Worms & Co.
900 Third Avenue
New York, NY 10022
Japan Omnibus Ltd....................... 2,236,111(4) 11.7 2,096,111(5) 140,000 *
Tropic Isle Building
Road Town, Tortola
British Virgin Islands
John F. Hawley and Barbara H. Hawley, as
Trustees.............................. 1,376,472(6) 7.2 -- 1,376,472 6.6
515 South Figueroa Street
Los Angeles, CA 900071
ATCO Holdings Limited................... 1,115,923 5.9 -- 1,115,923 5.3
c/o ATCO Development, Inc.
11777 Katy Freeway
Houston, TX 77079
Philip M. Hawley........................ 647,000(7) 3.3 -- 647,000 3.0
Thomas M. DeLitto....................... 105,700(8) * -- 105,700 *
Robert A. Burton........................ -- -- -- -- --
Herbert J. Friedman..................... 17,481(9) * -- 17,481 *
K. James McTaggart...................... 4,333(10) * -- 4,333 *
Klaus Tabar............................. 22,337(11) * -- 22,337 *
Stephen P. Anderson(13)................. -- -- -- -- --
Robert G. Sharpe(13).................... 55,378 * -- 55,378 *
Kamal G. Abdelnour...................... 43,892(12) * -- 43,892 *
Jeffrey H. Coats........................ -- -- -- -- --
Peter H. Dailey......................... 11,154(14) * -- 11,154 *
John A. Gavin........................... 11,154(14) * -- 11,154 *
All directors and executive officers as
a group (12 persons).................. 918,429 4.6 -- 918,429 4.2
</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 warrants to purchase 2,000,000 shares of Common Stock.

(3) Worms & Cie, through JOL, PCMI and certain other affiliates, is deemed to
be the beneficial owner of 4,854,421 shares of Common Stock and warrants to
purchase 265,811 shares of Common Stock, which amounts include 1,288,040
shares and 29,020 warrants held by two former directors of the Company, and
exclude 105,700 shares, options and warrants held by Mr. DeLitto and shown
separately below. The

46
<PAGE> 48

two former directors and Mr. DeLitto are directors and officers of
affiliates of Worms & Cie. Worms & Cie. disclaims ownership of the shares
held by these individuals.

(4) Includes a warrant to purchase 140,000 shares of Common Stock.

(5) JOL is the sole Selling Stockholder. Because JOL is deemed to be an
affiliate of Worms & Cie, shares beneficially owned by JOL are also
included as shares beneficially owned by Worms & Cie.

(6) As trustees for various Hawley Trusts, John F. Hawley and Barbara H. Hawley
are deemed to be beneficial owners of such shares.

(7) Includes options to purchase 617,000 shares of Common Stock.

(8) Includes options to purchase 9,998 shares of Common Stock, 6,154 deferred
stock units and a warrant to purchase 14,510 shares of Common Stock.

(9) Includes options to purchase 11,260 shares of Common Stock.

(10) Includes options to purchase 3,333 shares of Common Stock.

(11) Includes options to purchase 17,200 shares of Common Stock.

(12) Includes options to purchase 5,000 shares of Common Stock, 6,154 deferred
stock units and a warrant to purchase 32,738 shares of Common Stock.

(13) Resigned in January 1997.

(14) Consists of options to purchase 5,000 shares of Common Stock and 6,154
deferred stock units.

PLAN OF DISTRIBUTION

The Common Stock is being offered for sale by the Company and the Selling
Stockholder on a best efforts, all or nothing basis, primarily to selected
institutional investors. Cruttenden Roth Incorporated, the Placement Agent, has
been retained pursuant to a placement agency agreement to act as the exclusive
agent for the Company and the Selling Stockholder in connection with the
arrangement of offers and sales of the Common Stock on a best efforts basis.

The Placement Agent is not obligated to take for itself (or purchase) any
of the Shares offered hereby and does not intend to do so. It is anticipated
that the Placement Agent will obtain indications of interest from potential
investors for the amount of the offering and that effectiveness of the
Registration Statement will not be requested until indications of interest have
been received for the amount of the offering. No investor funds will be accepted
until indications of interest have been received for the amount of the offering,
and no investor funds will be accepted prior to effectiveness of the
Registration Statement. Confirmations and definitive prospectuses will be
distributed to all investors at the time of pricing, informing investors of the
closing date, which will be scheduled for three business days after pricing.
After the Registration Statement is declared effective and prior to the closing
date, all investor funds will promptly be placed in escrow with
, as Escrow Agent, in an escrow account established for the
benefit of the investors. The Escrow Agent will invest such funds in accordance
with Rule 15c2-4 promulgated under the Exchange Act. Prior to the closing date,
the Escrow Agent will advise the Company and the Selling Stockholder that
payment for the purchase of the Shares offered hereby has been affirmed by the
investors and that the investors have deposited the requisite funds in the
escrow account at the Escrow Agent. Upon receipt of such notice, the Company and
the Selling Stockholder will deliver the shares of Common Stock to be credited
to the accounts of the investors and will collect the necessary funds from the
Escrow Agent. Investor funds, together with interest thereon, if any, will be
collected by the Company and the Selling Stockholder through the facilities of
the Escrow Agent on the scheduled closing date. The offering will not continue
after the closing date. In the event that investor funds are not received in the
full amount necessary to satisfy the requirements of the offering, all funds
deposited in the escrow account will promptly be returned.

The Company and the Selling Stockholder have agreed (i) to pay to the
Placement Agent 9.0% of the proceeds of the Shares being sold by each of them in
this offering as the selling commission, and (ii) to indemnify the Placement
Agent against certain liabilities, including liabilities under the Securities
Act. In

47
<PAGE> 49

addition, the Company has agreed to reimburse the Placement Agent up to $100,000
for certain expenses incurred by them in connection with the offering.

The Company has agreed that for a period of 180 days from the date of this
Prospectus it will not, and certain officers, directors and affiliates of the
Company and the Selling Stockholder have agreed that for a period of 120 days
from the date of the Prospectus they will not, offer, sell or otherwise dispose
of any shares of capital stock or equity securities of the Company or any
securities convertible into, or exchangeable or exercisable for, Common Stock
(excluding those shares being sold pursuant to this offering), without the prior
written consent of the Placement Agent.

DESCRIPTION OF CAPITAL STOCK

The authorized capital stock of the Company consists of 35,000,000 shares
of Common Stock, par value $.001 per share (the "Common Stock") and 666,667
shares of Preferred Stock par value $.001 per share (the "Preferred Stock"). As
of November 2, 1997, there were 19,020,539 shares of Common Stock issued and
outstanding. No shares of Preferred Stock are issued and outstanding.

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 ratably 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.

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.

WARRANTS AND STOCK OPTIONS

As of November 2, 1997, the Company had warrants outstanding to purchase an
aggregate of 2,502,047 shares of its Common Stock. Of these warrants, 1,400,000
warrants were issued to GECC at a exercise price of $.001 per share. The
remaining 1,102,047 warrants have exercise prices ranging from $1.32 to $15.00
per share with expiration dates ranging from May 1998 to June 2005. The warrants
generally provide for certain anti-dilution adjustments. In addition, in
connection with the August 1997 financing, the Company agreed to issue warrants
to GECC and JOL to purchase up to 1,560,000 shares of Common Stock upon the
occurrence of certain events. See "Certain Transactions." The Company also has
24,616 shares of Common Stock issuable upon payment of deferred stock units and
options outstanding to purchase an additional 2,043,958 shares of Common Stock.

48
<PAGE> 50

REGISTRATION RIGHTS

After this offering, holders of 7,244,612 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 investors, including GECC
as well as certain other 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 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 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

49
<PAGE> 51

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 (i) six months
after Mr. Hawley ceases to be a Director of the Company and (ii) August 31,
1999.

SECTION 203 OF THE DELAWARE GENERAL CORPORATION LAW

The Company is subject to Section 203 of the Delaware General Corporation
Law ("Section 203"), an anti-takeover law that restricts certain transactions
and business combinations between a corporation and an "Interested Stockholder"
owning 15% or more of the corporation's outstanding voting stock, for a period
of three years from the date the stockholder becomes an Interested Stockholder.
Subject to certain exceptions, unless the transaction is approved by the board
of directors and the holders of at least two-thirds of the outstanding voting
stock of the corporation (excluding shares held by the Interested Stockholder),
Section 203 prohibits significant business transactions such as a merger with,
disposition of assets to, or receipt of disproportionate financial benefits by
the Interested Stockholder, or any other transaction that would increase the
Interested Stockholder's proportionate ownership of any class or series of the
corporation's stock. The statutory ban does not apply if, upon consummation of
the transaction in which any person becomes an Interested Stockholder, the
Interested Stockholder owns at least 85% of the outstanding voting stock of the
corporation (excluding shares held by persons who are both directors and
officers or by certain employee stock plans).

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
Morrison & Foerster LLP, Los Angeles, California. Certain matters in connection
with this offering will be passed upon for the Placement Agent by Snell & Wilmer
L.L.P., Phoenix, Arizona.

EXPERTS

The consolidated financial statements and financial statement schedule of
Krause's Furniture, Inc. as of February 2, 1997 and January 28, 1996, and for
the fiscal years ended February 2, 1997, January 28, 1996, and December 31,
1994, 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. The
consolidated financial statements and schedule referred to above are included in
reliance upon such reports, given upon the authority of such firm as experts in
accounting and auditing.

50
<PAGE> 52

ADDITIONAL INFORMATION

The Company is subject to the reporting requirements of the Exchange Act,
and accordingly files annual and quarterly reports, proxy statements and other
information with the Securities and Exchange Commission (the "Commission"). The
Company has filed with 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. The Common Stock is currently traded on the Nasdaq
SmallCap Market. Reports, proxy statements and other information concerning the
Company may also be inspected at the National Association of Securities Dealers,
Inc. at 1735 K Street, N.W., Washington D.C. 20006.

51
<PAGE> 53

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C>
Report of Ernst & Young LLP, Independent Auditors.................................. F-1
Consolidated Balance Sheet at February 2, 1997 and January 28, 1996................ F-2
Consolidated Statement of Operations for the years ended February 2, 1997, January
28, 1996 and December 31, 1994................................................... F-3
Consolidated Statement of Stockholders' Equity for the period from January 1, 1994
to February 2, 1997.............................................................. F-4
Consolidated Statement of Cash Flows for the years ended February 2, 1997, January
28, 1996 and December 31, 1994................................................... F-5
Consolidated Statement of Operations for the months ended January 29, 1995 and
January 30, 1994 (unaudited)..................................................... F-6
Consolidated Statement of Cash Flows for the months ended January 29, 1995 and
January 30, 1994 (unaudited)..................................................... F-7
Notes to Consolidated Financial Statements......................................... F-8
Unaudited Consolidated Balance Sheet at November 2, 1997........................... F-18
Unaudited Consolidated Statement of Operations for the thirty-nine weeks ended
November 2, 1997 and October 27, 1996............................................ F-19
Unaudited Consolidated Statement of Stockholders' Equity for the thirty-nine weeks
ended November 2, 1997........................................................... F-20
Unaudited Consolidated Statement of Cash Flows for the thirty-nine weeks ended
November 2, 1997 and October 27, 1996............................................ F-21
Notes to Unaudited Consolidated Financial Statements............................... F-22
</TABLE>

52
<PAGE> 54

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

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

We have audited the accompanying consolidated balance sheets of Krause's
Furniture, Inc. as of February 2, 1997 and January 28, 1996, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
the fiscal years ended February 2, 1997, January 28, 1996 and December 31, 1994,
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.

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

The Company has reported losses from operations in each of the past five
years, projects that it will incur a net loss for the year ending February 1,
1998 and may be required to obtain a waiver as of February 1, 1998 with respect
to compliance with covenants contained in its revolving credit agreement.
Management's plan for meeting obligations as they become due is summarized in
Note 2 to the consolidated financial statements.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Krause's Furniture, Inc. at February 2, 1997 and January 28, 1996, and the
consolidated results of its operations and its cash flows for the fiscal years
ended February 2, 1997, January 28, 1996 and December 31, 1994, and the month
ended January 29, 1995, in conformity with generally accepted accounting
principles.

/s/ ERNST & YOUNG LLP

Orange County, California
March 28, 1997,
except for Note 2, as to which the date is
December 17, 1997

F-1
<PAGE> 55

KRAUSE'S FURNITURE, INC.

CONSOLIDATED BALANCE SHEET
(IN THOUSANDS, EXCEPT SHARE DATA)

<TABLE>
<CAPTION>
FEBRUARY 2, JANUARY 28,
1997 1996
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents........................................... $ 1,227 $ 1,336
Accounts receivable, net of allowance for doubtful accounts of $327
($291 at January 28, 1996)....................................... 1,120 786
Inventories......................................................... 14,013 14,627
Prepaid expenses.................................................... 1,193 386
Income tax refund receivable........................................ -- 1,467
-------- --------
Total current assets............................................. 17,553 18,602
Property, equipment, and leasehold improvements, net.................. 6,389 6,738
Goodwill, net......................................................... 15,386 16,406
Leasehold interests, net.............................................. 1,504 1,830
Other assets.......................................................... 2,255 3,290
-------- --------
$ 43,087 $ 46,866
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................................... $ 7,506 $ 12,036
Accrued payroll and related expenses................................ 1,468 1,696
Other accrued liabilities........................................... 5,099 4,715
Customer deposits................................................... 5,621 7,014
Notes payable....................................................... 41 19
-------- --------
Total current liabilities........................................ 19,735 25,480
Long-term liabilities:
Notes payable....................................................... 6,306 5,584
Other............................................................... 1,503 1,817
-------- --------
Total long-term liabilities...................................... 7,809 7,401
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock, $.001 par value; 666,667 shares
authorized; no shares outstanding (117,694 at January 28, 1996)
at stated value.................................................. -- 7,523
Common stock, $.001 par value; 35,000,000 shares authorized,
19,020,539 shares outstanding (4,120,810 at January 28, 1996).... 19 4
Capital in excess of par value...................................... 49,874 27,419
Accumulated deficit................................................. (34,350) (20,961)
-------- --------
Total stockholders' equity....................................... 15,543 13,985
-------- --------
$ 43,087 $ 46,866
======== ========
</TABLE>

See accompanying notes.

F-2
<PAGE> 56

KRAUSE'S FURNITURE, INC.

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

<TABLE>
<CAPTION>
FISCAL YEARS ENDED
---------------------------------------------
FEBRUARY 2, JANUARY 28, DECEMBER 31,
1997 1996 1994
----------- ------------ ------------
<S> <C> <C> <C>
Net sales............................................. $ 112,737 $122,319 $116,471
Cost of sales......................................... 56,490 59,852 53,522
--------- --------- ---------
Gross profit.......................................... 56,247 62,467 62,949
Operating expenses:
Selling............................................. 57,573 60,257 53,460
General and administrative.......................... 10,101 10,578 10,867
Amortization of goodwill............................ 1,020 1,020 1,020
--------- --------- ---------
68,694 71,855 65,347
--------- --------- ---------
Loss from operations.................................. (12,447) (9,388) (2,398)
Interest expense...................................... (1,230) (721) (2,140)
Other income.......................................... 288 67 109
Gain from sale of Mr. Coffee stock.................... -- -- 12,115
Equity in earnings of Mr. Coffee...................... -- -- 316
--------- --------- ---------
Income (loss) before income taxes and extraordinary
item................................................ (13,389) (10,042) 8,002
Provision (benefit) for income taxes.................. -- (1,327) 2,171
--------- --------- ---------
Income (loss) before extraordinary item............... (13,389) (8,715) 5,831
Extraordinary loss from debt retirement, net of income
tax benefit of $291................................. -- -- (436)
--------- --------- ---------
Net income (loss)..................................... $ (13,389) $ (8,715) $ 5,395
========= ========= =========
Income (loss) per share:
Income (loss) before extraordinary item............. $ (1.28) $ (2.21) $ 1.08
Extraordinary loss.................................. -- -- (0.08)
--------- --------- ---------
Net income (loss)................................... $ (1.28) $ (2.21) $ 1.00
========= ========= =========
Number of shares used in computing income
(loss) per share.................................... 10,445 3,950 5,394
========= ========= =========
</TABLE>

See accompanying notes.

F-3
<PAGE> 57

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)

<TABLE>
<CAPTION>
CONVERTIBLE CAPITAL
PREFERRED STOCK COMMON STOCK IN EXCESS TOTAL
----------------- ---------------- OF PAR ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT VALUE DEFICIT EQUITY
------ ------- ------ ------ --------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
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................. -- -- -- -- -- (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
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
Compensation expense on
stock option grant..... -- -- -- -- 293 -- 293
Repurchase of common
stock.................. -- -- (12) -- (33) -- (33)
Net loss................. -- -- -- -- -- (13,389) (13,389)
---- ------ ------ --- ------- -------- -------
Balance at February 2,
1997................... -- $ -- 19,021 $ 19 $49,874 $ (34,350) $ 15,543
==== ====== ====== === ======= ======== =======
</TABLE>

See accompanying notes.

F-4
<PAGE> 58

KRAUSE'S FURNITURE, INC

CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FISCAL YEARS ENDED
---------------------------------------------
FEBRUARY 2, JANUARY 28, DECEMBER 31,
1997 1996 1994
----------- ------------ ------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss).................................... $ (13,389) $ (8,715) $ 5,395
Adjustments to reconcile net income (loss) to net
cash used by operating activities:
Depreciation and amortization................... 2,561 2,760 3,501
Deferred income taxes........................... -- 920 (920)
Gain from sale of Mr. Coffee stock.............. -- -- (12,115)
Other non-cash charges.......................... 618 283 1,153
Change in assets and liabilities:
Accounts receivable............................. (334) 404 340
Inventories..................................... 614 3,389 (2,567)
Prepaid expenses and other assets............... 229 1,210 (1,153)
Income tax refund receivable.................... 1,467 (1,467) --
Accounts payable and accrued liabilities........ (4,688) (2,166) 6
Customer deposits............................... (1,393) 205 (517)
--------- --------- ---------
Net cash used by operating activities......... (14,315) (3,177) (6,877)
--------- --------- ---------
Cash flows from investing activities:
Capital expenditures............................... (806) (1,883) (2,323)
Proceeds from sale-leaseback....................... -- 1,039 --
Proceeds from sale of Mr. Coffee stock............. -- -- 23,258
--------- --------- ---------
Net cash provided (used) by investing
activities................................. (806) (844) 20,935
--------- --------- ---------
Cash flows from financing activities:
Net borrowings (payments) on short-term notes...... 390 (18) (1,093)
Proceeds from long-term borrowings................. 142,612 141,371 100
Principal payments on long-term debt............... (138,178) (137,948) (17,700)
Proceeds from issuance of common stock............. 10,221 -- --
Other.............................................. (33) -- (50)
--------- --------- ---------
Net cash provided (used) by financing
activities................................. 15,012 3,405 (18,743)
--------- --------- ---------
Net decrease in cash................................. (109) (616) (4,685)
Cash and cash equivalents at beginning of year....... 1,336 1,952 6,302
--------- --------- ---------
Cash and cash equivalents at end of year............. $ 1,227 $ 1,336 $ 1,617
========= ========= =========
Supplemental disclosures of cash flow information --
Cash paid during the year for:
Interest........................................... $ 466 $ 543 $ 915
Income taxes....................................... 9 -- 2,100
Noncash investing and financing activities:
Preferred stock converted into common stock........ 7,523 2,932 1,401
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-5
<PAGE> 59

KRAUSE'S FURNITURE, INC.

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

<TABLE>
<CAPTION>
MONTH ENDED MONTH ENDED
JANUARY 29, JANUARY 30,
1995 1994
----------- -----------
(UNAUDITED)
<S> <C> <C>
Net 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................................................. $ (.87) $ (.63)
======= =======
Number of shares used in computing loss per share.................. 3,685 3,490
</TABLE>

See accompanying notes.

F-6
<PAGE> 60

KRAUSE'S FURNITURE, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
MONTH ENDED MONTH ENDED
JANUARY 29, JANUARY 30,
1995 1994
----------- -----------
(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.................................... 335 (3,277)
Cash and cash equivalents at beginning of month.................... 1,617 6,302
------- -------
Cash and cash equivalents at end of month.......................... $ 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-7
<PAGE> 61

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, Krauses Sofa Factory ("Krauses"). 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 week retail
fiscal year. The Company's 1996 fiscal year (53 weeks) ended February 2, 1997.
All significant intercompany transactions and balances have been eliminated.

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 statement of stockholders' equity,
all share and per share data presented 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
reporting periods. Actual results could differ from those estimates.

Certain reclassifications of previously reported financial information were
made to conform to the fiscal 1996 presentation.

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, and two licensed dealerships. As of February 2,
1997 there were 82 company-owned showrooms, all of which are leased, located in
12 states.

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 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 values of the secured revolving credit
note, the subordinated note, and other notes are based on borrowing rates
currently available to the Company for loans with similar terms or maturity and
approximate the carrying amounts reflected in the accompanying consolidated
financial statements.

F-8
<PAGE> 62

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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>
FEBRUARY 2, JANUARY 28,
1997 1996
----------- ------------
(IN THOUSANDS)
<S> <C> <C>
Finished goods....................................... $10,693 $ 12,345
Work in progress..................................... 254 297
Raw materials........................................ 3,066 1,985
------- -------
$14,013 $ 14,627
======= =======
</TABLE>

Showroom pre-opening expenses

Showroom pre-opening expenses are capitalized and amortized over periods of
up to 12 (previously 12-24) months subsequent to opening of the showroom.

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 over the shorter of the estimated useful life or the term of
the lease. Depreciation and amortization expense was $1,073,000 in fiscal 1996,
$1,100,000 in fiscal 1995, and $928,000 in fiscal 1994. Property, equipment and
leasehold improvements are summarized as follows:

<TABLE>
<CAPTION>
FEBRUARY 2, JANUARY 28,
1997 1996
----------- ------------
(IN THOUSANDS)
<S> <C> <C>
Leasehold improvements............................... $ 9,241 $ 8,985
Construction in progress............................. 463 214
Machinery and equipment.............................. 2,962 2,855
Office and store furniture........................... 872 923
------- -------
13,538 12,977
Less accumulated depreciation and amortization....... (7,149) (6,239)
------- -------
$ 6,389 $ 6,738
======= =======
</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. Accumulated amortization amounted to $4,940,000 as of February 2, 1997
and $3,920,000 as of January 28, 1996.

F-9
<PAGE> 63

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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 February 2, 1997. The
Company's analysis at February 2, 1997 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. The Company's
historical results of operations and its cash flows in fiscal years 1996, 1995,
and 1994 indicate that it is at least reasonably possible that such
circumstances could arise in fiscal 1997.

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 $1,819,000
as of February 2, 1997 and $1,493,000 as of January 28, 1996.

Revenue recognition

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

Advertising expenses

Advertising costs, which are principally newspaper ads, mail inserts and
radio spots, are charged to expense as incurred. Advertising expenses in the
fiscal years ended February 2, 1997, January 28, 1996 and December 31, 1994,
were $11,184,000, $11,181,000 and $10,029,000, respectively.

Warranty costs

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

Income taxes

The Company provides for income taxes under the liability method.
Accordingly, deferred income tax assets and liabilities are computed for
differences between financial reporting and tax bases of assets and liabilities
that will result in taxable or deductible amounts in the future based on enacted
tax laws and rates applicable to the periods in which the differences are
expected to affect taxable income; valuation allowances are established when
necessary to reduce deferred tax assets to amounts which are more likely than
not to be realized.

Income (loss) per share

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 1996 and 1995 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 years ended

F-10
<PAGE> 64

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

February 2, 1997 and January 28, 1996, had occurred at the beginning of the
years, the net loss per share for the fiscal years 1996 and 1995 would have been
$1.20 and $2.11, respectively.

Credit risk

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

2. OPERATIONS

The Company has reported losses from operations in each of the past five
years. As a result of such losses, the Company had an accumulated deficit of
$34,350,000 and a working capital deficiency of $2,182,000 at February 2, 1997.
In each of the three quarters subsequent to February 2, 1997, the Company has
reported unaudited net losses that aggregate $5,609,000 for the thirty-nine
weeks ended November 2, 1997. As a result of such losses, the Company reported
an unaudited accumulated deficit of $39,959,000 and an unaudited working capital
deficiency of $1,181,000 at November 2, 1997. The Company expects to incur a net
loss in its fourth quarter of fiscal 1997.

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 $5,000,000 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 shares of Series A
preferred stock were converted into 1,176,950 shares of common stock. Also the
Company's revolving credit agreement was amended to extend the expiration date,
reduce the interest rate and provide for an increase in borrowing availability.

On August 14, 1997, the Company completed transactions with two investors
in which it issued $3,000,000 of subordinated notes with (i) warrants to
purchase an aggregate of 740,000 shares of common stock at $1.25 per share and
(ii) warrants to purchase an aggregate amount of up to 1,000,000 shares of
common stock at $0.01 per share which warrants may be completely or partially
cancelled depending on the economic performance of the Company in fiscal 1999.
Also, the Company arranged a standby credit facility of $3,500,000 which the
Company may draw on between January 2, 1998 and February 28, 2000 if it attains
certain financial covenants. If the Company draws on the standby credit
facility, it will issue to the investors warrants to purchase an aggregate of up
to 560,000 additional shares of common stock at $1.25 per share.

In conjunction with the 1997 financing described above, the Company issued
a new 9.5% Subordinated Note due August 31, 2002 (the "Replacement Note") in the
principal amount of $5,501,091, to replace the Company's 10% Subordinated
Pay-In-Kind Note (the "Original Note") due August 31, 2001, in the principal
amount of $5,000,000 and certain additional notes in aggregate principal amount
of $501,091 reflecting related accrued interest. The Replacement Note is payable
semiannually, on a straight-line basis over three years beginning February 2000;
whereas, the Original Note was payable semiannually, on a straight-line basis
over three years beginning February 1999.

Also in August 1997, the Company renegotiated the term of its revolving
credit agreement by, among other things, making a change in the advance rate
which provided greater borrowing capacity. Under the credit agreement, the
Company is required to maintain certain financial covenants. As of November 2,
1997, the Company was out of compliance with one of these covenants but has
obtained a waiver. The Company may be in violation of one of these covenants as
of February 1, 1998 and anticipates being able to obtain a similar waiver, as
necessary, at the time. However, there can be no assurance that future financial
performance will

F-11
<PAGE> 65

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

result in compliance with these restrictions or restrictions contained in the
Company's other loan agreement, or that waivers will be obtained if the Company
fails to maintain compliance. Any default under the documents governing
indebtedness of the Company could have a significant adverse effect on the
financial position, results of operations or liquidity of the Company.

The Company's management, which underwent a substantial restructuring after
the 1996 financing described above, has developed a strategic plan for the
business which provides, among other things, for remodeling showrooms to provide
a more appealing setting for customers, opening new showrooms in existing
markets, increasing product prices to competitive levels, reducing promotional
discounting, reconfiguring selling commissions, remerchandising, refocusing
advertising, improving the manufacturing process and reducing expenses through
budgetary controls. In the opinion of management, all of these plans have been
implemented and 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. Management believes that
the Company has sufficient sources of financing to continue operations and fund
its plan to remodel showrooms and open new showrooms throughout fiscal 1997 and
1998; however, if this is not the case, the Company will need to obtain
additional capital and there can be no assurance that any additional equity or
debt financing will be available. The Company's long-term success is dependent
upon management's ability to successfully execute its strategic plan and,
ultimately, to achieve sustained profitable operations.

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 pretax gain to the Company of
$12,115,000. Since the Company and Mr. Coffee had certain members of the Board
of Directors in common, the investment in Mr. Coffee was accounted for using the
equity method. The Company's share of Mr. Coffee's earnings in 1994 up to the
time of the merger was $316,000.

4. NOTES PAYABLE

Notes payable consist of the following:

<TABLE>
<CAPTION>
FEBRUARY 2, JANUARY 28,
1997 1996
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Secured revolving credit notes...................... $ 1,999 $ 5,515
Subordinated note payable to shareholder............ 5,133 --
Unamortized debt discount, net of accumulated
amortization of $137,000.......................... (1,263) --
Other notes......................................... 478 88
------- ------
6,347 5,603
Less current portion................................ 41 19
------- ------
$ 6,306 $ 5,584
======= ======
</TABLE>

The secured revolving credit notes were issued under a revolving credit
agreement between Krause's and a financial institution that expires in January
2000. The credit agreement provides for revolving loans of up to $10 million
based on the value of inventories. As of February 2, 1997, borrowing under the
revolving credit facility was limited to approximately $6.0 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 as of
February 2, 1997 was payable monthly at the rate of 1.0% in excess of the prime
rate (8.25% at February 2, 1997).

F-12
<PAGE> 66

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

The subordinated note payable to shareholder was issued August 26, 1996 and
bears interest at 10% per annum, payable in additional subordinated notes for
the first two years after which interest is payable quarterly. Interest
aggregating approximately $133,000 was added to the principal balance of the
subordinated note during fiscal 1996. 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.

Pursuant to the terms of the Revolving Credit Agreement and the
Subordinated Note, the Company and Krause's are required to maintain certain
financial ratios and minimum levels of tangible net-worth and working capital.
In addition, the Company and Krause's are restricted from entering into certain
transactions or making certain payments and dividend distributions without the
prior consent of the lenders. As of February 2, 1997, the Company was in
compliance with all the terms and conditions of its Note Payable and Revolving
Credit Agreement.

5. INCOME TAXES

The provision (benefit) for income taxes consists of the following:

<TABLE>
<CAPTION>
FISCAL YEARS 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>

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 YEARS ENDED
--------------------------------------------
FEBRUARY 2, JANUARY 28, DECEMBER 31,
1997 1996 1994
----------- ----------- ------------
(IN THOUSANDS)
<S> <C> <C> <C>
Tax at federal statutory rate.......... $(4,552) $(3,414) $2,721
Goodwill amortization.................. 347 346 350
Adjustment of valuation allowance...... 5,333 2,144 (920)
Benefit of net operating loss
carryforwards........................ -- -- (752)
State income tax, net of federal
benefit.............................. (742) (557) 630
Other.................................. (386) 154 142
------- ------- ------
$ -- $(1,327) $2,171
======= ======= ======
</TABLE>

F-13
<PAGE> 67

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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>
FEBRUARY 2, JANUARY 28,
1997 1996
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Deferred tax liabilities............................ $ -- $ 200
Deferred tax assets:
Net operating loss carryforwards.................. 12,075 7,510
Reserves and accruals not currently deductible for
tax purposes................................... 1,443 900
Other............................................. 125 100
-------- -------
Total deferred tax assets......................... 13,643 8,510
Valuation allowance for deferred tax assets....... (13,643) (8,310)
-------- -------
Net deferred tax assets........................... -- 200
-------- -------
Net deferred taxes............................. $ -- $ --
======== =======
</TABLE>

The change in the valuation allowance was a net increase of $5,333,000 for
the fiscal year ended February 2, 1997, and a net increase of $2,144,000 for the
fiscal year ended January 28, 1996. The valuation allowance was increased since
the realization of net deferred tax assets is uncertain.

As of February 2, 1997 the Company has federal net operating loss
carryforwards of approximately $32 million which begin to expire in 2003, if not
utilized. As a result of various equity transactions, one of the Company's
subsidiaries has experienced a change 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 approximately $10 million of these net
operating loss carryforwards is limited to the future income of one of the
Company's subsidiaries and is further limited to approximately $1 million per
year on a cumulative basis. As of February 2, 1997, approximately $3 million of
the limited loss carryforwards was available. In addition, the Company had state
net operating loss carryforwards of approximately $14 million, which begin to
expire in the year 1997, if not utilized.

6. STOCKHOLDERS' EQUITY

At February 2, 1997, there were outstanding warrants to purchase 1,754,956
shares of the Company's common stock. One million four hundred thousand of such
shares are subject to a warrant, issued as part of the 1996 financing (Note 2),
at a exercise price of $.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 the Company's 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.

As of February 2, 1997, 4,688,956 shares of the company's common stock are
reserved for issuance upon exercise of warrants and stock options (Note 7).

7. STOCK OPTION PLANS

The Company has elected to follow APB 25, "Accounting for Stock Issued to
Employees" and related interpretations in accounting for its employee stock
options because, as discussed below, the alternative fair value accounting
provided for under SFAS 123, "Accounting for Stock-Based Compensation" requires
use of option valuation models that were not developed for use in valuing
employee stock options.

F-14
<PAGE> 68

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

The 1997 Stock Incentive 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. Until stockholder approval is
obtained all awards under this 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 this plan can
consist of options, stock appreciation rights, dividend equivalent rights,
restricted stock, performance shares, deferred stock units or other stock based
awards.

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 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 is made in five annual installments,
but a director may elect to receive a single payment.

In August 1996, the Company awarded the Chief Executive Officer of the
Company an option to purchase 1,234,000 shares of common stock at an exercise
price of $1.00 per share with vesting to occur over three years. Compensation
expense was recorded in fiscal 1996 in the amount of $293,000 based upon the
vesting provisions and the market value of the stock on the date of grant.

Options to purchase the Company's common stock are outstanding under the
Company's 1990 Employees Stock Option Plan, 1994 Directors Stock Option Plan,
and various plans established by Krause's prior to the time it was acquired by
the Company. All of these plans have been cancelled and no further grants may be
made under them.

Pro forma information regarding net income (loss) and earnings (loss) per
share is required by SFAS 123 and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted-average
assumptions for 1996 and 1995; risk-free interest rates of 6.85% and 6.79%,
dividend yields of 0% for both periods, volatility factors of the expected
market price of the Company's common stock of .68% for both periods; and a
weighted-average life of the options of 6.5 and 6.0 years, respectively.

The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimates, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting periods. The pro forma
disclosures are not likely to be representative of the effects on reported net
income (loss) for future years. The Company's pro forma information follows (in
thousands, except for per share information):

<TABLE>
<CAPTION>
1996 1995
------- ------
<S> <C> <C>
Pro forma net loss........................................ $13,188 $8,715
Pro forma net loss per share.............................. $ 1.26 $ 2.21
</TABLE>

As of February 2, 1997, under all option plans, a total of 2,934,000 shares
of common stock are reserved for future issuance, options to purchase 1,722,457
shares of common stock were outstanding, options to

F-15
<PAGE> 69

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

purchase 409,222 were exercisable, at a weighted average exercise price of
$1.25, and options for 1,211,543 shares were available for future grants.

The following table reflects option activity and related exercise prices,
actual and weighted average, under all stock option plans from December 31, 1993
to February 2, 1997.

<TABLE>
<CAPTION>
WEIGHTED
NUMBER OF ACTUAL AVERAGE
OPTIONS EXERCISE PRICE EXERCISE PRICE
--------- -------------- --------------
<S> <C> <C> <C>
Outstanding December 31, 1993........ 329,020 $3.09 - $8.34 --
Granted.............................. 35,501 $6.00 - $7.13 --
Exercised............................ (4,678) $3.09 --
---------
Outstanding December 31, 1994........ 359,843 $3.09 - $8.34 --
Granted.............................. 140,828 $2.16 - $6.48 $2.73
Forfeited............................ (140,298) $3.09 - $6.38 $5.02
---------
Outstanding January 28, 1996......... 360,373 $2.16 - $8.34 $4.48
Granted.............................. 1,617,000 $ .78 - $1.62 $1.12
Forfeited............................ (254,916) $ .78 - $8.34 $4.32
---------
Outstanding February 2, 1997......... 1,722,457 $ .78 - $7.13 $1.35
=========
</TABLE>

The weighted-average grant-date fair value of options granted during 1996
and 1995, for options where the exercise price on the date of grant was equal to
the stock price on that date, was $2.14 and $1.09, respectively. The weighted
average grant date fair value of options granted during 1996 for options where
the exercise price on the date of grant was less than the stock price on that
date was $1.29.

The following table reflects the weighted average exercise price of options
outstanding, weighted average remaining contractual life of options outstanding,
number of shares exercisable and the weighted average exercise price of
exercisable options as of February 2, 1997.

<TABLE>
<CAPTION>
WEIGHTED
WEIGHTED AVERAGE EXERCISE
NUMBER OF ACTUAL WEIGHTED AVERAGE NUMBER OF PRICE OF
OPTIONS EXERCISE AVERAGE REMAINING OPTIONS EXERCISABLE
OUTSTANDING PRICE RANGE EXERCISE PRICE CONTRACTUAL LIFE EXERCISABLE OPTIONS
- ---------- ------------- -------------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C> <C>
1,592,000 $ .78 - $1.95 $1.13 9.7 years 310,167 $1.00
69,832 $1.96 - $4.00 $2.52 .9 years 48,503 $2.55
60,625 $4.01 - $7.13 $5.71 2.1 years 50,552 $5.66
--------
1,722,457 $ .78 - $7.13 $1.35 9.0 years 409,222 $1.25
========
</TABLE>

8. RETIREMENT PLAN

The Company 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 the Company matches employees' contributions. The Company's
contributions were immaterial in fiscal 1996, 1995 and 1994.

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. The Company's administrative offices and manufacturing
facilities lease has a remaining term of 12 years with four five-year renewal
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.

F-16
<PAGE> 70

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Commitments as of February 2, 1997 under operating leases require
approximate future minimum annual rental payments as follows:

<TABLE>
<CAPTION>
FISCAL YEAR TOTAL
------------------------------------------------------ -----------------
(IN THOUSANDS)
<S> <C>
1997.................................................. $14,777
1998.................................................. 13,811
1999.................................................. 12,061
2000.................................................. 10,283
2001.................................................. 7,729
Thereafter............................................ 23,739
----------
$82,400
==========
</TABLE>

Total rent expense under all operating leases was approximately
$15,389,000, $15,631,000, and $14,965,000 for the fiscal years ended February 2,
1997, January 28, 1996 and December 31, 1994, respectively.

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 consolidated financial position,
liquidity or results of operations.

10. RELATED PARTY TRANSACTIONS

In fiscal 1996, 1995, and 1994, Permal Capital Management, Inc. (PCMI)
provided various management services for the Company and its subsidiaries, for
which PCMI received $58,333, $100,000, and $200,000, respectively. PCMI's
services for the Company included assistance with regard to executive
management, financial consulting and strategic planning. 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 Company's Board
of Directors.

F-17
<PAGE> 71

KRAUSE'S FURNITURE INC.

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

ASSETS

<TABLE>
<CAPTION>
NOVEMBER 2,
1997
-----------
<S> <C>
Current assets:
Cash and cash equivalents...................................................... $ 250
Accounts receivable, net of allowance of $194 for doubtful accounts............ 780
Inventories.................................................................... 16,499
Prepaid expenses............................................................... 552
--------
Total current assets........................................................ 18,081
Property, equipment, and leasehold improvements, net............................. 7,085
Goodwill, net.................................................................... 14,621
Leasehold interests, net......................................................... 1,269
Other assets..................................................................... 2,428
--------
$ 43,484
========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................................... $ 8,820
Accrued payroll and related expenses........................................... 1,469
Other accrued liabilities...................................................... 3,719
Customer deposits.............................................................. 5,213
Current portion of notes payable............................................... 41
--------
Total current liabilities................................................... 19,262
Long-term liabilities:
Notes payable.................................................................. 11,073
Other liabilities.............................................................. 2,137
--------
Total long-term liabilities................................................. 13,210
Commitments and contingencies.................................................... --
Stockholders' equity:
Convertible preferred stock, $.001 par value; 666,667 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................................................. 50,952
Accumulated deficit............................................................ (39,959)
--------
Total stockholders' equity.................................................. 11,012
--------
$ 43,484
========
</TABLE>

See accompanying notes.

F-18
<PAGE> 72

KRAUSE'S FURNITURE, INC.

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

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
---------------------------
NOVEMBER 2, OCTOBER 27,
1997 1996
----------- -----------
<S> <C> <C>
Net sales............................................................ $85,569 $ 82,738
Cost of sales........................................................ 41,840 42,364
------- --------
Gross profit......................................................... 43,729 40,374
Operating expenses:
Selling............................................................ 40,558 43,556
General and administrative......................................... 6,780 7,852
Amortization of goodwill........................................... 765 765
------- --------
48,103 52,173
------- --------
Loss from operations................................................. (4,374) (11,799)
Interest expense..................................................... (1,177) (782)
Other income (expense)............................................... (58) 207
------- --------
Net loss............................................................. $(5,609) $ (12,374)
======= ========
Net loss per share................................................... $ (.30) $ (1.62)
======= ========
Average number of common shares outstanding.......................... 19,021 7,661
</TABLE>

See accompanying notes.

F-19
<PAGE> 73

KRAUSE'S FURNITURE, INC.

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

<TABLE>
<CAPTION>
CONVERTIBLE CAPITAL IN
PREFERRED STOCK COMMON STOCK EXCESS OF TOTAL
--------------- --------------- PAR ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT VALUE DEFICIT EQUITY
------ ------ ------ ------ ------------ ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at February 2, 1997.... -- $-- 19,021 $ 19 $ 49,874 $ (34,350) $15,543
Issuance of common stock
purchase warrants............ -- -- -- -- 925 -- 925
Compensation expense on stock
option grant................. -- -- -- -- 153 -- 153
Net loss....................... -- -- -- -- -- (5,609) (5,609)
--- --- ------ --- ------- -------- -------
Balance at November 2, 1997.... -- $-- 19,021 $ 19 $ 50,952 $ (39,959) $11,012
=== === ====== === ======= ======== =======
</TABLE>

See accompanying notes.

F-20
<PAGE> 74

KRAUSE'S FURNITURE, INC.

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

<TABLE>
<CAPTION>
THIRTY-NINE WEEKS ENDED
---------------------------
NOVEMBER 2, OCTOBER 27,
1997 1996
----------- -----------
<S> <C> <C>
Cash flows from operating activities:
Net loss............................................................. $ (5,609) $ (12,374)
Adjustments to reconcile net loss to net cash used by operating
activities:
Depreciation and amortization................................... 1,802 1,853
Other non-cash charges.......................................... 786 --
Change in assets and liabilities:
Accounts receivable............................................. 340 51
Income tax refund receivable.................................... -- 1,467
Inventories..................................................... (2,486) 2,006
Prepaid expenses and other assets............................... 424 (291)
Accounts payable and other liabilities.......................... 653 (643)
Customer deposits............................................... (408) (650)
------- ---------
Net cash used by operating activities......................... (4,498) (8,581)
------- ---------
Cash flows from investing activities:
Capital expenditures............................................... (1,498) (563)
------- ---------
Net cash used by investing activities........................... (1,498) (563)
------- ---------
Cash flows from financing activities:
Proceeds from long-term borrowings................................. 102,005 97,050
Principal payments on long-term borrowings......................... (99,986) (101,072)
Proceeds from issuance of subordinated note........................ 3,000 5,000
Proceeds from issuance of notes.................................... -- 2,950
Net proceeds from issuance of common stock......................... -- 10,221
------- ---------
Net cash provided by financing activities....................... 5,019 14,149
------- ---------
Net increase (decrease) in cash...................................... (977) 5,005
Cash and cash equivalents at beginning of period..................... 1,227 1,336
------- ---------
Cash and cash equivalents at end of period........................... $ 250 $ 6,341
======= =========
Supplemental disclosures of cash flow information -- Cash paid during
the period for interest............................................ $ 373 $ 431
Noncash investing and financing activities:
Preferred stock converted into common stock........................ -- 7,523
Exchange of notes payable and related accrued interest for common
stock........................................................... -- 3,066
Issuance of common stock purchase warrants......................... 925 1,400
</TABLE>

See accompanying notes.

F-21
<PAGE> 75

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 Custom Crafted Furniture Corp.,
formerly Krause's Sofa Factory, ("Krause's"), have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission and reflect all
normal recurring 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 included in the
Company's Annual Report on Form 10-K for the year ended February 2, 1997. The
results of operations for the thirty-nine weeks ended November 2, 1997 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. The Company has reported losses from operations in each of the past five
years and for the thirty-nine weeks ended November 2, 1997 due to inefficiencies
within its operations and due to an industry-wide softness in retail sales. As a
result of such losses, the Company had an accumulated deficit of $39,959,000 and
a working capital deficiency of $1,181,000 at November 2, 1997. The Company
expects to incur operating losses in fiscal year 1997.

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 $5,000,000 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. Also the
Company's revolving credit agreement was amended to extend the expiration date,
reduce the interest rate and provide for an increase in borrowing availability.

The Company's management, which underwent a substantial restructuring after
the 1996 financing described above, has developed a strategic plan for the
business which provides, among other things, for remodeling showrooms to provide
a more appealing setting for customers, opening new showrooms in existing
markets, increasing product prices to competitive levels, reducing promotional
discounting, reconfiguring selling commissions, remerchandising, refocusing
advertising, improving the manufacturing process and reducing expenses through
budgetary controls. Many of these plans were implemented since the latter part
of fiscal 1996 and 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. Management believes
that the Company has sufficient sources of financing to continue operations
throughout fiscal 1997. However, the Company's long-term success is dependent
upon management's ability to successfully execute its strategic plan and,
ultimately, to achieve sustained profitable operations (see Note 4 for
discussion of 1997 financing).

F-22
<PAGE> 76

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

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>
NOVEMBER 2,
1997
--------------
(IN THOUSANDS)
<S> <C>
Finished goods................................................. $ 12,190
Work in progress............................................... 211
Raw materials.................................................. 4,098
-------
$ 16,499
=======
</TABLE>

4. Notes payable consists of the following:

<TABLE>
<CAPTION>
NOVEMBER 2,
1997
--------------
(IN THOUSANDS)
<S> <C>
Secured revolving credit notes................................. $ 4,094
Subordinated note payable to shareholder due 2002.............. 5,501
Unamortized debt discount, net of accumulated amortization of
$381......................................................... (1,019)
Subordinated notes payable to shareholders due 2003............ 3,000
Unamortized debt discount, net of accumulated amortization of
$60.......................................................... (865)
Other notes.................................................... 403
-------
11,114
Less current portion........................................... 41
-------
$ 11,073
=======
</TABLE>

The secured revolving credit notes were issued under a revolving credit
agreement between Krause's and a financial institution that expires in January
2000. The credit agreement, which was most recently amended December 11, 1997,
provides for revolving loans of up to $10 million based on the value of
inventories. As of November 2, 1997, borrowing under the revolving credit
facility was limited to approximately $7.7 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 1.0% in excess of the prime rate (8.50% at November 2, 1997).

On August 14, 1997, the Company concluded a Supplemental Securities
Purchase Agreement (the "Agreement") among the Company, General Electric Capital
Corporation ("GECC") and Japan Omnibus Ltd. ("JOL"), a company formerly known as
Edison Investments Inc. Under the Agreement, the Company sold 9.5% subordinated
notes in an aggregate principal amount of $3,000,000 to GECC and JOL, which
notes are payable semi-annually on a straight-line basis over three years
beginning February 2000, and issued to GECC and JOL warrants to purchase an
aggregate of 740,000 shares of common stock of the Company at a purchase price
of $1.25 per share. The fair value of the warrant of $925,000 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. The Company also issued to GECC and JOL a warrant to purchase
an aggregate amount of up to 1,000,000 shares of the Company's common stock at a
price of $0.01 per share which warrant may be completely or partially cancelled
depending on the economic performance of the Company in fiscal 1999.

Also, under the Agreement, the Company, at its option and subject to the
attainment of certain financial covenants, may draw on a standby credit facility
with GECC and JOL by selling additional 9.5% subordinated notes in an aggregate
principal amount of up to $3,500,000; such standby credit facility is available
from January 2, 1998 to February 28, 2000. If the Company elects to draw down on
the credit available from GECC

F-23
<PAGE> 77

KRAUSE'S FURNITURE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

and JOL by issuing notes, the Agreement provides that the Company shall issue to
GECC and JOL warrants to purchase an aggregate of up to 560,000 additional
shares of the common stock of the Company.

In conjunction with the financing described above, the Company issued to
GECC a new 9.5% Subordinated Note due August 31, 2002 (the "Replacement Note")
in the principal amount of $5,501,091, to replace the Company's 10% Subordinated
Pay-In-Kind Note (the "Original Note") due August 31, 2001, in principal amount
of $5,000,000, and certain additional notes in aggregate principal amount of
$501,091 reflecting accrued interest. The Original 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. The Replacement Note is payable
semiannually, on a straight-line basis over three years beginning February 2000
whereas the Pay-In-Kind Note was payable semiannually, on a straight-line basis
over three years beginning February 1999.

Pursuant to the terms of the revolving credit agreement and the
subordinated notes, the Company and Krause's are required to maintain certain
financial ratios and minimum levels of tangible net worth and working capital.
In addition, the Company and Krause's are restricted from entering into certain
transactions or making certain payments and dividend distributions without the
prior consent of the lenders. As of November 2, 1997, Krause's was not in
compliance with two of the covenants contained in the revolving credit agreement
and may not be in compliance with a financial covenant at the end of its current
fiscal year. On December 11, 1997, the financial institution waived the
non-compliance as it relates to the November 2, 1997 reporting period.

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.

In February 1997, the Financial Accounting Standards Board issued Statement
No. 128, Earnings per Share, which is required to be adopted on December 31,
1997. At that time, the Company will be required to change the method currently
used to compute earnings per share and to restate all prior periods. Under the
new requirements for calculating primary earnings per share, the dilutive effect
of stock options will be excluded. Equity instruments, such as options and
warrants are excluded if antidilutive in the calculation of diluted earnings per
share. Since the effect of stock options is already excluded in the computation
of net loss per share, the adoption of Statement 128 will not result in any
change in the loss per share amounts reported for the thirty-nine weeks ended
November 2, 1997 or October 27, 1996.

6. Effective in fiscal 1998, the Company will be required to adopt
Statements of Financial Accounting Standards (SFAS) No. 129 "Capital Structure",
SFAS No. 130 "Reporting Comprehensive Income" and SFAS No. 131 "Disclosures
about Segments of an Enterprise and Related Information". The impact of adoption
of these pronouncements is not expected to be material to the Company's
financial position or results of operations.

F-24
<PAGE> 78

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

NO DEALER, SALESPERSON OR OTHER INDIVIDUAL HAS BEEN AUTHORIZED TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN
CONNECTION WITH THIS OFFERING COVERED BY THIS PROSPECTUS. IF GIVEN OR MADE, SUCH
INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED
BY THE COMPANY, THE SELLING STOCKHOLDER OR THE PLACEMENT AGENT. THIS PROSPECTUS
DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, THE
COMMON STOCK IN ANY JURISDICTION WHERE, OR TO ANY PERSON TO WHOM, IT IS UNLAWFUL
TO MAKE SUCH OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR
ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATIONS
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.

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

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
Prospectus Summary.................... 2
Risk Factors.......................... 9
Use of Proceeds....................... 16
Dividend Policy....................... 16
Price Range of Common Stock........... 16
Dilution.............................. 17
Capitalization........................ 18
Selected Consolidated Financial
Data................................ 19
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 20
Business.............................. 29
Management............................ 36
Certain Transactions.................. 44
Principal and Selling Stockholders.... 46
Plan of Distribution.................. 47
Description of Capital Stock.......... 48
Legal Matters......................... 50
Experts............................... 50
Additional Information................ 51
Index to Consolidated Financial
Statements.......................... 52
</TABLE>

======================================================
======================================================
4,000,000 SHARES

[KRAUSE'S FURNITURE, INC. LOGO]

COMMON STOCK
-----------------

PROSPECTUS
-----------------

CRUTTENDEN ROTH
INCORPORATED
December , 1997
======================================================
<PAGE> 79

PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION

The following is an itemized list of the estimated expenses to be incurred
in connection with the offering of the securities being offered hereunder other
than underwriting discounts and commissions.

<TABLE>
<S> <C>
Registration Fee.......................................... $ *
--------
Printing and Engraving.................................... *
--------
Legal Fees and Expenses................................... *
--------
Blue Sky Fees and Expenses................................ *
--------
Accountants' Fees and Expenses............................ *
--------
Escrow Agent's Fees....................................... *
--------
Total**......................................... *
========
</TABLE>

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

* To be supplied by amendment.

** All costs to be borne by the Company.

ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS

Section 145 of the DGCL contains detailed provisions on indemnification of
directors and officers against expenses, judgments, fines and amounts paid in
settlement, actually and reasonably incurred in connection with legal
proceedings. Section 102(a)(7) of the DGCL permits a provision in the
certificate of incorporation of each corporation organized thereunder, such as
the Company, eliminating or limiting, with certain exceptions, the personal
liability of a director of the corporation or its stockholders for monetary
damages for breach of fiduciary duty as a director. The Certificate of
Incorporation of the Company eliminates the liability of each of its directors
to its stockholders or the Company for monetary damages for breach of fiduciary
duty to the full extent provided by the Delaware General Corporation Law (the
"DGCL"), as such law exists or may hereafter be amended.

Indemnification applies to any threatened, pending or completed action,
suit or proceeding, whether, civil, criminal, administrative or investigative.
Indemnification may include all expenses (including attorneys' fees, judgments,
fines, ERISA excise taxes and amounts paid in settlement) reasonably incurred by
the indemnified person.

The Company maintains a directors and officers liability and reimbursement
insurance policy intended to reimburse the Company for any payments made by it
pursuant to its indemnification obligations.

The foregoing statements are subject to the detailed provisions of Section
102(a)(7) of the DGCL and the Certificate of Incorporation of the Company, as
applicable.

ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES

1. Within the past three years the Company sold an aggregate of 1,677
shares of Common Stock to one employee for consideration in the aggregate amount
of $5,150 pursuant to the Company's 1990 Employees Stock Option Plan.

2. From May 13, 1996, through June 19, 1996, the Company sold an aggregate
principal amount of $950,000 of its Series 1996-I and Series 1996-II Convertible
Promissory Notes (the "Notes") to certain directors, officers and 5%
stockholders of the Company and parties related to them. In connection with the
General Electric Capital Corporation ("GECC") financing, the holders of the
Notes converted the principle amount and accrued interest due under the Notes
into an aggregate of 970,140 shares of Common Stock at a conversion price of
$1.00 per share. The purchasers of the Notes were certain officers, directors
and affiliates of the Company.

II-1
<PAGE> 80

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

4. On August 26, 1996, and September 10, 1996, the Company completed a
private placement of 10,699,000 shares of Common Stock to 55 investors, some of
whom are related to each other, at a price of $1.00 per share. In addition, the
Company issued its subordinated note in the aggregate principal amount of
$5,000,000 and a warrant to purchase 1,400,000 additional shares of Common Stock
at a purchase price of $.001 per share to GECC. The purchasers of shares in this
private placement and the number of shares purchased are as follows:

<TABLE>
<CAPTION>
NO. OF SHARES NO. OF SHARES
NAME ON AUGUST 26, 1996 ON SEPTEMBER 10, 1996
------------------------------- -------------------- -----------------------
<S> <C> <C>
GECC........................... 5,000,000
Permal Noscal Ltd.............. 405,000
Zaxis Partners, L.P............ 40,000
Sidney Kimmel.................. 50,000
Quadra Appreciation Fund,
Inc.......................... 5,000
Branagh Revocable Trust........ 5,000
Sanford J. Colen............... 20,000
Jean R. Perrette............... 250,000
Isaac Robert Souede............ 250,000
Thomas M. DeLitto.............. 25,000
C. Redington Barrett, III...... 5,000
Hurley & Co.................... 35,000
United Gulf Bank............... 225,000
ATCO Holdings Ltd.............. 400,000
ATCO Development, Inc.......... 100,000
G(2) Investment Partners....... 60,000 30,000
Fairmont Services Ltd.......... 400,000
Carlton Securities N.V......... 100,000
Emmanual Bagdjian.............. 210,000
Heliopolis Inc................. 100,000
T. Michael Wallace............. 100,000 300,000
Gary S. Gladstein.............. 100,000 100,000
Peter L. Rhulen................ 100,000
Pollat, Evans & Co., Inc....... 15,000
Maureen Erin Hawley Trust I.... 112,500
Allison Booth Hawley Trust I... 112,500
Caitlin Hale Hawley Trust I.... 112,500
Shannon Follen Hawley Trust
I............................ 112,500
Hawley Family Trust............ 500,000
Philip M. Hawley............... 30,000
Dr. Philip M. Hawley, Jr....... 20,000
H.D. Investment Group, Inc..... 25,000
Morgan Adams, Inc.............. 50,000
Theodore D. Konopisos.......... 22,000
</TABLE>

II-2
<PAGE> 81

<TABLE>
<CAPTION>
NO. OF SHARES NO. OF SHARES
NAME ON AUGUST 26, 1996 ON SEPTEMBER 10, 1996
------------------------------- -------------------- -----------------------
<S> <C> <C>
William A. MacLaughlin IRA..... 25,000
Gregory M. Simon............... 20,000
Hugh H. Wilson, Jr............. 15,000
Codell Holdings Ltd............ 100,000
J. Stephen Emerson IRA......... 100,000
J. Stephen Emerson............. 100,000
Paul Marciano Trust............ 100,000
G. Tyler Runnels............... 50,000
Charles Perez.................. 100,000
JMG Capital Partners L.P....... 50,000
William C. Miller, IV.......... 25,000
Tendencia Investments
Overseas..................... 250,000
Lawrence S. Black.............. 50,000
Maureen Erin Hawley Trust II... 25,000
Allison Booth Hawley Trust
II........................... 25,000
Caitlan Hale Hawley Trust II... 25,000
Shannon Follen Hawley Trust
II........................... 25,000
Ian and Francine Jack.......... 10,000
Keith and Tanya Jacobs......... 10,000
J. Richard Cordsen............. 27,000
J.D. Yates..................... 10,000
</TABLE>

5. On August 14, 1997, the Company concluded a Supplemental Securities
Purchase Agreement (the "1997 Financing") among the Company, GECC and Japan
Omnibus Ltd. ("JOL"). Under the terms of the 1997 Financing, the Company sold
subordinated notes in an aggregate principal amount of $3,000,000 to GECC and
JOL. The Company issued warrants in conjunction with the notes, as follows: (i)
to GECC a warrant to purchase 600,000 shares of the Common Stock at a purchase
price of $1.25 per share and to JOL a warrant to purchase 140,000 shares of the
Common Stock at a purchase price of $1.25 per share; (ii) to GECC and JOL
warrants for the purchase of up to 1,000,000 shares of the Company's common
stock at a price of $0.01 per share (the "Performance Warrants"); the
Performance Warrants will be canceled if the Company meets certain economic
performance targets. The Company also agreed to issue additional warrants if it
draws on the standby credit facility.

Except for the issuance of the Series 1996-II Convertible Promissory Notes
and the shares of Common Stock acquired upon conversion thereof described in
item 2, the issuances of securities in the above transactions were deemed to be
exempt from registration under the Securities Act in reliance on Section 4(2)
thereof or Regulation D promulgated thereunder as transactions not involving a
public offering. The issuance of Series 1996-II convertible Promissory Notes and
the shares of Common Stock acquired upon conversion thereof described in item 2
above, were deemed exempt from registration under Securities Act in reliance on
Regulation S promulgated thereunder.

II-3
<PAGE> 82

ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- ---------------------------------------------------------------------------------
<S> <C>
* 1 Form of Placement Agent Agreement.
3.1 Certificate of Incorporation.(1)
3.1a Certificate of Amendment of Certificate of Incorporation dated November 28,
1994.(5)
3.1b Certificate of Amendment of Certificate of Incorporation dated August 1, 1995.(6)
3.1c Certificate of Amendment of Certificate of Incorporation dated June 7, 1996.(7)
3.1d Certificate of Amendment of Certificate of Incorporation dated August 1, 1996.(7)
3.2 By-laws.(1)
4.1 Loan and Security Agreement dated January 20, 1995 by and between Congress
Financial Corporation (Western) and Krause's Sofa Factory and Castro Convertible
Corporation.(3)
4.1a First Amendment to Loan and Security Agreement dated May 10, 1996 by and between
Congress Financial Corporation (Western) and Krause's Sofa Factory and Castro
Convertible Corporation.(6)
4.1b Second Amendment to Loan and Security Agreement dated as of August 26, 1996 by
and between Congress Financial Corporation (Western) and Krause's Sofa Factory
and Castro Convertible Corporation.(10)
4.1c Third Amendment to Loan and Security Agreement dated as of November 25, 1996 by
and between Congress Financial Corporation (Western) and Krause's Sofa Factory
and Castro Convertible Corporation.(10)
4.1d Amended and Restated Subordination Agreement dated as of August 26, 1996 by and
between Congress Financial Corporation (Western) and Krause's Furniture, Inc.(10)
4.1e Fourth Amendment to Loan and Security Agreement dated as of August 14, 1997 by
and between Congress Financial Corporation (Western) and Krause's Sofa Factory
and Castro Convertible Corporation.(12)
4.1f Fifth Amendment to Loan and Security Agreement dated as of December 11, 1997 by
and between Congress Financial Corporation (Western) and Krause's Custom Crafted
Furniture Corp. and Castro Convertible Corporation.
4.1g Letter agreement between Krause's Furniture, Inc. and Congress Financial
Corporation (Western).(12)
4.2 Guarantee dated January 20, 1995 by Krause's Furniture, Inc. to Congress
Financial Corporation (Western).(3)
4.5 Certificate of Designations of Preferred Stock.(4)
* 5 Opinion of Morrison & Foerster LLP with respect to legality.
10.1 1994 Directors Stock Option Plan.(5)
10.2 1990 Employees Stock Option Plan.(2)
10.3 Form of Securities Purchase Agreement between the Company and GECC dated as of
August 26, 1996.
10.5 Form of Warrant to Purchase 1,400,000 Shares of Common Stock. (8)
10.6 Form of Securities Purchase Agreement between the Company and Certain
Stockholders dated as of August 26, 1996.(8)
10.7 Form of Stockholders Agreement among the Company, GECC and certain other
stockholders of the Company dated as of August 26, 1996.(8)
10.8 Form of Registration Rights Agreement among the Company and GECC and certain
other stockholders of the Company dated as of August 26, 1996.(8)
10.9 Employment Agreement with Philip M. Hawley.(8)
10.10 1997 Stock Incentive Plan.(11)
</TABLE>

II-4
<PAGE> 83

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- ---------------------------------------------------------------------------------
<S> <C>
10.11 Supplemental Securities Purchase Agreement among Krause's Furniture, Inc.,
General Electric Corporation and Japan Omnibus Ltd., dated as of August 14,
1997.(12)
10.12 Letter agreement dated August 14, 1997 regarding Permal Group shares.(12)
10.13 Letter agreement dated August 14, 1997 regarding warrant dilution provisions.(12)
11 Statement regarding computation of per share earnings.
21 Subsidiaries.
*23.1 Consent of Morrison & Foerster LLP (included in its opinion filed as Exhibit 5).
23.2 Consent of Ernst & Young LLP, Independent Auditors.
</TABLE>

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

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

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

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

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

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

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

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

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

(9) Incorporated herein by reference to Exhibits to Registrant's Form S-1 dated
March 12, 1997 (File No. 333-19485).

(10) Incorporated herein by reference to Exhibits to Registrant's Form 10-K
dated May 2, 1997 (File No. 0-17868).

(11) Incorporated herein by reference to Exhibit A to Registrant's Proxy
Statement on Schedule 14A dated May 7, 1997 (File No. 0-17868).

(12) Incorporated herein by reference to Exhibits to Registrant's Form 8-K dated
August 14, 1997 (File No. 0-17868).

(13) Incorporated herein by reference to Exhibits to Registrant's Form 10-Q
dated as of December 17, 1997 (File No. 0-17868).

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

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

II-5
<PAGE> 84

ITEM 17. UNDERTAKINGS

In accordance with Rule 430A of Regulation C under the Securities Act of
1933, as amended (the "Securities Act"), each of the undersigned registrants
hereby undertakes:

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

(b) That, for purposes of determining any liability under the
Securities Act, the information omitted from the form of prospectus filed
as part of this Registration Statement in reliance upon Rule 430A and
contained in a form of prospectus filed by the registrants pursuant to Rule
424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be
part of this Registration Statement as of the time it was declared
effective.

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

II-6
<PAGE> 85

SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, as amended, the
Registrant has duly caused this Registration Statement to be signed on its
behalf by the undersigned, thereunto duly authorized in the City of Brea, County
of Orange, State of California, on December 23, 1997.

KRAUSE'S FURNITURE, INC

By: /s/ ROBERT A. BURTON

------------------------------------
Robert A. Burton
Senior Vice President and Chief
Financial Officer

POWER OF ATTORNEY

The undersigned hereby constitutes and appoints Philip M. Hawley, Robert A.
Burton and Judith O. Lasker, and each of them, as his true and lawful
attorneys-in-fact and agents, jointly and severally, with full power of
substitution and resubstitution, for and in his stead, in any and all
capacities, to sign on his behalf this Registration Statement on Form S-1 in
connection with the offering of common stock by Krause's Furniture, Inc. and to
execute any amendments thereto (including post-effective amendments) or
certificates that may be required in connection with this Registration
Statement, and to file the same, with all exhibits thereto, and all other
documents in connection therewith, with the Securities and Exchange Commission
and granting unto said attorneys-in-fact and agents, and each of them, jointly
and severally, the full power and authority to do and perform each and every act
and thing necessary or advisable to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents, or any of them, jointly or severally, or their or
his substitute or substitutes, may lawfully do or cause to be done by virtue
hereof.

Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this Registration Statement on Form S-1 to be signed on its
behalf by the undersigned, each thereunto duly authorized, in the City of Brea,
County of Orange, State of California, as of December 23, 1997.

<TABLE>
<CAPTION>
SIGNATURE TITLE
- --------------------------------------------- ----------------------------------------------
<S> <C>

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

/s/ ROBERT A. BURTON Senior Vice President and Chief Financial
- --------------------------------------------- Officer (Principal Financial Officer,
Robert A. Burton Principal Accounting Officer)

/s/ THOMAS M. DELITTO Vice Chairman of the Board
- ---------------------------------------------
Thomas M. DeLitto

/s/ KAMAL G. ABDELNOUR Director
- ---------------------------------------------
Kamal G. Abdelnour

/s/ JEFFREY H. COATS Director
- ---------------------------------------------
Jeffrey H. Coats

/s/ PETER H. DAILEY Director
- ---------------------------------------------
Peter H. Dailey

/s/ JOHN A. GAVIN Director
- ---------------------------------------------
John A. Gavin
</TABLE>

II-7
<PAGE> 86

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

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

We have audited the consolidated financial statements of Krauses Furniture,
Inc. as of February 2, 1997 and January 28, 1996, and the related consolidated
statements of operations, stockholders' equity and cash flows for the fiscal
years ended February 2, 1997, January 28, 1996 and December 31, 1994, and for
the month ended January 29, 1995, and have issued our report thereon dated March
28, 1997, except for Note 2, as to which the date is December 17, 1997 (included
elsewhere in this Registration Statement). Our audits also included the
financial statement schedule listed in Item 16(b) of this Registration
Statement. This schedule is the responsibility of the Company's management. Our
responsibility is to express an opinion on this schedule based on our audits.

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

/s/ ERNST & YOUNG LLP

Orange County, California
March 28, 1997,
except for Note 2, as to which the date is
December 17, 1997

S-1
<PAGE> 87

KRAUSE'S FURNITURE, INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FISCAL YEARS ENDED FEBRUARY 2, 1997 AND JANUARY 28, 1996, MONTH ENDED JANUARY
29, 1995 AND FISCAL
YEAR ENDED DECEMBER 31, 1994

<TABLE>
<CAPTION>
ADDITIONS
BALANCE CHARGED TO CHARGED BALANCE
ALLOWANCE FOR BEGINNING COST AND TO OTHER END
DOUBTFUL ACCOUNTS OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS(A) OF PERIOD
- ------------------------------------- --------- ---------- --------- ------------- ---------
<S> <C> <C> <C> <C> <C>
Fiscal 1996.......................... $ 291,487 $244,613 $ -- $ 209,293 $ 326,807
Fiscal 1995.......................... 616,148 218,414 -- 543,075 291,487
Month ended January 29, 1995......... 591,744 24,404 -- -- 616,148
Fiscal 1994.......................... 395,322 566,000 (320,000)(b) 49,578 591,744
</TABLE>

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

(a) Represents accounts written off.

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

S-2
<PAGE> 88

EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------ ------------------------------------------------------------------------------------
<C> <S>
* 1 Form of Placement Agent Agreement.
3.1 Certificate of Incorporation.(1)
3.1a Certificate of Amendment of Certificate of Incorporation dated November 28, 1994.(5)
3.1b Certificate of Amendment of Certificate of Incorporation dated August 1, 1995.(6)
3.1c Certificate of Amendment of Certificate of Incorporation dated June 7, 1996.(7)
3.1d Certificate of Amendment of Certificate of Incorporation dated August 1, 1996.(7)
3.2 By-laws.(1)
4.1 Loan and Security Agreement dated January 20, 1995 by and between Congress Financial
Corporation (Western) and Krause's Sofa Factory and Castro Convertible
Corporation.(3)
4.1a First Amendment to Loan and Security Agreement dated May 10, 1996 by and between
Congress Financial Corporation (Western) and Krause's Sofa Factory and Castro
Convertible Corporation.(6)
4.1b Second Amendment to Loan and Security Agreement dated as of August 26, 1996 by and
between Congress Financial Corporation (Western) and Krause's Sofa Factory and
Castro Convertible Corporation.(10)
4.1c Third Amendment to Loan and Security Agreement dated as of November 25, 1996 by and
between Congress Financial Corporation (Western) and Krause's Sofa Factory and
Castro Convertible Corporation.(10)
4.1d Amended and Restated Subordination Agreement dated as of August 26, 1996 by and
between Congress Financial Corporation (Western) and Krause's Furniture, Inc.(10)
4.1e Fourth Amendment to Loan and Security Agreement dated as of August 14, 1997 by and
between Congress Financial Corporation (Western) and Krause's Sofa Factory and
Castro Convertible Corporation.(12)
4.1f Fifth Amendment to Loan and Security Agreement dated as of December 11, 1997 by and
between Congress Financial Corporation (Western) and Krause's Custom Crafted
Furniture Corp. and Castro Convertible Corporation.
4.1g Letter agreement between Krause's Furniture, Inc. and Congress Financial Corporation
(Western).(12)
4.2 Guarantee dated January 20, 1995 by Krause's Furniture, Inc. to Congress Financial
Corporation (Western).(3)
4.5 Certificate of Designations of Preferred Stock.(4)
* 5 Opinion of Morrison & Foerster LLP with respect to legality.
10.1 1994 Directors Stock Option Plan.(5)
10.2 1990 Employees Stock Option Plan.(2)
10.3 Form of Securities Purchase Agreement between the Company and GECC dated as of
August 26, 1996.(8)
10.4 Form of $5,000,000 10% Subordinated Pay-In-Kind Note due August 31, 2001.(8)
10.5 Form of Warrant to Purchase 1,400,000 Shares of Common Stock.(8)
10.6 Form of Securities Purchase Agreement between the Company and Certain Stockholders
dated as of August 26, 1996.(8)
10.7 Form of Stockholders Agreement among the Company, GECC and certain other
stockholders of the Company dated as of August 26, 1996.(8)
</TABLE>
<PAGE> 89

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------ ------------------------------------------------------------------------------------
<C> <S>
10.8 Form of Registration Rights Agreement among the Company and GECC and certain other
stockholders of the Company dated as of August 26, 1996.(8)
10.9 Employment Agreement with Philip M. Hawley.(8)
10.10 1997 Stock Incentive Plan.(11)
10.11 Supplemental Securities Purchase Agreement among Krause's Furniture, Inc., General
Electric Corporation and Japan Omnibus Ltd., dated as of August 14, 1997.(12)
10.12 Letter agreement dated August 14, 1997 regarding Permal Group shares.(12)
10.13 Letter agreement dated August 14, 1997 regarding warrant dilution provisions.(12)
11 Statement regarding computation of per share earnings.
21 Subsidiaries.
*23.1 Consent of Morrison & Foerster LLP (included in its opinion filed as Exhibit 5).
23.2 Consent of Ernst & Young LLP, Independent Auditors.
</TABLE>