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UNITED STATES SECURITIES AND EXCHANGE COMMISSION  Washington, DC 20549
 Form 10-Q (Mark
One) þ
    

    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended December 26, 2004
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from          to          .
 Commission File Number: 0-50387 RedEnvelope, Inc. (Exact Name of Registrant as Specified in Its Charter)
 Delaware
    
    33-0844285(State or Other Jurisdiction
    
    (IRS EmployerofIncorporation or
    
    Identification No.)Organization)
 149 New Montgomery Street, San Francisco, California 94105
 (Address of Principal Executive Offices and Zip Code)
 (415) 371-9100 (Registrants Telephone Number, Including Area Code)
 Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirement for the past 90 days. Yes
þ No
o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes
o No
þ The number of outstanding shares of the registrants common stock, $0.01 par value per share,
was 8,819,892 as of January 31, 2005.




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REDENVELOPE, INC.
REPORT ON FORM 10-Q
For the Quarter Ended December 26, 2004
TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATIONItem 1. Financial Statements (Unaudited)Condensed
Balance Sheets as of December 26, 2004, March 28, 2004 and
December 28, 2003
    
    
    2Condensed
Statements of Operations for the thirteen weeks and thirty-nine weeks
ended December 26, 2004 and December 28, 2003
    
    
    3Condensed Statements of Cash Flows for the thirty-nine weeks ended December 26, 2004 and December 28, 2003
    
    
    4Notes to Condensed Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    36Item 4. Controls and Procedures
    
    
    36PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    II-1Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    II-1Item 5. Other Information
    
    II-2Item 6. Exhibits
    
    II-2EXHIBIT 10.44EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
    1




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PART I.
FINANCIAL INFORMATION 
 Item 1.Financial Statements REDENVELOPE, INC. 
 CONDENSED BALANCE SHEETS (Unaudited)
 December 26,
    
    
    March 28,
    
    
    December 28,2004
    
    
    2004
    
    
    2003(In thousands, except per share data)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    21,466
    
    
    $
    18,409
    
    
    $
    34,756Short-term investments
    
    
    6,022
    
    
    
    6,971
    
    
    
    2,888Accounts receivable, net
    
    
    4,397
    
    
    
    1,055
    
    
    
    5,803Inventory
    
    
    13,401
    
    
    
    9,609
    
    
    
    7,873Prepaid catalog costs and other current assets
    
    
    2,411
    
    
    
    2,037
    
    
    
    1,462Total current assets
    
    
    47,697
    
    
    
    38,081
    
    
    
    52,782Property and equipment, net
    
    
    7,987
    
    
    
    4,746
    
    
    
    4,591Long-term investments
    
    
    
    
    
    
    1,844
    
    
    
    Other assets and restricted cash
    
    
    607
    
    
    
    505
    
    
    
    1,165Total assets
    
    $
    56,291
    
    
    $
    45,176
    
    
    $
    58,538LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    13,358
    
    
    $
    5,539
    
    
    $
    12,705Accrued expenses and other current liabilities
    
    
    7,501
    
    
    
    2,706
    
    
    
    7,268Accrued compensation
    
    
    954
    
    
    
    1,602
    
    
    
    820Capital lease obligations, current
    
    
    584
    
    
    
    596
    
    
    
    732Total current liabilities
    
    
    22,397
    
    
    
    10,443
    
    
    
    21,525Capital lease obligations, long-term
    
    
    436
    
    
    
    816
    
    
    
    997Other long-term liability
    
    
    829
    
    
    
    
    
    
    
    Total liabilities
    
    
    23,662
    
    
    
    11,259
    
    
    
    22,522Commitments and contingencies
Stockholders equity:Common stock, $0.01 par value; 100 million shares
authorized; 8.8 million, 8.5 million, and 8.5 million
issued and outstanding as of December 26, 2004 , March
28, 2004, and December 28, 2003, respectively
    
    
    89
    
    
    
    86
    
    
    
    86Additional paid-in capital
    
    
    113,354
    
    
    
    112,728
    
    
    
    113,006Deferred compensation
    
    
    (50
    )
    
    
    (197
    )
    
    
    (641
    )Notes receivable from stockholders
    
    
    (44
    )
    
    
    (44
    )
    
    
    (44
    )Accumulated deficit
    
    
    (80,723
    )
    
    
    (78,652
    )
    
    
    (76,391
    )Accumulated other comprehensive income (loss)
    
    
    3
    
    
    
    (4
    )
    
    
    Total stockholders equity
    
    
    32,629
    
    
    
    33,917
    
    
    
    36,016Total liabilities and stockholders equity
    
    $
    56,291
    
    
    $
    45,176
    
    
    $
    58,538
 See accompanying notes to these condensed financial statements. 2




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REDENVELOPE, INC. 
 CONDENSED STATEMENTS OF OPERATIONS (Unaudited)
 Thirteen Weeks Ended
    
    
    Thirty-Nine Weeks EndedDecember 26,
    
    
    December 28,
    
    
    December 26,
    
    
    December 28,2004
    
    
    2003
    
    
    2004
    
    
    2003(In thousands, except for per share data)Net revenues
    
    $
    47,514
    
    
    $
    35,922
    
    
    $
    79,219
    
    
    $
    61,972Cost of sales
    
    
    21,707
    
    
    
    18,149
    
    
    
    37,049
    
    
    
    31,496Gross profit
    
    
    25,807
    
    
    
    17,773
    
    
    
    42,170
    
    
    
    30,476Operating expenses:Fulfillment
    
    
    6,296
    
    
    
    5,195
    
    
    
    11,843
    
    
    
    9,446Marketing
    
    
    12,291
    
    
    
    7,434
    
    
    
    19,434
    
    
    
    12,860General and administrative
    
    
    4,445
    
    
    
    3,929
    
    
    
    12,970
    
    
    
    10,743Total operating expenses
    
    
    23,032
    
    
    
    16,558
    
    
    
    44,247
    
    
    
    33,049Income (loss) from operations
    
    
    2,775
    
    
    
    1,215
    
    
    
    (2,077
    )
    
    
    (2,573
    )Interest income
    
    
    61
    
    
    
    60
    
    
    
    219
    
    
    
    75Interest expense
    
    
    (68
    )
    
    
    (99
    )
    

    
    (213
    )
    
    
    (369
    )Net income (loss)
    
    $
    2,768
    
    
    $
    1,176
    
    
    $
    (2,071
    )
    
    $
    (2,867
    )Net income (loss) per share  basic
    
    $
    0.32
    
    
    $
    0.14
    
    
    $
    (0.24
    )
    
    $
    (0.41
    )Net income (loss) per share  diluted
    
    $
    0.30
    
    
    $
    0.13
    
    
    $
    (0.24
    )
    
    $
    (0.41
    )Weighted average shares outstanding  basic
    
    
    8,770
    
    
    
    8,522
    
    
    
    8,694
    
    
    
    7,071Weighted average shares outstanding  diluted
    
    
    9,330
    
    
    
    9,379
    
    
    
    8,694
    
    
    
    7,071
 See accompanying notes to these condensed financial statements. 3




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REDENVELOPE, INC. 
 CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)
 Thirty - Nine Weeks EndedDecember 26,
    
    
    December 28,2004
    
    
    2003(In thousands)Cash Flows From Operating Activities:Net loss
    
    $
    (2,071
    )
    
    $
    (2,867
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation and amortization
    
    
    1,996
    
    
    
    1,930Amortization of deferred stock compensation
    
    
    18
    
    
    
    201Loss on disposal of property and equipment
    
    
    61
    
    
    
    Other non-cash charges
    
    
    233
    
    
    
    35Issuance of stock for services rendered
    
    
    
    
    
    
    9Changes in current assets and liabilities:Accounts receivable
    
    
    (3,343
    )
    
    
    (5,517
    )Inventory
    
    
    (3,792
    )
    
    
    1,843Other assets
    
    
    (579
    )
    
    
    292Accounts payable
    
    
    7,819
    
    
    
    6,959Accrued expenses and other current liabilities
    
    
    4,151
    
    
    
    5,924Net cash provided by operating activities
    
    
    4,493
    
    
    
    8,809Cash Flows From Investing Activities:Maturities of investments
    
    
    10,588
    
    
    
    Purchase of investments
    
    
    (7,789
    )
    
    
    (3,435
    )Purchase of property and equipment
    
    
    (4,543
    )
    
    
    (1,636
    )Net cash used in investing activities
    
    
    (1,744
    )
    
    
    (5,071
    )Cash Flows From Financing Activities:Proceeds from exercise of common stock options,
exercise of warrants and ESPP purchases
    
    
    757
    
    
    
    128Principal payments on capital lease obligations
    
    
    (449
    )
    
    
    (469
    )IPO Proceeds
    
    
    
    
    
    
    28,952Repayment of loan
    
    
    
    
    
    
    (1,123
    )Payment of loan costs and other
    
    
    
    
    
    
    (414
    )Payment of IPO costs
    
    
    
    
    
    
    (1,053
    )Net cash provided by financing activities
    
    
    308
    
    
    
    26,021Net increase in cash and cash equivalents
    
    
    3,057
    
    
    
    29,759Cash and cash equivalents at beginning of period
    
    
    18,409
    
    
    
    4,997Cash and cash equivalents at end of period
    
    $
    21,466
    
    
    $
    34,756Supplemental Cash Flow Information:Cash paid for interest
    
    $
    109
    
    
    $
    194
 See accompanying notes to these condensed financial statements. 4




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REDENVELOPE, INC. 
 NOTES TO CONDENSED FINANCIAL STATEMENTS (Unaudited)
 1. Financial Statements  Basis of Presentation The accompanying unaudited financial statements include the accounts of RedEnvelope, Inc.
(referred to as the Company, we, us, and our). The condensed balance sheets as of December
26, 2004 and December 28, 2003, the condensed statements of operations for the thirteen-week and
thirty-nine week periods ended December 26, 2004 and December 28, 2003, and the condensed
statements of cash flows for the thirty-nine week periods ended December 26, 2004 and December 28,
2003 have been prepared by us, without audit. In our opinion, the financial statements include all
adjustments (which include only normal recurring adjustments) necessary to present fairly the
financial position at the balance sheet dates and the results of operations for the thirteen and
thirty-nine week periods then ended. The balance sheet at March 28, 2004, presented herein, has
been derived from the Companys audited balance sheet included in the Companys Annual Report on
Form 10-K, for the fiscal year ended March 28, 2004. Certain information and disclosures normally included in the notes to the annual financial
statements prepared in accordance with accounting principles generally accepted in the United
States of America have been omitted. These financial statements should be read in conjunction with
the condensed financial statements and notes thereto included in the Companys Annual Report on
Form 10-K, for the fiscal year ended March 28, 2004. Certain reclassifications have been made to
the prior period financial statements to conform to the presentation used in the current period. The results of operations for the thirteen and thirty-nine weeks ended December 26, 2004 are
not necessarily indicative of the operating results of the full year. Further, the preparation of
condensed financial statements requires management to make estimates and assumptions that affect
the recorded amounts reported therein. A change in facts or circumstances surrounding the estimates
could result in a change to the estimates and impact future operating results. Our fiscal year ends on the Sunday closest to March 31, resulting in a 52 or 53-week year.
Fiscal 2004 ended on March 28, 2004 and was 52 weeks long. Fiscal 2005 will end on April 3, 2005
and will be 53 weeks long. We report our interim results on a fiscal quarter basis rather than on a
calendar quarter basis. Under the fiscal quarter basis, each of the first three fiscal quarters is
thirteen weeks long, ending on the Sunday closest to the calendar quarter end, with the fourth
fiscal quarter covering the remaining part of the fiscal year. 2. Accounting Policies Our financial statements have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues
and expenses. We base our estimates on historical experience and on various other assumptions that
we believe to be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different assumptions or
conditions. Our significant accounting policies are set forth below. 5




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Stock Based CompensationThe Company accounts for stock-based employee compensation
arrangements using the intrinsic value method in accordance with provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees(APB No. 25), and
complies with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No.
123, Accounting for Stock-Based Compensation(SFAS No. 123) as amended by SFAS No. 148,
Accounting for Stock-Based Compensation  Transition and Disclosure(SFAS No. 148). Under APB No.
25, compensation cost is recognized based on the difference, if any, between the fair market value
of the Companys stock on the date of grant and the amount an employee must pay to acquire the
stock. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the
use of Black-Scholes option pricing models. Equity instruments issued to non-employees are
accounted for in accordance with the provision of SFAS No. 123 and Emerging Issues Task Force Issue
No. 96-18. The following table illustrates the effect on net income (loss) and income (loss) per share as
if we had applied the fair value recognition provisions of SFAS No. 123 as amended by SFAS No. 148,
to all our employee stock compensation arrangements: Thirteen Weeks Ended
    
    
    Thirty-Nine Weeks EndedDecember 26,
    
    
    December 28,
    
    
    December 26,
    
    
    December 28,2004
    
    
    2003
    
    
    2004
    
    
    2003(in thousands, except per share data)Net income (loss)  as reported
    
    $
    2,768
    
    
    $
    1,176
    
    
    $
    (2,071
    )
    
    $
    (2,867
    )Stock-based employee compensation
included in reported net income (loss)
    
    
    5
    
    
    
    77
    
    
    
    18
    
    
    
    212Stock-based compensation expense
determined under fair value base method
    
    
    (75
    )
    
    
    (225
    )
    
    
    (749
    )
    
    
    (533
    )Pro forma net income (loss)
    
    $
    2,698
    
    
    $
    1,028
    
    
    $
    (2,802
    )
    
    $
    (3,188
    )Basic and diluted earnings per share:As reported  basic
    
    $
    0.32
    
    
    $
    0.14
    
    
    $
    (0.24
    )
    
    $
    (0.41
    )As reported  diluted
    
    $
    0.30
    
    
    $
    0.13
    
    
    $
    (0.24
    )
    
    $
    (0.41
    )Pro forma  basic
    
    $
    0.31
    
    
    $
    0.12
    
    
    $
    (0.32
    )
    
    $
    (0.45
    )Pro forma  diluted
    
    $
    0.29
    
    
    $
    0.11
    
    
    $
    (0.32
    )
    
    $
    (0.45
    )
 Earnings (Loss) Per ShareFor the thirteen weeks ended December 26, 2004 and December 28,
2003, basic net income per share was greater than the diluted net income per share because the
effect of stock options, unvested shares and warrants outstanding was dilutive. The number of
dilutive stock options, unvested shares, and warrants excluded from the calculation for the
thirty-nine weeks ended December 26, 2004 and December 28, 2003, were approximately 1.4 million and
1.4 million, respectively, as the effect would be anti-dilutive. Comprehensive Income (Loss)Comprehensive income (loss) consists of two components, net
income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to
revenue, expenses, gains and losses that under generally accepted accounting principles are
recorded as an element of stockholders equity but are excluded from net income (loss).
Comprehensive income (loss) for the thirteen and thirty-nine weeks ended December 26, 2004 and
December 28, 2003 was as follows: Thirteen Weeks Ended
    
    
    Thirty-nine Weeks EndedDecember 26,
    
    
    December 28,
    
    
    December 26,
    
    
    December 28,2004
    
    
    2003
    
    
    2004
    
    
    2003(in thousands, except per share data)Net income (loss)  as reported
    
    $
    2,768
    
    
    $
    1,176
    
    
    $
    (2,071
    )
    
    $
    (2,867
    )Other comprehensive income (loss)
  unrealized gain (loss) on
marketable securities
    
    
    (1
    )
    
    
    
    
    
    
    7
    
    
    
    Comprehensive income (loss)
    
    $
    2,767
    
    
    $
    1,176
    
    
    $
    (2,064
    )
    
    $
    (2,867
    )
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New Accounting PronouncementsIn December 2003, the Financial Accounting Standards
Board published a revision to Financial Interpretation No. 46 (FIN 46), Consolidation of
Variable Interest Entities (hereafter referred to as FIN 46R) to clarify some of the provision
of FIN 46, and to exempt certain entities from its requirements. Under the new guidance, there are
new effective dates for companies that have interest in structures that are commonly referred to as
special-purpose entities. The rules are effective in financial statements for periods ending after
March 15, 2004. FIN 46R did not have any impact on our operating results or financial position as
we do not have any variable interest entities. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 03-1,
The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments (EITF
03-1). EITF 03-1 provides a three-step impairment model for determining whether an investment is
other-than-temporarily impaired and requires the Company to recognize such impairments as an
impairment loss equal to the difference between the investments cost and fair value at the
reporting date. The effective date of the guidance has been delayed by the EITF. The Company does
not believe that the adoption of EITF 03-1 will have a significant effect on its financial
statements. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS
123R). This statement replaces FASB Statement No. 123, Accounting for Stock-Based Compensation,
and supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires
all companies to measure compensation cost for all share-based payments, including stock options,
at fair value. Under the terms of SFAS 123R the fair value of any equity award will be estimated at
the grant date and this fair value will be recognized as compensation cost over the service period
for all awards that are subject to a vesting period. SFAS123R requires that fair value be estimated
using an option pricing model that takes into account at least the following items  the exercise
price, the expected term of the option, the current price of the underlying share, the expected
volatility of the price of the underlying share, the expected dividends on the underlying share and
the risk free rate of interest. The statement will be effective for public companies for interim
or annual periods beginning after June 15, 2005. The Company is currently evaluating the effect
that SFAS 123R will have on its condensed balance sheets, condensed statements of operations and
statements of shareholders equity and cash flows. However, the effect of SFAS 123R on the
Companys statement of operations is not expected to be materially different from the pro forma
disclosures included in Note 2 of the Notes to Condensed Financial Statements. 3. Investments Short-term investments consist of government securities and corporate bonds both with
maturities beyond three months but less than one year. Long term investments consist of corporate
bonds with maturities of one year or longer. All of the Companys investments are considered available-for-sale. Such securities are
carried at fair market value. Fair value is based on market quotes. Unrealized gains and losses,
net of tax, on securities in this category are reported as a separate component of stockholders
equity. The cost of securities sold is based on the specific identification method. Interest earned
on securities is included in interest income. 7




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Available-for-sale investments at December 26, 2004 were as follows (in thousands): Corporate bonds and auction preferred stock (short-term)
    
    $
    3,764Government securities (short-term)
    
    
    2,258Total available-for-sale investments
    
    $
    6,022
 The gross realized gains or losses during the thirteen and thirty-nine weeks ended
December 26, 2004 and for the thirteen and thirty-nine weeks ended December 28, 2003 were
immaterial. The contractual maturity of all available-for-sale investments was less than one year at
December 26, 2004. 4. Borrowing Arrangements The Company has a line of credit from CapitalSource Finance LLC. Per the terms of this
agreement, CapitalSource Finance LLC has made available to the Company a credit facility under a
revolving promissory note with a maximum principal amount of $11.0 million, subject to availability
guidelines that specify the amount that can be borrowed under the facility at any given time.
Amounts borrowed under this line of credit bear interest at rates equal to the greater of 9.5% or
the prime lending rate plus 5.75%, for advances up to a fluctuating base amount, and equal to the
greater of 11.5% or the prime lending rate plus 7.75% for advances in excess of that base amount.
Amounts borrowed under this line of credit are secured by substantially all of the Companys
assets. The line of credit agreement provides for certain events of default, sets forth a number of
affirmative and negative covenants to which the Company must adhere and expires on April 15, 2006.
The Company must pay an unused line fee of up to $0.05 million per year, which is payable monthly,
based on the unused portion of the loan commitment. The Company has borrowed funds under this
credit facility from time to time and periodically repaid such borrowings with available cash.
There were no borrowings outstanding during the thirty-nine weeks ended December 26, 2004. On June 21, 2004, the Company amended the terms of its credit facility with CapitalSource
Finance LLC. Under the terms of this Second Amendment, certain covenants for inventory ratios and
capital expenditure limitations were eliminated. The minimum earnings before interest, taxes,
depreciation and amortization (EBITDA) covenant was modified, and quarterly minimum unrestricted
cash balance levels were established. Further, under this Second Amendment, the EBITDA and minimum
unrestricted cash balance covenants were modified such that they are not applicable unless
borrowings are outstanding. In advance of any borrowings, the Company is required to deliver to CapitalSource Finance LLC
written notification of its intent to borrow, certain consents from the Companys landlords and
credit card processing firm, a list of domain name registrations, evidence of compliance with
EBITDA and minimum unrestricted cash balance levels on a prospective basis, and historical and
prospective financial statements. In addition, CapitalSource Finance LLC may perform due diligence
on the Companys financial projections. Events of default under this credit agreement include,
subject to grace periods and notice periods in certain circumstances, failure to pay any amount
owed under the line of credit when due, breach of representations contained in the agreement,
failure to perform covenants contained in the agreement, termination of any loan document or
security interest created under the agreement, a judgment against the Company in excess of certain
amounts, failure to pay certain amounts of indebtedness due under, or another default under, debt
or other agreements to which the Company is party, insolvency or petition for bankruptcy or
dissolution, certain defined change of control transactions, the termination of the employment of
the Companys Chief Executive Officer or Brand Strategist if not timely replaced by suitable
successors, a material adverse effect on the Companys business or material adverse change in the
validity of the credit agreement, the value of the Companys assets that are pledged as collateral
or the Companys business, operations, prospects, properties, assets, liabilities or condition, the
occurrence of an 8




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uninsured casualty loss in excess of certain amounts, indictment or conviction of
any director or senior officer of a felony or a levy, attachment or garnishment that could lead to
forfeiture of collateral under the agreement. The credit agreement requires us to pay and deliver all collections to an account over which
CapitalSource Finance LLC has sole control. When we borrow under the credit agreement, the
borrowings are repaid through the funds in this account. Under the terms of the Second Amendment,
if the Company is not borrowing, this account will not be utilized. As a result, funds settled from
our net revenues will be deposited directly into our bank account as long as no amounts are
outstanding under the credit agreement. In addition, the credit agreement requires, subject to exceptions in certain limited
circumstances, maintaining excess availability of a certain amount of capital at certain specified
times, a covenant which among other things restricts the Companys ability to engage in certain
acquisition and investment transactions, and other covenants which restrict or place limitations on
the Companys ability to incur indebtedness, issue securities, create or allow to exist any liens
on the Companys assets, transfer the Companys assets, or declare or pay dividends. As of December 26, 2004, the Company did not have an outstanding balance under this credit
facility. 5. Commitment In July 2004, the Company entered into an operating lease agreement for approximately 28,000
square feet of office space for our headquarters in San Francisco, California. The lease term is
five years with one option to extend for an additional two years and another option to extend for
an additional five years. The Company also paid approximately $205,000 in the form of a security
deposit in connection with the San Francisco office space lease. The future minimum lease payments
under the lease as of December 26, 2004 are as follows (in thousands): Fiscal 2005
    
    $
    154Fiscal 2006
    
    
    616Fiscal 2007
    
    
    616Fiscal 2008
    
    
    616Fiscal 2009 and thereafter
    
    
    1,078Total minimum lease payments
    
    $
    3,080
 6. Legal Proceedings By its letter dated March 9, 2000, Red Letter Days Plc, a United Kingdom company (Red Letter
Days), asserted trademark rights in the United Kingdom in the marks RED LETTER, RED LETTER DAYS and
the image of a red envelope. Red Letter Days offers experiential gifts in the United Kingdom. The
letter claimed that if we were to use our name and the REDENVELOPE service mark in the United
Kingdom in connection with retail sales of gifts, it would infringe Red Letter Days trademark
rights. Red Letter Days has opposed our applications to register the REDENVELOPE and RedEnvelope
stylized logo marks in the United Kingdom and the European Community. Red Letter Days oppositions
to our United Kingdom and European Community trademark applications are pending. Evidentiary
submissions have been made by the parties in connection with those opposition proceedings and a
decision is not expected for several months. The sole issue to be decided in the opposition
proceedings is whether the REDENVELOPE mark is entitled to registration in the stated
jurisdictions. Even if an opposition is successful in preventing the subject trademark from being
registered, that decision by the registration authorities does not prevent the applicant from using
the mark in that jurisdiction. In order to prevent us from using the RedEnvelope mark in the United
Kingdom or European Community or to obtain any other equitable relief or monetary relief, Red
Letter Days would need to bring a lawsuit against us in the appropriate jurisdiction. To the best
of our 9




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knowledge, no such lawsuit has been filed. We opposed Red Letter Days application to
register the RED LETTER mark in the United Kingdom, based on the descriptiveness of the RED LETTER
mark as applied to the services of Red Letter Days. The United Kingdom trademark office has denied
our opposition and has approved the registration of the Red Letter Days mark in the United Kingdom.
This decision did not address a comparison of the REDENVELOPE and RED LETTER marks. From time to time, the Company is subject to legal proceedings and claims in the ordinary
course of business, including claims of alleged infringement of trademarks and other intellectual
property rights. The Company is not currently aware of such legal proceedings or claims that it
believes will have, individually or in the aggregate, a material adverse effect on its financial
position or results of operations. 10




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the unaudited condensed financial
statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q. Forward-Looking Statements This report, together with the documents incorporated herein by reference, contains
forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. Such statements
are based upon current expectations and involve risks and uncertainties. Any statements contained
in this report that are not purely statements of historical fact may be deemed to be
forward-looking statements. Such forward-looking statements may include but are not limited to
statements regarding our future operations, modifications and enhancements, product offerings,
business, financial condition, results of operations and prospects. Additionally, statements
concerning possible changes in applicable rules or legislation are forward-looking statements.
Words such as expects, anticipates, intends, plans, believes, seeks, estimate, may,
should, could and similar expressions or variations of such words are intended to identify
forward-looking statements, but are not the exclusive means of identifying forward-looking
statements in this report. All forward-looking statements in this report are based upon information
available to us as of the date hereof, and we assume no obligation to revise or update any such
forward-looking statements in order to reflect any event or circumstance that may arise after the
date of this report. Actual results and the timing of certain events could differ materially from
our current expectations. Factors that could cause or contribute to such differences include, but
are not limited to, those set forth in this report under Factors That May Affect Future Results,
and elsewhere in this report, and those contained from time to time in our other filings with the
SEC. We caution investors that our business and financial performance are subject to substantial
risks and uncertainties. Overview In the third quarter of fiscal 2005, we began to see results from our recent infrastructure,
merchandising and marketing initiatives. The investments that we made to our infrastructure
enhanced our fulfillment capabilities during the holiday season. Our merchandise strategy, which
includes products designed by us, was widely accepted by customers. Our marketing efforts,
including the advertising campaigns, contributed to customer acquisition as well as strong
performance from our existing customers. We believe our most recent Holiday results position
RedEnvelope as an affordable luxury solution for peoples gift-giving needs. Our net revenues increased 32.3% from the third quarter of fiscal 2004 to $47.5 million in the
third quarter of fiscal 2005. Gross margins were 54.3% in the third quarter of fiscal 2005 compared
to 49.5% in the third quarter of fiscal 2004. Net income was $2.8 million in the third quarter of
fiscal 2005 which represented a 135.4% increase over net income of $1.2 million in the third
quarter of fiscal 2004. To enhance our operational execution, particularly for the busier holiday shopping season, we
implemented new warehouse management software and installed new materials handling equipment at our
fulfillment center during the second quarter of fiscal 2005. During the third quarter of fiscal
2005, we experienced improvements in our fulfillment process compared to the third quarter of
fiscal 2004. However, we believe that there exist further opportunities to improve our fulfillment
costs as a percentage of net revenues. We plan to improve our labor cost model associated with the
fulfillment center and to further address workflow around the personalization of products. If we
are unable to improve the performance of the fulfillment process at our fulfillment center, we may
incur additional labor and shipping costs, fail to satisfy demand for our products or experience
customer dissatisfaction, any of which could have a material adverse affect on our business,
financial condition, and operating results. Achieving operational effectiveness at times of peak
demand will continue to be a critical area of management focus. 11




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During the third quarter of fiscal 2005, we increased our marketing efforts through our
catalog, online, email, advertising and public relations campaigns. Consistent with our marketing
strategy, we believe all of these marketing efforts complemented each other. Revenues from
customers who receive our catalogs grew 36.0% over the third quarter of fiscal 2004. Additionally,
online revenues, through search, portals and affiliates, grew 37.9% from the third quarter of
fiscal 2004. Our revenues from new customers were 55.3% of total revenues in the third quarter of
fiscal 2005 compared to 54.0% in the third quarter of fiscal 2004. As of the end of the third
quarter of fiscal 2005, our internal database of customer names (customers who have purchased from
the Company in the past) increased to approximately 2.2 million, with approximately 285,000 new
customers names added in the third quarter of fiscal 2005. We intend to promote loyalty from these
new customers, as well as continued loyalty from existing customers, by offering unique and
innovative products, helpful and knowledgeable customer service, accurate fulfillment rates and
targeted marketing programs. Our new print and outdoor advertising campaigns were launched in the
third quarter of fiscal 2005. These campaigns were designed to introduce our brand to new customers
and reinforce it with our existing customer base. For the quarter, our website traffic increased
32% for new customers and 38% for existing customers. We believe our recent advertising campaigns
contributed to this increase and had a positive effect on our business during the holiday season. The holiday season represents an opportunity for us to showcase our product development
capabilities. This year was no exception. Of our top fifty sellers during the third quarter of
fiscal 2005, 84% of the product assortment was proprietary to RedEnvelope compared to 74% during
the same period last year. Moreover, 58% of our top fifty sellers during the third quarter of
fiscal 2005 were designed in-house compared to 30% during the same period last year. Some of the
product categories that experienced growth from last year include mens and womens accessories,
jewelry, children, plants and flowers. We believe the growth across this wide range of categories
suggests we are offering customers gifts they cannot find elsewhere in the market. We believe that
our expanded assortment of everyday occasion products will advance our mission to be recognized as
the gift-authority. Although we are committed to our strategic initiatives, there are inherent risks associated
with our business that may present challenges for us in the future and could prevent us from
achieving intended revenue growth, scalability and increased efficiencies. We have outlined
currently identified risks within the Factors That May Affect Future Results section of this
report. In addition, the following discussion and analysis of financial condition, results of
operations, liquidity and capital resources should be read in conjunction with our audited
financial statements and the notes thereto in our Report on Form 10-K which is available at the
SECs website at www.sec.gov. Critical Accounting Policies Our financial statements have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues
and expenses. We base our estimates on historical experience and on various other assumptions that
we believe to be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different assumptions or
conditions. Our critical accounting policies are set forth below. Revenue recognition.We derive our revenues from merchandise sales made to consumers and
businesses. We generally require payment by credit card prior to shipment. We recognize revenue on
the date on which we estimate that the product has been received by the customer and any payments
received prior to the estimated date of receipt of the goods by the customer are deferred. We use
our third-party freight carrier information to estimate when delivery has occurred. Revenues are
recorded net of estimated returns, coupons redeemed by customers, and other discounts. Significant
management judgments and estimates must be made and used in connection with determining revenue
recognized in any accounting period. In particular, our management must make estimates of potential
future product returns related to current period revenue. We analyze historical returns, current
economic trends and changes in customer 12




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demand and acceptance of our products when evaluating the adequacy of the sales returns and other
allowances in any accounting period. Actual returns may differ materially from our estimated
reserve. As a result, our operating results and financial condition could be affected adversely.
The reserve for returns was $1.0 million, $0.2 million and $1.4 million as of December 26, 2004,
March 28, 2004 and December 28, 2003, respectively. The extreme weather in the Midwest before Christmas impaired the operations of package
delivery services. Orders representing an additional approximately $0.7 million in net revenues
that were shipped from our fulfillment center were not delivered to recipients prior to the end of
the third fiscal quarter. Because we recognize revenue when goods are delivered to recipients,
these net revenues and related cost of sales were deferred at the end of the third fiscal quarter
and will be recognized in the fourth fiscal 2005 quarter. Shipping and Handling Costs.Shipping costs, which include inbound and outbound freight costs
and the cost of gift wrap, are included in cost of sales. Handling costs, which include fees paid
to our former third-party fulfillment service provider as well as fulfillment center expenses, are
included in operating expenses  fulfillment. Handling costs included in operating expenses 
fulfillment for the thirteen weeks ended December 26, 2004 and December 28, 2003 were $2.4 million
and $2.4 million, respectively. Handling costs included in operating expenses fulfillment for the
thirty-nine weeks ended December 26, 2004 and December 28, 2003 were $4.3 million and $3.9 million,
respectively. Our gross profit may not be comparable to other entities, which may allocate all
shipping and handling costs to either cost of sales, resulting in lower gross profit, or to
operating expenses, resulting in higher gross profit. Inventory.Inventories are stated at the lower of cost or market. We estimate a provision for
damaged, obsolete, excess and slow-moving inventory based on inventory aging reports and specific
identification. If actual obsolescence is different from our estimate, we will adjust our provision
accordingly. Specific provisions are recorded in the event the cost of the inventory exceeds the
fair market value. In addition, we estimate a reserve for expected inventory shrinkage based on
historical shrinkage factors and our current inventory levels. Actual shrinkage is recorded at
fiscal year-end based on the results of our physical inventory count. The obsolescence reserve was
$0.5 million, $0.3 million and $0.8 million as of December 26, 2004, March 28, 2004 and December
28, 2003, respectively. Accounting for income taxes.Significant management judgment is required in determining our
deferred tax assets and liabilities and any valuation allowance recorded against our net deferred
tax assets. As of March 28, 2004, we had recorded a valuation allowance of $28.0 million against
our net deferred tax asset balance due to uncertainties related to our deferred tax assets as a
result of our history of operating losses. The valuation allowance is based on our estimates of
taxable income by jurisdiction in which we operate and the period over which our deferred tax
assets will be recoverable. In the event that actual results differ from these estimates or we
adjust these estimates in future periods, we may need to change the valuation allowance, which
could materially impact our financial position and results of operations. Catalog Amortization.Prepaid catalog costs consist of third-party costs including paper,
printing, postage and mailing costs for all of our direct response catalogs. Such costs are
capitalized as prepaid catalog costs and are amortized over their expected period of future benefit
which generally does not exceed three months. Such amortization is based upon the ratio of actual
revenues to the total of actual and estimated future revenues on an individual catalog basis.
Prepaid catalog costs are evaluated for realizability at each reporting period by comparing the
carrying amount associated with each catalog to the estimated probable remaining future net benefit
of the catalog (defined as net revenues less merchandise cost of goods sold, selling expenses and
catalog completion costs) associated with that catalog. If the carrying amount is in excess of the
estimated probable remaining future net benefit of the catalog, the excess is expensed in the
reporting period. Stock based compensation.We account for stock options granted to employees using the
intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees. Accordingly, no compensation expense has been recognized in the
financial statements for 13




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stock options granted with exercise prices equal to the fair value of the stock on the date of
grant. SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148,
Accounting for Stock-Based Compensation  Transition and Disclosure, however, requires the
disclosure of pro forma net earnings and earnings per share as if we had adopted the fair value
method. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through
the use of option pricing models. These models require subjective assumptions, including future
stock price volatility and expected time to exercise, which affect the calculated values. Our
calculations are based on a single option valuation approach and forfeitures are recognized as they
occur. In fiscal 2004, we granted approximately 0.3 million options to employees at an exercise price
that was less than the fair market value of our stock on the date of grant. We recorded $0.7
million of deferred compensation related to these option grants, which is included as a separate
component of stockholders equity, and is being amortized over the vesting period of the awards
into general and administrative expenses in the statements of operations. We recorded amortization
expense of $5,000 and $18,000 for the thirteen and thirty-nine weeks ended December 26, 2004. We
recorded amortization expense of $77,000 and $212,000 for the thirteen weeks and thirty-nine weeks
ended December 28, 2003. Results of Operations The following table sets forth our statements of operations data for the thirteen and
thirty-nine weeks ended December 26, 2004 and December 28, 2003, respectively, expressed as a
percentage of net revenues. Thirteen Weeks
    
    
    Thirty-Nine WeeksDecember 26,
    
    
    December 28,
    
    
    December 26,
    
    
    December 28,2004
    
    
    2003
    
    
    2004
    
    
    2003Statements of Operation Data:Net revenues
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    45.7
    
    
    
    50.5
    
    
    
    46.8
    
    
    
    50.8Gross profit
    
    
    54.3
    
    
    
    49.5
    
    
    
    53.2
    
    
    
    49.2Operating expenses:Fulfillment
    
    
    13.3
    
    
    
    14.5
    
    
    
    14.9
    
    
    
    15.2Marketing
    
    
    25.9
    
    
    
    20.7
    
    
    
    24.5
    
    
    
    20.8General and administrative
    
    
    9.4
    
    
    
    10.9
    
    
    
    16.4
    
    
    
    17.3Total operating expenses
    
    
    48.6
    
    
    
    46.1
    
    
    
    55.8
    
    
    
    53.3Income (loss) from operations
    
    
    5.7
    
    
    
    3.4
    
    
    
    (2.6
    )
    
    
    (4.1
    )Interest income
    
    
    0.1
    
    
    
    0.2
    
    
    
    0.3
    
    
    
    0.1Interest expense
    
    
    (0.1
    )
    
    
    (0.3
    )
    
    
    (0.3
    )
    
    
    (0.6
    )Net income (loss)
    
    
    5.7
    %
    
    
    3.3
    %
    
    
    (2.6
    )%
    
    
    (4.6
    )%
 Revenues Our net revenues are comprised of product sales, shipping revenue and gift-wrap revenue.
Revenues are recorded net of estimated returns, coupons redeemed by customers, and other discounts.
Our shipping revenue represents the amounts we charge our customers for delivering the product. Our
gift wrap revenue consists of amounts we charge our customers for our signature red gift boxes. Net revenues were $47.5 million and $35.9 million for the thirteen weeks ended December 26,
2004 and December 28, 2003, respectively, representing a 32.3% increase. The increase was primarily
due to increased demand for our products resulting from additional marketing efforts through our
online, catalog, and advertising campaigns. Online revenues, through search, portals, and
affiliates, grew 37.9% over the 14




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same quarter in the prior year. During the third quarter of fiscal
2005, revenues from customers who receive our catalogs grew 36.0% over the third quarter of fiscal
2004. During the third quarter of fiscal 2005, we increased our holiday catalog circulation by
approximately 3.1 million catalogs, or 42.0% over the third quarter of fiscal 2004. The growth in
these two channels, which are our two largest channels, was slightly offset by the decline in
revenues from customers that order directly through our website without an apparent connection to
our catalog, online, email, or corporate marketing activities. The total number of orders in the
third quarter of fiscal 2005 increased by approximately 21.2% over the total number of orders in
the third quarter of fiscal 2004, primarily as a result of the increased marketing activities. Net
revenues per order in the third quarter of fiscal 2005 increased by approximately 9.1% over net
revenues per order in the third quarter of fiscal 2004 due to increased customer demand for our
jewelry, mens and womens accessories, and apparel product categories which typically carry higher
average item prices. During the week leading up to Christmas, extreme weather in the Midwest and
consequent hazardous road conditions delayed order processing at our fulfillment center. On
Wednesday, December 22nd and Thursday, December 23rd, the majority of the Companys fulfillment
center employees could not reach our fulfillment center, dramatically reducing the fulfillment
centers processing capacity. We believe that, as a result, shipment and delivery of orders
representing approximately $0.8 million in net revenues remained in the warehouse and were not
delivered until after the end of the third quarter. Absent these severe weather conditions these
orders would have been fulfilled and delivered prior to the end of the third fiscal quarter. The
net revenues and related cost of sales will be recognized in the
fourth fiscal quarter of 2005. If
these delivery delays negatively impact our customer loyalty, our operating results could be
materially harmed. Additionally, the extreme weather impaired the operations of package delivery services.
Orders representing approximately $0.7 million in net revenues that were shipped from our
fulfillment center were not delivered to recipients prior to the end of the third fiscal quarter.
We believe that absent these severe weather conditions, these orders would have been delivered
prior to the end of the third fiscal quarter. Because we recognizes revenue when goods are
delivered to recipients, these net revenues and related cost of sales were deferred at the end of
the third fiscal quarter and will be recognized in the fourth fiscal quarter of 2005. We made
efforts to contact customers to inform them of the potential delays. If the fulfillment or delivery delays resulting from the weather conditions negatively impact our
customer loyalty, our operating results could be materially harmed. Net revenues were $79.2 million and $62.0 million for the thirty-nine weeks ended December 26,
2004 and December 28, 2003, respectively, representing a 27.8% increase. The increase was primarily
due to increased demand for our products resulting primarily from additional marketing efforts through our
online, catalog and advertising campaigns. For the thirty-nine weeks ended December 26, 2004,
online revenues, through search, portals, and affiliates, grew 32.7% over the thirty-nine weeks
ended December 28, 2003. For the thirty-nine weeks ended December 26, 2004, revenues from customers
who receive our catalogs grew 36.8% over the thirty-nine weeks ended December 28, 2003. For the
initial thirty-nine weeks of fiscal 2005, we increased our catalog circulation by approximately 5.5
million catalogs, or 38.7% over the same period in fiscal 2004. The number of orders placed during
the initial thirty-nine weeks of fiscal 2005 increased by approximately 18.8% over the number of
orders placed during the initial thirty-nine weeks of fiscal 2004, primarily as a result of the
increased marketing activities. Net revenues per order in the initial thirty-nine weeks of fiscal
2005 increased by approximately 7.6% over the net revenues per order in the initial thirty-nine
weeks of fiscal 2004 primarily due to increased customer demand for our jewelry, mens and womens
accessories, and apparel product categories which typically carry higher average item prices. In
August of 2003, we changed the delivery charge for standard ground delivery to a flat rate
regardless of order value. As a result, our shipping revenues have not increased at the same rate
as product sales in the initial thirty-nine weeks of fiscal 2005 compared to the initial
thirty-nine weeks of fiscal 2004. Our customer base increased from approximately 1.7 million at the end of December 28, 2003 to
approximately 2.2 million at the end of the third quarter of fiscal 2005. 15




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Cost of Sales Cost of sales consists of the cost of the product sold, shipping costs including inbound and
outbound freight and gift-wrap expense. Handling costs, which include fees paid to our former
third-party fulfillment service provider and fulfillment center expenses, are included in operating
expenses  fulfillment. Cost of sales were $21.7 million and $18.1 million for the thirteen weeks ended December 26,
2004 and December 28, 2003, respectively, representing 45.7% and 50.5% of net revenues,
respectively. The 19.6% increase in costs of sales was mainly attributable to the 32.3% increase in
net revenues. As a percentage of net revenues, the decrease was primarily attributable to higher
average product margins resulting from an increase in overseas product sourcing, which typically
has lower product costs. Cost of sales were $37.0 million and $31.5 million for the thirty-nine weeks ended December
26, 2004 and December 28, 2003, respectively, representing 46.8% and 50.8% of net revenues,
respectively. The 17.6% increase in costs of sales was mainly attributable to the 27.8% increase in
net revenues. The decrease in cost of sales as a percentage of net revenues was primarily
attributable to higher average product margins resulting from an increase in overseas product
sourcing, which typically has lower product costs. Operating Expenses Fulfillment.Fulfillment expenses consist of wages and benefits for employees and seasonal
hires working in our fulfillment center and customer service facility, fees incurred to process
credit card transactions and certain fixed costs, such as rent and utilities, incurred by our
fulfillment center and our customer service facility. Prior to August 2003, fulfillment expenses
also included fees paid to our former third-party fulfillment service provider. Services performed
by our former third-party fulfillment service provider included receiving, picking, packing,
shipping and other warehousing activities. Fulfillment expenses were $6.3 million and $5.2 million for the thirteen weeks ended December
26, 2004 and December 28, 2003, respectively, representing 13.3% and 14.5% of net revenues,
respectively. The increase in dollars was primarily attributable to the 21.2% increase in the
number of orders. As a percentage of net revenues, the decrease was attributable to improved
fulfillment processes at our fulfillment center. In the third quarter of fiscal 2004, we
encountered delays in our fulfillment processes, which resulted in additional labor costs. Fulfillment expenses were $11.8 million and $9.4 million for the thirty-nine weeks ended
December 26, 2004 and December 28, 2003, respectively, representing 14.9% and 15.2% of net
revenues, respectively. The increase in dollars was primarily attributable to the 18.8% increase in
the number of orders. As a percentage of net revenues, the slight decrease was primarily
attributable to expense efficiencies at our fulfillment center
compared to the third quarter of last year. As a result of improved order fulfillment rates, our customer service center has been able
to focus on phone calls for order placing and less resources were needed for phone calls associated
with order fulfillment inaccuracies. Moreover, our return rates in the initial thirty-nine weeks of
fiscal 2005 have decreased compared to the initial thirty-nine weeks of fiscal 2004. During the third quarter of fiscal 2005, a winter storm affected transportation in and around
the areas of our fulfillment center. As a result, our third party shipping carriers were unable to
deliver shipments by December 26, 2004. We made efforts to contact customers to inform them of the
potential delays. If these delivery delays negatively impact our customer loyalty, our operating
results could be materially harmed. The investments we have made in our materials handling processes, materials handling equipment
and warehouse management software have provided us with the capabilities to better manage our
fulfillment operations and scale our business. Nevertheless, we believe there are further
improvements to be made. If we are unable to improve the performance and increase the efficiencies
of the fulfillment process at our distribution center, our operating results could be materially
harmed. 16




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Marketing.Marketing expenses consist primarily of online and catalog programs as well as
advertising, public relations, and other promotional expenditures. Marketing expenses were $12.3 million and $7.4 million for the thirteen weeks ended December
26, 2004 and December 28, 2003, respectively, representing 25.9% and 20.7% of net revenues,
respectively. The increase in expenses both in dollars and as a percentage of net revenues was
primarily due to additional spending in our online, catalog, advertising and corporate marketing
campaigns. During the third quarter of fiscal 2005, we increased our holiday catalog circulation by
approximately 3.1 million catalogs, or 42.0%, over the third quarter of fiscal 2004. Additionally,
we launched print and outdoor advertising campaigns for the Holiday season. Marketing expenses were $19.4 million and $12.9 million for the thirty-nine weeks ended
December 26, 2004 and December 28, 2003, respectively, representing 24.5% and 20.8% of net
revenues, respectively. The increase in expenses both in dollars and as a percentage of net
revenues was primarily due to additional spending in our online, catalog, advertising and corporate
marketing campaigns. During the initial thirty-nine weeks of fiscal 2005, we increased our catalog
circulation by approximately 5.5 million catalogs, or 38.7%, over the initial thirty-nine weeks of
fiscal 2004. Currently, we plan to increase the circulation of our Valentines Day catalogs for the
next fiscal quarter due to having a larger customer base than last year and to acquire additional
customers. Currently, we plan to continue our marketing through print and outdoor advertising campaigns.
As a result, we anticipate the costs of marketing for fiscal 2005 to increase compared to the prior
fiscal year. If we are unsuccessful in generating sufficient revenues through these marketing
vehicles to offset the increased costs, our operating results could be adversely affected. General and Administrative.General and administrative expenses consist of wages and benefits
for our administrative employees, located primarily at our corporate office. These expenses also
include costs incurred for computer and communications technology, rent and utilities for our
headquarters, travel, depreciation, and other general corporate expenditures. General and administrative expenses were $4.4 million and $3.9 million for the thirteen weeks
ended December 26, 2004 and December 28, 2003, respectively, representing 9.4% and 10.9% of net
revenues, respectively. The increase in dollars was primarily due to increased personnel related
costs, accounting fees, business taxes, costs, and depreciation expense. The decrease in expenses
as a percentage of net revenues was primarily due to the increase in net revenues. General and administrative expenses were $13.0 million and $10.7 million for the thirty-nine
weeks ended December 26, 2004 and December 28, 2003, respectively, representing 16.4% and 17.3% of
net revenues, respectively. The increase in dollars was primarily due to training and consulting
fees related to our software and systems implementations projects, increased personnel related
costs and the costs associated with being a publicly-held company, including those associated with
our Annual Meeting of Stockholders. The decrease in expenses as a percentage of net revenues was
primarily due to the increase in net revenues. The implementation of new software systems in fiscal year 2005 will result in additional
depreciation expense in future quarters. We also currently plan on increasing our general and
administrative employee headcount (i.e., employees other than fulfillment and customer service
employees) in order to support anticipated future business needs, which will add to general and
administrative expenses. Also, the compliance requirements associated with being a public company will likely increase our accounting
and legal expenses. 17




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Other Income and Expenses Interest Income.Interest income was $0.06 million and $0.06 million in the thirteen weeks
ended December 26, 2004 and December 28, 2003, respectively. Interest income was $0.2 million and
$0.08 million for the thirty-nine weeks ended December 26, 2004 and December 28, 2003,
respectively. The increases are primarily due to higher average cash balances and slightly higher
interest rates. Interest Expense.Interest expense was $0.07 million and $0.1 million in the thirteen weeks
ended December 26, 2004 and December 28, 2003, respectively. Interest expense was $0.2 million and
$0.4 million for the thirty-nine weeks ended December 26, 2004 and December 28, 2003, respectively.
The decreases are primarily attributable to lower amounts of debt outstanding. 18




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Liquidity and Capital Resources We have funded our operations primarily through private sales of equity securities,
borrowings, and the completion of our initial public offering which resulted in net offering
proceeds of approximately $29.0 million. Historically, revenues have been seasonal. Revenues have
been higher in the third fiscal quarter, reflecting higher consumer holiday spending. As a result,
our cash balances are seasonal in nature, with the third fiscal quarter representing a
significantly higher level of cash than other periods. Throughout the fiscal year, we utilize our
cash balances to build our inventory levels with the most significant use of working capital
occurring immediately prior to the month of December. In addition to our current cash balances
on-hand, we have an $11.0 million revolving credit facility which allows us to borrow funds for
working capital purposes, subject to certain provisions. Cash Flows From Operating Activities Net cash flows provided by operating activities were
$4.5 million and $8.8 million for the thirty-nine weeks ended December 26, 2004 and December 28,
2003, respectively. Net cash provided by operating activities resulted from changes in working
capital that was slightly offset by losses. Specifically, there was an increase in our accounts
payable, accrued expenses and an increase in our merchandise inventories. This was primarily due to
the timing of seasonal inventory receipts and payable disbursements. Cash Flows From Investing Activities Net cash flows used in investing activities were ($1.7)
million and ($5.1) million for the thirty-nine weeks ended December 26, 2004 and December 28, 2003,
respectively. Uses of cash flow from investing activities consisted of capital expenditures for
property and equipment purchases, which were partially offset by maturities of investments. We have
incurred capital expenditures for software systems to support our financial and warehouse
management systems. We are also planning capital expenditures for certain order management
functions. We believe the implementation of these software systems will support the needs of our
business and customers. Software implementation projects entail significant technical and business
risks. If we are unsuccessful in implementing these systems, it may hinder our ability to process
and fulfill customer orders as well as complete critical financial processing transactions. These
capital expenditures will result in an increase in our depreciation expense. For the initial
thirty-nine weeks of fiscal 2005, we have spent approximately $2.9 million for our warehouse
management system, materials handling equipment, and order management system projects. We currently
estimate spending an additional amount of approximately $0.2 million over the remainder of fiscal
2005 on our order management system project. Additionally, we incurred approximately $0.7 million
in tenant improvements and capital asset additions in connection with our new San Francisco office
space. Although we believe these estimates on expenditures to be reasonable given the current facts
and circumstances available to us, we can offer no assurance that the actual amounts expended will
not be significantly greater. Cash Flows From Financing Activities Net cash flows provided by financing activities were
$0.3 million and $26.0 million for the thirty-nine weeks ended December 26, 2004 and December 28,
2003, respectively. For the initial thirty-nine weeks of fiscal 2005, net cash flows from financing
activities consisted of proceeds from the exercises of stock options and warrants slightly offset
by payments for capital lease obligations. Revolving Credit Facility We also have funds available of up to $11.0 million pursuant to
our revolving credit facility with CapitalSource Finance LLC, which is described more fully in Note
4 to the financial statements contained in this report. Our ability to borrow under this credit
facility is subject to compliance with its terms. At December 26, 2004, we had no borrowings under
the revolving credit facility. On June 21, 2004, we amended the terms of our credit facility with CapitalSource Finance LLC.
Under the terms of this Second Amendment, certain covenants for inventory ratios and capital
expenditure - 19 -




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limitations were eliminated. The minimum earnings before interest, taxes, depreciation and
amortization (EBITDA) covenant was modified, and quarterly minimum unrestricted cash balance levels
were established. Further, under this Second Amendment, the EBITDA and minimum unrestricted cash
balance covenants were modified such that they are not applicable unless borrowings are
outstanding. CapitalSource Finance LLC previously has waived non-compliance with such covenants as
of prior dates, but we can offer no assurance that they will do so in the future in the event of
non-compliance with a covenant at a time when borrowings are outstanding, if ever. In advance of any borrowings, we are required to deliver to CapitalSource Finance LLC written
notification of our intent to borrow, certain consents from our landlords and credit card
processing firm, a list of domain name registrations, evidence of compliance with EBITDA and
minimum unrestricted cash balance levels on a prospective basis, and historical and prospective
financial statements. In addition, CapitalSource Finance LLC may perform due diligence on our
financial projections. In July 2004, we entered into an operating lease agreement for approximately 28,000 square
feet of office space for our headquarters in San Francisco, California. The lease for our former
headquarters expired in September 2004. The new monthly lease commitment amount is approximately
the same as the prior monthly rental amount. We believe that the cash currently on hand will be sufficient to continue operations through
at least the next twelve months. Our assessment is based on historical working capital needs,
operating loss trends, and current business outlook. Beyond the next twelve months, we intend to
utilize the cash on hand and the cash generated from operations to fund operations and capital
expenditures. We may, in the future, be required to raise funds through additional equity and /or
debt financings to support our long-term obligations and needs. However, there can be no assurance
that if additional financing is necessary it will be available, or if available, that such
financing can be obtained on satisfactory terms or without undue dilution to, or an adverse impact
on the rights of, our existing stockholders. Failure to generate sufficient revenues or raise
additional capital could have a material adverse effect on our ability to continue as a going
concern and to achieve our intended business objectives. Factors That May Affect Future Results You should consider carefully the risks and uncertainties relating to our business described
below. Additional risks and uncertainties not currently known to us or that we currently do not
deem material may also become important factors that may harm our business. The trading price of
our common stock could decline due to any of these risks and uncertainties. Our limited operating history makes evaluation of our business difficult. We were originally incorporated in 1997 and began selling products in September 1997. As a
result, we have limited historical financial data upon which to base planned operating expenses or
forecast accurately our future operating results. Further, our limited operating history will make
it difficult for investors and securities analysts to evaluate our business and prospects. You must
consider our business and prospects in light of the risks and difficulties we may face as an early
stage company with limited operating history. These risks and difficulties include challenges in
accurate financial planning as a result of limited historical data and the uncertainties resulting
from having had a relatively limited time period in which to implement and evaluate our business
strategies as compared to older companies with longer operating histories. Our failure to
successfully address these risks and difficulties would seriously harm our business. We have a history of significant losses. If we do not achieve or sustain
profitability, our financial condition and stock price could suffer. We have a history of losses and we may continue to incur losses for the foreseeable future. As
of December 26, 2004, our accumulated deficit was $80.7 million. We have not achieved profitability
for a - 20 -




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full fiscal year. If our revenues grow more slowly than we anticipate, or if our operating expenses
exceed our expectations, we may not be able to achieve full fiscal year profitability in the near
future or at all. Even if we do achieve full fiscal year profitability, we may not be able to
sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to
achieve full fiscal year profitability within a short period of time, or at all, or if we are
unable to sustain profitability at satisfactory levels, our financial condition and stock price
could be adversely affected. Because we experience seasonal fluctuations in our net sales, our quarterly
results will fluctuate and our annual performance will depend largely on
results from one quarter. Our business is highly seasonal, reflecting the general pattern of peak sales for the retail
industry during the holiday shopping season. Typically, a substantial portion of our net revenues
occur during our third fiscal quarter ending around December 31. We generally experience lower net
revenues during the first, second and fourth fiscal quarters and, as is typical in the retail
industry, have incurred and may continue to incur losses in these quarters. The third fiscal
quarter accounted for approximately 45% of net revenues in the fiscal year ended March 28, 2004. We
cannot predict with certainty what percentage of our total net revenues for fiscal year 2005 will
be represented by our third fiscal quarter revenues. In anticipation of increased sales activity
during the third fiscal quarter, we incur significant additional expenses, including significantly
higher inventory and staffing costs. If sales for the third fiscal quarter do not meet anticipated
levels, then increased expenses may not be offset, which would adversely affect our financial
condition. If we were to experience lower than expected sales during one of our third fiscal
quarters, for whatever reason, it would have a disproportionately large negative impact on our
annual operating results and financial condition for that fiscal year. If our net revenues during
our third fiscal quarter were to fall below projections or the expectations of securities analysts, our stock
price could decline, perhaps significantly. Our operating results are volatile and difficult to predict and may adversely affect our stock
price. Our annual and quarterly operating results have fluctuated in the past and may fluctuate
significantly in the future due to a variety of factors, many of which are outside of our control.
Further, because our business is seasonal, our operating results may vary significantly from one
quarter to the next as part of our normal business cycle. As a result, we believe that quarterly
comparisons of our operating results are not necessarily meaningful and that you should not rely on
the results of one quarter as an indication of our future performance. It is likely that in some
future quarter our operating results may fall below projections or the expectations of securities
analysts and investors. In this event, the trading price of our common stock could decline
significantly. Factors that could cause our operating results to fluctuate include the following:  
    The seasonality of our business
    Decreases in the number of visitors to our website or our inability to convert
those visitors into customers
    Technical difficulties, including system or Internet failures
    Fluctuations in the demand for our products
    The number of prior customers that make repeat purchases
    Overstocking or understocking of our merchandise
    Offering of new or enhanced services or more popular products by our competitors
    Fluctuations in the level of our product returns - 21 -




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
    Termination of existing marketing relationships or failure to develop successful
new marketing relationships
    Fluctuations in shipping costs, particularly during the holiday season
    Fluctuations in advertising, marketing or catalog production and distribution costs
    Fluctuations in personalization and fulfillment costs
    The amount and timing of operating costs and capital expenditures including those
relating to expansion or upgrade of our operations
    Changes in government regulations and taxation related to use of the Internet or
otherwise applicable to our business
    Wars, natural disasters or other catastrophic events
    Economic conditions generally or economic conditions specific to the Internet,
online commerce, the retail industry, the mail order industry or the gift industry
    Changes in the mix of products that we sell
    Fluctuations in levels of inventory theft, damage or obsolescence
    Costs associated with litigation or other disputes Our computer and communications hardware and software systems are vulnerable to
damage and interruption, which could harm our business. Our ability to receive and fulfill orders successfully through our website is critical to our
success and largely depends upon the efficient and uninterrupted operation of our computer and
communications hardware and software systems. Our systems and operations are vulnerable to damage
or interruption from power outages, computer and telecommunications failures, computer viruses,
security breaches, catastrophic events (such as natural disasters or terrorist attacks), and errors
in usage by our employees and customers. Further, our servers are located at the facilities of, and
hosted by, a third-party service provider in Santa Clara, California. In the event that this
service provider experiences any interruption in its operations or ceases operations for any reason
or if we are unable to agree on satisfactory terms for a continued hosting relationship, we would
be forced to enter into a relationship with another service provider or take over hosting
responsibilities ourselves. We cannot assure you that, in the event it became necessary to switch
hosting facilities, we would be successful in finding an alternative service provider on acceptable
terms or in hosting the computer servers ourselves. Any significant interruption in the
availability or functionality of our website, or our sales processing, fulfillment or
communications systems for any reason, particularly an interruption during the holiday season,
could seriously harm our business. If we fail to offer a broad selection of innovative merchandise that consumers
find attractive, our revenues could decline or fail to reach anticipated levels
and our stock price could be harmed. In order to meet our strategic goals, we must successfully offer, on a continuous basis, a
broad selection of appealing products. These products must satisfy the diverse tastes of our
customers and potential customers for a variety of gift-giving occasions. To be successful, our
product offerings must be affordable, well made, innovative and attractive to a wide range of
consumers whose preferences may change regularly. We cannot predict with certainty that we will be
successful in offering products that meet these requirements. If our products become less popular
with consumers, our revenues may decline or fail to - 22 -




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meet expected levels or we may decide to offer
our products at lower prices. If a wide range of consumers do not find our products attractive or
if we are required to reduce our prices, our revenues and earnings may decline or fail to meet
expected levels and our stock price could be affected adversely. Failure to successfully manage or expand our fulfillment and distribution
operation would have a material adverse effect on us. Our fulfillment and distribution operation is located in leased facilities in Lockbourne,
Ohio. Our agreement with the fulfillment services company that previously managed the fulfillment
and distribution operations at the Lockbourne, Ohio facility expired in August 2003, at which point
we assumed direct control of fulfillment and distribution operations. We have limited experience
managing fulfillment and distribution operations, and we cannot assure you that we will be
successful in this endeavor. We experienced significant difficulties managing the fulfillment and
distribution operations during the 2003 holiday season, including difficulties in inventory
management and timely gift personalization, and anticipated efficiencies from managing the
fulfillment center ourselves did not materialize during that period. If we are unable to manage
successfully our fulfillment and distribution operations and to meet our customers expectations
regarding personalization, presentation and delivery, our business reputation, operations and
financial condition could be seriously harmed. Further, any difficulty in managing our fulfillment
and distribution operations could require us to find one or more parties to provide these services
for us. If we are required to engage one or more service providers, we could incur higher
fulfillment expenses than anticipated or incur additional costs for balancing merchandise
inventories among multiple fulfillment facilities. Further, we may need to expand or upgrade our
fulfillment operations in the future to accommodate increases in customer orders, increased demand
for personalized products or changes in available technology. If we fail to successfully manage,
expand or make necessary upgrades to our fulfillment and distribution operations in a timely and
cost-effective manner, it would have a material adverse effect on our business. If we do not manage our inventory levels successfully, our operating results will be affected adversely. We must maintain sufficient inventory levels to operate our business successfully. Rapidly
changing trends in consumer tastes for gift items expose us to significant inventory risks,
particularly during our third fiscal quarter when inventory levels are highest due to the holiday
shopping season. Consumer preferences can change between the time we order a product and the time
it is available for sale. We base our product selection on our projections of consumer tastes and
preferences in a future period, and we cannot guarantee that our projections of consumer tastes and
preferences will be accurate. It is critical to our success that we accurately predict consumer
tastes and stock our product offerings in appropriate quantities. In the event that one or more
products do not achieve widespread consumer acceptance, we may be required to take significant
inventory markdowns, which could reduce our net sales and gross margins. This risk may be greatest
in the third fiscal quarter of each year, after we have significantly increased inventory levels
for the holiday shopping season. In addition, to the extent that demand for our products increases
over time, we may be forced to increase inventory levels. Any such increase would require the use
of additional working capital and subject us to additional inventory risks. Further, our failure to
stock sufficient quantities of popular products would likely cause us to miss revenue opportunities
and could cause our customers to become dissatisfied and look to our competitors for their gift
items, which could also harm our business reputation. In the past, some of our popular items were
not stocked in quantities sufficient to meet the demand for such items, which likely led to missed
sales opportunities. If we fail to stock popular products in sufficient quantities or if we
overstock products, our business, financial condition and operating results would be affected
adversely. We may have difficulty in product sourcing. More than half of our products are unique designs manufactured by third-party suppliers. We
enter into exclusive supply agreements for these products to maintain a competitive advantage.
However, since we do not have long-term arrangements with any vendor or distributor that would
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products from year to year, we do not have a predictable or
guaranteed supply of these products in the future. If we are unable to provide our customers with
continued access to popular, exclusive products, our operating results could be harmed. In addition, we may not receive products from our suppliers in a timely manner or we may
receive products from our suppliers that do not meet our quality standards. From time to time, we
receive products from suppliers that are of insufficient quality to provide to our customers.
Generally the supplier is able to quickly rectify the problem, but occasionally we have been unable
to obtain replacement product quickly enough to fulfill all customer orders for such product in a
timely manner, particularly with respect to items sourced overseas which tend to have longer
delivery lead time requirements. If we do not receive products from our suppliers in a timely
manner or if we receive products from our suppliers that do not meet our high quality standards and
we are unable to obtain suitable replacement products in a timely manner, our reputation and our
operating results could be harmed. Further, customers who do not receive their products in a timely
manner may look to our competitors for their gift items. Many of our products are sourced overseas. While products sourced overseas typically have
lower costs, our product margins may be slightly offset by an increase in inbound freight costs. As
security measures around shipping ports increase, these additional costs may result in higher
inbound freight costs. Furthermore, in recent years, U.S. companies were subject to port strikes
which delayed the delivery of goods. As we increase our overseas sourcing, we face the risk of
these delays which could seriously harm our business and results of operations. We cannot predict
whether any of the countries in which our merchandise currently is manufactured or may be
manufactured in the future will be subject to additional trade restrictions imposed by the U.S. and
other foreign governments, including the likelihood, type or effect of any such restrictions. Trade
restrictions, including increased tariffs or quotas, embargoes, and customs restrictions, against
items that we offer or intend to offer to our customers, as well as U.S. or foreign labor strikes,
work stoppages or boycotts, could increase the cost or reduce the supply of items available to us
and adversely affect our business, financial condition and results of operations. Our sourcing
operations also may be adversely affected by political and financial instability resulting in the
disruption of trade from exporting countries, significant fluctuation in the value of the U.S.
dollar against foreign currencies, restrictions on the transfer of funds and/or other trade
disruptions. Any disruption or delays in, or increased costs of, importing our products could have
an adverse effect on our business, financial condition and operating results. Our operating results could suffer if we fail to offer or sell sufficient quantities of
proprietary products. In recent periods, the majority of our most popular products has been designed in-house or was
otherwise exclusive to RedEnvelope. As proprietary products generally carry higher gross margins
than widely available products, any failure to offer and sell large numbers of proprietary products
could prevent us from achieving our gross margin objectives. If we are unable for any reason to
design or source popular proprietary products or if we are unable to sell sufficient quantities of
proprietary products during any future period, our operating results would be adversely affected. Our facilities and systems are vulnerable to natural disasters or other catastrophic events. Our headquarters, customer service center and the majority of our infrastructure, including
computer servers, are located in California, an area that is susceptible to earthquakes and other
natural disasters. Our distribution facility, located in Lockbourne, Ohio, houses substantially all of our product
inventory and is the location from which substantially all of our sales are shipped. A natural
disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in,
terrorist attack or other comparable problems could cause interruptions or delays in our business
and loss of data or render us unable to accept and fulfill customer orders in a timely manner, or
at all. Further, California has in the recent past - 24 -




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experienced power outages as a result of limited
electrical power supplies. These outages may recur in the future and we cannot determine the
effect, if any, that such outages would have on the operation of our business. In addition, as our
inventory and distribution facility is located in an area that is susceptible to harsh weather, a
major storm, heavy snowfall or other similar event could prevent us from delivering products in a
timely manner. Also, areas in and around San Diego, California, the site of our customer service
facility, have in the past experienced severe wildfires. The occurrence of any such wildfires in
the future could destroy, render inoperable or cause the evacuation of our customer service
facility, which could significantly disrupt our ability to provide satisfactory customer service.
We have no formal disaster recovery plan and our business interruption insurance may not adequately
compensate us for losses that may occur from any of the foregoing. In the event that an earthquake,
natural disaster or other catastrophic event were to destroy any part of our facilities or
interrupt our operations for any extended period of time, or if harsh weather conditions prevent us
from delivering products in a timely manner, our business, financial condition and operating
results could be seriously harmed. We have grown quickly and if we fail to manage our growth, our business will suffer. We have rapidly and significantly expanded our operations, and anticipate that further
significant expansion, including the possible acquisition of third-party assets, technologies or
businesses, will be required to address market opportunities and desired growth in our customer
base. Prior expansion has placed, and any future expansion is expected to continue to place, a
significant strain on our management, operational and financial resources. Some of our officers or
senior management personnel have no prior senior management experience at public companies. Our new
employees include key officers as well as a number of key managerial, technical and operations
personnel who have not yet been fully integrated into our operations. Additionally, we need to
properly implement and maintain our financial and managerial controls, reporting systems and
procedures, including the increased internal controls and procedures required by the recently
enacted Sarbanes Oxley Act of 2002. Moreover, if we are presented with appropriate opportunities,
we may in the future make investments in, or possibly acquire, assets, technologies or businesses
that we believe are complementary to ours. Any such investment or acquisition may further strain
our financial and managerial controls and reporting systems and procedures. These difficulties
could disrupt our business, distract our management and employees or increase our costs. If we are
unable to manage growth effectively, implement proper controls and systems in an efficient manner,
or successfully integrate any assets, technologies or businesses that we may acquire, or if we
acquire assets, technologies or business that do not prove complimentary to us, our business,
financial condition and results of operations would be affected adversely. We experience intense competition in the rapidly-changing retail gift market. We operate in a highly competitive environment. We principally compete with a variety of
department stores, Internet retailers, specialty retailers and other catalog merchandisers that
offer products similar to or the same as our products. Increased competition is likely to result in
price reductions, reduced gross margins and loss of market share, any of which could seriously harm
our net revenues and results of operations. We expect competition to intensify in the future
because current and new competitors can enter our market with little difficulty and can launch new
websites at a relatively low cost. We currently or potentially compete with a variety of other
companies, including:  
    other online retailers, such as Amazon.com
    major department stores, such as Macys, Bloomingdales and Neiman Marcus
    physical and online stores and catalog retailers that sell popular gift
items such as Williams-Sonoma, Brookstone, The Sharper Image, Tiffanys,
Harry & David, J Crew, and 1-800-Flowers
    Internet portals and online service providers that feature shopping
services, such as AOL, Yahoo! and Lycos - 25 -




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Many of our traditional store-based, catalog-based and online competitors have longer
operating histories, larger customer or user bases, greater brand recognition and significantly
greater resources, particularly financial and marketing resources. Many of these competitors can
devote substantially more resources to website development and catalog retailing than we can. In
addition, large, well-established and well-financed entities may establish more robust online sales
operations in the future. Our competitors may be able to secure products from vendors on more
favorable terms, provide popular products to which we do not have access, fulfill customer orders
more efficiently and adopt more aggressive pricing or inventory availability policies than we can. The U.S. retail industry, the specialty retail industry in particular, and the online commerce
sector are highly competitive, dynamic in nature and have undergone significant changes over the
past several years and will likely continue to undergo significant changes. Our ability to
anticipate and respond successfully to these changes is critical to our long-term growth and we
cannot assure you that we will anticipate and respond successfully to changes in the retail
industry and online commerce sectors. If we are unable to maintain or increase our market share or
compete effectively in the retail gift market, our business, financial condition and operating
results would be adversely affected. If we do not successfully expand our website and order processing systems or
respond to rapid technological changes, we could lose customers and our net
revenues could decline. If we fail to upgrade our website in a timely manner to accommodate higher volumes of traffic,
our website performance could suffer and we may lose customers. In addition, if we fail to expand
the computer systems that we use to process and ship customer orders and process customer payments,
we may not be able to fulfill customer orders successfully. As a result, we could lose customers
and our net revenues could be reduced. Further, to remain competitive, we must continue to enhance
and improve the functionality and features of our online store. The Internet and the online
commerce industry are subject to rapid technological change. If competitors introduce new features
and website enhancements, or if new industry standards and practices emerge, our existing website
and systems may become obsolete or unattractive. Developing our website and other systems entails
significant technical and business risks. We may use new technologies ineffectively or we may fail
to adapt our website, our transaction processing systems and our computer network to meet customer
requirements or emerging industry standards. If we are unsuccessful in upgrading our systems to
accommodate higher traffic or developing or implementing new technologies that enable us to meet
evolving industry standards and remain competitive, our operating results would be seriously
harmed. We recently implemented certain system enhancements and upgrades, including a new warehouse
management system, and an updated financial software package. We are currently in the process of
implementing a new order-entry software system and software to enhance the features of our website.
Also, we are in the process of modifying certain internal processes for the purpose of improving
our productivity and making our operations more cost efficient. However, we cannot assure you that
we will be successful in these efforts. Possible cost overruns in these implementation efforts may
result in higher than anticipated capital expenditures and delays in or other problems arising out
of these implementations could lead to customer dissatisfaction. If we do not successfully
implement one or more of these intended upgrades or modified processes or if we do not achieve
desired efficiencies or cost savings as a result of these changes or if attempts to enhance our
website are unsuccessful or are not appealing to our customers, our business and operating results
could be harmed, perhaps significantly. Delivery of our merchandise could be delayed or disrupted by factors beyond our
control, and we could lose customers as a result. As timely gift delivery is essential to our customers satisfaction, any delay disruption or
inaccuracy in order, fulfillment and shipping, particularly during the holiday shopping season,
could cause us to lose customers and negatively affect our business and reputation. In addition, we
rely upon third-party carriers for timely delivery of our product shipments. As a result, we are
subject to carrier disruptions and increased costs due to factors that are beyond our control,
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We rely on seasonal and temporary employees during periods of peak activity and any failure by
such employees to adequately perform their jobs could adversely affect our operations. We depend on temporary and seasonal employees to adequately staff our fulfillment facility and
customer service facilities during busy periods such as the holiday shopping season, including
individuals responsible for gift personalization and packaging and responding to customer and
potential customer inquiries. Temporary employees may not have the same levels of training or
commitment as full-time employees and, as a result, may be more likely to provide unsatisfactory
service. We cannot assure you that we will continue to receive adequate assistance from our
temporary employees, or that we will continue to have access to sufficient numbers of competent
temporary employees on a cost-effective basis, particularly during the holiday shopping season,
which season is critical to our business. If we are unable to adequately staff our fulfillment and
customer service facilities, particularly during the holiday shopping season and other periods of
increased activity or if our temporary and seasonal employees do not provide satisfactory service,
our operations and sales during such period could suffer, and our reputation could be harmed. Increased merchandise returns and a failure to accurately predict merchandise
returns could harm our business. As part of our customer service commitment, we maintain a merchandise return policy that
allows recipients to return most non-personalized merchandise items received from us if they are
dissatisfied with those items. We make allowances for merchandise returns in our financial
statements based on historical return rates. We cannot assure you that actual merchandise returns
will not significantly exceed our allowances for returns. In addition, because our allowances are
based on historical return rates, we cannot assure you that the introduction of new merchandise in
our catalogs, the introduction of new catalogs, increased sales over the Internet, changes in our
merchandise mix, changes in the habits of our gift item recipients, or other factors will not cause
actual returns to exceed return allowances, perhaps significantly. Any increase in merchandise
returns that exceed our allowances would affect our business adversely. Also, returned merchandise
that is personalized, perishable, or damaged likely cannot be re-sold, creating non-recoverable
inventory costs which detrimentally affects our operating results. If we are unable to successfully manage the costs of our catalog operations or
our catalogs fail to produce sales at satisfactory levels it could adversely
affect our business. Our catalog has been an important tool for the acquisition and retention of customers. We
believe that the success of our catalog as a cost-effective marketing tool depends on the following
factors:  
    effective management of costs associated with the production and distribution of our catalog
    achievement of adequate response rates to our mailings
    displaying a mix of merchandise in our catalog that is attractive to our customers
    cost-effective production of appealing catalogs
    timely delivery of catalog mailings to our customers Catalog production and mailings entail substantial paper, printing, postage and human labor
costs. Increases in the costs of producing and distributing the RedEnvelope catalog, including
increases in postage rates or paper, photography, or printing costs, may reduce the margin on sales derived from our
catalog. The U.S. Postal Service is likely to increase its postage rates in the future and other
delivery and overnight courier services that we utilize to deliver our products also will likely
raise their rates in the future, which could significantly increase the aggregate cost of mailing
our catalogs. As we incur nearly all of the costs associated with our catalogs prior to mailing, we
are unable to adjust the costs being incurred in connection with a particular mailing to reflect
the actual performance of the catalog. In addition, response rates to our mailings and, as a
result, revenues generated by each mailing, are affected by factors such as constantly - 27 -




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changing
consumer preferences and our ability to include a product assortment that satisfies those
preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by
the postal system of our catalog mailings, and changes in our merchandise mix, several or all of
which may be outside of our control. If we were to experience an increase in the costs associated
with producing or delivering our catalogs or a delay in distributing our catalogs or if our
catalogs fail to produce sales at satisfactory levels, our operating results would be adversely
affected. We are dependent on the success of our advertising and marketing efforts which
are costly and may not achieve desired results. Our revenues depend on our ability to advertise and market our products effectively through
the RedEnvelope catalog and our other advertising and marketing efforts. If we do not successfully
advertise and market our products, our operating results will be seriously harmed. Increases in the
cost of advertising and marketing, including paper and postage costs and the costs of complying
with applicable regulations, may limit our ability to advertise and market our business in a
cost-effective manner. In addition, individuals are increasingly using software programs that block
certain email marketing campaigns, and certain Federal and state laws and regulations may restrict
our ability to effectively utilize email as a marketing tool. We are currently in the process of
modifying our mix of advertising to include more print and outdoor advertising. If we decrease our
advertising or marketing activities, if the effectiveness of such activities is diminished, due to
increased costs, restrictions enacted by regulatory agencies or for any other reason or if our
current advertising strategy does not yield anticipated results, our future operating results could
be significantly harmed. We expect to increase spending on advertising and marketing in the future,
and if such efforts do not produce a sufficient level of sales to cover their costs, it would harm
our operating results. Recent changes to our shipping rate policy could cause our revenues to decline. In August 2003, we changed our shipping rate policy from a graduated rate schedule, based on
the cost of the item(s) purchased by a customer, to a consistent flat rate per shipment. This
change will have the effect of lowering our average per-shipment shipping fee, thereby reducing our
shipping revenues per order. While we believe that this change to our shipping rate policy will be
conducive to an increase in our order volume, we cannot assure you that our order volume will be
increased or that any increase in shipments will offset the reduction in per-shipment shipping
revenues resulting from our shipping rate policy change. We believe that this change in shipping
rate policy had an aggregate negative impact on our revenues for the third quarter of fiscal 2004,
which was the first full quarter following the policy change, and subsequent periods. If our
aggregate shipping revenues decrease as a result of the change in our shipping rate policy without
a commensurate rise in product revenue, our business, financial condition and results of operations
could be harmed. If we are unable to provide satisfactory customer service, we could lose customers. Our ability to provide satisfactory levels of customer service depends, to a large degree, on
the efficient and uninterrupted operation of our call center. Any material disruption or slowdown
in our order processing systems resulting from labor disputes, telephone or Internet failures,
power or service outages, natural disasters or other events could make it difficult or impossible
to provide adequate customer service and support. Further, we may be unable to attract and retain
adequate numbers of competent customer service representatives, which is essential in creating a
favorable interactive customer experience. Due to increased customer service needs during the holiday shopping season, we hire a relatively large number of
temporary employees during our third fiscal quarter. As a result, we may have difficulty properly
staffing our customer service operations during our peak sales season. If we are unable to
continually provide adequate staffing for our customer service operations, our reputation could be
seriously harmed. In addition, we cannot assure you that email and telephone call volumes will not exceed our
present system capacities. If this occurs, we could experience delays in placing orders, responding
to customer - 28 -




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inquiries and addressing customer concerns. Our customer service facility currently
accommodates customer service representatives at close to its capacity during our peak sales
period. We currently plan on hiring additional customer service representatives in our distribution
center in Ohio to accommodate the overflow of calls. Because our success depends in large part on
keeping our customers satisfied, any failure to provide high levels of customer service or
adequately staff our customer service operations would likely impair our reputation and have an
adverse effect on our business and operating results. The loss of our senior management or other key personnel could harm our current
and future operations and prospects. Our performance is substantially dependent on the continued services and on the performance of
our senior management and other key personnel. One of our long-time officers and directors, Hilary
Billings, recently resigned from RedEnvelope. While we believe that this will have no material
impact on our operations, we cannot assure you that disruptions occasioned by her departure will
not have an adverse impact on our near-term operations. Our performance also depends on our ability
to retain and motivate other officers and key employees. We do not have long-term employment
agreements with any of our key personnel. The loss of the services of Ms. May or any of our
executive officers or other key employees for any reason could harm our business, financial
condition and operating results. Our future success also depends on our ability to identify,
attract, hire, train, retain and motivate other highly-skilled technical, managerial, editorial,
merchandising, marketing and customer service personnel. Competition for such personnel is intense,
particularly in the San Francisco Bay Area, and we cannot assure you that we will be able to
successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to attract
and retain the necessary technical, managerial, editorial, merchandising, marketing and customer
service personnel would harm our business, financial condition and results of operations. If the protection of our trademarks and proprietary rights is inadequate, our
brand and reputation could be impaired and we could lose customers. We regard our copyrights, service marks, trademarks, trade dress, trade secrets and similar
intellectual property as critical to our success. We rely on trademark and copyright law, trade
secret protection and confidentiality agreements with our employees, consultants, partners,
suppliers, and others to protect our proprietary rights. Nevertheless, the steps we take to protect
our proprietary rights may be inadequate. Further, effective trademark, service mark, copyright and
trade secret protection may not be available in every country in which we will sell our products
and offer our services. Currently, we are involved in a trademark dispute with a company based in
the United Kingdom regarding trademark rights in the United Kingdom and European Community. For
more information on this dispute, see Part II. Item 1  Legal Proceedings below. In addition, the
relationship between regulations governing domain names and laws protecting trademarks and similar
proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring
domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks
and other proprietary rights. If we are unable to protect or preserve the value of our trademarks,
copyrights, trade secrets or other proprietary rights for any reason, our business would be harmed. We also rely substantially on technologies that we license from third parties. These licenses
may not continue to be available to us on commercially reasonable terms, or at all, in the future.
As a result, we may be required to develop or obtain substitute technology of lower quality or at
greater cost, or we may be prevented from providing features or functionality on our website that
our customers and potential customers desire, any of which could materially adversely affect our business, operating results
and financial condition. Intellectual property claims against us could be costly and could impair our business. Other parties may assert infringement or unfair competition claims against us. In the past, we
have received notices from third parties alleging that our trademarks or product offerings infringe
proprietary - 29 -




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rights held by them. We have also in the past received claims and have been a defendant
in a lawsuit alleging that our Internet marketing program and website operations infringe patents
held by third parties. We may receive other similar notices from, or have lawsuits filed against us
by, third parties in the future. We cannot predict whether third parties will assert claims of
infringement against us, or whether any past, present or future claims will prevent us from
offering popular products or operating our business as planned. If we are forced to defend against
thirty-party infringement claims, whether they are with or without merit or are determined in our
favor, we could face expensive and time-consuming litigation, which could distract technical and
management personnel, or result in product shipment delays. If an infringement claim is determined
against us, we may be required to pay monetary damages or ongoing royalties. Further, as a result
of infringement claims either against us or against those who license technology to us, we may be
required to develop non-infringing intellectual property or enter into costly royalty or licensing
agreements. Such royalty or licensing agreements, if required, may be unavailable on terms that are
acceptable to us, or at all. If a third-party successfully asserts an infringement claim against us
and we are required to pay monetary damages or royalties or we are unable to develop suitable
non-infringing alternatives or license the infringed or similar intellectual property on reasonable
terms on a timely basis, it could significantly harm our business. We face the risk of inventory shrinkage. We are subject to the risk of inventory loss and theft, particularly with respect to our
growing line of jewelry products. Although we believe that the levels of inventory shrinkage that
we have suffered in the past are within an acceptable range, we cannot assure you that incidences
of inventory loss and theft will not increase in the future or that the security measures we have
taken in the past will effectively address the problem of inventory theft. If we were to suffer
higher rates of inventory shrinkage or incur increased security costs to combat inventory theft,
our financial condition could be affected adversely. Poor economic conditions may constrain discretionary consumer spending on
retail products such as ours. Consumer spending patterns, particularly discretionary spending for products such as ours, are
affected by, among other things, prevailing economic conditions, stock market volatility, wars,
threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, and consumer
confidence. General economic, political and market conditions, such as recessions, may adversely
affect our business results and the market price of our common stock. The terrorist attacks of
September 11, 2001 and the wars in Afghanistan and Iraq had a negative effect on an already slowing
economy and on consumer confidence. Our business and revenues have been, and could continue to be,
negatively affected by poor economic conditions and any related decline in consumer demand for
discretionary items such as our products. We face uncertainty in the degree to which poor
performance in the retail industry, decreased consumer confidence or any economic slowdown will
negatively affect demand for our products. We may not be able to accurately anticipate the
magnitude of these effects on future quarterly results, which could seriously harm our financial
condition. As we do not have large cash reserves, we may not be able to survive an extended
recession or sluggish economy. We may need additional financing and may not be able to raise additional
financing on favorable terms or at all, which could increase our costs, limit
our ability to grow and dilute the ownership interests of existing
stockholders. We anticipate that we may need to raise additional capital in the future to facilitate
long-term expansion, to respond to competitive pressures or to respond to unanticipated financial
requirements. Since our inception, we have experienced negative cash flow from operations on a
fiscal year basis and may experience negative cash flow from operations on a fiscal year basis for
the foreseeable future. We cannot be certain that we will be able to obtain additional financing on
commercially reasonable terms or at all. Any failure to obtain necessary capital on commercially
reasonable terms could have severe consequences on our business. If we raise additional funds
through the issuance of equity, equity-related or debt securities, such securities may have rights,
preferences or privileges senior to those of the rights of our - 30 -




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common stock and our stockholders
would experience dilution of their ownership interests. Further, under the terms of our credit
agreement with CapitalSource Finance LLC, we are subject to certain contractual limitations with
respect to raising additional capital during the term of that agreement. A failure to obtain
additional financing or an inability to obtain financing on acceptable terms could require us to
incur indebtedness that has high rates of interest or substantial restrictive covenants, issue
equity securities that would dilute the ownership interests, and possibly affect the rights,
preferences and privileges of existing stockholders, or scale back, or fail to address
opportunities for expansion or enhancement of, our operations. If we default on any secured loan, all or a portion of our assets could be subject to forfeiture. We are currently party to a credit agreement that is secured by substantially all of our
tangible and intangible assets, and we may enter into secured credit or loan agreements in the
future. If we default on our current or any future secured loan for any reason and are unable to
cure the default pursuant to the terms of the relevant agreement, our lenders could take possession
of any or all assets in which they hold a security interest, including intellectual property, and
dispose of those assets to the extent necessary to pay off our debts, which could materially harm
our business. We may face product liability claims that are costly and create adverse publicity. If any of the products that we sell causes harm or financial damages to any of our customers
or other individuals, we could be vulnerable to product liability lawsuits. If we are found liable
under product liability claims, we could be required to pay substantial monetary damages and our
reputation could suffer. Further, even if we successfully defend ourselves against this type of
claim, we could be forced to spend a substantial amount of money in litigation expenses, our
management could be required to spend valuable time in the defense against these claims and the
claims could bring adverse publicity to us, any of which could harm our business. We may face difficulty expanding into international markets. We may expand our operations in the future to sell our products internationally, but we have
relatively little experience in purchasing, marketing and distributing products or services for
international markets. It will be costly to establish international facilities and operations,
promote our brand internationally, and develop localized websites, catalogs and other systems.
Governments in other countries may regulate Internet or other online services in such areas as
content, privacy, network security, encryption or distribution, which could significantly affect
our ability to conduct business in those countries. If we are unsuccessful in our attempts to
expand our operations into other countries, our operating results could be harmed. We may incur significant costs or experience delays in product availability due
to regulations applicable to the sale of food products and live plants, which
may hurt our business. We currently offer select food items and live plants for sale to our customers. Applicable
federal, state or local regulations may cause us to incur substantial compliance costs or delay the
availability of those products. In addition, any inquiry or investigation from a regulatory
authority could have a negative impact on our reputation. The occurrence of any of these events
could adversely affect our financial condition. If we fail to comply with the laws regulating the sale of tobacco products it
may have a negative impact on our reputation and make us vulnerable to
liability claims. We are required to verify the age of purchasers of our tobacco products. If we fail to request
or are unable to properly identify the age of our purchasers, we could face substantial penalties
and legal liability for sales of tobacco products to underage persons. Any inquiry or investigation
from a regulatory authority could have a negative impact on our reputation and any liability claims
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damages or require us to spend significant time and money in
litigation, any of which could adversely affect our business, financial condition and operating
results. Our charter documents, Delaware law and third-party contractual restrictions
may make an acquisition of us more difficult, even if an acquisition would be
beneficial to our stockholders. We are a Delaware corporation and the Delaware General Corporation Law contains certain
provisions that may make a change in control of our company or the removal of incumbent directors
more difficult. In addition, our Amended and Restated Certificate of Incorporation and Bylaws,
contain provisions that may have the same effect, including the elimination of the ability of
stockholders to call special meetings or vote by written consent, the elimination of cumulative
voting for directors, and procedures requiring advance notification for stockholder proposals. The
elimination of cumulative voting substantially reduces the ability of minority stockholders to
obtain representation on the Board of Directors. These provisions may discourage potential
acquirers from making a bid for our company, or make an acquisition of us or a tender offer to our
stockholders more difficult, even if such acquisition or tender offer would be beneficial to our
stockholders, and may reduce any premiums paid to stockholders for their common stock. Additionally, under the terms of our credit agreement with CapitalSource Finance LLC, we are
subject to covenants that could restrict or place limitations on our ability to be acquired by
another company during the term of the credit agreement, even if such acquisition would be
beneficial to our stockholders. Our success is tied in large part to the continued use of the Internet by a large number of consumers. Our future revenues and profits, if any, substantially depend upon the continued widespread
use of the Internet as an effective medium of commerce and communication. Factors which could
reduce the widespread use of the Internet include:  
    actual or perceived lack of privacy protection
    actual or perceived lack of security of credit card information
    possible disruptions or other damage to the Internet or telecommunications infrastructure
    increased governmental regulation and taxation
    decreased use of personal computers Any decrease or less than anticipated growth in Internet usage could significantly harm our
business. Customers may be unwilling to purchase goods on the Internet. As of March 28, 2004, approximately 72% of our products were purchased through our website.
Our long-term prospects therefore depend upon the general publics increasing willingness to use
the Internet as a means to purchase goods. The failure of the Internet to continue to develop into an effective and
reliable tool for consumer purchases would seriously damage our future operations. Online commerce
is a relatively new concept, and online purchases may decline or fail to increase as projected. The
future of online commerce is highly uncertain, many online commerce companies have ceased
operations in recent years and most existing online commerce companies have a relatively short
operating history. If consumers are unwilling to use the Internet to purchase retail products, our
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The security risks of online commerce, including credit card fraud, may
discourage customers from purchasing goods from us. In order for the online commerce market to develop successfully, we and other market
participants must be able to transmit confidential information, including credit card information,
securely over public networks. Third parties may have the technology or know-how to breach the
security of customer transaction data. Any breach could cause consumers to lose confidence in the
security of our website and choose not to purchase from us. Although we take the security of our
systems very seriously, we cannot guarantee that our security measures will effectively prohibit
others from obtaining improper access to our information and information of our customers. If a
person is able to circumvent our security measures, he or she could destroy or steal valuable
information or disrupt our operations. Any security breach could expose us to risks of data loss,
litigation and liability and could seriously disrupt our operations and harm our reputation, any of
which could adversely affect our business. We do not carry insurance against the risk of credit card fraud, so the failure to prevent
fraudulent credit card transactions could reduce our net revenues and gross margin. We may suffer
losses as a result of orders placed with fraudulent credit card data even though the associated
financial institution approved payment of the orders. Under current credit card practices, we may
be liable for fraudulent credit card transactions because we do not obtain a cardholders
signature. If we are unable to detect or control credit card fraud, our liability for these
transactions could harm our business, operating results and financial condition. If one or more states successfully assert that we should collect sales or other
taxes on the sale of merchandise purchased from our website, our business could
be harmed. We do not currently collect sales or other similar taxes for physical shipments of goods into
states other than California and Ohio. In the future, one or more local, state or foreign
jurisdictions may seek to impose sales tax collection obligations on us. If sales tax obligations
are successfully imposed upon us by a state or other jurisdiction, we may suffer decreased sales
into such state or jurisdiction as the effective cost of purchasing goods from us increases for
those residing in such states or jurisdictions. We may also be subject to value added and other
taxes if we sell merchandise to customers located in the European Union or elsewhere in the world
and we may incur significant financial and organizational burdens in order to set up the
infrastructure required to comply with applicable tax regulations. If additional states or any
other jurisdictions successfully assert that we should collect sales or other taxes on the sale of
our merchandise into these jurisdictions our business and operating results could be affected
adversely. Existing or future government regulation could harm our business. We are subject to the same federal, state and local laws as other companies conducting
business on the Internet, including consumer protection laws, user privacy laws and laws and
regulations prohibiting unfair and deceptive trade practices. In particular, under federal and
state financial privacy laws and regulations, we must provide notice to our customers of our
policies and practices regarding non-public personal information that we collect and use, including
whether we share that information with third parties, must provide advance notice of any changes to
our privacy policies and must inform our customers about how they can review and/or correct the
non-public personal information we possess about them. Further, the growth of online commerce could
result in more stringent consumer protection laws that impose additional compliance burdens on us.
Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many
additional laws and regulations relating to the Internet are being debated at the state and federal
levels. These laws and regulations could cover issues such as freedom of expression, pricing,
consumer privacy, fraud, quality of products and services, taxation, advertising, adult-oriented
content, intellectual property rights and information security. Applicability of existing laws to
the Internet relating to issues such as trademarks, copyrights and other intellectual property
issues, taxation, libel, obscenity and personal privacy could also harm our business. For example,
United States and international laws regulate our ability to use customer information and to
develop, buy and sell mailing lists. Many of these laws were adopted prior to the advent of the
Internet, and do not contemplate or address the unique issues raised by the Internet. Those laws
that do reference the Internet, such as the Digital Millennium Copyright Act and the recent federal
law regulating the commercial use of e-mail (popularly known as CAN-SPAM), are only beginning to - 33 -




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be interpreted by the courts and their applicability and reach are therefore uncertain. The
restrictions imposed by, and costs of complying with, current and possible future laws and
regulations related to our business could harm our business, operating results and financial
condition. Tax authorities in a number of states, as well as a Congressional advisory commission, are
currently reviewing the appropriate tax treatment of companies engaged in online commerce, and new
state tax regulations may subject us to additional state sales and income taxes, which could have
an adverse effect on our cash flows and results of operations. Further, there is a possibility that
we could be subject to significant fines or other payments for any past failures to comply with
these requirements. In its most recent session, Congress refused to extend the U.S. Internet tax
moratorium. Consequently, states are free to impose new taxes on Internet access, which could slow
the growth of Internet use and of electronic commerce transactions over the Internet. The State of California recently enacted new sections of the Civil Code that require any
company that does business in California and possesses computerized data, in unencrypted form,
containing certain personal information about California residents to (i) provide prompt notice to
such residents if that personal information was, or is reasonably believed to have been, obtained
by an unauthorized person such as a computer hacker and (ii) implement and maintain reasonable
security procedures and practices to protect that information from unauthorized access,
destruction, use, modification or disclosure . The law defines personal information as an
individuals name together with one or more of that individuals social security number, drivers
license number, California identification card number, credit card number, debit card number, or
bank account information, including any necessary passwords or access codes. As our customers,
including California residents, generally provide information to us that is covered by this
definition of personal information in connection with their purchases via our website, our business
will be affected by this new law. As a result, we will need to ensure that all computerized data
containing the previously-described personal information is sufficiently encrypted or that we have
implemented appropriate measures to protect the integrity and security of that information and to
notify our California customers of any unauthorized access or misappropriation. Such measures will
likely increase the costs of doing business and, if we fail to implement appropriate safeguards or
we fail to detect and provide prompt notice of unauthorized access as required by the new law, we
could be subject to potential claims for damages and other remedies available to California
residents whose information was improperly accessed or, under certain circumstances, the State of
California could seek to enjoin our business operations until appropriate corrective actions have
been taken. While we intend to comply fully with this new law, we cannot assure you that we will be
successful in avoiding all potential liability or disruption of business resulting from this law.
If we were required to pay any significant amount of money in satisfaction of claims under this new
law, or any similar law enacted by another jurisdiction, or if we were forced to cease our business
operations for any length of time as a result of our inability to comply fully with any such law,
our business, operating results and financial condition could be adversely affected. Further,
complying with the applicable notice requirements in the event of a security breach could result in
significant costs. Further, recently-enacted federal and state laws place restrictions on email marketing that
could make it more difficult for us to acquire new customers, or to obtain repeat purchases from
prior customers through inexpensive electronic marketing methods. The CAN-SPAM Act, for example,
requires every commercial e-mail message to include an opt-out mechanism and requires all senders to comply with their
recipients opt out requests. It also requires senders to label all commercial e-mail messages as advertisements or solicitations. These
requirements may reduce the effectiveness of our e-mail marketing activities. If any current or
future law requires us to eliminate or curtail our email marketing efforts, our ability to obtain
new customers and increase revenues could be adversely affected or we could incur greater marketing
costs, either of which could harm our business. While we intend to comply with applicable law
regarding email marketing, there is no assurance that we will not incur fines or other liability as
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In addition, because our website is accessible over the Internet in multiple states and other
countries, we may be subject to their laws and regulations or may be required to qualify to do
business in those locations. We are qualified to do business only in California and Ohio at
present. Our failure to qualify in a state or country where we are required to do so could subject
us to taxes and penalties and we could be subject to legal actions and liability in those
jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws
and regulations could harm our business, operating results and financial condition. Our ability to
enforce contracts and other obligations in states and countries in which we are not qualified to do
business could be hampered, which could have a material adverse effect on our business. Further, an
important aspect of the new Internet-focused laws is that where federal legislation is absent,
states have begun to enact consumer-protective laws of their own and these can vary significantly
from state to state (and country to country). Thus, it is difficult for any company to be
sufficiently aware of the requirements of all applicable state laws and it is also difficult or
impossible for any company to comply fully with the sometimes inconsistent standards and
requirements set by various states. In addition to the consequences that could result from
violating one or more state laws (or the laws of any other country), the costs of attempting to
comply could be considerable. Laws or regulations relating to privacy and data protection may adversely
affect the growth of our Internet business or our marketing efforts. We are subject to increasing regulation relating to privacy and the use of personal user
information. For example, we are subject to various telemarketing laws that regulate the manner in
which we may solicit future suppliers and customers. Such regulations, along with increased
governmental or private enforcement, may increase the cost of growing our business. California
recently enacted several new laws that require all commercial website operators that collect
personal information about California residents to adopt and post a privacy policy that meets
certain specified criteria. Any failure to comply with this new law could subject us to civil
penalties, injunctions, and/or lawsuits. California also recently enacted new sections of its Civil
Code that require companies maintaining personal information about California residents to take
reasonable measures to protect against identity theft and other unauthorized uses of such
information and to notify California residents in the event that such information has been (or is
likely to have been) misappropriated, inappropriately modified or destroyed. The new laws provide
no standards for satisfactory compliance, so it is impossible to know for certainty what steps the
Company needs to take to comply with them. Compliance could require the Company to implement
procedures that would require it to change the way it does business and such procedures may be
expensive. In addition, several states have proposed legislation that would limit the uses of
personal user information gathered online or require online services to establish privacy policies.
The Federal Trade Commission has adopted regulations regarding the collection and use of personal
identifying information obtained from children under 13 years of age. Bills proposed in Congress
would extend online privacy protections to adults. Moreover, proposed legislation in the United
States and existing laws in other countries require companies to establish procedures to notify
users of privacy and security policies, obtain consent from users for collection and use of
personal information, and/or provide users with the ability to access, correct and delete personal
information stored by companies. These data protection regulations and enforcement efforts may
restrict our ability to collect demographic and personal information from users, which could be
costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and
regulations may subject us to fines, penalties and damages and may otherwise have a material adverse effect on our business, results of operations
and financial condition. We may be subject to liability for the Internet content that we publish. As a publisher of catalogs and online content, we face potential liability for defamation,
negligence, intellectual property infringement, or other claims based on the information and other
content contained in our catalogs and website. In the past, parties have brought these types of
claims and sometimes successfully litigated them against online services. If we incur liability for
our catalog or online content, our financial condition could be affected adversely and our
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Our directors, executive officers and significant stockholders hold a
substantial portion of our stock, which may lead to conflicts with other
stockholders over corporate transactions and other corporate matters. Our directors, executive officers and current beneficial holders of 5% or more of our
outstanding common stock own a significant portion of our stock. These stockholders, acting
together, are able to influence significantly all matters requiring stockholder approval, including
the election of directors and significant corporate transactions such as mergers or other business
combinations. This control may delay, deter or prevent a third-party from acquiring or merging with
us. 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk.We currently maintain a portfolio of fixed and variable rate investments
consisting of cash equivalents and short-term marketable securities, which can be affected by
changes in market interest rates. The objective of our investment activities is to preserve
principal, while at the same time maximizing yields without significantly increasing risk. To
achieve this objective, we invest in highly liquid, investment grade and government debt
securities. Our investments in debt securities are subject to interest rate risk. According to our
investment policy, we may invest in taxable and tax exempt instruments. In addition, the policy
establishes limits on credit quality, maturity, issuer and type of instrument. Marketable
securities are classified as available for sale. Marketable securities are comprised of
government securities and corporate bonds. We do not use derivative financial instruments in our
investment portfolio. (See Note 3 of Notes to Condensed Financial Statements) All highly liquid investments with maturity of three months or less at the date of purchase
are considered to be cash equivalents. The remaining investments in marketable securities are
considered short-term investments if maturities range over three months but less than one year, or
long term investments if maturities are one year or longer. The following table lists our cash and cash equivalents, short-term investments and long-term
investments at December 26, 2004: December 26, 2004(In thousands)Cash and cash equivalents
    
    $
    21,466Short-term investments
    
    
    6,022Total
    
    $
    27,488
 If interest rates changed adversely by 100 basis points, our results from operations
and cash flows would not be materially affected. Foreign Currency Risk.We purchase a significant amount of inventory from vendors outside of
the U.S. in transactions that are denominated in U.S. dollars. As of December 26, 2004, any
currency risks related to these transactions were not significant to us. A decline in the relative
value of U.S. dollar to other foreign currencies could, however, lead to increased purchasing
costs. 
 Item 4.Controls and Procedures The Company evaluated the design and operation of its disclosure controls and procedures to
determine whether they are effective in ensuring that the disclosure of required information is
timely and made in accordance with the Exchange Act and the rules and forms of the Securities and
Exchange Commission. This evaluation was made as of the end of the Companys most recent fiscal
quarter under the supervision and with the participation of management, including the Companys
principal executive officer and - 36 -




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principal financial officer. Maintenance of disclosure controls and
procedures is an ongoing process and controls and procedures may change over time. The Company also
has established a Disclosure Committee, which consists of certain members of the Companys senior
management. Based on this evaluation, our chief executive officer and our chief financial officer
have concluded that our disclosure controls and procedures, as defined at Exchange Act Rules
13a-15(e) and 15d-15(e), are effective to ensure that information required to be disclosed by the
Company in reports that it files under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange Commission rules and forms.
During the fiscal quarter, no changes were made to the Companys internal controls over financial
reporting that materially affected, or are reasonably likely to affect, such internal controls over
financial reporting. 
 PART II.
OTHER INFORMATION 
 Item 1.Legal Proceedings By its letter dated March 9, 2000, Red Letter Days Plc, a United Kingdom company (Red Letter
Days), asserted trademark rights in the United Kingdom in the marks RED LETTER, RED LETTER DAYS and
the image of a red envelope. Red Letter Days offers experiential gifts in the United Kingdom. The
letter claimed that if we were to use our name and the REDENVELOPE service mark in the United
Kingdom in connection with retail sales of gifts, it would infringe Red Letter Days trademark
rights. Red Letter Days has opposed our applications to register the REDENVELOPE and RedEnvelope
stylized logo marks in the United Kingdom and the European Community. Red Letter Days oppositions
to our United Kingdom and European Community trademark applications are pending. Evidentiary
submissions have been made by the parties in connection with those opposition proceedings and a
decision is not expected for several months. The sole issue to be decided in the opposition
proceedings is whether the REDENVELOPE mark is entitled to registration in the stated
jurisdictions. Even if an opposition is successful in preventing the subject trademark from being
registered, that decision by the registration authorities does not prevent the applicant from using
the mark in that jurisdiction. In order to prevent us from using the RedEnvelope mark in the United
Kingdom or European Community or to obtain any other equitable relief or monetary relief, Red
Letter Days would need to bring a lawsuit against us in the appropriate jurisdiction. To the best
of our knowledge, no such lawsuit has been filed. We opposed Red Letter Days application to
register the RED LETTER mark in the United Kingdom, based on the descriptiveness of the RED LETTER
mark as applied to the services of Red Letter Days. The United Kingdom trademark office has denied
our opposition and has approved the registration of the Red Letter Days mark in the United Kingdom.
This decision did not address a comparison of the REDENVELOPE and RED LETTER marks. From time to time, the Company is subject to legal proceedings and claims in the ordinary
course of business, including claims of alleged infringement of trademarks and other intellectual
property rights. The Company is not currently aware of such legal proceedings or claims that it believes will have,
individually or in the aggregate, a material adverse effect on its financial position or results of
operations. 
 Item 2.Unregistered Sales of Equity Securities and Use of Proceeds On September 24, 2003, a Registration Statement on Form S-1 (Commission File No. 333-106120)
relating to our initial public offering was declared effective by the Securities and Exchange
Commission. The net proceeds to us from the offering were approximately $29.0 million after
deducting underwriting discounts of $1.8 million. We used approximately $1.5 million of the net
proceeds for fees related to the offering (excluding banker fees). Since the initial public
offering, we have used approximately $6.5 million for purchases of property and equipment. We also
use the net proceeds to fund our working capital requirements throughout the year. 
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Item 5.Other Information On December 22, 2004, we entered into an employment offer letter with Gary Korotzer for the
position of Vice President of Marketing. The offer letter provides for a base salary of $225,000
per year, a sign-on bonus of $35,000, reimbursement of up to $20,000 of moving expenses and an
option to purchase 30,000 shares of common stock. In addition, Mr. Korotzers offer letter
provides that he will receive six months severance payments in the total amount of $112,000, paid
ratably over a six month period, and six months continued health care insurance coverage under
COBRA in the event of his employment is terminated by us without cause and provided that he signs
our standard general release of any claims against RedEnvelope. Mr. Korotzers employment offer
letter is filed with this Report on Form 10-Q as Exhibit 10.44. 
 Item 6.Exhibits (a) Exhibits 10.44
    
    Employment agreement dated December 22, 2004 between RedEnvelope, Inc. and Gary Korotzer31.1
    
    Certification of Chief Executive Officer required by Exchange Act Rules 13a-14(a) (Section 302)31.2
    
    Certification of Chief Financial Officer required by Exchange Act Rules 13a-14(a) (Section 302)32.1
    
    Certification required by 18 U.S.C.§1350, as adopted pursuant to §906 of the Sarbanes-Oxley
Act of 200232.2
    
    Certification required by 18 U.S.C.§1350, as adopted pursuant to §906 of the Sarbanes-Oxley
Act of 2002
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. REDENVELOPE, INC.By:
    
    /s/ ERIC C. WONGEric C. WongChief Financial Officer
 Date: February 8, 2005 II-3




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EXHIBIT INDEX 10.44
    
    Employment agreement dated
December 22, 2004 between RedEnvelope, Inc. and Gary Korotzer31.1
    
    Certification of Chief Executive Officer required by Exchange Act Rules 13a-14(a)
(Section 302)31.2
    
    Certification of Chief Financial Officer required by Exchange Act Rules 13a-14(a)
(Section 302)32.1
    
    Certification required by 18 U.S.C. § 1350, as adopted pursuant to § 906 of the
Sarbanes-Oxley Act of 200232.2
    
    Certification required by 18 U.S.C. § 1350, as adopted pursuant to § 906 of the
Sarbanes-Oxley Act of 2002