<PAGE> 1
PROSPECTUS
4,400,000 SHARES
(KRAUSE'S FURNITURE, INC. LOGO)
COMMON STOCK
------------------------
Of the 4,400,000 shares of common stock, par value $.001 per share (the
"Common Stock"), offered hereby, 2,303,889 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." As of the date of this Prospectus, the
Company's Common Stock will commence trading on the American Stock Exchange
under the symbol "KFI" and will cease trading on the Nasdaq SmallCap Market. On
March 30, 1998, the last reported sale price of the Common Stock, as quoted on
the Nasdaq SmallCap Market, was $3.19. See "Price Range of Common Stock."
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>
UNDERWRITING
PRICE TO DISCOUNTS AND PROCEEDS TO PROCEEDS TO
PUBLIC COMMISSIONS(1) COMPANY(2) SELLING STOCKHOLDER
<S> <C> <C> <C> <C>
======================================================================================================================
Per Share.................... $3.00 $0.24 $2.76 $2.76
- ----------------------------------------------------------------------------------------------------------------------
Total(3)..................... $13,200,000 $1,056,000 $6,358,734 $5,785,266
======================================================================================================================
</TABLE>
(1) The Company and the Selling Stockholder have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933, as amended (the "Securities Act"). See
"Underwriting."
(2) Before deducting expenses payable by the Company estimated at $623,400,
including $100,000 for specified out-of-pocket expenses and a
non-accountable expense allowance payable to the Representatives. See
"Underwriting."
(3) The Company has granted the Underwriters a 45-day option to purchase up to
660,000 additional shares of Common Stock on the same terms and conditions
as the securities offered hereby solely to cover over-allotments, if any. To
the extent that the option is exercised, the Underwriters will offer the
additional shares at the Price to Public shown above. If such option is
exercised in full, the total Price to Public, Underwriting Discounts and
Commissions and Proceeds to Company will be $15,180,000, $1,214,400 and
$8,180,334, respectively. See "Underwriting."
The shares of Common Stock are being offered severally by the Underwriters,
subject to prior sale, when, as, and if delivered to and accepted by the
Underwriters and subject to the right to reject any order in whole or in part
and certain other conditions. It is expected that delivery of the shares will be
made against payment therefor at the offices of Cruttenden Roth Incorporated,
Irvine, California, or the facilities of the Depository Trust Company, on or
about April 3, 1998.
CRUTTENDEN ROTH
INCORPORATED
BLACK & COMPANY, INC.
MORGAN FULLER CAPITAL GROUP, LLC
THE DATE OF THIS PROSPECTUS IS MARCH 31, 1998
<PAGE> 2
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK OF
THE COMPANY, INCLUDING ENTERING STABILIZING BIDS, EFFECTING SYNDICATE COVERING
TRANSACTIONS OR IMPOSING PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES,
SEE "UNDERWRITING."
2
<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, all information in
this Prospectus assumes no exercise of the Underwriters' over-allotment option
and 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 83
furniture showrooms under the Krause's (69 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 22 existing showrooms, 16 of which were remodeled during fiscal 1997,
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 plans to remodel approximately 20 additional
showrooms during the balance of fiscal 1998. The Company has also taken
significant steps to improve margins by increasing prices to competitive levels,
reducing promotional discounting
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<PAGE> 4
and improving manufacturing 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 fiscal year ended February 1, 1998 (a fifty-two week
period), same-store sales (for showrooms opened a year or more) increased 5.9%
compared to the similar number of weeks in the prior fiscal year (a fifty-three
week period), with remodeled store sales exceeding management's goal of 25%.
Improved 1997 results were achieved despite delays in raw materials from a
fabric supplier, which reduced fourth quarter sales by approximately $1.2
million. The Company anticipates that these delays will be rectified during
fiscal 1998. In addition, gross profit increased from 49.9% to 51.3% of net
sales in fiscal 1997 compared to fiscal 1996. The Company has opened three new
showrooms, one of which was opened during fiscal 1997, featuring its new
showroom design and has plans to open approximately 18 additional showrooms
during the balance of 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. According to the
American Furniture Manufacturers Association, the domestic residential furniture
industry was estimated to generate $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. 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 and price. 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. Since the 1996 investment, the Company
has 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 three
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 February 1, 1998, the
Company operated 81 showrooms, primarily in California and the New York
City metropolitan area, and in selected other
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<PAGE> 5
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 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. The Company has remodeled 22 showrooms,
16 of which were remodeled during fiscal 1997, and expects to remodel
approximately 20 more showrooms during the balance 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. The Company has opened three new showrooms, one of which was
opened during fiscal 1997, and expects to open approximately 18
additional showrooms during the balance of fiscal 1998.
- 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.
- 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
fiscal year 1997, the Company introduced twelve new sofa styles. 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
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<PAGE> 6
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
1997, accessories, custom-made chairs and recliners accounted for 5%, 8%,
and 7%, 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 1, 1998, the
Company's sales per square foot of selling space averaged $116. 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. As of the date of this Prospectus, the Company's Common Stock will
commence trading on the American Stock Exchange under the symbol "KFI" and will
cease trading on the Nasdaq SmallCap Market.
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<PAGE> 7
THE OFFERING
<TABLE>
<S> <C>
Common Stock Offered by the Company......................... 2,303,889 shares
Common Stock Offered by the Selling Stockholder............. 2,096,111 shares
Common Stock to be Outstanding After the Offering........... 21,324,428 shares(1)
Use of Proceeds............................................. To remodel showrooms, to open
new showrooms and for working
capital and other general
corporate purposes
American Stock Exchange Symbol.............................. KFI
</TABLE>
- ---------------
(1) Based upon the number of shares outstanding on February 1, 1998, excluding
5,147,740 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 and has a significant working capital
deficiency; the Company may violate covenants in its loan agreements, which
could restrict its ability to raise additional capital; the Company depends on a
small number of suppliers, and disruptions in delivery of supplies have
occasionally affected and could in the future adversely affect the Company; and
future performance of the Company is substantially dependent upon the success of
its remodeling and expansion program.
7
<PAGE> 8
SUMMARY CONSOLIDATED FINANCIAL DATA
The following data as of and for the year ended February 1, 1998 has been
derived from consolidated financial statements appearing elsewhere herein that
have been audited by Arthur Andersen LLP, independent public accountants. The
following data as of February 2, 1997 and January 28, 1996 and for each of the
two years in the period ended February 2, 1997 has been derived from
consolidated financial statements appearing elsewhere herein that have been
audited by Ernst & Young LLP, independent auditors. The information set forth
below is not necessarily indicative of the results of future operations and
should be read in conjunction with the consolidated financial statements and
notes thereto appearing elsewhere in this Prospectus.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
------------------------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28,
1998(2) 1997(2) 1996(2)
-------------- ----------- -----------
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS:
Net sales.............................. $115,201 $112,737 $122,319
Gross profit........................... 59,048 56,247 62,467
Loss from operations................... (5,594) (12,447) (9,388)
Net loss............................... (7,480) (13,389) (8,715)
Net loss per share(1).................. $ (0.39) $ (1.28) $ (2.21)
Number of shares used in computing loss
per share(1)........................ 19,021 10,445 3,950
</TABLE>
<TABLE>
<CAPTION>
FEBRUARY 1, 1998 FEBRUARY 2, JANUARY 28,
ACTUAL AS ADJUSTED(3) 1997 1996
------- -------------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets........................... $45,312 $47,235 $43,087 $46,866
Inventories............................ 16,013 16,013 14,013 14,627
Working capital deficiency............. (922) 1,001 (2,182) (6,878)
Intangible assets...................... 15,557 15,557 16,890 18,236
Short-term debt........................ 22 22 41 19
Long-term debt......................... 13,731 9,919 6,306 5,584
Stockholders' equity................... 9,892 15,627 15,543 13,985
</TABLE>
- ---------------
(1) Per share amounts reflect the adoption of SFAS 128 and represent basic and
diluted per share amounts. See Note 1 to the Consolidated Financial
Statements. Previously reported share and per share amounts have been
restated to reflect a one-for-three reverse stock split effected August 1,
1995.
(2) The fiscal year ended February 2, 1997 is a 53-week period while the fiscal
years ended February 1, 1998 and January 28, 1996 are 52-week periods.
(3) Adjusted to reflect the sale of 2,303,889 shares of Common Stock offered by
the Company in this offering based on an offering price of $3.00 per share
(after deducting the underwriting discounts and estimated offering expenses
payable by the Company) and the anticipated application of the estimated net
proceeds therefrom. See "Use of Proceeds" and "Capitalization."
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<PAGE> 9
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 had an accumulated deficit of $41.8 million at February 1, 1998. 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 February 1, 1998, the Company had a working capital deficiency of
approximately $.9 million and current liabilities at February 1, 1998 were $19.5
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 credit facility and internally generated cash are
insufficient. The Company expects its existing capital resources, borrowings
under its revolving credit facility, internally generated cash and proceeds from
this offering will enable it to fund its plan to remodel and upgrade
approximately 26 showrooms and open approximately 20 new showrooms during fiscal
1998 at a projected cost of approximately $7.3 million. However, if this is not
the case, the Company will need to obtain additional capital. 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.
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 February 1, 1998, the Company had $13.7 million of long-term debt and
had a negative tangible net worth (stockholders' equity less intangible assets)
of $5.7 million. For the fiscal year ended February 1, 1998, earnings before
interest, taxes, depreciation and amortization were negative $3.3 million. A
high percentage of
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<PAGE> 10
the Company's operating expenses are relatively fixed, including approximately
$1.3 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. Specifically, as of February 1, 1998, the
Company was out of compliance with four performance-related financial covenants:
a covenant in its agreement with Congress Financial Corporation ("Congress")
requiring Krause's Custom Crafted Furniture Corp. (a wholly owned subsidiary of
the Company) to maintain its EBITDA (earnings before interest, taxes,
depreciation and amortization) above certain levels, and financial covenants in
the Company's agreement with GECC requiring it to maintain its debt-to-equity
ratio at a level no higher than 192% and its fixed charge ratio at a level no
less than .80, and not to exceed capital expenditures of $3,500,000 during
fiscal 1997. The Company has obtained from each lender a permanent waiver of any
default relating to non-compliance with those covenants during the fiscal year
ended February 1, 1998. In addition, because of a likelihood that the Company
may not comply with the Congress covenant regarding EBITDA and the GECC covenant
regarding debt-to-equity ratio during certain periods of fiscal 1998, the
Company obtained Congress's agreement to suspend compliance with the relevant
covenant during fiscal 1998 (which ends on January 31, 1999) and GECC's
agreement to modify the relevant covenant for fiscal 1998. However, the Company
will have to seek new amendments or waivers for subsequent periods if its
financial performance does not reach the levels originally specified in the
agreements. There can be no assurance that if the Company's future financial
performance again fails to keep it in compliance with the covenants and
restrictions in its credit agreements the Company could obtain additional
waivers or amendments. 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
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<PAGE> 11
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.
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. The Company has agreed
to extend this agreement to January 31, 2001. See "Management -- Employment
Agreements."
POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS
Because the Company sells most of its products on a made-to-order basis
with a three-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. For example, because
one of the Company's fabric suppliers could not supply all of the Company's
needs on a timely basis, customer orders representing approximately $1,200,000
in sales were not completed as expected in the fourth quarter of 1997. 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, 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 market. For
example, results for the first quarter of fiscal 1998 may be modestly affected
by inclement weather in the California market. 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.
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 accounted for approximately 55.9% of its aggregate purchases
in the fiscal year ended February 1, 1998. During the fiscal year ended February
1, 1998, approximately 11.5% of certain products and raw materials purchases
consisted of leather purchased from a supplier, constituting approximately 85.8%
of the leather purchases made by the Company during this period, and
approximately 9.5% of these purchases consisted of pre-cut wood components
purchased from a supplier, constituting nearly all of the pre-cut wood component
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. One of the
Company's fabric suppliers has been unable to supply all of the Company's needs
on a timely basis due to unanticipated customer demand for some of its patterns.
As a result, customer orders representing approximately $1,200,000 in sales were
not completed as expected in the fourth quarter of fiscal year 1997. The Company
is likely to recoup most of these sales in the subsequent period but some sales
may be lost due to customer cancellations. Similarly, if the Company could not
develop alternative sources of supply of leather, pre-
11
<PAGE> 12
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."
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 50% and 18%, respectively, of the Company's sales in
the fiscal year ended February 1, 1998 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 January 1998, the consumer confidence index, as reported by the Conference
Board, for the Middle Atlantic Region, which includes New York, was 102.1, the
index for the Pacific Region, which includes California, was 132.7, and the
average index for the United States as a whole, was 128.3.
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
12
<PAGE> 13
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.
CONTROL BY PRINCIPAL STOCKHOLDERS
The current management, directors and other principal stockholders of the
Company own in the aggregate approximately 70.5% 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 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 1, 1998, the Company had approximately $37 million of
federal net operating loss carryforwards 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
February 1, 1998 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 is listed on the American Stock Exchange and
previously has been reported and traded on the Nasdaq SmallCap Market.
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 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
As of the date of this Prospectus, the Company's Common Stock will commence
trading on the American Stock Exchange under the symbol "KFI" and will cease
trading on the Nasdaq SmallCap Market. The American Stock Exchange may at its
discretion suspend or delist the securities of a company without
13
<PAGE> 14
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 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 21,324,428
shares of Common Stock outstanding. Of these shares, 8,436,154 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
9,625,329 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 5,147,740 shares of Common Stock. In connection with
prior financings and subject to future contingencies, warrants to purchase an
additional 1,000,000 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
14
<PAGE> 15
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, 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> 16
USE OF PROCEEDS
The net proceeds from the sale of the 2,303,889 shares of Common Stock
offered by the Company hereby at an offering price of $3.00 per share are
estimated to be $5,735,334 after deducting the Underwriters' fees and the
estimated offering expenses ($7,537,134 million if the Underwriters'
over-allotment option is exercised in full). 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 26 existing showrooms and to open
approximately 20 new showrooms, which will be leased, are $7.3 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
Through March 30, 1998, the Company's Common Stock traded on the Nasdaq
SmallCap 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 quarter of
fiscal 1998 and for each quarter during the 1997 (52 weeks ended February 1,
1998) and 1996 (53 weeks ended February 2, 1997) fiscal years. Quotations are as
reported by Nasdaq.
<TABLE>
<CAPTION>
1998 1997 1996
-------------- -------------- --------------
QUARTER HIGH LOW HIGH LOW HIGH LOW
------- ----- ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C>
First(1)................... $3.81 $2.44 $2.06 $1.25 $2.56 $ .88
Second..................... -- -- 1.81 1.48 1.63 .69
Third...................... -- -- 4.19 1.50 2.19 .50
Fourth..................... -- -- 3.25 2.13 2.13 1.00
</TABLE>
- ---------------
(1) Information for the first quarter of fiscal 1998 is for the period through
March 30, 1998.
As of March 2, 1998, there were approximately 355 holders of record of the
Company's Common Stock.
As of the date of this Prospectus, the Company's Common Stock will commence
trading on the American Stock Exchange under the symbol "KFI" and will cease
trading on the Nasdaq SmallCap Market.
16
<PAGE> 17
DILUTION
As of February 1, 1998, the net tangible book value per share of the
Company's Common Stock was negative $.30. 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 2,303,889 shares of Common Stock
offered hereby at an offering price of $3.00 per share and after deduction of
the Underwriters' 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 February 1, 1998 would have been $0. This would result in
dilution to the new investors of $3.00 per share, which is equal to the offering
price. The following table illustrates the per share dilution:
<TABLE>
<S> <C> <C>
Public offering price per share(1).......................... $3.00
Net tangible book deficit per share as of February 1,
1998...................................................... $(.30)
Decrease in net tangible deficit per share attributable to
the sale by the Company of the shares offered hereby...... .30
Pro forma net tangible book value per share after the
offering(2)............................................... 0.00
-----
Dilution of net tangible book value per share to new
investors................................................. $3.00
=====
</TABLE>
- ---------------
(1) Before deducting the Underwriters' 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 February 1, 1998. Outstanding options, all of which were
issued under option plans prior to February 1, 1998, cover the purchase of
an aggregate of 2,043,958 shares at a weighted average exercise price of
$1.29. 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 3,065,502 shares at an average
exercise price of $1.10. 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 per share of the Common Stock as of February 1, 1998 after the
offering would have been $.19. This would result in dilution to the new
investors of $2.81 per share.
17
<PAGE> 18
CAPITALIZATION
The following table sets forth the capitalization of the Company as of
February 1, 1998, and as adjusted to give effect to the sale of 2,303,889 shares
of Common Stock offered by the Company at an offering price of $3.00 per share
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>
FEBRUARY 1, 1998
-----------------------
ACTUAL AS ADJUSTED
-------- -----------
(IN THOUSANDS)
<S> <C> <C>
Current portion of notes payable............................ $ 22 $ 22
Long-term notes payable:
Secured revolving credit notes............................ 3,812 --
Subordinated notes payable to stockholders, net of $2,435
of unamortized debt discount........................... 9,566 9,566
Other notes, excluding current portion.................... 353 353
-------- --------
Total long-term notes payable.......................... 13,731 9,919
-------- --------
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 (21,324,428
shares outstanding as adjusted)(1)..................... 19 21
Capital in excess of par value............................ 51,703 57,436
Accumulated deficit....................................... (41,830) (41,830)
-------- --------
Total stockholders' equity............................. 9,892 15,627
-------- --------
Total capitalization................................... $ 23,645 $ 25,568
======== ========
</TABLE>
- ---------------
(1) Excludes 2,043,958 shares issuable upon exercise of options, 3,065,502
shares issuable upon exercise of warrants and 38,280 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.
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<PAGE> 19
SELECTED CONSOLIDATED FINANCIAL DATA
The following data as of and for the year ended February 1, 1998 has been
derived from consolidated financial statements appearing elsewhere herein that
have been audited by Arthur Andersen LLP, independent public accountants. The
following data as of February 2, 1997 and for each of the two years in the
period ended February 2, 1997 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 January 28, 1996, January
29, 1995 and December 31, 1993 and for the years ended December 31, 1994 and
1993 and for the month ended January 29, 1995 has been derived from audited
consolidated financial statements not included herein. The following data 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>
FISCAL YEAR ENDED MONTH ENDED
--------------------------------------------------------------------- -------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28, DECEMBER 31, DECEMBER 31, JANUARY 29, JANUARY 30,
1998(4) 1997(4) 1996(4) 1994 1993 1995(4)(5) 1994(5)
----------- ----------- ----------- ------------ ------------ ----------- -----------
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS:
Net sales................. $115,201 $112,737 $122,319 $116,471 $96,894 $ 7,179 $ 7,326
Gross profit.............. 59,048 56,247 62,467 62,949 50,792 3,532 3,807
Loss from operations...... (5,594) (12,447) (9,388) (2,398) (7,852) (3,231) (2,041)
Gain from sale of Mr.
Coffee stock(2)......... -- -- -- 12,115 -- -- --
Income (loss) before
extraordinary items..... (7,480) (13,389) (8,715) 5,831 (9,751) (3,221) (2,185)
Extraordinary items(3).... -- -- -- (436) (221) -- --
Net income (loss)......... (7,480) (13,389) (8,715) 5,395 (9,972) (3,221) (2,185)
Income (loss) per
share(1):
Income (loss) before
extraordinary items... (0.39) (1.28) (2.21) 1.08 (3.88) (.87) (.63)
Extraordinary items..... -- -- -- (0.08) (0.09) -- --
Net income (loss)....... $ (0.39) $ (1.28) $ (2.21) $ 1.00 $ (3.97) $ (0.87) $ (.63)
Number of shares used in
computing income (loss)
per share(1)............ 19,021 10,445 3,950 5,394 2,510 3,685 3,490
</TABLE>
<TABLE>
<CAPTION>
FEBRUARY 1, FEBRUARY 2, JANUARY 28, JANUARY 29, DECEMBER 31,
1998 1997 1996 1995 1993
----------- ----------- ----------- ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets.............. $ 45,312 $ 43,087 $ 46,866 $ 53,750 $64,749
Inventories............... 16,013 14,013 14,627 18,016 14,690
Working capital
deficiency.............. (922) (2,182) (6,878) (3,751) (1,404)
Intangible assets......... 15,557 16,890 18,236 19,910 22,826
Short-term debt(2)........ 22 41 19 17 1,147
Long-term debt(2)......... 13,731 6,306 5,584 2,181 17,700
Stockholders' equity...... 9,892 15,543 13,985 22,700 20,626
</TABLE>
- ---------------
(1) Per share amounts reflect the adoption of SFAS 128 and represents diluted
per share amounts. See Note 1 to the Consolidated Financial Statements.
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 while the fiscal
years ended February 1, 1998 and January 28, 1996 are 52-week periods.
(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.
19
<PAGE> 20
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 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 $41,830,000 and a working capital deficiency of
$922,000 at February 1, 1998.
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. These
plans have been 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> 21
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>
FISCAL YEAR ENDED
-----------------------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28,
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Net sales................................. 100.0% 100.0% 100.0%
Cost of sales............................. 48.7 50.1 48.9
----- ----- -----
Gross profit.............................. 51.3 49.9 51.1
Operating expenses:
Selling................................. 47.3 51.1 49.3
General and administrative.............. 7.9 9.0 8.7
Amortization of goodwill................ 0.9 0.9 0.8
----- ----- -----
56.1 61.0 58.8
----- ----- -----
Loss from operations...................... (4.8) (11.1) (7.7)
Interest expense.......................... (1.5) (1.1) (0.6)
Other income (expense).................... (0.1) 0.3 0.1
----- ----- -----
Loss before income taxes.................. (6.4) (11.9) (8.2)
Income tax benefit........................ -- -- (1.1)
----- ----- -----
Net loss.................................. (6.4)% (11.9)% (7.1)%
===== ===== =====
</TABLE>
STORE (SHOWROOM) DATA
<TABLE>
<CAPTION>
FISCAL YEAR ENDED(3)
-----------------------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28,
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Stores open at beginning of period........ 82 83 89
Stores opened during period............... 1 1 4
Stores closed during period............... 2 2 10
------ ------ ------
Stores open at end of period.............. 81 82 83
Average sales per showroom (in
thousands)(1)........................... $1,422 $1,361 $1,432
Comparable store sales increase
(decrease)(2)........................... 2.7% (6.0)% (2.9)%
</TABLE>
- ---------------
(1) Based upon the weighted average number of stores open during the period
indicated.
(2) Comparable store sales are calculated by excluding the net sales of any
store for any month of the period if the store was not open during the same
month of the prior period. Also, a store opened at any time during the month
is deemed to have been open for the entire month.
(3) Fiscal 1997 and 1995 were 52 week years while fiscal 1996 was a 53 week
year.
52 WEEKS ENDED FEBRUARY 1, 1998 (FISCAL 1997) AS COMPARED TO 53 WEEKS ENDED
FEBRUARY 2, 1997 (FISCAL 1996)
Net Sales. Net sales for fiscal 1997, a 52 week fiscal period, were
$115,201,000 compared with $112,737,000 for fiscal 1996, a 53 week fiscal
period. Sales for the 53rd week of fiscal 1996 totaled $3,417,000; on a
comparable 52 week basis, sales increased $5,881,000 or 5.4% with same store
sales increasing 5.9%. The increase in sales is due principally to management's
strategy of remodeling existing showrooms to provide a more appealing setting
for customers (16 showrooms were remodeled in fiscal 1997), to management's
strategies of developing new products, increasing the promotion and sale of
accessories and revamping the marketing and sales promotion program and to
improved economies in selected regions where the Company operates.
21
<PAGE> 22
Gross Profit. Gross profit was 51.3% of net sales in fiscal 1997 compared
with 49.9% of net sales in fiscal 1996. The increase in gross profit resulted
primarily from the Company's decision in the third quarter of fiscal 1996 to
raise prices to competitive levels and reduce promotional discounting.
Selling Expenses. Selling expenses were $54,481,000 or 47.3% of net sales
in fiscal 1997 and were $57,573,000 or 51.1% of net sales in fiscal 1996. The
decrease of $3,092,000 in selling expenses was primarily due to a decrease of
$1,737,000 in variable selling payroll, resulting from a new commission
structure, and decreases of $1,044,000 and $554,000 in store non-payroll
expenses and delivery expenses, respectively, resulting primarily from tighter
cost controls, offset in part by increased advertising costs of $574,000.
General and Administrative Expenses. General and administrative expenses
for fiscal 1997 were $9,141,000 compared to $10,101,000, for fiscal 1996, a
decrease of $960,000. This decrease was primarily the result of lower costs
generally and specifically lower professional fees, contract labor costs and
computer rental and maintenance costs which were offset in part by higher
management payroll costs.
Interest Expense. Interest expense for fiscal 1997 increased by $493,000
over fiscal 1996 due to higher average debt outstanding.
Income Taxes. The Company paid no taxes and no tax benefit was recorded for
either of fiscal 1997 or 1996 due to uncertainties regarding the realization of
deferred tax assets available.
As of February 1, 1998, the Company had Federal net operating loss
carryforwards of approximately $37 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 1, 1998, approximately $4 million of
the limited losses were available. In addition, the Company had state net
operating loss carryforwards of approximately $30 million which begin to expire
in the year 1998, if not utilized.
The valuation allowance for deferred tax assets totaled $16,304,000 at
February 1, 1998 and $13,643,000 at February 2, 1997. The valuation allowance
increased since the realization of net deferred tax assets is uncertain.
Net Loss. As a result of the above factors, the net loss was $7,480,000 for
fiscal 1997 as compared to a net loss of $13,389,000 for fiscal 1996. Net loss
per share in the 1997 period was $0.39 based on 19,021,000 shares outstanding.
In fiscal 1996 the net loss per share was $1.28 based on 10,445,000 weighted
average shares outstanding.
53 WEEKS ENDED FEBRUARY 2, 1997 (FISCAL 1996) AS COMPARED TO 52 WEEKS ENDED
JANUARY 28, 1996 (FISCAL 1995)
Net Sales. Net 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
22
<PAGE> 23
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. After 1996 the Company amortized
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.
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. 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 the caption "Liquidity and Capital Resources."
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 fiscal 1998, management plans to remodel and upgrade approximately 26
existing showrooms, as well as add approximately 20 additional showrooms, at an
aggregate cost of approximately $7.3 million. Management expects to fund such
capital expenditures by internally generated cash, by borrowings under the
Company's revolving credit facility, and by the proceeds to the Company of the
sales of its shares in this offering.
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%
subordinated promissory note in the principal amount of $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."
On August 14, 1997, the Company completed transactions with two investors
in which it issued $3 million 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 million shares of
23
<PAGE> 24
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 $3.5 million which the
Company drew down on December 30, 1997. At the time the standby credit facility
was drawn down, the Company issued to the investors warrants to purchase an
aggregate of up to 560,000 additional shares of common stock at $1.25 per share.
Also in August 1997, the Company renegotiated the terms of its existing
revolving line of credit with Congress Financial Corporation 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. As of February 1, 1998, the Company had unused borrowing capacity under
its credit facility of approximately $4 million.
Under the terms of the agreement related to the Company's subordinated
notes, as well as under the terms of the revolving credit agreement, 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. As of February 1, 1998, the Company was out of compliance with
certain of the financial covenants contained in both of the agreements but has
obtained waivers. The Company may also be in violation of certain of these
covenants as of interim periods during 1998, but has obtained agreements to
waive or amend covenants related to these potential default events. Management
believes it will be in compliance with other covenants, but in the event of
noncompliance, the Company also believes it can obtain waivers. However, there
can be no assurance that additional waivers will be obtained if the Company
fails to maintain compliance.
The Company believes that the net proceeds from this offering, combined
with borrowings under its credit facility 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. 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 1, 1998 are approximately as follows:
$22,000 in 1998, $60,000 in 1999, $7,879,000 in 2000, $4,227,000 in 2001, and
$4,000,000 in 2002. Management anticipates such payments will be made out of
operating cash flow or refinancing.
As of February 1, 1998, the Company had cash and cash equivalents of
$916,000 and borrowing capacity under its revolving credit agreement of
$4,000,000. Cash flow activity for the fiscal years ended February 1, 1998,
February 2, 1997 and January 28, 1996 is presented in the Consolidated
Statements of Cash Flows.
1997 Cash Flow. During fiscal 1997, cash and cash equivalents decreased by
$311,000. Operating activities used net cash of $4,998,000, principally from a
cash loss from operations of $3,806,000 and an increase in inventory of
$2,000,000 which was partially offset by an increase in Accounts Payable and
Other Liabilities of $753,000. The increase in inventory is principally due to
the Company's decision to expand its accessories business. Investing activities
during the period included capital expenditures of $3,521,000, nearly all of
which was used to remodel certain retail showrooms and open one new showroom.
Financing activities during the period consisted principally of net borrowings
of $1,813,000 under the Company's revolving credit facility and $6,500,000
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 $7,300,000 related
to this program 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
24
<PAGE> 25
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 public accountants to audit the Company's
consolidated financial statements. The reports of Ernst & Young LLP on the
Company's consolidated financial statements for the 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 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
Effective in fiscal 1998, the Company will be required to adopt 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.
25
<PAGE> 26
QUARTERLY OPERATING RESULTS
The following tables set forth certain unaudited consolidated financial
information for each of the four quarters in fiscal 1996 and 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
--------------------------------------------------------------------------------------------------
FEBRUARY 1, NOVEMBER 2, AUGUST 3, MAY 4, FEBRUARY 2, OCTOBER 27, JULY 28, APRIL 28,
1998 1997 1997 1997 1997(1) 1996 1996 1996
----------- ----------- --------- ------- ----------- ----------- -------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net sales............... $29,632 $30,159 $27,768 $27,642 $29,999 $26,865 $26,236 $29,637
Cost of sales........... 14,313 14,560 14,005 13,275 14,126 12,781 13,860 15,723
------- ------- ------- ------- ------- ------- ------- -------
Gross profit............ 15,319 15,599 13,763 14,367 15,873 14,084 12,376 13,914
Operating costs and
expenses:
Selling............... 13,923 13,698 13,832 13,028 14,017 14,081 15,006 14,469
General and
administrative...... 2,361 2,191 2,293 2,296 2,249 2,084 3,072 2,696
Amortization of
goodwill............ 255 255 255 255 255 255 255 255
------- ------- ------- ------- ------- ------- ------- -------
16,539 16,144 16,380 15,579 16,521 16,420 18,333 17,420
------- ------- ------- ------- ------- ------- ------- -------
Loss from operations.... (1,220) (545) (2,617) (1,212) (648) (2,336) (5,957) (3,506)
Interest expense........ (546) (467) (370) (340) (448) (296) (304) (182)
Other income
(expense)............. (105) (35) (8) (15) 81 111 45 51
------- ------- ------- ------- ------- ------- ------- -------
Net loss................ $(1,871) $(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.
26
<PAGE> 27
BUSINESS
THE COMPANY
The Company is a leading vertically integrated manufacturer and retailer of
made-to-order upholstered furniture and accessories. The Company operates 83
furniture showrooms under the Krause's (69 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 22 existing showrooms, 16 of which were remodeled during
fiscal 1997, 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 plans to remodel
approximately 20 additional showrooms during the balance of 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 fiscal year ended February 1, 1998 (a fifty-two week period),
same-store sales (for showrooms opened a year or more) increased 5.9% compared
to the similar number of weeks in the prior fiscal year (a fifty-three week
period), with remodeled store sales exceeding management's goal of 25%. In
addition, gross profit increased from 49.9% to 51.3% of net sales in fiscal 1997
compared to fiscal 1996. Since the management change, the Company has also
opened three new showrooms, one of which was opened during fiscal 1997,
featuring its new store design and has plans to open approximately 18 additional
showrooms during the balance of 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. According to the
American Furniture Manufacturers Association, the domestic residential furniture
industry was estimated to generate $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. Upholstered
27
<PAGE> 28
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 ratio are positioned to increase market share.
- 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. Since the 1996 investment, the Company
has 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 February 1, 1998, 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
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
by pursuing 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
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65 showrooms which will incorporate the new layout, design and visual
presentation themes. The Company has remodeled 22 showrooms, 16 of which
were remodeled during fiscal 1997, and expects to remodel approximately
20 more showrooms during the balance 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 three new showrooms, one of
which was opened during fiscal 1997, and expects to open approximately 18
additional showrooms during the balance of fiscal 1998.
- 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.
- 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
fiscal year 1997, the Company introduced twelve new sofa styles. 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 1997, accessories, custom-made chairs and
recliners accounted for 5%, 8%, and 7%, 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 1, 1998, the
Company's sales per square foot of selling space averaged $116. 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.
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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 22 showrooms, 16
of which were remodeled during fiscal 1997, and has plans to remodel
approximately 20 additional showrooms during the balance 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 three new
showrooms, one of which was opened during fiscal 1997, since it began its
expansion program and intends to open approximately 18 additional showrooms
during the balance of 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 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
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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 9% 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 12 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 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
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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 550 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 February 1, 1998 was approximately $10.7 million compared to
$10.2 million at February 2, 1997.
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 55.9% of its purchased raw materials during the
fiscal year ended February 1, 1998, including one such supplier that provided
approximately 11.5% and another that provided 9.5% 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. For example, one of the Company's
fabric suppliers has been unable to supply all of the Company's needs on a
timely basis due to unanticipated customer demand for some of its patterns. As a
result, customer orders representing approximately $1,200,000 in sales were not
completed as expected in the fourth quarter of fiscal year 1997. The Company is
likely to recoup most of these sales in the subsequent period but some sales may
be lost due to customer cancellations.
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.
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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 the greater New York area.
At February 1, 1998, the total work force numbers approximately 1,006, with
approximately 384 working in manufacturing, 535 in retail and warehousing
operations, and 87 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.
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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 stockholder 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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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 stockholder 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. Dailey 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 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, or his nominee if he is
unavailable, is elected to serve as a director. See "Certain Transactions."
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
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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 1997, and will continue to be
so reimbursed. The four non-employee directors other than Jeffrey H. Coats were
each paid a fee of $10,000 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 1997. 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 1998. Also, additional deferred
stock units valued at $10,000 will be granted to each non-employee director
(other than Mr. Coats) in office on December 31, 1998 and on December 31 of each
year thereafter during the term of the 1997 Stock Incentive Plan.
SUMMARY COMPENSATION TABLE
The following table sets forth all compensation paid by the Company during
fiscal 1997, 1996, and 1995 to (i) each of the individuals serving as the
Company's Chief Executive Officer during fiscal 1997 and (ii) the four other
most highly compensated executive officers of the Company during fiscal 1997
(collectively referred to as the "Named Executive Officers").
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
ANNUAL ---------------
COMPENSATION SECURITIES ALL OTHER
------------------------------- UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS/SARS(#) ($)
--------------------------- ---- --------- ---------- --------------- ------------
<S> <C> <C> <C> <C> <C>
Philip M. Hawley.................. 1997 233,842 --
Chairman of the Board and Chief 1996 101,959 1,234,000
Executive Officer
Robert A. Burton.................. 1997 155,160 50,000
Senior Vice President and 1996 28,978 50,000 50,000(1)
Chief Financial Officer
Herbert J. Friedman............... 1997 156,959 50,000 39,119(2)
Senior Vice President of 1996 152,301 50,000
Merchandising, Product 1995 136,770 1,200 1,000
Development, Marketing and
Stores
K. James McTaggart................ 1997 135,633 40,000
Senior Vice President of 1996 121,953 45,000
Manufacturing
and Distribution
Klaus Tabar....................... 1997 155,159 17,030 50,000
Senior Vice President of 1996 141,645 34,030 50,000
Real Estate and Construction 1995 117,899 13,505 1,000
</TABLE>
- ---------------
(1) Represents reimbursement for out-of-pocket relocation costs.
(2) Represents payment for prior years accrued but unused vacation.
36
<PAGE> 37
OPTION/SAR GRANTS IN LAST FISCAL YEAR
The following table sets forth information regarding stock options and
deferred stock units granted during fiscal 1997 to the Named Executive Officers.
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
% OF TOTAL VALUE AT ASSUMED
NUMBER OF OPTIONS/SARS ANNUAL 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.......... -- -- -- -- -- --
Robert A. Burton.......... 50,000 11.6% 1.56 08/14/07 127,140 202,020
Herbert J. Friedman....... 50,000 11.6% 1.56 08/14/07 127,140 202,020
K. James McTaggart........ 40,000 9.3% 1.56 08/14/07 101,712 161,616
Klaus Tabar............... 50,000 11.6% 1.56 08/14/07 127,140 202,020
</TABLE>
- ---------------
(1) The Company granted options for a total of 13,664 deferred stock units to
directors and 417,000 shares of Common Stock to employees of the Company
during 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 1, 1998, the end of the Company's 1997 fiscal year. No
Named Executive Officers exercised any options during fiscal 1997.
<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............................. 617,000 617,000 925,500 925,500
Robert A. Burton............................. 12,500 87,500 11,000 80,000
Herbert J. Friedman.......................... 23,760 87,500 11,000 80,000
K. James McTaggart........................... 13,333 71,667 13,600 66,400
Klaus Tabar.................................. 29,700 87,500 11,000 80,000
</TABLE>
- ---------------
(1) Based on the closing price of the Common Stock as quoted on the Nasdaq
SmallCap Market of $2.50 on January 30, 1998.
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 provided that such employees would earn eight
percent of their respective base salaries if the Company's earnings before
interest, taxes, depreciation and amortization reached $1,100,000 during the
last six months of fiscal year 1997 and additional amounts if the target was
exceeded. The target was not achieved. The plan also provided that certain
management employees may receive up to seven percent of their base salaries
based on their personal achievements. No decision has been made as to these
discretionary bonuses. The Management Plan is administered by the Compensation
Committee.
37
<PAGE> 38
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 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 5,000 shares of
Common Stock, at an exercise price equal to the fair market value for such
shares as of the
38
<PAGE> 39
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.
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 Directors Plan.
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 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
39
<PAGE> 40
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. The Company and Mr. Hawley have
agreed to extend this agreement to January 31, 2001. 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.
The Company has entered into agreements with Messrs. Burton, Friedman,
McTaggart 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.
40
<PAGE> 41
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 Stockholders Agreement with investors. See
"Description of Capital Stock -- Stockholders Agreement." Pursuant to the
Stockholders Agreement, Mr. Hawley was appointed Chief Executive Officer
and named Chairman of the Board. Also pursuant to the Stockholders
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.
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
41
<PAGE> 42
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 could 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.
The Company borrowed funds pursuant to the Standby Notes on December 30,
1997 and issued 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.
- The Company amended the Registration Rights Agreement and the
Stockholders Agreement. See "Description of Capital Stock -- Registration
Rights Agreement" and "Description of Capital Stock -- Stockholders
Agreement."
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.
42
<PAGE> 43
Succession Agreement. 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, or his
nominee if he is unavailable, is elected to serve as a director. Furthermore,
GECC and each of the members of the Hawley Group agreed to cooperate in
connection with the acquisition by either of them of Common Stock held by the
Permal Group. The agreement will continue as long as the Hawley Group owns an
aggregate of at least 1,000,000 shares of Common Stock.
43
<PAGE> 44
PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth certain information with respect to
beneficial ownership of the Company's Common Stock as of March 2, 1998 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 OWNED SHARES BENEFICIALLY
PRIOR TO OFFERING(1) NUMBER OF OWNED AFTER OFFERING
-------------------------- SHARES ----------------------
NAME AND ADDRESS OF BENEFICIAL OWNER NUMBER PERCENT BEING OFFERED NUMBER PERCENT
- ------------------------------------ ----------- --------- ------------- --------- -------
<S> <C> <C> <C> <C> <C>
GECC................................ 7,400,000(2) 34.5% -- 7,400,000 31.2%
260 Long Ridge Road
Stamford, CT 06927
Worms & Cie......................... 5,278,818(3)(5) 27.1 -- 3,182,707(5) 14.6
55 rue la Boetie
75008 Paris, France
Japan Omnibus Ltd................... 2,396,111(4) 12.4 2,096,111(5) 300,000 1.4
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 6.5
515 South Figueroa Street
Los Angeles, CA 90071
ATCO Holdings Limited............... 1,115,923 5.9 -- 1,115,923 5.2
c/o ATCO Development, Inc.
11777 Katy Freeway
Houston, TX 77079
Philip M. Hawley.................... 647,000(7) 3.3 -- 647,000 2.9
Thomas M. DeLitto................... 109,327(8) * -- 109,327 *
Robert A. Burton.................... 12,500(9) * -- 12,500 *
Herbert J. Friedman................. 29,981(10) * -- 29,981 *
K. James McTaggart.................. 14,333(11) * -- 14,333 *
Klaus Tabar......................... 34,837(12) * -- 34,837 *
Kamal G. Abdelnour.................. 47,520(13) * -- 47,520 *
Jeffrey H. Coats.................... -- -- -- -- --
Peter H. Dailey..................... 14,570(14) * -- 14,570 *
John A. Gavin....................... 14,570(14) * -- 14,570 *
All directors and executive officers
as a group (10 persons)........... 924,638 4.7 -- 924,638 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 2,400,000 shares of Common Stock.
(3) Worms & Cie, through JOL, PCMI and certain other affiliates, may be deemed
to be the beneficial owner of 4,851,421 shares of Common Stock and warrants
to purchase 427,397 shares of Common Stock, which amounts include 1,288,040
shares and 29,442 warrants held by two former directors of the Company, and
exclude 109,327 shares, options and warrants held by Mr. DeLitto and shown
separately below. The 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 warrants to purchase 300,000 shares of Common Stock.
44
<PAGE> 45
(5) JOL is the sole Selling Stockholder. Worms & Cie's principal business is
investing. While Worms & Cie does not directly own any shares of Common
Stock, James Hodge, who is senior vice president of Worms & Co., Inc., an
affiliate of Worms & Cie, makes investment decisions for JOL in his
capacity as its Portfolio Manager and, accordingly, Worms & Cie may be
deemed to share voting and dispositive power with respect to, and therefore
to beneficially own, the shares of Common Stock beneficially owned by JOL.
Therefore, the number of shares beneficially owned after this offering by
Worms & Cie reflects a reduction by the number of shares sold by JOL, even
though Worms & Cie is not the seller thereof.
(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 option to purchase 617,000 shares of Common Stock.
(8) Includes options to purchase 9,998 shares of Common Stock, 9,570 deferred
stock units and a warrant to purchase 14,721 shares of Common Stock.
(9) Represents options to purchase 12,500 shares of Common Stock.
(10) Includes options to purchase 23,760 shares of Common Stock.
(11) Includes options to purchase 13,333 shares of Common Stock.
(12) Includes options to purchase 29,700 shares of Common Stock.
(13) Includes option to purchase 5,000 shares of Common Stock, 9,570 deferred
stock units and a warrant to purchase 32,950 shares of Common Stock.
(14) Consists of options to purchase 5,000 shares of Common Stock and 9,570
deferred stock units.
45
<PAGE> 46
UNDERWRITING
Subject to the terms and conditions of the Underwriting Agreement, each of
the underwriters named below (the "Underwriters"), for whom Cruttenden Roth
Incorporated, Black & Company, Inc. and Morgan Fuller Capital Group, LLC are
acting as representatives (the "Representatives"), has severally agreed to
purchase from the Company and the Selling Stockholder, and the Company and the
Selling Stockholder have agreed to sell to each Underwriter, the aggregate
number of shares of Common Stock set forth opposite the name of each such
Underwriter below:
<TABLE>
<CAPTION>
NUMBER
UNDERWRITERS OF SHARES
------------ ---------
<S> <C>
Cruttenden Roth Incorporated................................ 1,155,000
Black & Company, Inc........................................ 1,155,000
Morgan Fuller Capital Group, LLC............................ 1,155,000
Josephthal & Co. Inc........................................ 205,000
Ladenburg Thalmann & Co. Inc................................ 205,000
Branch, Cabell & Company.................................... 105,000
Ferris, Baker Watts, Inc.................................... 105,000
Genesis Merchant Group Securities........................... 105,000
Scott & Stringfellow, Inc................................... 105,000
Trautman, Kramer & Company, Inc............................. 105,000
---------
Total............................................. 4,400,000
=========
</TABLE>
The Underwriting Agreement provides that the obligations of the several
Underwriters are subject to certain conditions precedent, including conditions
that no stop order suspending the effectiveness of the Registration Statement is
in effect and no proceedings for such purpose are pending before or threatened
by the Commission, and that there has been no material adverse change in the
condition of the Company. The nature of the Underwriters' obligation is such
that they are committed to purchase and pay for all of the shares of Common
Stock if any are purchased.
The Company and the Selling Stockholder have been advised by the
Representatives that the Underwriters propose to offer shares of Common Stock
directly to the public initially at the public offering price set forth on the
cover page of this Prospectus and to certain selected dealers at such price less
a concession not in excess of $0.14 per share. The Underwriters may allow, and
such selected dealers may reallow, a discount not in excess of $0.10 per share
to certain other dealers. After commencement of the public offering, the
offering price and other selling terms may be changed by the Representatives. No
change in such terms shall change the amount of proceeds to be received by the
Company as set forth on the cover page of this Prospectus.
The Company has granted an option to the Underwriters, exercisable for a
period of 45 days after the date of this Prospectus, to purchase up to an
aggregate of 660,000 additional shares of Common Stock at the public offering
price set forth on the cover page of this Prospectus, less the underwriting
discounts and commissions. The Underwriters may exercise such option only to
cover over-allotments made in connection with the sale of Common Stock offered
hereby. To the extent that the Underwriters exercise such option, each of the
Underwriters will be committed, subject to certain conditions, to purchase a
number of the additional shares of Common Stock proportionate to such
Underwriters initial commitment as indicated in the preceding table. The Company
will be obligated, pursuant to such option, to sell such shares to the
Underwriters to the extent such option is exercised.
Until the distribution of the Common Stock is completed, rules of the
Securities and Exchange Commission may limit the ability of the Underwriters and
certain selling group members to bid for and purchase shares of Common Stock. As
an exception to these rules, the Representatives are permitted to
46
<PAGE> 47
engage in certain transactions that stabilize the price of the Common Stock.
Such transactions may consist of bids or purchases for the purpose of pegging,
fixing or maintaining the price of the Common Stock.
If the Underwriters create a short position in the Common Stock in
connection with the Offering (i.e., if they sell more shares of Common Stock
than are set forth on the cover page of this Prospectus), the Representatives
may reduce that short position by purchasing Common Stock in the open market.
The Representatives also may elect to reduce any short position by exercising
all or part of the over-allotment options described herein. The Representatives
also may impose a penalty bid on certain Underwriters and selling group members.
This means that, if the Representatives purchase shares of Common Stock in the
open market to reduce the Underwriters' short position or to stabilize the price
of the Common Stock, they may reclaim the amount of the selling concession from
the Underwriters and selling group members who sold those shares as part of the
offering.
In general, purchases of a security for the purpose of stabilization or to
reduce a syndicate short position could cause the price of the security to be
higher than it might otherwise be in the absence of such purchases. The
imposition of a penalty bid might have an effect on the price of a security to
the extent that it were to discourage resales of the security by purchasers in
the offering. Neither the Company nor any of the Underwriters makes any
representation or prediction as to the direction or magnitude of any effect that
the transactions described above may have on the price of the Common Stock. In
addition, neither the Company nor any of the Underwriters makes any
representation that the Representatives will engage in such transactions or that
such transactions, once commenced, will not be discontinued without notice.
The Company and the Selling Stockholder have agreed to pay the
Representatives a non-accountable expense allowance equal to 1% of the aggregate
Price to Public (including with respect to shares of common stock underlying the
over-allotment option, if and to the extent it is exercised) set forth on the
front cover of this Prospectus for expenses in connection with this offering,
and the Company has agreed to reimburse the Underwriters up to an additional
$100,000 for certain specified out-of-pocket expenses incurred by them in
connection with the offering. The Representatives' expenses in excess of such
allowance will be borne by the Representatives. To the extent that the expenses
of the Representatives are less than the non-accountable expense allowance, the
excess may be deemed to be compensation to the Representatives.
The Company and the Selling Stockholder have agreed to indemnify the
Underwriters and their controlling persons against certain liabilities,
including liabilities under the Securities Act or to contribute to payments that
may be required to be made in respect thereof.
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 Underwriters.
Lawrence S. Black, Chairman Emeritus, Black & Company, Inc., owns 95,000
shares of the Company's common stock for his own account. The shares were
acquired from time to time prior to the involvement of Black & Company, Inc. in
the offering.
47
<PAGE> 48
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 February 1, 1998, 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 February 1, 1998, the Company had warrants outstanding to purchase an
aggregate of 3,065,502 shares of its Common Stock. Of these warrants, 1,400,000
warrants were issued to GECC at a exercise price of $.001 per share. Also, in
connection with the August, 1997 financing, 1,000,000 warrants were issued to
GECC and 300,000 were issued to JOL, all at an exercise price of $1.25 per
share. The remaining 365,502 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 1,000,000 shares of Common Stock upon
the occurrence of certain events, and which expire August 31, 2006. See "Certain
Transactions." The Company also has 38,280 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.
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 on August 14, 1997, 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
48
<PAGE> 49
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. The Amendment to the Registration Rights
Agreement provides for a one-time registration right for the benefit of JOL and
members of the Permal Group, as JOL may designate, whereby JOL is permitted to
offer for sale or sell a maximum of 2,096,111 shares of Common Stock in the
aggregate and a minimum of 1,000,000 shares of Common Stock.
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, as
amended on August 14, 1997, 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 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.
49
<PAGE> 50
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 Boston EquiServe.
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 Underwriters by Snell & Wilmer
L.L.P., Phoenix, Arizona.
EXPERTS
The financial statements and schedule as of February 1, 1998 and for the
fiscal year then ended included in this Prospectus and Registration Statement
have been audited by Arthur Andersen LLP, independent public accountants, as
indicated in their reports with respect thereto, and are included herein in
reliance upon the authority of said firm as experts in giving said reports. The
consolidated financial statements and financial statement schedule of Krause's
Furniture, Inc. as of February 2, 1997 and for the fiscal years ended February
2, 1997 and January 28, 1996 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 firms as experts in
accounting and auditing.
50
<PAGE> 51
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> 52
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C>
Report of Arthur Andersen LLP, Independent Public
Accountants............................................... F-2
Report of Ernst & Young LLP, Independent Auditors........... F-3
Consolidated Balance Sheet at February 1, 1998 and February
2, 1997................................................... F-4
Consolidated Statement of Operations for the years ended
February 1, 1998, February 2, 1997 and January 28, 1996... F-5
Consolidated Statement of Stockholders' Equity for the years
ended February 1, 1998, February 2, 1997 and January 28,
1996...................................................... F-6
Consolidated Statement of Cash Flows for the years ended
February 1, 1998, February 2, 1997 and January 28, 1996... F-7
Notes to Consolidated Financial Statements.................. F-8
</TABLE>
F-1
<PAGE> 53
REPORT OF ARTHUR ANDERSEN LLP INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors and Stockholders
Krause's Furniture, Inc.
We have audited the accompanying consolidated balance sheet of Krause's
Furniture, Inc. as of February 1, 1998, and the related consolidated statements
of operations, stockholders' equity and cash flows for the year then ended.
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 audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Krause's
Furniture, Inc. as of February 1, 1998 and the results of their operations and
their cash flows for the year then ended in conformity with generally accepted
accounting principles.
/s/ ARTHUR ANDERSEN LLP
Orange County, California
March 11, 1998
F-2
<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 sheet of Krause's
Furniture, Inc. as of February 2, 1997 and the related consolidated statements
of operations, stockholders' equity, and cash flows for the fiscal years ended
February 2, 1997 and January 28, 1996. 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 the consolidated results of its
operations and its cash flows for the fiscal years ended February 2, 1997 and
January 28, 1996 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-3
<PAGE> 55
KRAUSE'S FURNITURE, INC.
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS
<TABLE>
<CAPTION>
FEBRUARY 1, FEBRUARY 2,
1998 1997
----------- -----------
<S> <C> <C>
Current assets:
Cash and cash equivalents................................. $ 916 $ 1,227
Accounts receivable, net of allowance for doubtful
accounts of $164 ($327 at February 2, 1997)............ 1,148 1,120
Inventories............................................... 16,013 14,013
Prepaid expenses.......................................... 515 1,193
-------- --------
Total current assets................................... 18,592 17,553
Property, equipment, and leasehold improvements, net........ 8,577 6,389
Goodwill, net............................................... 14,366 15,386
Leasehold interests, net.................................... 1,191 1,504
Other assets................................................ 2,586 2,255
-------- --------
$ 45,312 $ 43,087
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 8,111 $ 7,506
Accrued payroll and related expenses...................... 1,993 1,468
Other accrued liabilities................................. 3,967 5,099
Customer deposits......................................... 5,421 5,621
Notes payable............................................. 22 41
-------- --------
Total current liabilities.............................. 19,514 19,735
Long-term liabilities:
Notes payable............................................. 13,731 6,306
Other..................................................... 2,175 1,503
-------- --------
Total long-term liabilities............................ 15,906 7,809
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock, $.001 par value; 666,667
shares authorized; no shares outstanding............... -- --
Common stock, $.001 par value; 35,000,000 shares
authorized; 19,020,539 shares outstanding.............. 19 19
Capital in excess of par value............................ 51,703 49,874
Accumulated deficit....................................... (41,830) (34,350)
-------- --------
Total stockholders' equity............................. 9,892 15,543
-------- --------
$ 45,312 $ 43,087
======== ========
</TABLE>
See accompanying notes.
F-4
<PAGE> 56
KRAUSE'S FURNITURE, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FISCAL YEARS ENDED
----------------------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28,
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Net sales................................................... $115,201 $112,737 $122,319
Cost of sales............................................... 56,153 56,490 59,852
-------- -------- --------
Gross profit................................................ 59,048 56,247 62,467
Operating expenses:
Selling................................................... 54,481 57,573 60,257
General and administrative................................ 9,141 10,101 10,578
Amortization of goodwill.................................. 1,020 1,020 1,020
-------- -------- --------
64,642 68,694 71,855
-------- -------- --------
Loss from operations........................................ (5,594) (12,447) (9,388)
Interest expense............................................ (1,723) (1,230) (721)
Other income (expense)...................................... (163) 288 67
-------- -------- --------
Loss before income taxes.................................... (7,480) (13,389) (10,042)
Income tax benefit.......................................... -- -- (1,327)
-------- -------- --------
Net loss.................................................... $ (7,480) $(13,389) $ (8,715)
======== ======== ========
Basic and diluted loss per share............................ $ (0.39) $ (1.28) $ (2.21)
======== ======== ========
Number of shares used in computing loss per share........... 19,021 10,445 3,950
======== ======== ========
</TABLE>
See accompanying notes.
F-5
<PAGE> 57
KRAUSE'S FURNITURE, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK CAPITAL IN TOTAL
---------------- --------------- EXCESS OF ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT PAR VALUE DEFICIT EQUITY
------ ------- ------ ------ ---------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at 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
Issuance of common stock purchase
warrant............................... -- -- -- -- 1,625 -- 1,625
Compensation expense on stock option
grant................................. -- -- -- -- 204 -- 204
Net loss................................ -- -- -- -- -- (7,480) (7,480)
---- ------- ------ --- ------- -------- -------
Balance at February 1, 1998............. -- $ -- 19,021 $19 $51,703 $(41,830) $ 9,892
==== ======= ====== === ======= ======== =======
</TABLE>
See accompanying notes.
F-6
<PAGE> 58
KRAUSE'S FURNITURE, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FISCAL YEARS ENDED
-----------------------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28,
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss................................................ $ (7,480) $ (13,389) $ (8,715)
Adjustments to reconcile net loss to net cash used by
operating activities:
Depreciation and amortization...................... 2,431 2,561 2,760
Deferred income taxes.............................. -- -- 920
Other non-cash charges............................. 1,243 618 283
Change in assets and liabilities:
Accounts receivable................................ (28) (334) 404
Inventories........................................ (2,000) 614 3,389
Prepaid expenses and other assets.................. 283 229 1,210
Income tax refund receivable....................... -- 1,467 (1,467)
Accounts payable and accrued liabilities........... 753 (4,688) (2,166)
Customer deposits.................................. (200) (1,393) 205
--------- --------- ---------
Net cash used by operating activities......... (4,998) (14,315) (3,177)
--------- --------- ---------
Cash flows from investing activities:
Capital expenditures.................................. (3,521) (806) (1,883)
Proceeds from sale-leaseback.......................... -- -- 1,039
--------- --------- ---------
Net cash used by investing activities......... (3,521) (806) (844)
--------- --------- ---------
Cash flows from financing activities:
Proceeds from long-term borrowings.................... 145,458 143,002 141,371
Principal payments on long-term debt.................. (137,250) (138,178) (137,966)
Proceeds from issuance of common stock................ -- 10,221 --
Other................................................. -- (33) --
--------- --------- ---------
Net cash provided by financing activities..... 8,208 15,012 3,405
--------- --------- ---------
Net decrease in cash.................................... (311) (109) (616)
Cash and cash equivalents at beginning of year.......... 1,227 1,336 1,952
--------- --------- ---------
Cash and cash equivalents at end of year................ $ 916 $ 1,227 $ 1,336
========= ========= =========
Supplemental disclosures of cash flow information --
Cash paid during the year for:
Interest........................................... $ 754 $ 466 $ 543
Income taxes....................................... -- 9 --
Noncash investing and financing activities:
Preferred stock converted into common stock........ -- 7,523 2,932
Exchange of notes payable and related accrued
interest for common stock........................ -- 3,066 --
Issuance of common stock purchase warrant.......... 1,625 1,400 --
</TABLE>
See accompanying notes.
F-7
<PAGE> 59
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of presentation
The consolidated financial statements include the accounts of Krause's
Furniture, Inc., (the "Company") and its wholly owned subsidiaries, including
the Company's principal subsidiary, Krause's Custom Crafted Furniture Corp.,
formerly known as Krause's 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
fiscal year ended February 1, 1998 (fiscal 1997) is a 52-week period; the fiscal
year ended February 2, 1997 (fiscal 1996) is a 53-week period; and the fiscal
year ended January 28, 1996 (fiscal 1995) is a 52-week period. 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 1997 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. As of February 1, 1998 there were 81 Company
owned showrooms, all of which are leased, located in 12 states.
Cash and cash equivalents
Cash and cash equivalents include cash on hand, cash in money market
accounts and certificates of deposit 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 notes, 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> 60
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 1, FEBRUARY 2,
1998 1997
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Finished goods........................................ $12,368 $10,693
Work in progress...................................... 66 254
Raw materials......................................... 3,579 3,066
------- -------
$16,013 $14,013
======= =======
</TABLE>
Showroom pre-opening expenses
Showroom pre-opening expenses are capitalized and amortized over periods of
up to 12 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 $1,099,000 in fiscal 1997,
$1,073,000 in fiscal 1996, and $1,100,000 in fiscal 1995. Property, equipment
and leasehold improvements are summarized as follows:
<TABLE>
<CAPTION>
FEBRUARY 1, FEBRUARY 2,
1998 1997
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Leasehold improvements................................ $10,708 $ 9,241
Construction in progress.............................. 1,922 463
Machinery and equipment............................... 3,014 2,962
Office and store furniture............................ 886 872
------- -------
16,530 13,538
Less accumulated depreciation and amortization........ (7,953) (7,149)
------- -------
$ 8,577 $ 6,389
======= =======
</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 $5,960,000 as of February 1, 1998
and $4,940,000 as of February 2, 1997.
F-9
<PAGE> 61
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 1, 1998. The
Company's analysis at February 1, 1998 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 1997, 1996,
and 1995 indicate that it is at least reasonably possible that such
circumstances could arise in fiscal 1998.
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 $2,132,000
as of February 1, 1998 and $1,819,000 as of February 2, 1997.
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 1, 1998, February 2, 1997, and January 28, 1996 were
$11,758,000, $11,184,000 and $11,181,000, 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.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 130 (SFAS 130), "Reporting
Comprehensive Income," and No. 131 (SFAS 131), "Disclosures About Segments of an
Enterprise and Related Information." These statements are effective for fiscal
years commencing after December 15, 1997. The Company will be required to comply
with the
F-10
<PAGE> 62
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
provisions of these statements in fiscal 1998. The impact of adoption of these
pronouncements is not expected to be material to the Company's financial
position or results of operations.
Loss per share
Loss per share for fiscal 1997, 1996 and 1995 was 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 February 2, 1997 and January 28, 1996, had occurred
at the beginning of the years, the net loss per share would have been $1.20 and
$2.11, respectively.
The Company has adopted SFAS 128, "Earnings Per Share," and applied this
pronouncement to all periods presented. This statement requires the presentation
of both basic and diluted net income (loss) per share for financial statement
purposes. Basic net income (loss) per share is computed by dividing income
(loss) available to common stockholders by the weighted average number of common
shares outstanding. Diluted net income (loss) per share includes the effect of
the potential shares outstanding, including dilutive stock options and warrants
using the treasury stock method. Because the impact of options and warrants are
antidilutive, there is no difference between the loss per share amounts computed
for basic and diluted purposes. Also, the adoption of SFAS 128 resulted in no
change in amounts previously reported.
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 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 $41,830,000 and a working capital deficiency of $922,000
at February 1, 1998.
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 (the "Original 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 drew down on December 30, 1997. At the time the standby credit facility
was drawn down, the Company issued 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
F-11
<PAGE> 63
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 terms of its revolving
credit agreement by, among other things, making a change in the advance rate
which provided greater borrowing capacity.
Under the terms of the agreement related to the Company's subordinated
notes, as well as under the terms of the revolving credit agreement, 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. As of February 1, 1998, the Company was out of compliance with
certain of the financial covenants contained in both of the agreements but has
obtained waivers. The Company may also be in violation of certain of these
covenants as of interim periods during 1998, but has obtained agreements to
waive or amend covenants related to these potential default events. Management
believes it will be in compliance with other covenants, but in the unlikely
event of noncompliance, the Company also believes it can obtain waivers.
However, there can be no assurance that additional 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 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. NOTES PAYABLE
Notes payable consist of the following:
<TABLE>
<CAPTION>
FEBRUARY 1, FEBRUARY 2,
1998 1997
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Secured revolving credit notes........................ $ 3,812 $ 1,999
Subordinated notes payable to shareholders............ 12,001 5,133
Unamortized debt discount, net of accumulated
amortization of $590,000 at February 1, 1998 and
$137,000 at February 2, 1997........................ (2,435) (1,263)
Other notes........................................... 375 478
------- -------
13,753 6,347
Less current portion.................................. 22 41
------- -------
$13,731 $ 6,306
======= =======
</TABLE>
F-12
<PAGE> 64
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The secured revolving credit notes were issued under a revolving credit
agreement between Krause's and a financial institution (the "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 February 1, 1998, borrowing
under the revolving credit facility was limited to approximately $7.8 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 February 1, 1998).
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
Edson 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 warrants of $925,000 was reflected in
the consolidated financial statements as a discount on the subordinated notes
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 notes. 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, on December 30, 1997, the Company drew on a
standby credit facility with GECC and JOL by selling additional 9.5%
subordinated notes in an aggregate principal amount of $3,500,000. As part of
the agreement, the Company issued to GECC and JOL warrants to purchase an
aggregate of up to 560,000 shares of common stock of the Company at a purchase
price of $1.25 per share. The fair value of the warrants of $700,000 was
reflected in the consolidated financial statements as a discount on the
subordinated notes 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 notes.
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 Original Note was payable semiannually, on a straight-line basis
over three years beginning February 1999.
Pursuant to the terms of the Agreement and the revolving credit agreement,
the Company and Krause's are required to maintain certain financial ratios and
minimum levels of tangible net worth and working capital as well as to achieve
certain levels of earnings before interest, taxes, depreciation and
amortization. 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 1, 1998, the Company
and Krause's were not in compliance with certain of the covenants contained in
the agreements but have obtained waivers.
The aggregate annual maturities of long-term debt during each of the five
fiscal years subsequent to February 1, 1998 are approximately as follows:
$22,000 in 1998, $60,000 in 1999, $7,879,000 in 2000, $4,227,000 in 2001, and
$4,000,000 in 2002.
F-13
<PAGE> 65
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. INCOME TAXES
The income tax benefit recorded for the fiscal year ended January 28, 1996
consists of the following (in thousands):
<TABLE>
<S> <C>
Current federal............................................. $(2,247)
Deferred federal............................................ 920
-------
$(1,327)
=======
</TABLE>
Income tax benefits differ from the amounts computed by applying the
federal statutory rate of 34% to the loss before income taxes, as follows:
<TABLE>
<CAPTION>
FISCAL YEARS ENDED
-----------------------------------------
FEBRUARY 1, FEBRUARY 2, JANUARY 28,
1998 1997 1996
----------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Tax at federal statutory rate............. $ (2,543) $(4,552) $(3,414)
Goodwill amortization..................... 347 347 346
Adjustment of valuation allowance......... 2,661 5,333 2,144
State income tax, net of federal
benefit................................. (390) (742) (557)
Other..................................... (75) (386) 154
-------- ------- -------
$ -- $ -- $(1,327)
======== ======= =======
</TABLE>
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
FEBRUARY 1, FEBRUARY 2,
1998 1997
----------- -----------
(IN THOUSANDS)
<S> <C> <C>
Deferred tax liabilities.............................. $ -- $ --
Deferred tax assets:
Net operating loss carryforwards.................... 14,200 12,075
Reserves and accruals not currently deductible for
tax purposes..................................... 2,104 1,443
Other............................................... -- 125
------- -------
Total deferred tax assets........................... 16,304 13,643
Valuation allowance for deferred tax assets......... (16,304) (13,643)
------- -------
Net deferred tax assets............................. -- --
------- -------
Net deferred taxes.................................. $ -- $ --
======= =======
</TABLE>
The change in the valuation allowance was a net increase of $2,661,000 for
the fiscal year ended February 1, 1998, and a net increase of $5,333,000 for the
fiscal year ended February 2, 1997. The valuation allowance was increased since
the realization of net deferred tax assets is uncertain.
As of February 1, 1998 the Company has federal net operating loss
carryforwards of approximately $37 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 1, 1998, approximately $4 million of
the limited loss carryforwards was available. In addition,
F-14
<PAGE> 66
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
the Company had state net operating loss carryforwards of approximately $30
million, which begin to expire in the year 1998, if not utilized.
5. STOCKHOLDERS' EQUITY
At February 1, 1998, the Company had warrants outstanding to purchase an
aggregate of 3,065,502 shares of its Common Stock. Of these warrants, 1,400,000
warrants were issued to GECC in fiscal 1996 at an exercise price of $.001 per
share and 1,300,000 were issued to GECC and JOL in fiscal 1997 at an exercise
price of $1.25 (see further discussion in Note 3). The remaining 365,502
warrants have exercise prices ranging from $1.32 to $15.00 per share and
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 issued warrants to GECC and JOL to
purchase up to 1,000,000 shares of Common Stock upon the occurrence of certain
events; such warrants expire August 31, 2006. The Company also has 38,280 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.
As of February 1, 1998, 5,347,740 shares of the Company's common stock are
reserved for issuance upon exercise of warrants and stock options (see Note 6)
and upon the payment of deferred stock units.
6. 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.
The 1997 Stock Incentive 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 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 over three years. Compensation expense was
recorded in fiscal 1997 and 1996 in the amount of $204,000 and $293,000,
respectively, 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 loss and 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 1997
and 1996; risk-free interest
F-15
<PAGE> 67
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
rates of 6.28% and 6.85%, dividend yields of 0% for both periods, volatility
factors of the expected market price of the Company's common stock of 82% and
68%; and a weighted-average life of the options of 7.0 and 6.5 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 since only options granted since fiscal 1995 are
considered. The Company's pro forma information follows (in thousands, except
for per share information):
<TABLE>
<CAPTION>
1997 1996
------ -------
<S> <C> <C>
Pro forma net loss.......................................... $7,700 $13,188
Pro forma net loss per share................................ $ 0.40 $1.26
</TABLE>
As of February 1, 1998, under all option plans, a total of 2,243,958 shares
of common stock are reserved for future issuance, options to purchase 2,043,958
shares of common stock were outstanding, options to purchase 758,541 were
exercisable, at a weighted average exercise price of $1.27, and options for
200,000 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, 1994
to February 1, 1998.
<TABLE>
<CAPTION>
WEIGHTED
NUMBER OF ACTUAL AVERAGE
OPTIONS EXERCISE PRICE EXERCISE PRICE
---------- -------------- --------------
<S> <C> <C> <C>
Outstanding December 31, 1994............. 359,843 $3.09-$8.34 $5.40
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
Granted................................... 417,000 $1.56 $1.56
Forfeited................................. (95,499) $2.16-$7.13 $3.54
---------
Outstanding February 1, 1998.............. 2,043,958 $ .78-$6.38 $1.29
=========
</TABLE>
The weighted average grant-date fair value of options granted during 1997
and 1996, for options where the exercise price on the date of grant was equal to
the stock price on that date, was $1.22 and $2.14, 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.
F-16
<PAGE> 68
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 1, 1998.
<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
- ----------- ----------- -------------- ---------------- ----------- -------------------
<C> <S> <C> <C> <C> <C>
2,009,000 $ .78-$1.62 $1.22 9.0 years 723,583 $1.08
34,958 $3.09-$6.38 $5.23 3.7 years 34,958 $5.23
- ----------- -----------
2,043,958 $ .78-$6.38 $1.29 8.9 years 758,541 $1.27
=========== ===========
</TABLE>
7. 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 not significant in fiscal 1997, 1996 and 1995.
8. COMMITMENTS AND CONTINGENCIES
Leases
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 11 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.
Commitments as of February 1, 1998 under operating leases require
approximate future minimum annual rental payments as follows:
<TABLE>
<CAPTION>
TOTAL
FISCAL YEAR (IN THOUSANDS)
----------- --------------
<S> <C>
1998......................................... $15,550
1999......................................... 14,088
2000......................................... 12,091
2001......................................... 9,793
2002......................................... 8,191
Thereafter................................... 21,882
-------
$81,595
=======
</TABLE>
Total rent expense under all operating leases was approximately
$15,456,000, $15,389,000, and $15,631,000 for the fiscal years ended February 1,
1998, February 2, 1997 and January 28, 1996, respectively.
Litigation
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.
F-17
<PAGE> 69
KRAUSE'S FURNITURE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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.
Letter of Credit
The Company has a $1,000,000 letter of credit outstanding at February 1,
1998 related to the lease of its headquarters.
9. RELATED PARTY TRANSACTIONS
In fiscal 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 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.
10. MAJOR SUPPLIERS
During the year ended February 1, 1998, the Company's ten largest suppliers
accounted for 55.9% of its aggregate purchases. One supplier represented
approximately 11.5% of aggregate purchases for fiscal 1997.
F-18
<PAGE> 70
======================================================
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 UNDERWRITERS. 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.................... 3
Risk Factors.......................... 9
Use of Proceeds....................... 16
Dividend Policy....................... 16
Price Range of Common Stock........... 16
Dilution.............................. 17
Capitalization........................ 18
Background of the Company............. 18
Selected Consolidated Financial
Data................................ 19
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 20
Business.............................. 27
Management............................ 34
Certain Transactions.................. 41
Principal and Selling Stockholders.... 44
Underwriting.......................... 46
Description of Capital Stock.......... 48
Legal Matters......................... 50
Experts............................... 50
Additional Information................ 51
</TABLE>
======================================================
======================================================
4,400,000 SHARES
(KRAUSE'S FURNITURE, INC. LOGO)
COMMON STOCK
-----------------
PROSPECTUS
-----------------
CRUTTENDEN ROTH
INCORPORATED
BLACK & COMPANY, INC.
MORGAN FULLER
CAPITAL GROUP, LLC
March 31, 1998
======================================================
