**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

----

 

**Form 10-K/A****AMENDMENT NO. 1 TO FORM 10-K**

 
| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934:** |
|------------|--------------------------------------------------------------------------------------------|
|       |                                                                                       |
|       | **For  the fiscal year ended March 31, 2002**                                              |

 

**OR**

 
| **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 0-26829**

 

----

 

**TULLY’S COFFEE CORPORATION**

(Exactname of registrant as specified in its charter)

 

| **Washington**                                                                    |   | **91-1557436**                        |
|-----------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdictionof incorporation or organization)                    |   | (I.R.S. Employer  Identification No.) |
|                                                                              |   |                                  |
| **3100 Airport Way South**                                                        |
| **Seattle, Washington 98134**                                                     |
| (Address of principal  executive offices) (Zip Code)                              |
| Registrant’s telephone  number, including area code: **(206) 233-2070** |
|                                                                              |   |                                  |
| Securities registered  pursuant to Section 12(b) of the Act:                 |
| **None**                                                                          |
|                                                                              |   |                                  |
| Securities registered  pursuant to Section 12(g) of the Act:                 |
| **Common Stock, no par value**                                                    |
| **(Title of each class)**                                                         |

 

----

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No  o

 

Indicate by check markif disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to thisForm 10-K. o

 

As of June 20, 2002,the number of shares of the registrant’s Common Stock outstanding was16,336,114.

 

 

----

 

**TABLE OF CONTENTS**

 
| **Item****No.**                              |                                                                                        |   |
|----------------------------------------------|---------------------------------------------------------------------------------------------|--------|
|                                         |                                                                                        |
| A  WARNING  ABOUT FORWARD-LOOKING STATEMENTS |
|                                         |                                                                                        |
|                                         | PART  I                                                                                     |
| ITEM 1.                                      | BUSINESS                                                                                    |
| ITEM 2.                                      | PROPERTIES                                                                                  |
| ITEM 3.                                      | LEGAL PROCEEDINGS                                                                           |
| ITEM  4.                                     | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                        |
|                                         |                                                                                        |
|                                         | PART  II                                                                                    |
| ITEM  5.                                     | MARKET  FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                 |
| ITEM 6.                                      | SELECTED FINANCIAL  DATA                                                                    |
| ITEM  7.                                     | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
| ITEM  7(a).                                  | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 |
| ITEM  8.                                     | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                |
| ITEM  9.                                     | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE       |
|                                         |                                                                                        |
|                                         | PART  III                                                                                   |
| ITEM  10.                                    | DIRECTORS  AND EXECUTIVE OFFICERS OF THE REGISTRANT                                         |
| ITEM 11.                                     | EXECUTIVE COMPENSATION                                                                      |
| ITEM  12.                                    | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                             |
| ITEM  13.                                    | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                             |
|                                         |                                                                                        |
|                                         | PART  IV                                                                                    |
| ITEM  14.                                    | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                      |
|                                         | SIGNATURES AND CERTIFICATIONS                                                               |

 

2

----

 

**A Warning About Forward-LookingStatements**

 

We make forward–lookingstatements in this report that are subject to risks and uncertainties. Theseforward–looking statements include information about possible or assumedfuture results of the company’s operations and its financial condition, plans,objectives and performance. Additionally, when we use the words “believe,”“expect,” “anticipate,” “estimate” or similar expressions, we are makingforward–looking statements. Many possible events or factors could affectour future financial results and performance. The forward-looking statementsare not guarantees of future performance and results or performance may differmaterially from those expressed in our forward–looking statements.  In addition to the factors discussedelsewhere in this annual report, the following possible events or factors couldcause our actual results to differ materially:

 

**•****                                         **future sources of financing may not beavailable when needed or may not be available on terms favorable to Tully’s;

 

•                                          our growth strategy maynot be as successful as we expect if we are unable to achieve market acceptancein new geographic areas or to locate and open stores in suitable locations;

 

•                                          our marketing and newproduct introduction strategies may not be as successful as we expect;

 

•                                          competition within theretail specialty coffee market may intensify;

 

•                                          competition andconsolidation within the food service and supermarket channels could result inreduced opportunities for product placement, or increase price competitionamong coffee suppliers, thereby adversely affecting our revenues or grossmargins;

 

•                                          adverse changes in thegeneral economic climate, interest rates or other factors affectingdiscretionary spending by consumers could adversely affect our revenues andgrowth potential; and

 

•                                          natural or politicalevents could either interrupt the supply or increase the price of premiumcoffee beans, thereby significantly increasing our operating costs.

 

In addition, thisdocument contains forward–looking statements relating to estimatesregarding the specialty coffee business. You should not place undue reliance onany of these forward–looking statements. Except to the extent required by the federal securities laws, we do notintend to update or revise the forward-looking statements contained in thisreport.

 

3

----

 

**PART I**

 

**ITEM 1.  BUSINESS**

 

**General**

 

Tully’s CoffeeCorporation  (“Tully’s” or the“Company”) sells high quality, premium roasted whole bean coffees, richlybrewed coffees, Italian–style espresso and other hot and cold beverages,baked goods, pastries and other food products, and coffee–relatedaccessories and equipment.  As of June20, 2002, Tully’s operated 104 retail stores, all of which are located in the western United States.

 

Tully’s complements itsretail operations with additional channels for distribution of its brandedproducts.  Tully’s previously referredto this complementary distribution business as its “specialty coffeedivision.”  This part of the Tully’sbusiness has experienced significant growth in recent years, and has expandedalong two paths which the Company began to manage as separate business segmentsduring the fiscal yearended March 31, 2002: (1) its Internationaldivision, which sells Tully’s coffee and related products and supplies toforeign licensees and manages the relationships with these licensees, and (2)its Wholesale division, which sells Tully’s whole bean coffee, related productsand supplies to domestic customers for resale viasupermarket, foodservice, restaurant, office coffee service, and institutional channels.  The Wholesale division is also responsiblefor the Company’s mail order and internet sales activities.  Due to the past growth and anticipatedopportunities for the International and Wholesale divisions, they are now beingseparately reported by the Company, and prior historical information for theformer “specialty coffee division” has been segregated to reflect the newreporting perspective.  See “Item8 – Financial Statements and Supplementary Data – Note 1 and Note 25 to theConsolidated Financial Statements.”

 

The InternationalDivision has significant relationships with two Japanese companies.  Tully’s has a license and supply agreementwith Tully’s Coffee Japan, Ltd. (“Tully’s Coffee Japan”) which, as of June 20,2002, operated 49 Tully’s retail stores in Japan and had franchised anadditional 14 stores in Japan under its license with the Company.  Tully’s has licensed Ueshima Coffee CompanyLtd. (“Ueshima Coffee Company” or “UCC”), a Japanese company, to operate coffeestores under the Tully’s name throughout Asia, excluding Japan.

 

The Company’s retailstore philosophy focuses on providing an upscale atmosphere, with quick,friendly service where customers can relax and enjoy some of the finest coffeeand espresso drinks available, together with other tasty treats. It ismanagement’s goal to make each location a friendly, neighborhood meeting place,with employees who go out of their way to make customers feel special. TheCompany believes that developing customer loyalty and brand recognition on the foundationof product appeal and customer service is of the utmost importance in itsbusiness and growth strategy, and that its retail image builds product andbrand credibility for its Wholesale and International divisions.

 

**Fiscal Periods**

 

The Company ends itsfiscal year on the Sunday closest to March 31. As a result, the Company records its revenue and expenses on a 52-53week period.  The fiscal year endedMarch 31, 2002 included 52 weeks (“Fiscal 2002”), the fiscal year ended April1, 2001 included 52 weeks (“Fiscal 2001”) and the fiscal year ended April 2,2000 included 53 weeks (“Fiscal 2000”). The fiscalyear ending March 30, 2003 will include 52 weeks(“Fiscal 2003”).

 

**CompanyBackground**

 

Tully’s was formed inJuly 1992 after its founder and Chairman of the Board, Tom T. O’Keefe,concluded that an opportunity to develop, own and operate a chain of specialtycoffee stores existed in the greater Puget Sound, Washington area. During theearly 1990s, Mr. O’Keefe’s real estate company was approached by numerouscompanies inquiring about locating specialty coffee stores in the propertiesowned and managed by his company.  As aresult, Mr. O’Keefe began researching the specialty coffee industry anddetermined that an opportunity existed for development of a company focused onthe sale of high-quality coffee beans, coffee drinks and coffee relatedproducts in an upscale atmosphere that emphasized customer service. OnSeptember 16, 1992, Tully’s opened its first store in Kent, Washington.

 

Tully’s Coffee Corporationis a Washington corporation and is headquartered at 3100 Airport Way South,Seattle, Washington 98134. The Company’s telephone number is(206) 233-2070 or 1-800-96Tully.

 

4

----

 

**Strategy**

 

*General*

 

During its first tenyears of operations, the Company’s objective has been to establish Tully’s asone of the most respected coffee brands in the world.  Under this strategy, the Company has made significant investmentsin marketing and building its brand. The Company wants each Tully’s retail store to provide a warm andinviting atmosphere that will attract customers and encourage those customersto stay and enjoy Tully’s coffee, espresso and other beverages and foodproducts. Tully’s seeks to employ people who contribute to the “coffeeexperience” of its customers.

 

The Companybelieves that it has successfully developed its brand identity and that it canmodify its strategy to place greater emphasis on improving store performanceand overall corporate profitability and less emphasis on branddevelopment.  Management believes thatthe Tully’s brand and retail store model have been developed to a point wherethey can be leveraged for improved operating results, and then replicated toadditional locations and markets.

 

Tully’s strives todevelop customer loyalty and brand recognition by providing superior serviceand offering quality coffee products that are competitively priced. Managementbelieves that the Company’s staff is well trained and knowledgeable about thecoffee products offered for sale.  It isthe Company’s belief that customer service, along with product freshness andconsistency, has become its hallmark, and it seeks to sustain these attributesin all three of its operating divisions- Retail, Wholesale, and International.

 

The Company believesthat its customers enjoy the flavor profiles and qualities of its coffeebeverages and other products, and often purchase them from more than onechannel.  For example, customers maypatronize Tully’s stores and may also enjoy Tully’s coffee beverages at afavorite restaurant or espresso bar, and may purchase Tully’s whole bean coffeefrom a supermarket for home consumption. Tully’s also believes that its customers will be receptive to theintroduction of other complementary product categories into its stores andthrough its Wholesale division. Further, products that are successful in Tully’s domestic stores mayhave opportunities for export or for license to the stores operated orfranchised by Tully’s licensees in Asia. In May 2002, the Company introduced Tully’s Premium Softened Ice CreamTMinto several Tully’s stores, and will be expanding the availability of thisproduct line into most of its Washington state stores during Fiscal 2003.  This product line is based upon premiumsoft-serve vanilla and Tully’s espresso flavor ice cream, and supports anexpanded menu including cones, sundaes, cold beverages and more.  Tully’s also believes that customers will bereceptive to improved value, variety and convenience through broaderdistribution, and it seeks expanded market share through its Wholesale divisionin the supermarket, food service, and institutional channels.  It is the Company’s belief that expandedproduct mix and broader distribution will help Tully’s reach prospectivecustomers that do not currently buy the Company’s products, and increase thefrequency and size of customer purchases.

 

Another importantelement of the Company’s strategy is to become an integral part of the localneighborhood served by each retail store. This is accomplished in a variety of ways, such as becoming involved inlocal fundraising and charitable organizations, participating in primary andsecondary school programs and by providing jobs to area high school students.The Company believes that community involvement not only helps the Company bybuilding goodwill, but also strengthens its market position.

 

*Historical Expansion and Future Growth Strategy*

 

Tully’s principaldomestic expansion strategy has been to develop new retail stores in theCompany’s current geographic markets in the western United States and tointroduce its Wholesale division to targeted wholesale segments (supermarket,food service and restaurants, office coffee services and institutional clients)in those same markets.  Tully’s also hasexpanded into new markets by purchasing existing retail coffee locations, withthe goal of converting these into Tully’s stores.

 

During Fiscal2001, Tully’s acquired the assets and real property leases of four LosAngeles-area stores and one Seattle-area store from Coffee Station, Inc.(“Coffee Station”), and the Company entered the Portland, Oregon market byacquiring nine stores from Tri-Brands, Inc., dba Marsee Baking (“MarseeBaking”).  No stores were acquired inFiscal 2002.

 

In light of theCompany’s current capital constraints and management’s focus on achievingoperating efficiencies and profitability, the Company anticipates opening veryfew new retail stores during Fiscal 2003. In Fiscal 2003, Tully’s intends to focus its Retail division primarilyon improving the results of its existing stores through introduction of newproducts, increased focus on marketing, merchandising, and advertising,operating cost savings, and closure of stores that do not meet Company expectationsDuring Fiscal 2003, Tully’s will continue to investigate and evaluateacquisition or other expansion opportunities that fit strategically into itsfuture growth plans, but presently expects few, if any, store acquisitionsduring Fiscal 2003.

 

5

----

 

Tully’s regularlyevaluates store performance, and periodically closes stores not meeting Companyexpectations.  During Fiscal 2002, theCompany opened two new stores and closed 12 stores.  During Fiscal 2001, the Company opened 37 new stores, closed twostores, and acquired 14 stores.  DuringFiscal 2000, the Company opened 10 new stores and closed four stores.

 

The Company’s primary international growth strategy has been to license othersto (i) operateor franchisethe right to operate Tully’s-branded retail stores and (ii) sellTully’s-branded products in the licensed geographic markets.  The Company expects continuing growth in itsInternational division in Fiscal 2003 and the Company may pursue other internationallicensing and joint venture opportunities.

 

In Fiscal 2003, Tully’s expects to continue developing its Wholesaledivision, especially in the supermarket and food service channels.  Growth in the wholesale segment is expectedto include addition of new customers in the Company’s principal market areas,and also programs to expand the volume of products sold through currentcustomers.

 

**Marketing**

 

*Retail Stores*

 

Tully’s focus onconsistency and quality in both its products and customer service has been akey element of its marketing program. Point of sale signage, custom bags, boxes, cups, gift sets, products andliterature with the Company’s distinctive name and logo, and communityactivities in which Tully’s name and logo are featured, are intended toincrease name awareness and to reinforce the Company’s image.

 

*Wholesale*

 

Tully’s Wholesaledivision provides additional opportunities for coffee consumers to experiencethe Company’s coffee and reinforces Tully’s branded logo and name.  The Wholesale division makes many of theCompany’s branded products available through supermarkets, restaurants,espresso bars, office coffee services, mail order, and institutional foodservice.  The Company’s productsgenerally feature branded packaging. Tully’s also provides logo-bearing coffee cups, banners and point of usesignage to customers of the Wholesale division.  The Company believes that marketing programs that support itsretail stores, such as its presence in the Seattle Mariners Safeco Fieldballpark and its community programs are also beneficial to its Wholesaledivision.

 

*International*

 

The Internationaldivision expands the geographic reach of the Tully’s brand and products toconsumers outside the United States. Tully’s Coffee Japan operates and franchises Tully’s-branded stores inJapan.  These stores bring the look andfeel of the Tully’s store, and the flavor of Tully’s coffees and beverages, tothe Japanese customer.  The license withUCC is expected to expand this international presence to other countries inAsia.  The Company believes that thetourism, media, and trade ties between the principal domestic markets served byits Retail and Wholesale divisions with other Pacific Rim nations (inparticular, Japan) are beneficial to the international expansion of the Tully’sbrand.

 

*Community*

 

Tully’s commitment to the local community isanother key element of its marketing strategy. Tully’s supports local and nationalorganizations focusing on children’s educational and health-relatedissues.  Each store supports eventswithin its neighborhood and community. The Company’s employees volunteerservice and the Company donates product to local non-profit organizations,including schools, sports teams, food banks, charities and serviceorganizations.  The Company alsoprovides product and resource donations to national organizations working toimprove the health and development of children.

 

*Media*

 

Tully’s seeks to generate awareness of itsbrand by encouraging local and national media coverage of Tully’s events, newproduct launches, community programs, and promotions.  Tully’s also does local area marketing such as advertising inneighborhood newspapers, supporting community activities, customer appreciationpromotions, direct mail and targeted marketing.  During Fiscal 2003, Tully’s expects to periodically supplementthese methods with other media such billboards, bus boards, newspapers andradio.

 

6

----

 

The Company is asponsor of the Seattle Mariners and is the exclusive coffee provider at SafecoField pursuant to an agreement entered into in 1999 that is effective throughDecember 31, 2003.  Thissponsorship agreement includes prominent signage at several places in thestadium, including the left field wall, and allows Tully’s to use the Mariners’trademarks in advertising and in certain geographic areas.  The annual fees payable by Tully’s underthis contract  are approximately $505,000 in Fiscal 2003 and $520,000in Fiscal 2004 (with additional charges for any tickets, food service and otherincidentals provided to Tully’s). The Company has a similar arrangementwith the San Francisco Giants and PacBell Stadium.  The PacBell Stadium agreement was to expire onOctober 31, 2002 and provided for fees payable by Tully’s of $950,000 forFiscal 2003.  During August 2002, theparties amended this agreement to extend the term of the agreement throughOctober 31, 2003 with an aggregate fee payable by Tully’s of $1,100,000 for thetwo years ($825,000 payable in Fiscal 2003 and $275,000 payable in Fiscal2004), and with a reduced level of marketing benefits during Fiscal 2004.    In addition, Tully’s has a supplypartnership with PacWest Racing pursuant to which Tully’s coffee and logo cupsare available in the pit area and hospitality suites at PacWest Racingevents.  The Company gainsexposure to potential new customers with no investment other than the cost ofits coffee and cups under this informal arrangement.

 

**International**

 

The Company’sInternational division sells Tully’s whole bean coffees and other proprietarymerchandise, and supporting supplies, equipment and materials to itsinternational licensee customers. Product sales to licensees located outside the United States accountedfor approximately 5.6% of Tully’s net sales in Fiscal 2002, 3.7% of Tully’s netsales in Fiscal 2001 and approximately 2.0% of Tully’s net sales in Fiscal2000.  The Company expects thispercentage to decline as its international licensees establish more localsourcing of products and materials, and expects the level of royalty income tothe Company to increase.

 

In April 2001, theCompany entered into an exclusive license agreement (the “License Agreement”)with UCC, a Japanese company that is one of Asia’s largest coffeepurveyors.  Under the terms of theLicense Agreement, Tully’s granted UCC an exclusive, perpetual license to useTully’s business names, trademarks, and other intellectual property rights todevelop and operate specialty coffee stores throughout Asia, except for Japan.  In April 2001, the parties completed thetransaction upon payment by UCC to Tully’s of a $12,000,000 license fee.  In further consideration of the license, UCCwill pay Tully’s a royalty and service fee, commencing in April 2009, based onthe aggregate net revenues of the stores that UCC operates under the Tully’sbusiness name, and all other sales of products or services made under theTully’s business names and trademarks in Asia. UCC plans to roast coffee for the licensed stores in Asia.

 

On April 26, 2001, Tully’s entered into alicense and a supply agreement with Tully’s Coffee Japan, which, as of June 20,2002, operated 49 retail stores in Japan as a licensee of the Company and hadfranchised 14 stores in Japan.  In October 2001, the Company received $4,200,000 and 300 shares of Tully’s Coffee Japanstock (with a market value of approximately $1,771,000 at October 1, 2001) fromTully’s Coffee Japan in connection with the amendment of Tully’s license andsupply agreements with Tully’s Coffee Japan. The amendments allow Tully’s Coffee Japan to be theexclusive wholesaler of Tully’s coffee in Japan and to roast Tully’s coffee inJapan, which will provide more efficient delivery and a lower cost, and toacquire other suppliesand equipment from sources other than the Company, subject to various productand quality requirements.  Tully’sCoffee Japan has contracted with UCC to roast Tully’s coffee for Tully’s CoffeeJapan, and UCC commenced roasting in May 2002. Under the amended supply agreement, the Company receives a royalty fromTully’s Coffee Japan for coffee roasted in Japan.  Although Tully’s expects that Tully’s Coffee Japan will purchasesome coffee and supplies from Tully’s in Fiscal 2003, it expects that most ofthe coffee will be roasted in Japan, and that Tully’s Coffee Japan will seek toshift much of its supplies and equipment purchasing to Japanese-basedsuppliers.  During Fiscal 2002 and the first two months of Fiscal2003, the Companyperiodically sold shares of its Tully’s Coffee Japan stock investment, and onJune 20, 2002, the Company’s had five shares of Tully’s Coffee Japan commonstock remaining with a market value of approximately $20,000.

 

Internationalsales for Fiscal 2002 include $1,958,000 of revenue related to the $12,000,000UCC license fee and the$5,971,000 license fee (reflecting the cash portion of the fee plus the fairmarket value, at the time received, of the stock consideration) received inconnection with the roasting and wholesale agreement with Tully’s Coffee Japan.  This amount represented 3.8% of net salesfor Fiscal 2002.

 

Tully’s EuropeB.V. (“TEB”) was a licensee of the Company that operated in Sweden, and waspartially owned by Tully’s.  DuringFiscal 2002, the Company and the other owners of TEB liquidated TEB.  The Company recognized a loss of $46,000 inFiscal 2002 and $1,036,000 in Fiscal 2001 related to the termination ofTEB.  The Company is engaged innegotiations with the licensee of its Spinelli brand in Singapore and Taiwan tosell the licensee the rights to the name in those markets and to terminate theexisting license agreement.

 

7

----

 

**Competition**

 

The specialtycoffee market is highly fragmented and very competitive.  A number of Tully’s competitors have muchgreater financial and marketing resources, brand name recognition and largercustomer bases than Tully’s.  Tully’scompetes with a number of specialty coffee retailers, including StarbucksCorporation, which has stores in most of the United States and around theworld, and regional retailers such as Coffee Bean and Tea Leaf, DiedrichCoffee, Inc., Seattle’s Best Coffee and Peet’s Coffee & Tea.  Coffee manufacturers including StarbucksCorporation, Kraft Foods, Inc., The Proctor & Gamble Company andNestle, Inc. distribute premium coffee products nationally andinternationally in supermarkets and convenience stores.  Many of these products may be alternativesto Tully’s coffees and coffee drinks. Consumers also may choose non-coffee products and beverages offered bythese and other competitors as alternatives to the Company’s products.  Tully’s coffee beverages, teas, and otherbeverages compete directly against all restaurant and beverage outlets thatserve coffee, tea and other beverages, and the many single location specialtycoffee outlets (espresso stands, carts, kiosks, drive-throughs andstores).  Tully’s whole bean and groundcoffees and its coffee beverages compete indirectly against all other coffeesavailable in the market.  The specialtycoffee industry is evolving toward a variety of retailers, wholesalers, andmanufacturers, all seeking their own niche. Tully’s believes that its customers choose among specialty coffee brandsprimarily on the basis of product quality, service, convenience, and, to alesser extent, on price.  Tully’s alsobelieves that the flavor profile of its coffee and coffee products, and thevariety and quality of other food products provided by Tully’s stores, serve asa point of differentiation for many customers.

 

Tully’s Retail divisionfaces intense competition for suitable new store sites and for qualifiedpersonnel to operate both new and existing stores.  Due to this competition, Tully’s may not be ableto continue to secure sites at acceptable rent levels or to attract asufficient number of qualified workers.

 

**Store Operations And Management /Employees**

 

As of June 20, 2002,Tully’s employed approximately 1,000 people, approximately 900 of whom wereemployed in retail stores or regional operations.  The balance of the employees work in the Company’sadministrative, wholesale, roasting and warehouse operations.  All employees are non-union and managementanticipates this will continue to be the case. Approximately 800 of the Company’semployees work 20 hours or more per week.

 

Tully’s believes thatits employees are an integral part of its business, and has structured itsbenefit programs accordingly.  Full timeemployees are eligible for vacation, holidays, medical and dental insurance, maternityleave and sick leave.  To promoteproduct loyalty and enhance expertise, all employees receive discounts onbeverages and merchandise items. Tully’s believes that its current relations with employees areexcellent.

 

To maintain Tully’shigh standards of quality products and customer service, new store employeescomplete a two-day training course, plus on-site training while working in astore.  Training hours are devoted toorientation, Company philosophy, cash register and paperwork procedures, storeequipment use, cash handling, retail product knowledge, sales techniques,customer service and thorough familiarization with Tully’s EmployeeHandbook.  Training also covers coffeehistory, roasting, decaffeinating processes, tasting (“cuppings”) of Tully’sproprietary blends, and hands-on beverage preparation.  Employees who will serve in the Wholesaleand International divisions, and those who serve in administrative supportroles, receive much of the same training in order to build their specialtycoffee industry expertise.

 

Tully’s is committed toattracting and retaining excellent employees through its corporate culture,employee ownership and quality employee benefits.  In addition to the benefits described above, Tully’s offers aStock Option Plan and a 401k savings plan.

 

**Suppliers And Equipment Vendors**

 

Tully’s roasts its own coffees to its ownspecifications.  This enables theCompany to develop distinctive coffee beverages and unique ground or whole beancoffees, to modify products to better fit the needs of particular customersegments, and to control more elements of this aspect of its product mix.  Other materials such as dairy products,juices, and accessories are purchased from various vendors and are generallyless specialized, although some materials and products are made to theCompany’s proprietary recipes, or packaged to the Company’s proprietaryspecifications.

 

*Coffee Markets*

 

The Company purchasesunroasted, or “green” coffee beans. There are many varieties of green coffeebeans and a range of quality grades within each variety. Tully’s purchases onlypremium grade arabica coffee beans and believes these beans are the bestavailable from each producing region. Tully’s seeks to purchase the finestqualities and varieties of coffee

 

8

----

 

beans by identifying the unique characteristics andflavors of the varieties available from each region of the world.

 

Coffee is the world’ssecond largest agricultural product and is grown commercially in over fiftycountries in tropical regions of the world. The price and supply of coffee aresubject to significant volatility. While most coffee trades in the commoditymarket, coffee beans of the quality sought by the Company tend to trade on anegotiated basis at a substantial premium above commodity coffee bean prices,depending upon the supply and demand at the time of purchase.  Supply and price can be affected by multiplefactors in the producing countries including weather and political and economicconditions.  In addition, green coffeebean prices have been affected in the past, and may be affected in the future,by the actions of certain organizations and associations that have historicallyattempted to influence commodity prices of green coffee beans throughagreements establishing export quotas or restricting coffee suppliesworldwide.  The Company’s ability toraise sales prices in response to rising coffee bean prices may be limited, andthe Company’s future profitability could be adversely affected if coffee beanprices were to rise substantially.

 

During the buyingseason, Tully’s often enters into forward commitments for the purchase of greencoffee beans that may only be available in small quantities.  Rotating the coffee bean selection enablesthe Company to provide its customers with a wider variety of coffees, as wellas certain coffees that are available only on a seasonal basis.  Tully’s enters into contracts for futuredelivery of green coffee beans to help ensure adequacy of supply.  As of June 20, 2002, the Company hadapproximately $2,700,000 in fixed–price purchase commitments for Fiscal2003, which, together with existing inventory, are expected to provide anadequate supply of green coffee beans through Fiscal 2003(exceptfor supplies of certain varietals that will need to be replenished).  Tully’s believes, based on relationshipsestablished with its suppliers, that the risk of non-delivery on such purchasecommitments is remote.  However, ifcoffee spot market prices are attractive, or if Company sales volumes increasebeyond the levels anticipated for Fiscal 2003, the Company may elect to, or berequired to, purchase coffee on the spot market, which might be at pricesgreater or less than the fixed contract pricing.

 

*Roasting*

 

Tully’s procures androasts green coffee beans to its exacting specifications at its roasting plantin Seattle.  Tully’s employs a roastingprocess that varies based upon the variety, quality, origin and physicalcharacteristics of the coffee beans being roasted.  Each batch is craft roasted to maximize the flavorcharacteristics.

 

The Company’s roastingprocess produces coffee in “small batches.” Coffee is roasted daily and sealed in bags.  Production and inventory levels are carefully monitored to minimizethe time between roasting and delivery to the customer as coffee or a beverage,and coffee date codes are monitored to maintain fresh coffee stocks.

 

Tully’s has authorizedits licensees, Tully’s Coffee Japan and UCC, to roast coffee under the Tully’s brand for sale in the stores operated orfranchised by these licensees in their respective territories.  The Company’s amended supply agreement withTully’s Coffee Japan provides for UCC to be the preferred contract coffeeroaster for Tully’s Coffee Japan, and in May 2002, UCC commenced roastingcoffee in Japan for Tully’s Coffee Japan. The Company’s agreements with its licensees require that they roast toTully’s specifications, recipes and quality standards, which will beperiodically audited by Tully’s.

 

*Equipment and Store Supplies*

 

Tully’s purchasesnon-coffee merchandise, and the equipment, fixtures and supplies for its retailstore locations from a number of vendors. The materials are purchased through purchase orders on an as neededbasis.  Some materials and items aredistributed through Tully’s roasting plant and warehouse facility, while thesuppliers deliver other items directly to the Company’s retail stores.  Shipments to Wholesale division andInternational division customers are generally distributed from the sameroasting plant and warehouse facility. In the past Tully’s has used different vendors for the same type ofequipment and supplies.  During Fiscal2002, Tully’s increased its effort to standardize and consolidate its vendorsand suppliers to improve the cost of purchases and simplify operations. Tully’sbelieves that its relationships with vendors are currently satisfactory.However, if a particular supplier or vendor is unable to meet Tully’s needs,begins to deliver unsatisfactory materials or is not price competitive, Tully’sbelieves that there are a number of alternative sources to meet all of itsmerchandise, equipment, store supplies and other materials needs.

 

**Trademarks**

 

The Company ownsseveral trademarks that are registered with the United States Patent and TrademarkOffice, including Swirkle® and Tullini®. In addition, Tully’s has applied for federal trademark registration in the United States and fortrademark registration in several foreign countries for Tully’sTM. The duration of trademark registrations variesfrom country to country.  However,trademarks are generally valid and may be renewed indefinitely as long as theyare in use and/or

 

9

----

 

their registrations are properly maintained, and they have not beenfound to become generic.

 

Since Tully’s filed itsapplication for federal trademark registration for Tully’sTM, another companyhas applied to register the mark “Tully’s” in a somewhat different form.  This claimant filed an opposition to theissuance of a trademark registration to the Company. It is claiming use of aTully’s trademark prior to the Company. If it can successfully support its claim, it may be able to exclude theCompany’s use of the Tully’s name in certain markets. That claimant currentlyoperates a chain of four restaurants in the greater Syracuse, New York area.  On January 31, 2001, the Trademark Trial andAppeal Board of the U.S. Patent and Trademark Office issued its opinionsustaining the claimant’s opposition to Tully’s trademark registrationapplication and refusing registration of the Tully’s mark.  In response, Tully’s filed a complaintagainst the claimant in the U.S. District Court for the Northern District ofNew York on April 2, 2001.  The Companyintends to pursue this case vigorously or, if appropriate, to seek anout-of-court settlement.  During Fiscal2002, the Company and another party settled a dispute regarding the otherparty’s use of a commercial designation that the Company believed wasconfusingly similar to the Tully’s trademark and trade name, and the otherparty agreed to discontinue use of that commercial designation.

 

In addition toregistered and pending trademarks, Tully’s considers the overall design andvisual language of its trade dress to be a valuable asset.  The design of its stores, including but notlimited to the use of materials, furniture, signage, layout and overallaesthetics, developed in conjunction with packaged goods and marketingcollateral, create a distinctive “look and feel” as well as a unique visuallanguage.  This “look and feel” andvisual language continues to build its brand exposure and deliver “The Tully’sExperience” through all channels of its business.  Although Tully’s considers store design, packaging and marketingcollateral to be essential to brand identity, Tully’s has not applied toregister these trademarks and trade dress, and thus cannot rely on the legalprotections afforded by trademark registration.

 

The ability todifferentiate the Tully’s brand from its competitors depends, in part, on thestrength and enforcement of its trademarks. If a competitor infringes on Tully’s trademark rights, the Company mayhave to litigate to protect its rights, in which case Tully’s may incursignificant expenses and management’s attention may be diverted from theCompany’s business operations.

 

Tully’s does not holdany patents.

 

**Seasonality**

 

The Company’s businessis subject to seasonal fluctuations. Greater portions of Tully’s net sales aregenerally realized during the third quarter of Tully’s fiscal year, whichincludes the December holiday season.  Seasonalpatterns are generally applicable to all three divisions, Retail, Wholesale andInternational.  In addition, quarterlyresults are affected by the timing of the opening of new stores or the closureof stores not meeting Company expectations. Because of the seasonality ofTully’s business, results for any quarter are not necessarily indicative of theresults that may be achieved for the full fiscal year.

 

**Risk Factors**

 

In this section “Risk Factors,” the terms “we,”“us,” and “our” refer to Tully’s Coffee Corporation.  The following factors may affect our future results and financialcondition and should be considered in evaluating our business, operations andprospects.

 

*Company Risks*

 

*Our history of losses may continue in the future and thiscould have an adverse affect on our ability to grow.*

 

To date, we havenot made a profit from operations.  Weexpect to continue to incur losses in Fiscal 2003 and cannot assure you that wewill ever become or remain profitable.

 

*Rapid growth in some of our divisions may make it difficultto effectively allocate our resources and manage our business.*

 

During Fiscal 2000 and2001, the Company greatly expanded its retail store base, which placed strain on our management,production, financial and other resources.  In Fiscal2001 and 2002, both the Wholesale and International divisions grewsubstantially.  Tully’s expects tocontinue to grow its Wholesale and International divisions in Fiscal 2003 andbeyond. Although Retail division operations will focus primarily on improvingoperating results in existing stores in Fiscal 2003 rather than opening newstores, we expect to increase the number of stores in future years.  We cannot assure you that we will be able tomanage any future growth effectively. Continued growth could further strain our management, production,financial and other resources.  Tomanage our growth effectively, we must:

 

10

----

 

•                  improve theproductivity of the average store and lower the average capital investmentrequired to establish a new store,

 

•                  evolve the retailconcept to be more differentiated from our competition, without losing the keyelements of the Tully’s store concept,

 

•                  provideconsumer-focused initiatives to improve the movement of our products throughthe food service and supermarket sectors,

 

•                  add production capacitywhile maintaining high levels of quality and efficiency,

 

•                  continue to enhance ouroperational, financial and management systems, and

 

•                  successfully attract,train, manage and retain our employees.

 

Any failure to manageour growth effectively could have an adverse effect on our business, financialcondition and results of operations.

 

*Our operating flexibility and abilityto raise additional capital is restricted by our new credit facility.  If we were to default under the facility,the lender, the guarantors, or both would have a right to seize our assets.*

 

On November 1, 2002, the Company entered into a new creditfacility.  See Note 28 to the Consolidated FinancialStatements.  The terms of the newcredit facility, and a related agreement among the Company and certaindirectors and shareholders who are guarantors of the debt under the creditfacility, include provisions that, among other things, restrict the Company’sability to incur additional secured debt or liens and to sell, lease ortransfer assets.  These agreements alsoprovide the lender and the guarantors with a security interest in substantiallyall of the Company’s assets.  Otherprovisions of these agreements would require accelerated repayment of theborrowed amounts in certain circumstances, including the issuance of newequity, certain mergers and changes and control, certain sales of assets, andupon certain changes or events relating to the guarantors.  These provisions could limit the Company’sability to raise additional capital when needed, and a default by the Companyunder these agreements could result in the lender or guarantors taking actionsthat might be detrimental to the interests of other creditors and shareholdersof the Company.

 

*We may not be able to obtain additional capital when needed.*

 

To date, we have notgenerated sufficient cash to fully fund operations and typically operate withminimal or deficit working capital.  Wehistorically have financed this cash shortfall through the issuance of debt andequity securities, through borrowings, and through cash provided under ourinternational licensing relationships. We will need to raise additional capital in the future to fundoperations and planned growth.  Anyequity or debt financing may not be available on favorable terms, if atall.  Such a financing might providelenders with a security interest in Company assets or other liens that would besenior in position to current investors and creditors.  If financing is unavailable to us or isavailable only on a limited basis, we may be unable to take advantage ofbusiness opportunities or respond to competitive pressures that could have anadverse effect on our business, operating results and financial condition.   In such event, the Company would need to modify or discontinue itsgrowth plans and its investments in store improvements, new customers and newproducts, and substantially reduce operating, marketing, general and administrativecosts related to its continuing operations, and might be required to sellstores or other assets (such aswholesale territories or international contract interests).  Store sales would involve the assignment orsub-lease of the store location (which may require the lessor’s consent) andthe sale of the store equipment, leasehold improvements and relatedassets.  The Company has previouslydisposed of only underperforming store locations, but might be required todispose of its better-performing locations in order to obtain a significantamount of sales proceeds.  The proceedsreceived from the sale of stores or other assets might not be in amounts ortiming satisfactory to the Company, and the sale of better-performing locationsor other income-producing assets could adversely affect the Company’s futureoperating results and cash flows.

 

The Company’s articlesof incorporation provide that its Series A Preferred Stock is senior to thecommon stock for liquidation preferences, and the Series B Preferred stock isjunior to both the Series A Preferred Stock and a stated dollar amount ofliquidation preference for the holders of common stock.  If the Company were to sell all or asubstantial portion of its assets in order to meet its operating needs andsatisfy its obligations, the amounts remaining for distribution to shareholdersmight be less than the aggregate liquidation preferences of the more seniorshareholders, and no amounts might be available for distribution to the morejunior shareholders.

 

11

----

 

*New senior management has only recently joined the Company*

 

During Fiscal 2002, theCompany’s chief executive officer (CEO) and chief financial officer (CFO) leftthe Company, and the Company operated under interim executive leadership.  In February 2002, Tully’s hired a new CFOand in May 2002 the new CEO joined the Company.  Because these new executives may not concur with the Company’s previous management’s strategies,they may implementchangesin Company strategy. Further, evenif they agree with such strategy, their unfamiliarity with the Company could cause delays in implementing our strategy, which couldcause ourbusiness and results of operations to suffer.

 

*Our international licensees may not be successful in theiroperations and growth.*

 

The Company hassignificant relationships with its Asian licensees, Tully’s Coffee Japan andUCC.  Tully’s expects to enjoy continuedgrowth in the revenues and profits from its International division.  If these licensees experience businessdifficulties or modify their business strategies, Tully’s results of operationscould suffer. Becausethese licensees are located outside of the United States, the factors thatcontribute to their success may be different than those affecting companies inthe United States.  This makes it moredifficult for the Company to predict the prospects for continued growth in itsrevenues and profits from these relationships.

 

*If we are unable to successfully integrate futureacquisitions, our business could be negatively impacted.*

 

We may consider futurestrategic acquisitions similar to our acquisitions of the Coffee Station andMarsee Baking stores in Fiscal 2001. Integrating newly–acquired businesses is expensive andtime-consuming.  Due to capitallimitations, Tully’s has not yet fully conformed all of the Coffee Station andMarsee Baking stores to the Tully’s standards. If we acquire a business, we may not manage these integration effortssuccessfully, and our business and results of operations could suffer.

 

*Onesupplier presently provides our entire new ice cream product base.*

 

During the first two quarters of Fiscal 2003, we introduced Tully’sPremium Softened Ice Cream into 63 Tully’s stores.  A single supplier presently manufactures the ice cream productbase for Tully’s.  If that supplier isunable to provide product to meet the requirements of the Company, or if therelationship between Tully’s and this supplier is otherwise interrupted,Tully’s may experience interruptions in the availability of this product andour results of operations could suffer.

 

*We have limited supplier choices providing our bakerycategory products.*

 

We use local bakeries to supply our stores with a multitude of bakeryitems.  Most of these bakeries areindependently owned with limited capital resources to fund growth.  If one (or more) of these suppliers isunable to provide high quality products to meet the requirements of theCompany, or if the relationship between Tully’s and the supplier(s) isotherwise interrupted, Tully’s may experience interruptions in the productavailability and our results of operations could suffer.

 

*If we are required to relocate our offices androasting plant, our business could be negatively impacted.*

 

The Company and the lessor for the building housing the Company’s headquarters,roasting plant and distribution facilities have agreed that the lessor may, at its option, terminate the leaseupon 150 days notice, and the Company would be required to relocate itsoperations.  Although the lessor haslisted the property for sale or lease, the Company is not aware of any currentintention by the lessor to terminate the lease and the Company expects tocontinue its tenancy under the terms of the lease.  If we were required to relocate, we might experience aninterruption to our business, or incur extra costs related to the relocation orto the replacement facility.  In theevent of such an early lease termination, the recoverability of the Company’sleasehold improvements at the facility would be impaired; such leaseholdimprovements had a net book value of $1,342,000 at December 29, 2002.

 

*Our two largest stockholders havesignificant influence over matters subject to stockholder vote and may**support corporate actions thatconflict with other stockholders’ interests.*

 

As of June 20,2002, Mr. Tom T. O’Keefe, our founder and chairman, beneficially ownedapproximately 32% of our common stock and Mr. Keith McCaw, a former director,beneficially owned approximately 23% of our common stock.  This ownership position gives each of themindividually, and on a combined basis if acting in unison, the ability tosignificantly influence the election of our directors and other matters broughtbefore the stockholders for a vote, including any potential sale or merger ofour Company or a sale of its assets. This voting power could prevent or significantly delay another company

 

12

----

 

from acquiring or mergingwith us, even if the acquisition or merger was in the best interests of ourstockholders.

 

*Industry Risks*

 

*We cannot be certain that the specialty coffee industry willbe accepted in new markets. Failure to achieve market acceptance will adverselyaffect our revenues.*

 

Although the specialtycoffee industry has gained substantial market acceptance throughout the UnitedStates over the last several years through the operation of a variety ofspecialty coffee shops, there is a risk that our brand or products may not beaccepted in new markets. Consumer tastes and brand loyalties vary from onelocation or region of the country to another. Consumers in areas other than thePacific Northwest, San Francisco, Los Angeles and Japanese markets may notembrace specialty coffee or the Tully’s brand if Tully’s were to expand itsdomestic or international operations into new geographic areas.

 

*We cannot be certain that expanded product variety will beaccepted in current or new markets. Failure to achieve market acceptance willadversely affect our revenues.*

 

Tully’s retail storeoperations, and to a lesser extent, its Wholesale and International divisions,sell various foodstuffs and products other than coffee and coffeebeverages.  The Company believes thatgrowth of these complementary product categories is important to the growth ofthe Company’s revenues from existing stores, and for growth in total netrevenues and profits.  Customers may notembrace these complementary product offerings, or may substitute them forproducts currently purchased from Tully’s.

 

*We compete with a number of companies for customers. Thesuccess of these companies could have an adverse effect us.*

 

Our Retail division andour Wholesale division operate in highly competitive markets in the PacificNorthwest, San Francisco and Los Angeles. Our specialty coffees compete directly against all restaurant andbeverage outlets that serve coffee and the large number of independent espressostands, carts and stores. Companies that compete directly with us in the retailand wholesale channels include, among others, Starbucks Corporation, CoffeeBean and Tea Leaf, Diedrich Coffee, Inc., Peet’s Coffee and Tea, KraftFoods, Inc., The Proctor & Gamble Company, Nestle, Inc., andSeattle’s Best Coffee.  Some of thesecompanies compete with our International division and we also face competitionfrom companies local to those international markets that may better understandthose markets, or be better established in those markets.  We must spend significant resources todifferentiate our product from the products offered by these companies, but ourcompetitors still may be successful in attracting our Retail, Wholesale andInternational customers.  Our failure tocompete successfully against current or future competitors would have anadverse effect on our business, including loss of customers, declining revenuesand loss of market share.

 

*Our**whole bean coffee sales must competewith supermarkets and warehouse clubs, and with other companies selling throughthose channels.*

 

Supermarkets andwarehouse clubs pose both an opportunity and a competitive challenge in thewhole bean coffee market.  A number ofglobal coffee suppliers, such as Starbucks Corporation, Kraft Foods, Inc.,The Procter & Gamble Company, and Nestle Inc., distribute premiumcoffee products in supermarkets and warehouse clubs that may serve assubstitutes for our whole bean coffees, and compete with the Tully’s whole beanand ground coffees sold in our stores and through our supermarket customers.

 

*Competition for store locations and qualified workers couldadversely affect our growth plans.*

 

We face intensecompetition from both restaurants and other specialty retailers for suitablesites for new stores and for qualified personnel to operate both new andexisting stores.  We may not be able tocontinue to secure adequate sites at acceptable rent levels or attract asufficient number of qualified workers. These factors could impact our plans for expansion and our ability tooperate existing stores.  Similarfactors could impact our Wholesale customers and our International customers,and could adversely impact our plans to grow revenues from those customers.

 

*A shortage in the supply or an increase in price of coffeebeans could adversely affect our revenues.*

 

Our future successdepends to a large extent upon the availability of premium quality unroasted,or green, coffee beans at reasonable prices. The world coffee bean market is largely a commodity market, althoughpurchases of premium Arabica coffee beans are typically negotiated on a persale basis with growers.  Natural orpolitical events, or disruption of

 

13

----

 

shipping and port channels could interrupt thesupply of these premium beans, or impact the cost.  In addition, green coffee bean prices have been affected in thepast, and could be affected in the future, by the actions of organizations suchas the International Coffee Organization and the Association of CoffeeProducing Countries, which have attempted to influence commodity prices ofgreen coffee beans through agreements establishing export quotas or restrictingcoffee supplies worldwide.  Priceincreases for whole bean coffee result in increases in the costs of coffeebeverages served in our stores. These cost increases may force us to increasethe retail and wholesale prices for our coffee products, which could adverselyaffect our revenues.

 

*Changes in economic climates could adversely affect ourrevenues.*

 

Our business is notdiversified. Our revenues are derived predominantly from the sale of coffee,coffee beverages, baked goods and pastries and coffee–related accessoriesand equipment.  Given that many of theseitems are discretionary items in our customers’ budgets, our business dependsupon a healthy economic climate for the coffee industry as well as the economygenerally.  The Company believes thatthe weak economy during Fiscal 2002 has adversely impacted its revenues.  If the economic climate does not improve, orif it worsens, there could be further adverse impact on the Company’s revenues.

 

*Investment Risks*

 

*We may need additional capital, which if raised, coulddilute your interest in our Company.*

 

If we raiseadditional funds through the issuance of equity, convertible debt or othersecurities, current stockholders may experience dilution and the securitiesissued to the new investors may have rights or preferences senior to those ofcommon stock.

 

In addition, prior toOctober 1999, holders of our capital stock were entitled to preemptiverights pursuant to our Articles of Incorporation and the Washington BusinessCorporation Act.    Asa result, some of our shareholders may be entitled to purchase shares of ourcommon stock and Series A preferred stock at the respective purchase prices atwhich they were originally offered.  Atsome time the Company may be required to either satisfy these preemptive rights(through the sale of shares to these shareholders in exchange for theapplicable cash consideration) or seek waivers of these preemptive rights fromsuch shareholders, but it has not yet undertaken any efforts to do so.  The Company estimates the maximum number ofshares that may be issuable upon exercise of preemptive rights to which certainshareholders may be entitled is be as follows:

 
| **Description of Shares and  Historical Offering Price:** |   | **Estimated Maximum  Number of Shares to Be  Offered** |   |
|-----------------------------------------------------------|--------|--------------------------------------------------------|--------|
| Common Shares priced at $0.33 per share                   |   | 220,000                                                |   |
| Common Shares priced at $1.50 per share                   |   | 490,000                                                |   |
| Common Shares priced at $1.75 per share                   |   | 180,000                                                |   |
| Common Shares priced at $2.25 per share                   |   | 860,000                                                |   |
| Series A Preferred Shares priced at $2.50 per  share      |   | 14,200,000                                             |   |

 

The willingness ofshareholders who may have a right to purchase additional shares to eitherpurchase additional shares or waive such rights will depend upon a number offactors including the difference between the value of the Company’s shares atthat time and the purchase price applicable to such shares.  Any additional issuances of our capitalstock pursuant to the exercise of a shareholder’s preemptive rights couldfurther dilute other existing shareholders.

 

*The lack of a public market for Tully’s capital stock andrestrictions on transfer substantially limit the liquidity of an investment inour capital stock.*

 

There is currently nopublic market for our common stock or our preferred stock, and consequentlyliquidity of an investment in our capital stock currently is limited.  Whether Tully’s would ever “go public” and if so the timing andparticulars of such a transaction, would be determined by our evaluation of themarket conditions, strategic opportunities and other important factors at thetime, based on the judgment of our management, board of directors andprofessional advisors.  Therefore, therecan be no assurance that such a public market will ever become available forour common or preferred stock.

 

14

----

 

**ITEM 2.  PROPERTIES**

 

As of June 20, 2002, Tully’s operated 104retail stores in the United States (including the Safeco Field store, whichoperates seasonally), all of which are located on property leased by TheCompany.  The Company regularly reviewsthe operating results of its stores, and from time to time will identify storesthat do not meet its expectations.  Suchstores are evaluated for possible closure, lease termination or sublease.  Through June 10, 2002, sixteen of the 19leases identified by the Company inFiscal 2001 for termination had been terminated, two were unresolved, andone is expected to be developed into a new retail store in Fiscal 2003.

 

In late 1999, theCompany entered into a ten-year lease for approximately 220,000 square feet ina building that housesthe Company’s headquarters,roasting plant and distribution facilities in Seattle, Washington.   When the Company first occupied this property in Fiscal2001, the lessor funded $1,000,000 of tenant improvements to the property, andthe lease was amended at that time to reimburse the lessor for the improvementallowance through increased lease payments. As a result, in Fiscal 2001 the Company recorded this $1,000,000 amountas a deferred lease cost liability, and has been amortizing this liability asrent was paid.  During November 2002,the Company and the lessor amended the lease in connection with the extensionby the lessor to the Company of the credit facility described in Note 28 of theNotes to the Consolidated Financial Statements.  Under the provisions of the credit facility and the November 2002lease amendment, the parties agreed to add the unamortized tenant improvementallowance of $890,037 to the borrowed principal amount under the creditfacility and to reduce the monthly rental for the remainder of the lease termby approximately $16,000 per month.   Inaddition, the amended lease provides that the lessor may, at its option,terminate the lease prior to the expiration of its term by giving the Company150 days written notice of termination. Although the lessor has listed the property for sale or lease, theCompany is not aware of any current intention by the lessor to terminate the leaseand the Company expects to continue its tenancy under the terms of the amendedlease.  However, if the lessor were toterminate the lease prior to the expiration of its term, the recoverability ofthe Company’s leasehold improvements at the facility would be impaired; suchleasehold improvements had a net book value of $1,342,000 at December 29, 2002.

 

**ITEM 3.  LEGAL PROCEEDINGS**

 

The Company is aparty to various legal proceedings arising in the ordinary course of itsbusiness, including the trademark-related proceeding described at “Trademarks”in Item 1 on page 9, but is not currently a party to any legal proceeding whichthe Company believes will have a material adverse effect on the financialposition or results of operations of the Company.

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

No matters weresubmitted for a vote of stockholders of the Company during the fourth quarterof Fiscal 2002.

 

15

----

 

**PART II**

 

**ITEM 5.****    ****MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERMATTERS**

 

**Market Information, Holders and Dividends**

 

Currently there is nopublic market for Tully’s common stock. As of June 20, 2002, there were 4,905holders of Tully’s common stock.

 

The Company has notpaid dividends in the past and Tully’s presently does not plan to pay dividendsin the foreseeable future. The Company intends to retain and use earnings tofinance the growth of its business for an indefinite period. Any determinationto pay cash dividends will be at the discretion of the Board of Directors andwill be dependent upon the Company’s financial condition, results ofoperations, capital requirements, restrictions within its borrowing agreements,and such other factors as the Board of Directors deems relevant.

 

**Securities Authorized for IssuanceUnder Equity Compensation Plans**

 

Equity Compensation Plan Information

(As of March 31, 2002)

 
| **Plan Category**                                           |   | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights  (a)** |   | **Weighted average  exercise price of  outstanding options,  warrants and rights  (b)** |   | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a))  (c)** |      |
|-------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------|
| Equity compensation plans approved by security holders      |   | 2,242,065                                                                                               |   | $                                                                                       | 0.48   |                                                                                                                                                       | 1,957,935 |   |
| Equity compensation plans not approved by security holders* |   | 1,704,317                                                                                               |   | $                                                                                       | 0.01   |                                                                                                                                                       | —    |   |
| Total                                                       |   | 3,946,382                                                                                               |   | $                                                                                       | 0.28   |                                                                                                                                                       | 1,957.935 |   |

 

----

*   These options were granted by the Company’s chairmanto employees and third parties and may be exercised to purchase shares of theCompany’s common stock owned by the chairman. We refer to these options as being granted under the “Founder’s StockOption Plan.”  The Company does notexpect any additional options to be granted under the Founder’s Stock OptionPlan.

 

For a description of the Company’s equity compensationplans, see Note 21 to the Consolidated Financial Statements.

 

**Recent Sales of Unregistered Securities**

 

The Company issued and sold securities in thetransactions described below during Fiscal 2002.  The offer and sale of these securities were made in reliance on theexemptions from registration provided by Section 4(2) of the Securities Act of1933, as amended, as offers and sales not involving a public offering, based on the limitednumber of purchasers and their pre-existing relationship with the Company.

 

•                  During Fiscal 2002, theCompany granted options to purchase an aggregate of 69,750 shares of its commonstock to 12 directors pursuant to the Company’s Amended and Restated 1994 StockOption Plan in consideration for their service as directors during Fiscal2002.  The options have an exercise price of $.01per share, are vested and fully exercisable upon grant, and have a ten-yearterm.

 

•                  Between April 2001 andOctober 2001, the Company granted options to purchase an aggregate of 105,112shares of its common stock to its Chairman of the Board and to a director inconsideration for their personal guarantees of the Company’s bank line ofcredit.  The number of option shares were determinedeach month based upon the outstanding guaranteed debt amounts and had anestimated fair market value of

 

16

----

 

$209,000 at the time of grant. The options have an exercise price of $.01 per share, are vested andfully exercisable upon grant, and have a ten-year term.

 

•                  In May 2001, theCompany issued 12,000 shares of its common stock, valued at approximately$30,000, to one vendor for goods and services provided to the Company.

 

•                  During Fiscal 2002, the Company issued 10,076shares of its common stock to one director and four employees upon exercise ofstock options, as follows:

 
| **Date of  Sale** |   | **Purchaser** |   | **Number of  Shares** |   | **Price per Share** |   | **Proceeds** |   |
|-------------------|--------|---------------|--------|-----------------------|--------|---------------------|--------|--------------|--------|
| April 2001        |   | Employee      |   | 1,200                 |   | $                   | 2.25   |         | $      | 2,700 |   |
| April 2001        |   | Employee      |   | 375                   |   | $                   | 0.01   |         | 4      |   |
| July 2001         |   | Employee      |   | 4,501                 |   | $                   | 0.01   |         | 45     |   |
| August 2001       |   | Director      |   | 500                   |   | $                   | 0.01   |         | 5      |   |
| March 2002        |   | Employee      |   | 3,500                 |   | $                   | 0.01   |         | 35     |   |
| Totals            |   |          |   | 10,076                |   |                |   | $            | 2,789  |   |

 

•                  In August 2001, theCompany issued 125,000 shares of its common stock, valued at approximately$250,000, to a grocery store chain as settlement for the termination of a grocerystore agreement.

 

•                  In March 2002, the Company issued7,500 shares of its common stock to one warrant holder upon exercise ofwarrants for aggregate consideration to the Company of approximately $2,000.

 

•                  In January 2002, theCompany issued warrants to purchase 240,000 shares of its common stock valuedat $480,000, to a company ownedby a former director of the Company inaccordance with the terms of a convertible promissory note held by suchcompany. The warrants were issued in lieu of annualinterest on the promissory note in theprincipal amount of $3.0 million, have an exercise price of$0.01 and are exercisable for ten years from the issuance date thereof.

 

17

----

 

**ITEM 6.  SELECTED FINANCIAL DATA**

 

The following selectedfinancial data have been derived from the consolidated financial statements ofthe Company. The data set forth below should be read in conjunction with“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and the Company’s consolidated financial statements and notesthereto appearing elsewhere in this Form 10-K.

 
|                                                                        |   | **Year Ended**                            |    |
|-----------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                        |   | **Mar 31, 2002  (52 weeks)(1)(2)**        |    | **Apr 1, 2001  (52weeks)(1)** |   | **Apr 2, 2000  (53 weeks)(3)** |   | **Mar 28, 1999  (52 weeks)** |   | **Mar 29, 1998  (52 weeks)** |   |
|                                                                        |   | **(in thousands, except per share data)** |    |
| **Results of Operations Data**                                              |   |                                      |    |   |   |   |   |   |   |   |   |
| Net sales                                                                   |   | $                                         | 51,548  |   | $ | 42,102 |   | $ | 27,698 |   | $ | 20,207 |   | $ | 9,020 |   |
| Operating loss                                                              |   | (13,111                                   | )       | (23,797 | ) | (7,717 | ) | (5,088 | ) | (3,267 | ) |
| Net loss                                                                    |   | (11,152                                   | )       | (25,057 | ) | (8,066 | ) | (6,581 | ) | (3,820 | ) |
| Preferred stock  dividend/accretion                                         |   | —                                    |    | — |   | (8,794 | ) | (5,968 | ) | — |   |
| Net loss applicable to  common stockholders                                 |   | $                                         | (11,152 | ) | $ | (25,057 | ) | $ | (16,860 | ) | $ | (12,549 | ) | $ | (3,820 | ) |
|                                                                        |   |                                      |    |   |   |   |   |   |   |   |   |
| Basic and diluted loss per  common share                                    |   | $                                         | (0.69   | ) | $ | (1.59 | ) | $ | (1.15 | ) | $ | (0.88 | ) | $ | (0.29 | ) |
| Weighted-average number of  common and common equivalent shares outstanding |   | 16,274                                    |    | 15,777 |   | 14,599 |   | 14,299 |   | 13,366 |   |
|                                                                        |   |                                      |    |   |   |   |   |   |   |   |   |
| **Balance Sheet Data**                                                      |   |                                      |    |   |   |   |   |   |   |   |   |
| Working capital deficit                                                     |   | $                                         | (269    | ) | $ | (12,006 | ) | $ | (47 | ) | $ | (5,799 | ) | $ | (1,617 | ) |
| Total assets                                                                |   | 33,140                                    |    | 39,278 |   | 36,844 |   | 20,719 |   | 8,078 |   |
| Long-term debt (including  current portion)                                 |   | 5,400                                     |    | 8,476 |   | 3,108 |   | 6,657 |   | 4,293 |   |
| Stockholders’ equity                                                   |   | 6,417                                     |    | 15,245 |   | 25,286 |   | 9,976 |   | 427 |   |
|                                                                        |   |                                      |    |   |   |   |   |   |   |   |   |
| Number of stores at  year-end(4)                                            |   | 104                                       |    | 114 |   | 65 |   | 59 |   | 33 |   |

 

----

(1)          Fiscal 2002 and 2001 include significantcharges as follows (dollars in thousands):

 
|                                                                    |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Impairment of long-lived  assets                                        |   | $        | 2,350  |     | $      | 5,006 |   |
| Store closures and lease  termination costs                             |   | 1,583    |   | 2,620    |   |
| Liquidation and write-off of  Tully’s Europe B.V (“TEB”) |   | 46       |   | 1,036    |   |
| Total                                                                   |   | $        | 3,979  |     | $      | 8,662 |   |

 

(2)          During Fiscal 2002, the Company received a$12,000,000 license fee from UCC.  In addition, the Company received $4,200,000and 300 shares of Tully’s Coffee Japan stock (with a market value ofapproximately $1,771,000 at October 1, 2001) in connection with the amendmentof its license and supply agreements with Tully’s Coffee Japan.  Tully’s sold all of these shares of Tully’sCoffee Japan stock during Fiscal 2002 and the first two quarters of Fiscal2003.

 

(3)          The additional week during Fiscal 2000accounted for $503,000 in net sales.

 

(4)          Store counts include the store at SafecoField, which operates seasonally.

 

18

----

 

**ITEM 7.****    ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF****OPERATIONS**

 

*The following discussion and analysisprovides information that Tully’s believes is relevant to an assessment andunderstanding of its results of operations and financial condition for thefiscal years ended March 31, 2002, April 1, 2001 and April 2, 2000.  The following discussion should be read inconjunction with the consolidated financial statements and related notesappearing elsewhere in this report.  TheCompany believes that certain statements herein, including statementsconcerning anticipated store openings, planned capital expenditures, and trendsin or expectations regarding Tully’s operations, constitute “forward–lookingstatements” within the meaning of Section 21E of the Securities Exchange Actof 1934, as amended.  Such statementsare based on currently available operating, financial and competitiveinformation, and are subject to risks and uncertainties.  Actual future results and trends may differmaterially depending on a variety of factors, including, but not limited to,coffee and other raw materials prices and availability, successful execution ofinternal performance and expansion plans, the impact of competition, the effectof legal proceedings, and other risks summarized at “Item 1 – Business - RiskFactors.”*

 

**Overview**

 

Tully’s derives itsrevenues from sales from (1) its Retail division, which operates retail storesin Washington,Oregon, California and Idaho,  (2) itsWholesale division, which sells Tully’s-branded products to domesticsupermarkets, food service distributors, restaurants, institutions, and officecoffee services, and through direct mail order sales, and (3) its Internationaldivision, which sells Tully’s-branded products to its foreign licensees andreceives royalty and licensing fees from those licensees.  For Fiscal 2002, Tully’s derivedapproximately 80.6% of net sales from its Retail division.

 

The Company’s cash flow from operations has notbeen sufficient to cover operating expenses and the Company has not made aprofit from operations in any year since inception.  These losses are primarily due to costs associated with theCompany’s significant growth, especially opening new stores and expansion intonew markets, and its significant investment in building the Tully’s brand, andwere exacerbated in Fiscal 2002 by the weak economy in its principal geographicmarkets.  During Fiscal 2003, theCompany intends to focus primarily on improving the operations of its existingretail stores including expansion of the products offered in the stores,expanding its Wholesale division sales and International division licenseeopportunities, and managing its costs more effectively.  Tully’s expects to open  one new store in Fiscal 2003, and expects toclose four or more stores not meeting Company expectations.

 

The Company has historically funded its cash flowshortfalls through the issuance of debt and equity securities, throughborrowings, and with proceeds from its licensing agreements with UCC andTully’s Coffee Japan.

 

**Results of Operations**

 

The following tablesets forth, for the periods indicated, selected statement of operations dataexpressed as a percentage of sales.

 
|                                               |   | **Fiscal Year Ended** |   |
|----------------------------------------------------|--------|-----------------------|--------|
|                                               |   | **March 31,  2002**   |   | **April 1,  2001** |   | **April 2,  2000** |   |
| STATEMENTS OF OPERATIONS  DATA:                    |   |                  |   |   |   |   |   |
| Net sales                                          |   | 100.0                 | %      | 100.0 | % | 100.0 | % |
| Cost of goods sold and  related occupancy expenses |   | 50.3                  | %      | 53.5 | % | 50.4 | % |
| Store operating expenses                           |   | 33.8                  | %      | 36.2 | % | 35.0 | % |
| Other operating expenses                           |   | 3.1                   | %      | 7.2 | % | 4.2 | % |
| Marketing, general and  administrative costs       |   | 21.2                  | %      | 29.3 | % | 24.7 | % |
| Non-cash stock option  compensation expense        |   | 0.5                   | %      | 1.9 | % | 4.4 | % |
| Depreciation and  amortization                     |   | 8.9                   | %      | 10.4 | % | 9.2 | % |
| Impairment of long-lived  assets                   |   | 4.6                   | %      | 11.9 | % | — |   |
| Store closure and lease  termination costs         |   | 3.1                   | %      | 6.2 | % | — |   |
| Operating loss                                     |   | (25.5                 | )%     | (56.6 | )% | (27.9 | )% |
| Interest expense                                   |   | 1.6                   | %      | 1.8 | % | 1.3 | % |
| Interest income                                    |   | (0.3                  | )%     | (0.1 | )% | (1.0 | )% |
| Gain on sale of investments                        |   | (5.6                  | )%     | — |   | — |   |
| Miscellaneous expense  (income)                    |   | 0.1                   | %      | (0.3 | )% | (0.5 | )% |
| Loan guarantee fee expense                         |   | 0.4                   | %      | 1.6 | % | 1.5 | % |
| Net loss                                           |   | (21.7                 | )%     | (59.6 | )% | (29.1 | )% |

 

19

----

 

**Fiscal Year Ended March 31, 2002Compared To Fiscal Year Ended April 1, 2001**

 

*Net Sales*

 

The Company’s net salesfor Fiscal 2002 increased $9,356,000 or 22.2% to $51,458,000 as compared to netsales of $42,102,000 for Fiscal 2001. During the same period, Retail division sales increased 16% to$41,477,000 from $35,759,000.  This $5,718,000increase in Retail division sales resulted from the opening during Fiscal 2002of two new retail stores ($390,000); and stores opened or acquired duringFiscal 2001 and operating for the full year in Fiscal 2002 contributed$8,178,000.  These amounts werepartially offset by a comparable store sales decrease of (6.1%) which representeda $1,662,000 decrease, and $1,235,000 of sales declines from twelve storesclosed during Fiscal 2002.  Managementbelieves that the comparable store sales decrease was caused by (i) the weakeconomy, exacerbated by consumer uncertainty following the events of September11, 2001, (ii)cannibalization of, ordiversion of customers from, comparablestores by new Tully’s stores opened during Fiscal2001, (iii) customers purchasing Tully’s ground coffee through supermarketsinstead of Tully’s retail stores, and (iv) limited product innovation andmarketing during Fiscal 2002. Comparable store sales are defined as sales generated in stores open forat least 12 months in each of the periods. At March 31, 2002, the Company operated 104 retail stores (including theSafeco Field store which operates seasonally).

 

Wholesale division netsales increased $333,000 or 7.0% to $5,116,000 for Fiscal 2002 from $4,783,000for Fiscal 2001.  The increase was dueprimarily to new supermarket and food service accounts, partially offset bydeclines in the office coffee service sales.

 

Net sales for theInternational division increased by $3,297,000 or 211.3% for Fiscal 2002 from$1,560,000 for Fiscal 2001. International licensing fees, on an amortized basis, accounted for$1,958,000 of the increase and sales of coffee and supplies to Tully’s CoffeeJapan represented $1,339,000 of the increase.

 

*Operating**Expenses*

 

Cost of goods sold andrelated occupancy costs increased $3,400,000 or 15.1% to $25,905,000 in Fiscal2002 from $22,505,000 in Fiscal 2001. This increase was largely the result of higher sales volumes and theimpact of stores open only part of Fiscal 2001 but open all of Fiscal2002.  As a percentage of net sales,cost of goods sold and related occupancy costs decreased to 50.3% for Fiscal2002 compared with 53.5% for Fiscal 2001, primarily as a result of (i) theconsolidation of the Company’s bakery vendors and improved pricing, (ii)reduced costs of green coffee and improved inventory controls and (iii) awarenessof cost savings, including more careful management of perishable inventories andsupplies.

 

Store operatingexpenses increased $2,154,000 or 14.1% to $17,390,000 in Fiscal 2002 from$15,236,000 in Fiscal 2001.  Labor andother expenses from new stores operated during part of Fiscal 2001 but all ofFiscal 2002 generated $1,423,000 of the increase, two new stores opened inFiscal 2002 represented $175,000 of the increase, and costs associated withstores closed in Fiscal 2002 accounted for $555,000 of the increase. As apercentage of net sales, store operating expenses decreased to 33.8% for Fiscal2002 from 36.2% for Fiscal 2001.  Thisdecrease resulted from the closing of stores that did not meet Companyexpectations offset by an increase in labor and related costs.

 

Other operatingexpenses (expenses associated with all operations other than retail stores)decreased $1,430,000 or 47.5% to $1,581,000 in Fiscal 2002 from $3,011,000 inFiscal 2001.  The expense decrease isprimarily due to factors in Fiscal 2001 including the write-down of theCompany’s investment in TEB and related trade receivables totalingapproximately $1,036,000 and the remaining decrease is due to the reduction inlabor and overhead costs.

 

Marketing, generaland administrative costs (excluding non-cash stock option compensation expense)decreased $1,446,000 or 11.7% to $10,900,000 in Fiscal 2002 from $12,346,000 inFiscal 2001 reflecting Company efforts to reduce costs to levels appropriatefor its revenue base.  The decreasereflects reduced spending on community relations and donations ($715,000), areduction in professional fees and services of approximately $373,000, andreduced bad debt expense by $390,000. As a percentage of net sales, marketing, general and administrativecosts decreased to 21.2% in Fiscal 2002 from 29.3% in Fiscal 2001.

 

Non-cash stock optioncompensation expense decreased $523,000 or 66.9% to $259,000 in Fiscal 2002from $782,000 in Fiscal 2001.  As apercentage of net sales, stock option expense decreased to 0.5% for Fiscal 2002from 1.9% for Fiscal 2001.  Non-cashstock compensation expense is a non-cash charge representing the differencebetween the exercise price and fair market value of the stock at the date ofgrant and is recognized as expense over the vesting period.

 

Depreciation andamortization expense increased $207,000 or 4.7% to $4,600,000 in Fiscal 2002from $4,393,000 in Fiscal 2001, reflecting a full year of depreciation andamortization on stores added during Fiscal 2001.  As a percentage of net

 

20

----

 

sales, depreciation and amortization expensedecreased to 8.9% for Fiscal 2002 from 10.4% for Fiscal 2001.  Retail sales grew faster than depreciation and amortization (primarily due to a full year ofsales in Fiscal 2002 at stores opened during Fiscal 2001) and, to a lesser extent,due to the reduced depreciable value of the assets impaired in Fiscal2001 (described below).

 

*Impairment of Long-Lived Assets*

 

A non-cash charge of $2,350,000 for the impairmentof long-lived assets was recognized during Fiscal 2002 compared to $5,006,000during Fiscal 2001 under the application of FASB Statement No. 121, “Accountingfor the Impairment of Long-Lived Assets and for Long-Lived Assets to beDisposed Of” (“SFAS 121”).  See Note 10to the Consolidated Financial Statements. The charge consists of a non-cash write-off of the goodwill, leaseholdimprovements and other long term assets determined to be impaired.  Asa result of the Fiscal 2002 impairment charge, depreciation and amortizationexpense for Fiscal 2003 on these assets will decline by approximately $350,000.

 

*Store Closure and Lease TerminationCosts*

 

Store closure and lease termination costs of $1,583,000 for Fiscal 2002reflect the Company’s estimate of write-offs to be made and costs to beincurred in connection with the closure of twelve retail stores (and thetermination of the related leases), the termination ofone lease (for an unopened store) and additional costs(in excess of the Fiscal 2001 estimate of costs) related to the termination offour leases identified for termination during Fiscal 2001.  During Fiscal 2001, store closure and leasetermination costs of $2,620,000 reflected the Company’s estimate of write-offsto be made and costs to be incurred in connection with the closure of the fourretail stores (and termination of the related leases)and termination of 18 leases (for unopened stores, includingthe four leases eventually terminated in Fiscal 2002).  Lease termination costs include rent,brokers fees, and other anticipated lease settlement costs, and were determinedusing management’s best estimate. During Fiscal 2002, the Company reached negotiated settlements for mostof the store closures and lease terminations recognized in Fiscal 2002 andFiscal 2001, however, accrued liabilities at March 31, 2002, include an accrualof approximately $852,000 with respect to those leases for which the Companyhas not yet reached a negotiated settlement. See Note 19 to the Consolidated Financial Statements.

 

*Other Expenses (Income)*

 

Interest expense wasessentially unchanged at $812,000 in Fiscal 2002 compared to $778,000 forFiscal 2001.  During Fiscal 2001 theCompany repaid its bank line of credit, but incurred a full year of interest onthe convertible promissory note in Fiscal 2002 compared to only a partial yearin Fiscal 2001.  See Note15 to the Consolidated Financial Statements.

 

Gain on sale ofinvestments of $2,887,000 in Fiscal 2002 reflects the recognized gain from thesale of the Company’s holdings of Tully’s Coffee Japan stock.

 

Miscellaneous incomedecreased $89,000 or 47.1% to $100,000 for Fiscal 2002 from $189,000 for Fiscal2001.  The decrease is due to the following losses thatoffset other income in Fiscal 2002:(i) the  loss on the liquidation of TEB of $46,000 and (ii)the $39,000 loss on the sale of Company equipment that offset other income inFiscal 2002.

 

Loan guarantee feeexpense decreased $455,000 or 67.8% to $216,000 in Fiscal 2002 from $671,000for Fiscal 2001. The bank line of credit was repaid on October 1, 2001.  This non-cash expense is for options topurchase common stock of the Company granted to two directors in considerationof their guarantees of the Company’s bank line of credit, with the number ofoptions based on the amount outstanding on the line of credit.

 

*Net Loss*

 

Net loss decreased$13,905,000 or 55.5% to $11,152,000 in Fiscal 2002 from $25,057,000 for Fiscal2001. The smaller net loss in Fiscal 2002 reflects the $3,693,000 reduction incharges relating to the impairment of long-lived assets and store closure andlease termination costs, and the $2,887,000 recognized gain on the Fiscal 2002sale of the Company’s Tully’s Coffee Japan stock.  The remaining $7 million improvement in net loss resulted fromthe increase in net sales (including the international license fee revenue),improved gross margins, cost management efforts, and lower financing costs inFiscal 2002 as compared to Fiscal 2001. The Company recognized no income tax benefit from its net loss in Fiscal2002 or Fiscal 2001.  Net lossapplicable to common stockholders decreased $13,905,000 or 55.5% to $11,152,000from $25,057,000 for Fiscal 2001.  Therewas no preferred stock dividend/accretion in Fiscal 2002 or Fiscal 2001.  Net loss applicable to common stockholdersper share decreased by $0.90 or 56.6% to $0.69 per share in Fiscal 2002 from$1.59 per share in Fiscal 2001.

 

21

----

 

**Fiscal Year Ended April 1, 2001Compared To Fiscal Year Ended April 2, 2000**

 

*Net Sales*

 

The Company’s net salesfor Fiscal 2001 increased $14,404,000 to $42,102,000 from $27,698,000 forFiscal 2000, which represents a 52.0% increase.  During the same period, Retail division sales increased$11,697,000 to $35,759,000 from $24,062,000, a 48.6% increase.  The increase in Retail division salesresulted from:  a) the opening of 37 newretail stores which contributed $8,523,000, b) the acquisition of 14 retailstores which contributed $2,413,000 and c) comparable store sales growth of3.5% which accounted for the remaining $761,000 of the increase.  At Fiscal 2001 year-end, Tully’s operated114 retail stores, all located in the western United States compared to 65 atApril 2, 2000.

 

Wholesale division netsales increased $1,589,000 or 49.7% to $4,783,000 for Fiscal 2001 from$3,194,000 for Fiscal 2000.  Theincrease was due to new domestic wholesale and office coffee service customeraccounts.

 

International divisionsales increased $1,118,000 or 252.9% to $1,560,000 for Fiscal 2001 from$442,000 for Fiscal 2000.  This increasewas due to an increase in sales to Tully’s Coffee Japan.

 

*Operating**Expenses*

 

Cost of goods sold andrelated occupancy costs increased $8,546,000 or 61.2% to $22,505,000 in Fiscal2001 from $13,959,000 in Fiscal 2000. This increase was the result of higher sales volumes and the substantialgrowth in the number of stores in operation during Fiscal 2001 compared toFiscal 2000.  As a percentage of netsales, cost of goods sold and related occupancy costs increased to 53.5% forFiscal 2001 compared with 50.4% for Fiscal 2000, primarily as a result ofrelatively higher rents compared to sales in the Company’s new stores,increased costs of paper products and drink supplies and the roll-out of a newsandwich program at certain locations.

 

Store operatingexpenses increased $5,550,000 or 57.3% to $15,236,000 in Fiscal 2001 from$9,686,000 in Fiscal 2000.  Labor andother expenses from newly opened and acquired stores in Fiscal 2001 generated$4,233,000 of the increase.  Theremaining cost increases resulted primarily from ten stores added during Fiscal2000 that were open all of Fiscal 2001. As a percentage of net sales, store operating expenses increased to36.2% for Fiscal 2001 from 35.0% for Fiscal 2000, reflecting the fact that andincreasing percentage of the Company’s stores are less-mature, which theCompany generally considers to be stores open less than two years. These stores typically have higher operating expenses than stores openedfor a longer period.

 

Other operatingexpenses (expenses associated with all operations other than retail stores)increased $1,849,000 or 159.1% to $3,011,000 in Fiscal 2001 from $1,162,000 inFiscal 2000.  The increase resultedfrom: a) the write-down of the Company’s investment in Tully’s Europe B.V. andrelated trade receivables totaling approximately $1,036,000, and 2) increasedsales and distribution costs required to support the growth of Wholesaledivision sales.

 

Marketing, generaland administrative costs (excluding non-cash stock option compensation expense)increased $5,494,000 or 80.2% to $12,346,000 in Fiscal 2001 from $6,852,000 inFiscal 2000.  The $5,494,000 increaseresulted from: a) an increase of $1,203,000 in marketing expenditures whichconsisted primarily of the new PacBell stadium sponsorship), b) an increase of$846,000 in professional fees for legal, accounting and auditing services, c) a$777,000 increase in payroll expenditures related to the general growth in thebusiness, d) $513,000 of incremental occupancy expenses associated with the newroasting plant and corporate headquarters, and e) an increase of $606,000 incommunity relations and donations.   Asa percentage of net sales, marketing, general and administrative costsincreased to 29.3% in Fiscal 2001 from 24.7% in Fiscal 2000.

 

Non-cash stock optioncompensation expense decreased $426,000 or (35.3)% to $782,000 in Fiscal 2001from $1,208,000 in Fiscal 2000.  As apercentage of net sales, stock option expense decreased to 1.9% for Fiscal 2001from 4.4% for Fiscal 2000.  Non-cashstock compensation expense is a non-cash charge representing the differencebetween the exercise price and fair market value of the stock at the date ofgrant and is recognized as expense over the vesting period.

 

Depreciation andamortization expense increased $1,845,000 or 72.4% to $4,393,000 in Fiscal 2001from $2,548,000 in Fiscal 2000. This increase was due to the opening of 37 newstores, the acquisition of five Coffee Station stores in September 2000 andnine Marsee Baking stores in December 2000. As a percentage of net sales,depreciation and amortization expense increased to 10.4% for Fiscal 2001 from9.2% for Fiscal 2000.

 

22

----

 

*Impairmentof Long-Lived Assets*

 

A non-cash charge of $5,006,000 for the impairment of long-lived assetswas recognized during Fiscal 2001 under the application of FASB Statement No.121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed Of” (“SFAS 121”). See Note 10 to the Consolidated Financial Statements.  The charge consists of a non-cash write-offof the goodwill, leasehold improvements and other long term assets determinedto be impaired under the application of SFAS 121.

 

*Store Closure and Lease TerminationCosts*

 

Store closure and lease termination costs of $2,620,000 for Fiscal 2001reflect the Company’s estimate of write-offs to be made and costs to beincurred in connection with the closure of four retail stores and terminationof leases for unopened store sites.  Asof April 1, 2001, the Company had 18 retail store locations for which leaseshad been signed but stores had not been opened.  In March 2001, the Company determined that it would not buildthese retail stores due to capital constraints and because current financialprojections for these locations did not meet management’s financialcriteria.  Estimated lease terminationcosts, which include rent and broker fees, were determined using management’sbest estimate.  See Note 18 to theConsolidated Financial Statements.

 

*Other Expenses (Income)*

 

Interest expenseincreased $427,000 or 121.7% to $778,000 in Fiscal 2001 compared to $351,000for Fiscal 2000 due to higher average borrowings on the Company’s bank line ofcredit in Fiscal 2001 compared with Fiscal 2000 and due to interest from theconvertible promissory note issued at the end of the third quarter of Fiscal 2001.

 

Interest andmiscellaneous income decreased $241,000 or 56.1% to $189,000 for Fiscal 2001from $430,000 for Fiscal 2000. The decrease reflects less interest income dueto lower average cash balances in Fiscal 2001.

 

Loan guarantee feeexpense increased $243,000 or 56.8% to $671,000 in Fiscal 2001 from $428,000for Fiscal 2000. This non-cash expense is for options to purchase common stockof the Company, granted to the two directors in consideration of theirguarantees of the Company’s bank line of credit, with the number of optionsbased on the amount outstanding on the line of credit.  This increase is due to higher average borrowingson the bank line of credit.

 

*Net Loss*

 

Net loss increased$16,991,000 or 210.6% to $25,057,000 in Fiscal 2001 from $8,066,000 for Fiscal2000. Fiscal 2001 results include $7,626,000 of costs from the write-down forthe impairment of long-lived assets and store closure and lease terminationcosts.  The addition of 51 new retailstores in Fiscal 2001 in addition to the ten added in Fiscal 2000 greatlyincreased the percentage of less mature stores in operation and the rapidgrowth resulted in higher store operating expenses, marketing, general andadministrative costs, and depreciation and amortization.  The Company recognized no income tax benefitfrom its net loss in Fiscal 2001 or Fiscal 2000.  Net loss applicable to common stockholders increased $8,197,000or 48.6% to $25,057,000 from $16,860,000 for Fiscal 2000. There was nopreferred stock dividend/accretion in Fiscal 2001 compared to $8,794,000 in Fiscal 2000,discussed below. Net loss applicable tocommon stockholders per share increased by $0.44 or 38.3% to $1.59 per share inFiscal 2001 from $1.15 per share in Fiscal 2000.

 

In connection withthe issuance of Series A Preferred Stock in Fiscal 2000, the Companyissued 4,580,392 warrants to purchase common stock at an exercise price of$0.33 per share. The exercise price of the warrant at the date of issuance wasbelow management’s estimation of the fair market value of the common stock andis therefore considered an “in the money” or beneficial conversion feature.Accounting for the issuance of convertible preferred stock with a nondetachablebeneficial conversion feature at the date of issue requires that the conversionfeature be recognized and measured in the financial statements by allocating aportion of the preferred stock offering proceeds to additional paid in capital.The discount resulting from the allocation of the proceeds to the beneficialconversion feature is conceptually similar to a dividend and is recognized as areturn to preferred stockholders from the date of issuance through the date thewarrants are exercisable. As a result of this accounting, the Company allocated$8,794,000 of the preferred stock proceeds to additional paid in capital.

 

*Liquidity and Capital Resources*

 

Tully’s ended Fiscal2002 with $3,389,000 in cash and cash equivalents and short-term investmentscompared to cash of $408,000 at the end of Fiscal 2001.  Tully’s had a working capital deficit of$269,000 at March 31, 2002 compared to a working capital deficit of $12,006,000at April 1, 2001, for a net improvement of $11,737,000.  The increase in cash and short-term

 

23

----

 

investments and decrease in working capital deficitwas due primarily to cash from the licensing fees received from UCC and Tully’sCoffee Japan under the license and supply agreements and the sale of stock received thereunder.

 

Because the Company principally operates asa “cash business,” it generally does not require a significant net investmentin working capital.  Further, Companymanagement has placed increased emphasis on management of the Company’sinvestment in inventory and accounts receivable.  As a result, the Company typically has operated with currentliabilities in excess of its current assets (excluding cash and cashequivalents).  The Company’s inventorylevels typically increase during the spring due to coffee crop seasonality and,to a lesser degree, during the autumn due to holiday season merchandise.  Tully’s expects that its investment in accountsreceivable will increase in connection with anticipated sales growth in itsWholesale and International divisions. Losses from uncollectible accounts receivable from the Company’sWholesale division historically have been small and the related allowance fordoubtful wholesale accounts has been relatively consistent with the level ofthe underlying receivables; this may change in future periods, however,depending on the Company’s business practices and growth strategies and changesin the economy generally.  The Companydoes not currently expect to experience any significant losses on its accountsreceivable from its current international licensees.  During Fiscal 2000 and 2001 the Company experienced lossesrelated to Tully’s Europe B.V. and the foreign licensee of the Company’sSpinelli brand, which increased the Company’s losses from uncollectibleaccounts receivable and the related reserve for doubtful accounts receivable.

 

Operating with minimal or deficit workingcapital has reduced the Company’s historical requirements for capital, butprovides the Company with limited immediately available resources to addressshort-term needs and unanticipated business developments, and increases theCompany’s dependence upon ongoing financing activities.

 

The following tablesets forth, for the periods indicated, selected statement of cash flows data:.

 
|                                                                                     |   | **Fiscal Year Ended**      |    |
|------------------------------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                                     |   | **March 31,  2002**        |    | **April 1,  2001** |   | **April 2,  2000** |   |
|                                                                                     |   | **(dollars in thousands)** |    |
| STATEMENTS  OF CASH FLOWS DATA                                                           |   |                       |    |   |   |   |   |
| Cash provided by (used for):                                                             |   |                       |    |   |   |   |   |
| Net loss                                                                                 |   | $                          | (11,152 | ) | $ | (25,057 | ) | $ | (8,066 | ) |
| Adjustments to net loss for  depreciation and other non-cash operating statement amounts |   | 6,968                      |    | 14,557 |   | 4,497 |   |
| Net loss adjusted for  non-cash operating statement amounts                              |   | (4,184                     | )       | (10,500 | ) | (3,569 | ) |
| Deferred licensing revenue                                                               |   | 14,287                     |    | — |   | — |   |
| Cash provided (used) for  other changes in assets and liabilities                        |   | (3,140                     | )       | 3,889 |   | (2,413 | ) |
| Net cash provided by (used  in) operating activities                                     |   | 6,963                      |    | (6,611 | ) | (5,982 | ) |
|                                                                                     |   |                       |    |   |   |   |   |
| Proceeds from sale of  investment in TCJ stock                                           |   | 3,025                      |    | — |   | — |   |
| Purchases of property and  equipment                                                     |   | (3,024                     | )       | (11,020 | ) | (7,695 | ) |
| Additions to intangibles and  other assets                                               |   | (12                        | )       | (183 | ) | (1,037 | ) |
| Business acquisitions                                                                    |   | —                     |    | (2,745 | ) | — |   |
| Net borrowings (repayments)  of debt                                                     |   | (6,282                     | )       | 5,623 |   | (3,550 | ) |
| Proceeds from equity  transactions                                                       |   | 606                        |    | 11,570 |   | 20,889 |   |
| Other                                                                                    |   | —                     |    | (1,284 | ) | 1,284 |   |
|                                                                                     |   |                       |    |   |   |   |   |   |   |   |
| Net increase (decrease) in  cash and cash equivalents                                    |   | $                          | 1,276   |   | $ | (4,650 | ) | $ | 3,909 |   |

 

Cash provided byoperating activities was $6,963,000 in Fiscal 2002, a $13,574,000 improvementfrom cash used in operating activities of $6,611,000 in Fiscal 2001.  The cash provided by operating activitiesprimarily resulted from the $14,287,000 licensing and supply agreement proceedsreceived from UCC and Tully’s Coffee Japan, and a reduction of inventories of$2,670,000.  TheCompany used these cash sources to reduce trade accounts payableand accrued liabilities of approximately $5,024,000, which included payment ofamounts that were in arrears under vendor terms.  TheCompany incurred a loss of $11,152,000 in Fiscal 2002.  The Fiscal 2002 loss and the cash providedby operating activities both reflect significant improvements as compared toFiscal 2001, but the Company expects to incur a loss in Fiscal 2003.  The Company has closed stores that did notmeet its performance criteria, and is continuing to evaluate store locationsand operations to determine if closing, downsizing or relocation of certainstores that do not meet performance objectives is necessary.  The Company is taking other actionsto reduce negative cash flow from operations, including revisions tooperational procedures and expansion of its Wholesale division.

 

Cash used in investingactivities in Fiscal 2002 totaled approximately $11,000.  This includes cash used for additions

 

24

----

 

to property, plant and equipment of $3,024,000,including approximately $ 2,390,000 of payments for accounts payable at April1, 2001 for Fiscal 2001 capital additions, and the Fiscal 2002 capital investedin two new retail stores and remodeling other stores.  During Fiscal 2002, Tully’s sold 56% of its shareholdings ofTully’s Coffee Japan stock and received net proceeds of $3,025,000.  During the first two quarters of Fiscal2003, the Company sold all of its remaining shares of Tully’s Coffee Japanstock and received additional net cash proceeds of $1,829,000.

 

Net cash used infinancing activities for Fiscal 2002 totaled $5,676,000.  These activities included the full repayment ofthe $5,500,000 bank line of credit, the net repayment of related party notes payable ($350,000 in theaggregate), and repayments on other notes payable ($737,000 in theaggregate).  These cash uses werepartially offset by $601,000 received from a stockholder in full payment of thenote receivable from the stockholder, and by $305,000 of proceeds from aninstallment note payable.

 

As of March 31, 2002,the Company had fixed price inventory purchase commitments for green coffeetotaling approximately $2,700,000 for deliveries scheduled at various datesduring Fiscal 2003.  As of December 31, 2002, the Company hadremaining Fiscal 2003 purchase commitments totaling approximately $700,000, andwas negotiating contracts for delivery in Fiscal 2004 expected to total approximately$2,700,000.  The Company believes, based on relationships established with itssuppliers, that the risk of loss on nondelivery on such purchase commitments isremote.

 

In late 1999, theCompany entered into a ten-year lease for the facility that houses the Company’sheadquarters, roasting plant and distribution facilities in Seattle,Washington.   During November 2002, the Company and thelessor parties amended the lease in connection with the establishment of thenew credit facility as described below and in Note 28 to the ConsolidatedFinancial Statements.  When the Companyfirst occupied this property in Fiscal 2001, the lessor funded $1,000,000 oftenant improvements to the property, and the lease was amended at that time toreimburse the lessor for the improvement allowance through increased leasepayments.  As a result, in Fiscal 2001the Company recorded $1,000,000 as a deferred lease cost liability, and hasbeen amortizing this liability as rent was paid.  Under the provisions of the new credit facility and the November2002 lease amendment, the parties agreed to add the unamortized tenantimprovement allowance of $890,037 to the borrowed principal amount under thecredit facility and to reduce the monthly rental for the remainder of the leaseterm by approximately $16,000 per month. In addition, the amended lease provides that the lessor may, at itsoption, terminate the lease prior to the expiration of its term early by givingthe Company 150 days written notice of termination.  Although the lessor has listed the property for sale or lease,the Company is not aware of any current intention by the lessor to terminatethe lease and the Company expects to continue its tenancy under the terms ofthe amended lease.  However, if thelessor were to terminate the lease prior to the expiration of its term, early,the recoverability of the Company’s leasehold improvements at the facilitywould be impaired; such leasehold improvements had a net book value of$1,342,000 at December 29, 2002.

 

The Company hassponsorship agreements with PacBell Stadium in San Francisco and Safeco Fieldin Seattle expiring on October 31, 2002 and December 31, 2003,respectively, that provide certain advertising and marketing rights to theCompany in exchange for the payment of annual fees.  The PacBell Stadium agreement, which required the Company to payfees of $950,000 during Fiscal 2003, was to expire on October 31, 2002 andprovided for fees of $950,000 for Fiscal 2003. During August 2002, the parties extended the term through October 31,2003 with an aggregate fee of $1,100,000 for the two years ($825,000 payable inFiscal 2003 and $275,000 payable in Fiscal 2004), and with a reduced level ofmarketing benefits during Fiscal 2004. The annual fees payable by Tully’s under the Safeco Field agreement areapproximately $505,000 in Fiscal 2003 and $520,000 in Fiscal 2004 (withadditional charges for any tickets, food service and other incidentals providedto Tully’s).

 

Cash requirements for Fiscal 2003, other thannormal operating expenses and the commitments described above, are expected toconsist primarily of capital expenditures related to the remodeling andaddition of a limited number of new retail stores, fixtures and equipmentrelated to the introduction of other products into Tully’s stores, equipmentand accounts receivable related to new Wholesale division customers, androasting plant equipment.  Managementexpects total Fiscal 2003 capital expenditures will be approximately$1,100,000, in addition to approximately $1,200,000 of store and roasting plantfixtures and equipment that are expected to be provided through operating orcapital leases.

 

25

----

 

The following table summarizes the Company’sprincipal financial commitments (other than ordinary trade obligations such asaccounts payable and accrued liabilities) as of March 31, 2002:

 
|                      |   | **Payments Due by Fiscal Year** |   |
|---------------------------|--------|---------------------------------|--------|
|                      |   | **Total**                       |   | **Fiscal 2003** |   | **Fiscal 2004** |   | **Fiscal 2005** |   | **Fiscal 2006** |   | **Fiscal 2007** |   | **Thereafter** |   |
|                      |   | **(dollars in thousands)**      |   |
| Notes Payable             |   | $                               | 334    |   | $ | 308 |   | $ | 20 |   | $ | 5 |   | $ | 1 |   | $ | — |   | $ | — |   |
| Convertible Note          |   | 3,000                           |   | — |   | — |   | 3,000 |   | — |   | — |   | — |   |
| Capital Leases            |   | 320                             |   | 33 |   | 31 |   | 22 |   | 21 |   | 19 |   | 194 |   |
| Operating Leases          |   | 36,430                          |   | 5,324 |   | 5,124 |   | 5,053 |   | 4,919 |   | 4,398 |   | 11,612 |   |
| Green Coffee Purchase     |   | 2,700                           |   | 2,700 |   | — |   | — |   | — |   | — |   | — |   |
| Sponsorship Agreements(1) |   | 2,125                           |   | 1,330 |   | 795 |   | — |   | — |   | — |   | — |   |
| Executive Employment(2)   |   | —                          |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                      |   | $                               | 44,909 |   | $ | 9,695 |   | $ | 5,970 |   | $ | 8,080 |   | $ | 4,941 |   | $ | 4,417 |   | $ | 11,806 |   |

 

Notes to Schedule:

 

----

(1)          The obligations underthe sponsorship agreements with PacBell Stadium and Safeco Field incorporatethe August 2002 amendment to the PacBell agreement as described above and inNote 28 of the Notes to the Consolidated Financial Statements.

 

(2)          Pursuant to theemployment agreement with the Company’s CEO, and the employment summaries forfive other members of Company management, the Company has agreed to payseverance compensation to the Company’s CEO and these executives in the eventtheir employment by the Company is terminated for reasons other than certainexcluded circumstances.  The amount ofseverance to be paid would depend upon the rate of salary at the time oftermination and other factors.  As ofDecember 31, 2002, the aggregate contingent obligation for severance to thesesix individuals was $640,000.

 

The Company hashistorically funded its capital requirements principally through the issuanceof equity and debt securities, through borrowings and lease financing, and through cashprovided under its international licensing relationships.

 

On November 1,2002, the Company entered into a new credit facility with the lessor of itsheadquarters, roasting plant and distribution facilities, Kent Central LLC(“KCL”), which is secured by substantially all of the Company’s assets andguaranteed by certain directors and stockholders of the Company (the“guarantors”).  The KCL credit facilityallows the Company toborrow up to $2,000,000 through October 31, 2003.  The terms of the credit facility, and a related agreementamong the Company and the guarantors, include provisions that, among otherthings, restrict the Company’s ability to incur additional secured debt orliens and to sell, lease or transfer assets. Other provisions of these agreements would require accelerated repaymentof the borrowed amounts in certain circumstances, including the issuance of newequity, certain mergers and changes and control, certain sales of assets, andupon certain changes or events relating to the guarantors.  The KCL credit facility and related agreements permit theCompany to enter into an additional borrowing facility of up to $1.0 millionwith another lender, subject to the consent of KCL and the guarantors.  This additional facility may be secured bythe Company’s accounts receivable and inventory, in which case KCL wouldsubordinate its interest in that collateral to that of the new lender.  The Company is evaluating possible lendersfor this additional secured borrowing and expects to enter into such a facilityas part of its Fiscal 2003 financing strategy. See Note 28 of the Notesto the Consolidated Financial Statements.

 

Additional sources of funding are expectedto include debt or equity financings. The Company is currently evaluating alternatives for raising additionalcapital but has not identified or obtained specific sources of long-termfunding.  If the Company is unable tosecure the additional secured borrowing or other sources of capital areunavailable, or are available only on a limited basis or under unsatisfactoryterms, then the Company would be required to substantially reduceoperating, marketing, general and administrative costs related to itscontinuing operations, and to reduce or discontinue its investments in storeimprovements, new customers and new products. In addition, the Company might be required to sell individual or groupsof stores or other assets (such as wholesale distribution territories orinternational contract interests) and would be unable to take advantage of business opportunities or respond tocompetitive pressures.  Store saleswould involve the assignment or sub-lease of the store location (which mayrequire the lessor’s consent) and the sale of the store equipment, leaseholdimprovements and related assets.   TheCompany has previously disposed of only underperforming store locations, butmight be required to dispose of its better-performing locations in order toobtain a significant amount of sales proceeds. The price received from the sale of stores or other assets might not bein amounts or timing satisfactory to the Company, and the sale ofbetter-performing locations or other income-producing assets could adverselyaffect the Company’s future operating results and cash flows.

 

The Company believesthat the combination of cash and cash equivalents at March 31, 2002, proceedsfrom the KCL credit facility, and the $1.0 million additional secured borrowingthat the Company expects to obtain will be sufficient to fund

 

26

----

 

ongoing operations of the Company through Fiscal2003.  In order to fund unanticipatedoperating requirements in excess of the Company’s Fiscal 2003 operating planand future capital expenditures, the Company will require additional capital.  The Company expects that additionalsources of funding will be required in subsequent periods to meet operatingrequirements, fund capital expenditures, and fund repayment of debt and otherlong-term obligations.

 

The Company’s articlesof incorporation provide that its Series A Preferred Stock is senior to thecommon stock for liquidation preferences, and the Series B Preferred stock isjunior to both the Series A Preferred Stock and a stated dollar amount ofliquidation preference for the holders of common stock.  If the Company were to sell all or asubstantial portion of its assets in order to meet its operating needs andsatisfy its obligations or were to be liquidated, the amounts available fordistribution to shareholders might be less than the aggregate liquidationpreferences of the more senior shareholders, and no amounts might be availablefor distribution to the more junior shareholders.

 

**Application of Critical AccountingPolicies**

 

We have identifiedthe policies below as critical to our business operations and the understandingof our results of operations.  Theimpact and any associated risks related to these policies on our businessoperations is discussed throughout Management’s Discussion and Analysis ofFinancial Condition and Results of Operations where such policies affect ourreported and expected financial results. For a detailed discussion on the application of these and otheraccounting policies, see Note 1 to the Consolidated Financial Statements.  Note that our preparation of theconsolidated financial statements requires us to make estimates and assumptionsthat affect the reported amount of assets and liabilities, disclosure ofcontingent assets and liabilities at the date of our financial statements, andthe reported amounts of revenue and expenses during the reporting period.  There can be no assurance that actualresults will not differ from those estimates.

 

The Company’sdiscussion and analysis of its financial condition and results of operationsare based upon its consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates.  The Company believes thefollowing critical accounting policies affect its more significant judgmentsand estimates used in the preparation of its consolidated financial statements,and should be read in conjunction with the Consolidated FinancialStatements.  The Company’s criticalaccounting policies relate particularly to (1) Revenue recognition and (2)Estimating valuation allowances, specifically those related to long-livedassets and lease termination reserves.

 

*Revenue recognition*

 

Sales are generally recognized at the time of thesale at retail store locations.  Salesfor the Wholesale and International divisions are recognized upon delivery orupon shipment of the products depending on individual terms with thecustomers.    Royaltyrevenues are recognized in accordance with the license agreements, which arebased primarily upon the licensee sales and pounds of coffee roasted.  Revenues from advance license fees arerecognized on the straight-line basis over the expected life of the agreementsof seven to fifteen years.

 

*Estimating valuation allowances and accrued liabilities*

 

The Company usessignificant judgment and estimates in the preparation of its financialstatements that affect the carrying values of its assets and liabilities. On anon-going basis, the Company reevaluates its estimates.

 

We periodicallyreview the carrying value of our long-lived assets for continuedappropriateness.  This review is basedupon our projections of anticipated future cash flows.  We record impairment losses on long-livedassets used in operations when events and circumstances indicate that theassets might be impaired and the undiscounted cash flows estimated to begenerated by those assets are less than the carrying amount of thoseitems.  Our cash flow estimates arebased on historical results adjusted to reflect our best estimate of futuremarket and operating conditions.  Whilewe believe that our estimates of future cash flows are reasonable, differentassumptions regarding such cash flows could materially affect ourevaluations.  The net carrying value ofassets not recoverable are reduced to their fair value. Our estimates of fairvalue represent our best estimate based on either discounted cash flows orappraised values, depending on the nature of the asset.

 

Periodically, the Company will determine that certain leases will beterminated and the store or other operation will be closed.  At such determination, the Company accruesfor the net future minimum lease payments of the related lease agreements.  Amounts accrued as net future minimum lossesinclude the discounted estimated future rental payments and lease termination fees.

 

27

----

 

**New Accounting Standards**

 

See Note 1 to the Consolidated Financial Statements.

 

**ITEM 7(a).QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

The Company is exposed to market risk related to changes inavailable-for sale security prices and foreign currency exchange rates onforeign investments.

 

Short-terminvestments consist of available-for-sale securities, which are subject tosignificant risk of changes in value. The Company’s investment balance consists of the common stock of Tully’sCoffee Japan (See Note 6 to the Consolidated Financial Statements).  The investment is recorded at fair valuewith unrealized gains and losses reported as a component of comprehensiveincome (loss).  The investment isdenominated in Japanese yen and is translated at the exchange rate on thebalance sheet date.  Tully’s sold all ofthese shares of Tully’s Coffee Japan stock during Fiscal 2002 and the first twoquarters of Fiscal 2003.

 

The Company currently has no foreign currency exchange rate exposurerelated to its licensing activities in Asia or its purchasing of coffee beans,because all transactions are denominated in U.S. dollars.  At the present time, the Company does nothedge foreign currency risk, but may hedge known transaction exposure in thefuture.

 

The supply and price of coffee beans aresubject to significant volatility and can be affected by multiple factors inproducing countries, including weather, political and economic conditions.  In addition, green coffee bean prices havebeen affected in the past, and may be affected in the future, by the actions ofcertain organizations and associations that have historically attempted toinfluence commodity prices of green coffee beans through agreementsestablishing export quotas or restricting coffee bean supplies worldwide. Inorder to limit the cost exposure of the main commodity used in the Company’sbusiness, the Company enters into fixed-price purchase commitments.  The Company’s practice has been to annuallycontract for most of its green coffee bean purchases in advance for the nextfiscal year.  This allows the Company tosecure an adequate supply of quality green coffee beans and fix its cost of greencoffee beans.  As of December 29, 2002,the Company had fixed price inventory purchase commitments for green coffeeremaining for delivery in Fiscal 2003 totaling approximately $700,000, and wasnegotiating contracts for delivery in Fiscal 2004 expected to totalapproximately $2,700,000.  The Companybelieves, based on relationships established with its suppliers, that the riskof loss on nondelivery on such purchase commitments is remote.

 

Under the new KCL credit facility described in Note28 to the Consolidated Financial Statements, the Company borrows at an interestrate that is based upon the prime borrowing rate.  From time to time, the Company has other transactions andagreements that include provisions for interest at a variable rate.  Accordingly, the Company expects to besubject to fluctuating interest rates in the normal course of business duringFiscal 2003 and subsequent periods.

 

28

----

 

**ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

The followingconsolidated financial statements and related notes thereto, of Tully’s CoffeeCorporation, and the Report of Independent Accountants, are filed as a part ofthis amended report on Form 10-K/A

 

**Index toConsolidated Financial Statements**

 
| Report of Independent  Accountants                                                                                                    |
|---------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                  |
| Consolidated  Balance Sheets – March 31, 2002 and April 1, 2001                                                                  |
|                                                                                                                                  |
| Consolidated  Statements of Operations for the years ended March 31, 2002, April 1, 2001  and April 2, 2000                           |
|                                                                                                                                  |
| Consolidated  Statements of Comprehensive Loss for the years ended March 31, 2002, April 1,  2001 and April 2, 2000                   |
|                                                                                                                                  |
| Consolidated  Statements of Changes in Stockholders’ Equity for the years ended March 31,  2002, April 1, 2001 and April 2, 2000 |
|                                                                                                                                  |
| Consolidated  Cash Flow Statements for the years ended March 31, 2002, April 1, 2001 and  April 2, 2000                               |
|                                                                                                                                  |
| Notes  to Consolidated Financial Statements                                                                                           |

 

29

----

 

**Report of Independent Accountants**

 

To the Board of Directors and Stockholders of  Tully’s Coffee Corporation

 

In our opinion, theaccompanying consolidated balance sheets and the related consolidatedstatements of operations, of comprehensive loss, of changes in stockholders’equity and of cash flows present fairly, in all material respects, thefinancial position of Tully’s Coffee Corporation at March 31, 2002 and April 1,2001, and the results of its operations and its cash flows for each of theyears ended March 31, 2002, April 1, 2001 and April 2, 2000, in conformity withaccounting principles generally accepted in the United States of America. Thesefinancial statements are the responsibility of the Company’s management; ourresponsibility is to express an opinion on these financial statements based onour audits.  We conducted our audits ofthese statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

See Note 2 fordiscussion of the Company’s recent and prospective liquidity issues.

 

PricewaterhouseCoopers LLP

Seattle, Washington

June 28, 2002

 

30

----

 

**Tully’s Coffee Corporation Consolidated Balance Sheets**

 
|                                                                                                                                                                                                                              |   | **March 31,  2002**                            |   | **April 1,  2001** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------|--------|--------------------|--------|
|                                                                                                                                                                                                                              |   | **(dollars in thousands, except  share data)** |   |
| **Assets**                                                                                                                                                                                                                        |   |                                           |   |               |   |
| Current assets                                                                                                                                                                                                                    |   |                                           |   |               |   |
| Cash and cash equivalents                                                                                                                                                                                                         |   | $                                              | 1,684  |               | $      | 408 |   |
| Short-term investments                                                                                                                                                                                                            |   | 1,705                                          |   | —             |   |
| Accounts receivable, net of  allowance for doubtful accounts of $349 and $652 at 2002 and 2001,  respectively                                                                                                                     |   | 1,071                                          |   | 884                |   |
| Other receivables                                                                                                                                                                                                                 |   | —                                         |   | 195                |   |
| Inventories                                                                                                                                                                                                                       |   | 2,258                                          |   | 4,928              |   |
| Prepaid expenses and other  current assets                                                                                                                                                                                        |   | 710                                            |   | 635                |   |
| Total current assets                                                                                                                                                                                                              |   | 7,428                                          |   | 7,050              |   |
| Property and equipment, net                                                                                                                                                                                                       |   | 20,297                                         |   | 26,345             |   |
| Goodwill, net                                                                                                                                                                                                                     |   | 3,572                                          |   | 4,101              |   |
| Other intangible assets, net                                                                                                                                                                                                      |   | 1,120                                          |   | 1,248              |   |
| Other assets                                                                                                                                                                                                                      |   | 723                                            |   | 534                |   |
| Total assets                                                                                                                                                                                                                      |   | $                                              | 33,140 |               | $      | 39,278 |   |
|                                                                                                                                                                                                                              |   |                                           |   |               |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                                                    |   |                                           |   |               |   |
| Current liabilities                                                                                                                                                                                                               |   |                                           |   |               |   |
| Current portion of long-term  debt                                                                                                                                                                                                |   | $                                              | 308    |               | $      | 515 |   |
| Bank line of credit                                                                                                                                                                                                               |   | —                                         |   | 5,500              |   |
| Accounts payable                                                                                                                                                                                                                  |   | 2,259                                          |   | 7,664              |   |
| Accrued liabilities                                                                                                                                                                                                               |   | 3,018                                          |   | 5,027              |   |
| Deferred licensing revenue                                                                                                                                                                                                        |   | 2,112                                          |   | —             |   |
| Related party notes payable                                                                                                                                                                                                       |   | —                                         |   | 350                |   |
| Total current liabilities                                                                                                                                                                                                         |   | 7,697                                          |   | 19,056             |   |
| Long-term debt, net of  current portion                                                                                                                                                                                           |   | 26                                             |   | 210                |   |
| Capital lease obligation                                                                                                                                                                                                          |   | 127                                            |   | 168                |   |
| Deferred lease costs                                                                                                                                                                                                              |   | 2,225                                          |   | 2,006              |   |
| Convertible promissory note,  net of discount                                                                                                                                                                                     |   | 2,703                                          |   | 2,593              |   |
| Deferred licensing revenue                                                                                                                                                                                                        |   | 13,945                                         |   | —             |   |
| Total liabilities                                                                                                                                                                                                                 |   | 26,723                                         |   | 24,033             |   |
| Commitments and  contingencies (Note 20) Stockholders’ equity                                                                                                                                                                |   |                                           |   |               |   |
| Series A Convertible  Preferred stock, no par value; 17,500,000 shares authorized, 15,378,264  issued and outstanding at 2002 and 2001; stated value of $2.50 per share and  a liquidation preference of $38,446 at 2002 and 2001 |   | 34,483                                         |   | 34,483             |   |
| Series B Convertible  Preferred stock, no par value; 8,000,000 shares authorized 4,990,709 issued  and outstanding at 2002 and 2001, stated value of $2.50 per share and a  liquidation preference of $12,477 at 2002 and 2001    |   | 11,066                                         |   | 11,066             |   |
| Common stock, no par value;  120,000,000 shares authorized at 2002 and 2001; 16,320,613 and 16,166,037  shares issued and outstanding at 2002 and 2001, respectively                                                              |   | 9,265                                          |   | 8,980              |   |
| Note receivable from  stockholder                                                                                                                                                                                                 |   | —                                         |   | (601               | )      |
| Additional paid-in capital                                                                                                                                                                                                        |   | 27,093                                         |   | 25,545             |   |
| Accumulated other  comprehensive loss                                                                                                                                                                                             |   | (110                                           | )      | —             |   |
| Accumulated deficit                                                                                                                                                                                                               |   | (75,380                                        | )      | (64,228            | )      |
| Total stockholders’ equity                                                                                                                                                                                                   |   | 6,417                                          |   | 15,245             |   |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                  |   | $                                              | 33,140 |               | $      | 39,278 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

31

----

 

**Tully’s Coffee Corporation ConsolidatedStatements of Operations**

 
|                                                                                                                                                                       |   | **Years ended**                                    |    |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------|---------|
|                                                                                                                                                                       |   | **March 31,  2002**                                |    | **April 1,  2001** |   | **April 2,  2000** |   |
|                                                                                                                                                                       |   | **(dollars in thousands, except per  share data)** |    |
| Net sales                                                                                                                                                                  |   | $                                                  | 51,458  |   | $ | 42,102 |   | $ | 27,698 |   |
| Cost of goods sold and  related occupancy expenses                                                                                                                         |   | 25,905                                             |    | 22,505 |   | 13,959 |   |
| Store operating expenses                                                                                                                                                   |   | 17,390                                             |    | 15,236 |   | 9,686 |   |
| Other operating expenses                                                                                                                                                   |   | 1,581                                              |    | 3,011 |   | 1,162 |   |
| Marketing, general and  administrative costs (excluding non-cash stock option compensation expense of  $259, $782 and $1,208 for Fiscal 2002, 2001 and 2000, respectively) |   | 10,901                                             |    | 12,346 |   | 6,852 |   |
| Non-cash stock option  compensation expense                                                                                                                                |   | 259                                                |    | 782 |   | 1,208 |   |
| Depreciation and  amortization                                                                                                                                             |   | 4,600                                              |    | 4,393 |   | 2,548 |   |
| Impairment of long-lived  assets                                                                                                                                           |   | 2,350                                              |    | 5,006 |   | — |   |
| Store closure and lease  termination costs                                                                                                                                 |   | 1,583                                              |    | 2,620 |   | — |   |
| Operating loss                                                                                                                                                             |   | (13,111                                            | )       | (23,797 | ) | (7,717 | ) |
| Other (income) expenses                                                                                                                                                    |   |                                               |    |   |   |   |   |
| Interest expense                                                                                                                                                           |   | 812                                                |    | 778 |   | 351 |   |
| Interest income                                                                                                                                                            |   | (124                                               | )       | (50 | ) | (280 | ) |
| Gain on sale of investments                                                                                                                                                |   | (2,887                                             | )       | — |   | — |   |
| Miscellaneous expense  (income)                                                                                                                                            |   | 24                                                 |    | (139 | ) | (150 | ) |
| Loan guarantee fee expense                                                                                                                                                 |   | 216                                                |    | 671 |   | 428 |   |
| Total other (income) expenses                                                                                                                                              |   | (1,959                                             | )       | 1,260 |   | 349 |   |
| Net loss                                                                                                                                                                   |   | (11,152                                            | )       | (25,057 | ) | (8,066 | ) |
| Preferred stock  dividend/accretion                                                                                                                                        |   | —                                             |    | — |   | (8,794 | ) |
| Net loss applicable to  common stockholders                                                                                                                                |   | $                                                  | (11,152 | ) | $ | (25,057 | ) | $ | (16,860 | ) |
|                                                                                                                                                                       |   |                                               |    |   |   |   |   |
| Weighted-average number of  common and common equivalent shares outstanding                                                                                                |   | 16,274                                             |    | 15,777 |   | 14,599 |   |
|                                                                                                                                                                       |   |                                               |    |   |   |   |   |
| Basic and diluted loss per  common share                                                                                                                                   |   | $                                                  | (0.69   | ) | $ | (1.59 | ) | $ | (1.15 | ) |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

32

----

 

**Tully’s Coffee Corporation Consolidated Statements ofComprehensive Loss**

 
|                                                                                                       |   | **Years ended**             |    |
|------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                       |   | **March 31, 2002**          |    | **April 1, 2001** |   | **April 2, 2000** |   |
|                                                                                                       |   | **(dollars  in thousands)** |    |
| Net loss                                                                                                   |   | $                           | (11,152 | ) | $ | (25,057 | ) | $ | (16,860 | ) |
|                                                                                                       |   |                        |    |   |   |   |   |
| Other comprehensive income  (loss):                                                                        |   |                        |    |   |   |   |   |
| Unrealized  holding gain on short-term investments, arising in the period                                  |   | 2,777                       |    | — |   | — |   |
| Less:  Reclassification adjustment for realized  gain on short-term investments, included in net loss |   | (2,887                      | )       | — |   | — |   |
|                                                                                                       |   | (110                        | )       | — |   | — |   |
| Total  comprehensive loss                                                                                  |   | $                           | (11,262 | ) | $ | (25,057 | ) | $ | (16,860 | ) |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

33

----

 

**Tully’sCoffee Corporation Consolidated Statements of Changes in Stockholders’ EquityYears Ended March 31, 2002, April 1, 2001****and April 2, 2000**

 
|                                                                         |   | **Convertible Preferred Stock** |   | **Common Stock** |   |       |   |         |   |       |   |       |   |
|------------------------------------------------------------------------------|--------|---------------------------------|--------|------------------|--------|------------|--------|--------------|--------|------------|--------|------------|--------|
| **(dollars in thousands, except********per share data)**                     |   | **Shares**                      |   | **Series A**     |   | **Shares** |   | **Series B** |   | **Shares** |   | **Amount** |   | **Note  receivable  from  stockholder** |   | **Additional  paid-in  capital** |   | **Accumu  lated  deficit** |   | **Total** |   |
| Balance,  March 28, 1999                                                     |   | 6,217,480                       |   | $                | 14,352 |       | — |         | $      | —     |   | 14,314,000 |   | $ | 7,445 |   | $ | — |   | $ | 10,490 |   | $ | (22,311 | ) | $ | 9,976 |   |
| Issuance  of 190,948 options in exchange for loan guarantees                 |   |                            |   |             |   |       |   |         |   |       |   |       |   |   |   | 428 |   |   |   | 428 |   |
| Sale  of preferred stock at $2.50 per share                                  |   | 9,160,784                       |   | 22,902           |   |       |   |         |   |       |   |       |   |   |   |   |   |   |   | 22,902 |   |
| Issuance  of common stock warrants                                           |   |                            |   | (8,794           | )      |       |   |         |   |       |   |       |   |   |   | 8,794 |   |   |   | — |   |
| Issuance  of common stock in connection with purchase agreements             |   |                            |   |             |   |       |   |         |   | 152,089    |   | 337        |   |   |   |   |   |   |   | 337 |   |
| Issuance  of common stock in connection with purchases of goods and services |   |                            |   |             |   |       |   |         |   | 226,171    |   | 514        |   |   |   |   |   |   |   | 514 |   |
| Preferred  stock dividend/accretion                                          |   |                            |   | 8,794            |   |       |   |         |   |       |   |       |   |   |   |   |   | (8,794 | ) | — |   |
| Stock  issuance costs                                                        |   |                            |   | (2,046           | )      |       |   |         |   |       |   |       |   |   |   |   |   |   |   | (2,046 | ) |
| Issuance  of stock options                                                   |   |                            |   |             |   |       |   |         |   |       |   |       |   |   |   | 1,208 |   |   |   | 1,208 |   |
| Exercise  of common stock warrants                                           |   |                            |   |             |   |       |   |         |   | 799,074    |   | 264        |   |   |   |   |   |   |   | 264 |   |
| Note  receivable from stockholder                                            |   |                            |   |             |   |       |   |         |   |       |   |       |   | (231 | ) |   |   |   |   | (231 | ) |
| Net  loss                                                                    |   |                            |   |             |   |       |   |         |   |       |   |       |   |   |   |   |   | (8,066 | ) | (8,066 | ) |
| Balance,  April 2, 2000                                                      |   | 15,378,264                      |   | $                | 35,208 |       | — |         | $      | —     |   | 15,491,334 |   | $ | 8,560 |   | $ | (231 | ) | $ | 20,920 |   | $ | (39,171 | ) | $ | 25,286 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

34

----

 
|                                                                          |   | **Convertible Preferred Stock** |   | **Common Stock** |   |       |      |         |   |       |   |       |   |
|-------------------------------------------------------------------------------|--------|---------------------------------|--------|------------------|--------|------------|-----------|--------------|--------|------------|--------|------------|--------|
| **(dollars in thousands, except********per share data)**                      |   | **Shares**                      |   | **Series A**     |   | **Shares** |      | **Series B** |   | **Shares** |   | **Amount** |   | **Note  receivable  from  stockholder** |   | **Additional  paid-in  capital** |   | **Accumu  lated  deficit** |   | **Total** |   |
| Balance,  April 2, 2000                                                       |   | 15,378,264                      |   | $                | 35,208 |       | —    |         | $      | —     |   | 15,491,334 |   | $ | 8,560 |   | $ | (231 | ) | $ | 20,920 |   | $ | (39,171 | ) | $ | 25,286 |   |
| Issuance  of 287,676 options in exchange for loan guarantees                  |   |                            |   |             |   |       |      |         |   |       |   |       |   |   |   | 669 |   |   |   | 669 |   |
| Sale  of preferred stock at $2.50 per share                                   |   |                            |   |             |   | 4,990,709  |      | 12,477       |   |       |   |       |   |   |   |   |   |   |   | 12,477 |   |
| Issuance  of common stock warrants under terms of convertible promissory note |   |                            |   |             |   |       |      |         |   |       |   |       |   |   |   | 456 |   |   |   | 456 |   |
| Beneficial  conversion feature on convertible debt                            |   |                            |   |             |   |       |      |         |   |       |   |       |   |   |   | 456 |   |   |   | 456 |   |
| Issuance  of preferred stock warrants                                         |   |                            |   |             |   |       |      |         |   |       |   |       |   |   |   | 1,555 |   |   |   | 1,555 |   |
| Issuance  of common stock in connection with purchase agreements              |   |                            |   |             |   |       |      |         |   | 55,000     |   | 124        |   |   |   |   |   |   |   | 124 |   |
| Issuance  of common stock in connection with purchases of goods and services  |   |                            |   |             |   |       |      |         |   | 59,737     |   | 127        |   |   |   | 85 |   |   |   | 212 |   |
| Issuance  of common stock to employee                                         |   |                            |   |             |   |       |      |         |   | 6,044      |   | 13         |   |   |   |   |   |   |   | 13 |   |
| Exercise  of stock options                                                    |   |                            |   |             |   |       |      |         |   | 28,297     |   | 7          |   |   |   |   |   |   |   | 7 |   |
| Stock  issuance costs                                                         |   |                            |   | (725             | )      |       |      | (1,411       | )      |       |   |       |   |   |   | 725 |   |   |   | (1,411 | ) |
| Issuance  of stock options                                                    |   |                            |   |             |   |       |      |         |   |       |   |       |   |   |   | 679 |   |   |   | 679 |   |
| Exercise  of common stock warrants                                            |   |                            |   |             |   |       |      |         |   | 525,625    |   | 149        |   |   |   |   |   |   |   | 149 |   |
| Note  receivable from stockholder                                             |   |                            |   |             |   |       |      |         |   |       |   |       |   | (370 | ) |   |   |   |   | (370 | ) |
| Net  loss                                                                     |   |                            |   |             |   |       |      |         |   |       |   |       |   |   |   |   |   | (25,057 | ) | (25,057 | ) |
| Balance,  April 1, 2001                                                       |   | 15,378,264                      |   | $                | 34,483 |       | 4,990,709 |         | $      | 11,066     |   | 16,166,037 |   | $ | 8,980 |   | $ | (601 | ) | $ | 25,545 |   | $ | (64,228 | ) | $ | 15,245 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

35

----

 
|                                                                                |   | **Convertible Preferred Stock** |   | **Common Stock** |   |       |      |         |   |       |   |       |   |                                    |   |
|-------------------------------------------------------------------------------------|--------|---------------------------------|--------|------------------|--------|------------|-----------|--------------|--------|------------|--------|------------|--------|-----------------------------------------|--------|
| **(dollars in thousands, except********per share data)**                            |   | **Shares**                      |   | **Series A**     |   | **Shares** |      | **Series B** |   | **Shares** |   | **Amount** |   | **Note  receivable  from  stockholder** |   | **Additional  paid-in  capital** |   | **Accumu  lated  Other  Compre  hensive loss** |   | **Accumu  lated  deficit** |   | **Total** |   |
| Balance,  April 1, 2001                                                             |   | 15,378,264                      |   | $                | 34,483 |       | 4,990,709 |         | $      | 11,066     |   | 16,166,037 |   | $                                       | 8,980  |   | $ | (601 | ) | $ | 25,545 |   | $ | — |   | $ | (64,228 | ) | $ | 15,245 |   |
| Issuance  of common stock warrants in payment of accrued liability                  |   |                            |   |             |   |       |      |         |   |       |   |       |   |                                    |   | 599 |   |   |   |   |   | 599 |   |
| Issuance  of 105,112 options in exchange for loan guarantees                        |   |                            |   |             |   |       |      |         |   |       |   |       |   |                                    |   | 210 |   |   |   |   |   | 210 |   |
| Issuance  of common stock warrants under terms of convertible promissory note       |   |                            |   |             |   |       |      |         |   |       |   |       |   |                                    |   | 480 |   |   |   |   |   | 480 |   |
| Issuance  of common stock in connection with purchases of goods and services        |   |                            |   |             |   |       |      |         |   | 12,000     |   | 30         |   |                                    |   |   |   |   |   |   |   | 30 |   |
| Exercise  of stock options                                                          |   |                            |   |             |   |       |      |         |   | 10,076     |   | 3          |   |                                    |   |   |   |   |   |   |   | 3 |   |
| Issuance  of stock options                                                          |   |                            |   |             |   |       |      |         |   |       |   |       |   |                                    |   | 259 |   |   |   |   |   | 259 |   |
| Exercise  of common stock warrants                                                  |   |                            |   |             |   |       |      |         |   | 7,500      |   | 2          |   |                                    |   |   |   |   |   |   |   | 2 |   |
| Issuance  of common stock in connection with termination of grocery store agreement |   |                            |   |             |   |       |      |         |   | 125,000    |   | 250        |   |                                    |   |   |   |   |   |   |   | 250 |   |
| Note  receivable from stockholder                                                   |   |                            |   |             |   |       |      |         |   |       |   |       |   | 601                                     |   |   |   |   |   |   |   | 601 |   |
| Other  comprehensive loss                                                           |   |                            |   |             |   |       |      |         |   |       |   |       |   |                                    |   |   |   | (110 | ) |   |   | (110 | ) |
| Net  loss                                                                           |   |                            |   |             |   |       |      |         |   |       |   |       |   |                                    |   |   |   |   |   | (11,152 | ) | (11,152 | ) |
| Balance,  March 31, 2002                                                            |   | 15,378,264                      |   | $                | 34,483 |       | 4,990,709 |         | $      | 11,066     |   | 16,320,613 |   | $                                       | 9,265  |   | $ | — |   | $ | 27,093 |   | $ | (110 | ) | $ | (75,380 | ) | $ | 6,417 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

36

----

 

**Tully’s Coffee Corporation ConsolidatedStatements of Cash Flows**

 
|                                                                                      |   | **Years ended**            |    |
|-------------------------------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                                      |   | **March 31,  2002**        |    | **April 1,  2001** |   | **April 2,  2000** |   |
|                                                                                      |   | **(dollars in thousands)** |    |
| **Cash flows from operating activities**                                                  |   |                       |    |   |   |   |   |
| Net loss                                                                                  |   | $                          | (11,152 | ) | $ | (25,057 | ) | $ | (8,066 | ) |
| Adjustments to reconcile net  loss to net cash provided by (used in) operating activities |   |                       |    |   |   |   |   |
| Depreciation and  amortization                                                            |   | 4,600                      |    | 4,393 |   | 2,548 |   |
| Impairment of long-lived  assets                                                          |   | 2,350                      |    | 5,006 |   | — |   |
| Store closure costs charged  to operations                                                |   | 1,583                      |    | 2,620 |   | — |   |
| Gain on sale of investments                                                               |   | (2,887                     | )       | — |   | — |   |
| Stock option expense                                                                      |   | 259                        |    | 782 |   | 1,208 |   |
| Provision for doubtful  accounts                                                          |   | 7                          |    | 797 |   | 218 |   |
| Stock issued in exchange for  services                                                    |   | 280                        |    | 127 |   | 64 |   |
| Loan guarantee fee expense                                                                |   | 210                        |    | 669 |   | 428 |   |
| Non-cash interest expense                                                                 |   | 566                        |    | 163 |   | — |   |
| Loss on sale of property                                                                  |   | —                     |    | — |   | 31 |   |
| Changes in assets and  liabilities, net of effects of acquisitions:                       |   |                       |    |   |   |   |   |
| Accounts receivable                                                                       |   | (194                       | )       | (898 | ) | (387 | ) |
| Other receivables                                                                         |   |                       |    | (113 | ) | (2 | ) |
| Inventories                                                                               |   | 2,670                      |    | (1,241 | ) | (1,824 | ) |
| Prepaid expenses and other  assets                                                        |   | (229                       | )       | 1,198 |   | (1,688 | ) |
| Accounts payable                                                                          |   | (3,136                     | )       | 1,288 |   | 584 |   |
| Accrued liabilities                                                                       |   | (2,470                     | )       | 2,490 |   | 949 |   |
| Deferred lease costs                                                                      |   | 219                        |    | 1,165 |   | (45 | ) |
| Deferred licensing revenue                                                                |   | 14,287                     |    | — |   | — |   |
| Net cash provided by (used  in) operating activities                                      |   | 6,963                      |    | (6,611 | ) | (5,982 | ) |
| **Cash flows from investing  activities**                                                 |   |                       |    |   |   |   |   |
| Proceeds from the sale of  investments                                                    |   | 3,025                      |    | — |   | — |   |
| Purchases of property and  equipment                                                      |   | (3,024                     | )       | (11,020 | ) | (7,695 | ) |
| Additions to intangible  assets                                                           |   | (12                        | )       | (183 | ) | (1,037 | ) |
| Purchase of Marsee Baking  and Coffee Station stores                                      |   | —                     |    | (2,745 | ) | — |   |
| Net cash used in investing  activities                                                    |   | (11                        | )       | (13,948 | ) | (8,732 | ) |
| **Cash flows from financing  activities**                                                 |   |                       |    |   |   |   |   |
| Net borrowings (repayments)  under bank line of credit                                    |   | (5,500                     | )       | 2,500 |   | (3,500 | ) |
| Payments on notes payable  and capital leases                                             |   | (737                       | )       | (629 | ) | (189 | ) |
| Proceeds from notes payable                                                               |   | 305                        |    | 402 |   | 139 |   |
| Payments on related party notes payable                                                   |   | (1,350                     | )       | — |   | — |   |
| Proceeds from related party notes payable                                                 |   | 1,000                      |    | 350 |   | — |   |
| Proceeds from issuance of  convertible promissory note                                    |   | —                     |    | 3,000 |   | — |   |
| Proceeds from exercise of  stock options                                                  |   | 3                          |    | — |   | — |   |
| Proceeds from exercise of  warrants                                                       |   | 2                          |    | — |   | — |   |
| Proceeds from issuance of  common stock                                                   |   | —                     |    | 149 |   | 264 |   |
| Proceeds from issuance of  preferred stock                                                |   | —                     |    | 12,477 |   | 22,902 |   |
| Stock issuance costs                                                                      |   | —                     |    | (811 | ) | (2,046 | ) |
| Repayments of (increases in)  note receivable from stockholder                            |   | 601                        |    | (245 | ) | (231 | ) |
| Checks drawn in excess of  bank balances                                                  |   | —                     |    | (1,284 | ) | 1,284 |   |
| Net cash (used in) provided  by financing activities                                      |   | (5,676                     | )       | 15,909 |   | 18,623 |   |
| **Net  increase (decrease) in cash and cash equivalents**                                 |   | 1,276                      |    | (4,650 | ) | 3,909 |   |
| Cash and cash equivalents                                                                 |   |                       |    |   |   |   |   |
| Beginning of period                                                                       |   | 408                        |    | 5,058 |   | 1,149 |   |
| End of period                                                                             |   | $                          | 1,684   |   | $ | 408 |   | $ | 5,058 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

37

----

 

**Supplemental disclosure of cash flowinformation and non-cash investing and financing activities:**

 
|                                                                                                                                        |   | **Years ended**            |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                                                                        |   | **March 31,  2002**        |   | **April 1,  2001** |   | **April 2,  2000** |   |
|                                                                                                                                        |   | **(dollars in thousands)** |   |
| Cash paid during the period  for interest                                                                                                   |   | $                          | 246    |   | $ | 591 |   | $ | 337 |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Non-cash investing and  financing activity                                                                                                  |   |                       |   |   |   |   |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Accounts payable to purchase  equipment                                                                                                     |   | 121                        |   | 2,390 |   | 1,593 |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Issuance of warrants in  payment of accrued liabilities                                                                                     |   | 599                        |   | 1,555 |   | — |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Available-for-sale  securities received for deferred licensing revenue                                                                      |   | 1,771                      |   | — |   | — |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Notes issued to purchase  equipment                                                                                                         |   | —                     |   | 10 |   | — |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Common stock issued to  purchase equipment and leasehold Improvements                                                                       |   |                       |   | 124 |   | 338 |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Common stock issued to  purchase other assets                                                                                               |   | —                     |   | — |   | 450 |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Deemed preferred stock  dividend on preferred stock issuance as a result ofbeneficial conversion  feature of attached common stock warrants |   | —                     |   | — |   | 8,794 |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Debt discount due to  beneficial conversion feature                                                                                         |   | —                     |   | 456 |   | — |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Issuance of warrants in lieu  of cash interest on convertible debt                                                                          |   | 480                        |   | 456 |   | — |   |
|                                                                                                                                        |   |                       |   |   |   |   |   |
| Liability incurred for  underwriting fees to be paid in equity                                                                              |   | —                     |   | 599 |   | — |   |
|                                                                                                                                             |        |                            |        |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

38

----

 

**Tully’s Coffee Corporation Notes to Consolidated FinancialStatements**

 

**1. The Company and significant accounting policies**

 

**The Company and nature of operations**

 

Tully’s CoffeeCorporation, (the “Company”) was formed in 1992 for the purpose of developingand operating retail specialty coffee shops. The Company sells high quality,premium roasted whole bean coffees, rich brewed coffees, Italian-style espressoand cold beverages, baked goods and pastries and coffee–related hardwareand supplies through its three divisions. In addition to its Retail divisionoperations, the Company’s Wholesale division sells to domestic customers in thefood service, supermarket, restaurant, office coffee service and institutionalsegments.  The International divisionhas licensed third parties to operate Tully’s-branded stores and to sellTully’s-branded coffee and other products in Asia.

 

As of March 31, 2002,the Company’s Retail division operated 104 domestic retail stores in theSeattle, San Francisco, Portland and Los Angeles metropolitan areas (includingthe Safeco Field store which operates seasonally).  Tully’s has a license andsupply agreement with Tully’s Coffee Japan, which, as of June 20, 2002,operated 49 Tully’s retail stores in Japanas a licensee of the Company and franchised 14 stores in Japan.  The Company has licensed Ueshima CoffeeCompany to use the Tully’s brand to operate specialty coffee stores throughoutAsia other than Japan (see Note 16).  Alicensee of the Company’s Spinelli brand operates retail stores in certainAsian countries and is in discussion with the Company regarding the terminationof the license and the purchase of certain Spinelli brand rights outside of theUnited States.

 

**Fiscal periods**

 

The Company’s fiscalyear ends on the Sunday closest to March 31st.  The Company records revenue and expenses on a 52-53 weekperiod.  The fiscal year ending March31, 2002 included 52 weeks (“Fiscal 2002”). The fiscal year ended April 1, 2001 included 52 weeks (“Fiscal 2001”)and the fiscal year ended April 2, 2000 included 53 weeks (“Fiscal 2000”).

 

**Consolidation**

 

The consolidatedfinancial statements include the accounts of the Company and its wholly ownedsubsidiary, Spinelli Coffee Company. All significant inter-company balances and transactions have beeneliminated in consolidation. Investments in companies and joint venturesrepresenting ownership interests of less than 20%, and for which the Companydoes not exercise significant influence, are carried at cost.

 

**Use of estimates**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amount of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reportingperiod. Actual results could differ from those estimates.

 

**Cash**

 

The Company considersall short-term investments with a maturity of three months or less whenpurchased to be cash equivalents.

 

**Inventories**

 

Inventories are statedat the lower of cost (on the first-in, first-out basis) or market.  The Company’s buying process iscentralized. The Company purchases its green coffee beans primarily from threevendors and is not dependent on any single source of supply.

 

**Property and equipment**

 

Property and equipmentare carried at cost less accumulated depreciation and amortization.  Depreciation of property and equipmentincludes amortization of assets under capital leases and is provided on thestraight-line method over the estimated useful lives.  Machinery and equipment are depreciated over 5 to7 years.  Leasehold improvementsare depreciated over the shorter of their estimated useful lives or the relatedlease life, generally 3 to 15 years. Software is depreciated over 3 years.  The cost of property held under capital lease is equal to thelower of the net present value of the

 

39

----

 

minimum lease payments orthe fair value of the leased property at the inception of the lease.  Expenditures for additions and improvementsare capitalized and expenditures for repairs and maintenance are charged toexpense as incurred.  The cost andaccumulated depreciation of assets sold or retired are removed from theaccounts, and the related gains and losses are included in the results ofoperations.  Certain properties andequipment have been reduced below cost due to impairment charges (see Note 10).

 

**Goodwill and other intangible assets**

 

Other intangible assetsinclude leasehold interests, trademark and logo design costs, covenants not tocompete, goodwill and other assets. Amortization of leasehold interests is provided over the life of thelease, including options to renew. Goodwill is amortized on the straight-linemethod over 15 years.  Otherintangible assets are amortized on the straight-line method over 5 to15 years.  Effective April 1, 2002,the Company intends to cease amortization of goodwill in accordance with thenew accounting standard related to goodwill and other intangible assetsreferred to below.

 

**Impairment of long-lived assets**

 

Statement of Financial Accounting Standards No. 121, “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”(“SFAS 121”) requires that long-lived assets and certain intangibles bereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of the asset may not be recoverable.  If impairment has occurred, an impairmentloss must be recognized.

 

As part of the Company’s review, assets are grouped and evaluated at thelowest level for which there are identifiable cash flows that are largelyindependent of the cash flows of other groups of assets.  The Company has identified this lowest levelto be principally individual stores. The Company considers historical performance and future estimatedresults in its evaluation of potential impairment and then compares thecarrying amount of the asset to the estimated future cash flows expected toresult from the use of the asset.  Ifthe carrying amount of the asset exceeds estimated expected undiscounted futurecash flows, the Company measures the amount of the impairment by comparing thecarrying amount of the asset to its fair value.  The estimation of fair value is measured by discounting expectedfuture cash flows.

 

**Lease termination costs**

 

Periodically, theCompany will determine that certain leases will be terminated and the store orother operation will be closed.  At suchdetermination, the Company accrues for the net future minimum lease payments ofthe related lease agreements.  Amountsaccrued as net future minimum losses include the discounted estimated futurerental payments and lease termination fees.

 

**Segment reporting**

 

The Company isorganized into three principal business units. The Company complements its domestic Retail division’s operations withadditional channels for distribution of its branded products.  The Company previously referred to thiscomplementary distribution business as its “specialty coffee division.”  This part of the Company’s business hasexperienced significant growth in Fiscal 2002 and recent years, and hasexpanded along two paths which the Company manages as separate businesssegments: (1) its International division, which sells Tully’s coffee andrelated products and supplies to the Company’s foreign licensees and managesthe relationships with these licensees, and (2) its Wholesale division, whichsells Tully’s coffee and related products and supplies to domestic resellers inthe supermarket, food service, restaurant, office coffee service, andinstitutional channels.  The Wholesaledivision is also responsible for the Company’s mail order and internet salesactivities.  Due to the past growth andanticipated opportunities for the International and Wholesale divisions, theyare now being separately reported by the Company, and prior historicalinformation for the former “specialty coffee division” has been segregated toreflect the new reporting perspective.

 

**Revenue recognition**

 

Sales are generallyrecognized at the time of the sale at retail store locations.  Sales for the Wholesale and Internationaldivisions are recognized upon delivery or upon shipment of the productsdepending on individual terms with the customers.

 

Revenues from advancelicense fees are recognized on the straight-line basis over the expected lifeof the agreements of seven to fifteen years. Royalty revenues are recognized in accordance with the licenseagreements, which are based primarily upon sales at specific franchise storelocations and pounds of coffee roasted.

 

40

----

 

**Concentrationsof credit risk**

 

The Company sells to various individuals and organizations.  Accounts receivable at March 31, 2002 andApril 1, 2001 include amounts due from Tully’s Coffee Japan, which represent28% and 11% of the respective totals.

 

**Store pre-opening costs**

 

Costs incurred inconnection with start-up and promotion of new store openings are expensed whenincurred.

 

**Advertising costs**

 

Costs incurred foradvertising and promotions are expensed when incurred and totaled $1,630,000,$1,406,000 and $472,000 during Fiscal 2002, 2001 and 2000, respectively.  Included in advertising and promotions arebaseball park and other sponsorship fees totaling approximately $1,392,000,$1,323,000 and $282,000, during Fiscal 2002, 2001 and 2000, respectively.

 

**Rent expense**

 

The Company (includingits retail stores) operates in leased buildings.  Certain lease agreements provide for scheduled rent increasesduring the lease terms or for rental payments commencing on a date other thanthe date of initial occupancy.  Such“stepped” rent expense is recorded on a straight-line basis over the respectiveterms of the leases.  Certain leasesrequire contingent rent based on gross sales. Such rent expense is recognized as incurred.

 

**Income taxes**

 

Income taxes areaccounted for under the asset and liability method.  Deferred tax assets and liabilities are recognized for the futuretax consequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases and for operating loss and tax credit carryforwards.  Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled.  The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date.

 

**Fair value of financial instruments**

 

The carrying amount ofcash and cash equivalents and other current assets and liabilities, such asaccounts receivable and accounts payable as presented in the consolidatedfinancial statements approximates fair value based on the short-term nature ofthese instruments. The Company believes the carrying amounts of the Company’snotes payable, line of credit and long-term debt approximate fair value becausethe interest rates are subject to change with, or approximate, market interestrates.

 

**Stock-based compensation**

 

The Company adopted thedisclosure-only provisions of Statement of Financial Accounting StandardsNo. 123 (SFAS No. 123), “Accounting for Stock-BasedCompensation.”  The Company has chosento continue to account for stock-based compensation using the intrinsic valuemethod prescribed in Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations.  Accordingly, compensation cost for stockoptions is measured as the excess, if any, of the fair value of the Company’sstock at the date of grant over the amount an employee must pay to acquire thestock.  Compensation cost is amortizedon a straight-line basis, over the vesting period of the individual options.

 

**Net loss per share**

 

Basic loss per share is calculated as net loss applicable to the commonstockholders divided by the weighted-average number of common sharesoutstanding during the period.  Dilutedloss per share is based on the weighted-average number of shares of common stockand common stock equivalents outstanding during the period, including options,warrants, convertible preferred stock and convertible debt computed using thetreasury stock method.  Common stockequivalent shares are excluded from the calculation of diluted loss per shareif their effect is antidilutive.  TheCompany had a net loss for all periods presented herein; therefore none of theoptions, warrants, convertible preferred stock or convertible debt outstandingduring each of the periods presented were included in the computation ofdiluted loss per share as they were antidilutive. Such instruments wereconvertible into a total of 31,874,014, 32,235,854, and 24,604,381 shares of

 

41

----

 

common stock and wereexcluded from the calculations of diluted loss per share for Fiscal 2002,Fiscal 2001 and Fiscal 2000, respectively.

 

**Reclassifications**

 

Reclassifications ofprior year balances have been made to conform to the current yearclassifications and have no impact on net loss or financial position.

 

**New accounting standards**

 

In June 1998, theFinancial Accounting Standards Board (“FASB”) issued SFAS 133, Accountingfor Derivative Instruments and Hedging Activities.  This pronouncement requires the Company to recognize certainderivatives on its balance sheet at fair value.  Changes in the fair values of derivatives that qualify as cashflow hedges will be recognized in comprehensive income until the hedged item isrecognized in earnings.  SFAS 133was amended by SFAS 137, “Accounting for Derivative Instruments andHedging Activities – Deferral of the Effective Date of FASB Statement No. 133,”deferring the effective date to fiscal years beginning after June 15,2001.  In June 2000, the FASB issuedStatement of Financial Accounting Standards Board No. 138, “Accounting forCertain Derivative Instruments and Certain Hedging Activities,” (“SFAS 138”),which amends certain provision of SFAS 133. SFAS 138 will be implemented concurrently with SFAS 133.  The adoption of these standards did not havea material impact on the Company’s financial position or the results of itsoperations.

 

In July 2001, theFASB issued SFAS 141, “Business Combinations” (“SFAS 141”).   SFAS 141 addresses financial accounting andreporting for business combinations and is effective for all businesscombinations for which the date of acquisition is July 1, 2001 or later.  This pronouncement did not have an impact onthe Company’s financial statements, as the Company has not completed any businesscombinations after July 1, 2001.

 

In July 2001, theFASB issued SFAS 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).  SFAS 142 addresses financial accounting andreporting for acquired goodwill and other intangible assets.  The provisions of SFAS 142 will be effectivefor fiscal years beginning after December 15, 2001, except that certainprovisions of SFAS 142 shall be applied to goodwill and other acquiredintangible assets for which the acquisition date is after June 30, 2001.  As a result of the adoption of SFAS 142, theCompany will stop amortizing goodwill effective April 1, 2002.  See Note 28 “Subsequent Events (Unaudited)”for further information related to the adoption of SFAS 142.

 

In July 2001, theFASB issued SFAS 143, “Accounting for Asset Retirement Obligations” (“SFAS143”).  SFAS 143 addresses financialaccounting and reporting for obligations associated with the retirement oftangible long-lived assets and the associated asset retirement costs.  It applies to legal obligations associatedwith the retirement of long-lived assets that result from the acquisition,construction, development, and (or) the normal operation of a long-livedasset.  The provisions of SFAS 143 willbe effective for fiscal years beginning after June 15, 2002, however earlyapplication is permitted.  The Companyis currently evaluating the implications of adoption of SFAS 143.

 

In August 2001,the FASB issued SFAS 144 “Accounting for the Impairment or Disposal ofLong-Lived Assets” (“SFAS 144”).  SFAS144 addresses financial accounting and reporting for the impairment or disposalof long-lived assets.  SFAS 144supersedes FASB Statement No. 121, Accounting for the Impairment of Long-LivedAssets and for Long-Lived Assets to Be Disposed Of, and the accounting andreporting provisions of APB Opinion No. 30, Reporting the Results of Operations— Reporting the Effects of Disposal of a Segment of a Business, andExtraordinary, Unusual and Infrequently Occurring Events and Transactions, forthe disposal of a segment of a business. The provisions of SFAS 144 will be effective for fiscal years beginningafter December 15, 2001.  The Companybelieves that the provisions of SFAS 144 will impact the presentation ofoperating results for certain closed stores in the financial statements byrequiring separate classification as discontinued operations.  The Company is currently evaluating thefurther implications of adoption of SFAS 144.

 

In April 2002, theFASB issued SFAS 145 “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB StatementNo. 13, and Technical Corrections ” (“SFAS 145”).  SFAS 145 rescinds FASB Statement No. 4, Reporting Gains and Losses fromExtinguishment of Debt, and an amendment of that Statement, FASB Statement No.64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS145 also rescinds FASB Statement No.44, Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB Statement No. 13, Accountingfor Leases, to eliminate an inconsistency between the required accounting forsale-leaseback transactions and the required accounting for certain leasemodifications that have economic effects that are similar to sale-leasebacktransactions.  SFAS 145 also amendsother existing authoritative pronouncements to make various technicalcorrections, clarify meanings, or describe their applicability under changedconditions.  The provisions ofSFAS 145 will be effective for fiscal years beginning after May 15, 2002.  The Company believes that the adoption of SFAS 145will not have a material impact on the Company’s

 

42

----

 

financial position or the results of its operations.

 

**2.Liquidity**

 

As of March 31, 2002 the Company had cash and cashequivalents and short-term investments in the aggregate amount of $3,389,000,and a working capital deficit of $269,000. The Company incurred a loss of $11,152,000 in Fiscal 2002.  Each of these amounts reflects animprovement as compared to April 1, 2001 and the year then ended, but the Companyexpects to incur a loss in Fiscal 2003. The Company has closed stores that did not meet its performancecriteria, and is continuing to evaluate store locations and operations todetermine if closing, downsizing or relocation of certain stores that do notmeet performance objectives is necessary. The Company is taking other actionsto reduce negative cash flow from operations, including revisions tooperational procedures and expansion of its Wholesale division.

 

Because the Company principally operates as a “cash business,” itgenerally does not require a significant net investment in working capital andhistorically has operated with current liabilities in excess of its currentassets (excluding cash and cash equivalents). The Company has placed increased emphasis in recent periods on managingits investment in inventory and accounts receivables.  The Company’s inventory levels typically increase during thespring due to coffee crop seasonality and, to a lesser degree, during theautumn due to holiday season merchandise. Tully’s expects that its investment in accounts receivable will increasein connection with anticipated sales growth in its Wholesale and Internationaldivisions.  Operating with minimal ordeficit working capital has reduced the Company’s historical requirements forcapital, but provides the Company with limited immediately available resourcesto address short-term needs and unanticipated business developments, andincreases the Company’s dependence upon ongoing financing activities.

 

The Company has historically funded its capital requirements principallythrough the issuance of equity and debt securities, through borrowings andlease financing, and through cash providedunder its international licensing relationships.  During Fiscal 2003, the Company expects toraise additional capital through bank borrowings, the issuance of debt or thesale of stock.  Previously, the Companyhad a credit facility collateralized by substantially all Company assets andbacked by personal guarantees of Company directors, but that facility was fullyrepaid in Fiscal 2002.  The Company’sassets are currently unencumbered by security interests.  In June 2002 certain directors andstockholders of the Company (the “financial backers” or “guarantors”) agreed toprovide financial support as may be required by the Company, up to an aggregateamount of $2,000,000.  At the electionof the financial backers, this support may be made through purchases of theCompany’s stock, by loans to the Company with a maturity no earlier than June30, 2003, or by personal guarantees of a bank loan to the Company with amaturity no earlier than the earlier of June 30, 2003 or the successfulcompletion of the Company’s capital raising efforts in an amount not less than$3,000,000.

 

Additional sources of funding are expected to include debt or equityfinancings.  The Company is currentlyevaluating alternatives for raising additional capital but has not identifiedor obtained specific sources of long-term funding.  If the Company is unable tosecure the additional secured borrowing or other sources of capital areunavailable, or are available only on a limited basis or under unsatisfactoryterms, then the Company would be required to substantially reduceoperating, marketing, general and administrative costs related to itscontinuing operations, and to reduce or discontinue its investments in storeimprovements, new customers and new products. In addition, the Company might be required to sell individual or groupsof stores or other assets (such as wholesale distribution territories) andwould be unable to take advantage ofbusiness opportunities or respond to competitive pressures.    Store sales would involve the assignmentor sub-lease of the store location (which may require the lessor’s consent) andthe sale of the store equipment, leasehold improvements and relatedassets.   The proceeds received from thesale of stores or other assets might not be sufficient to satisfy the Company’scapital needs, and the sale of better-performing stores or otherincome-producing assets could adversely affect the Company’s future operatingresults and cash flows.

 

The Company believes that the combination of cashand cash equivalents at March 31, 2002, proceeds from the KCL credit facility(see Note 28), and the $1.0 million additional secured borrowing that theCompany expects to obtain will be sufficient to fund ongoing operations of theCompany through Fiscal 2003.  In orderto fund unanticipated operating requirements in excess of the Company’s Fiscal2003 operating plan and future capital expenditures, the Company will requireadditional capital.  The Company expects that additional sourcesof funding will be required in subsequent periods to meet operatingrequirements, fund capital expenditures, and fund repayment of debt and otherlong-term obligations.

 

See Note 28 “Subsequent Events (Unaudited)” for further informationrelated to the financial condition and liquidity of the Company.

 

43

----

 

**3. Acquisitions**

 

In September 2000, the Company purchased the assets and realproperty leases of four stores from Coffee Station, Inc. as an entry into theLos Angeles market.  The purchase alsoincluded one Seattle area store.  InDecember 2000, the Company purchased the assets and real property leases ofnine stores from Tri-Brands, Inc., dba Marsee Baking as an entry into thePortland market.  The Company paidapproximately $2,745,000 in cash and incurred liabilities of $498,000 for thesestores.  All of theseacquisitions were structured as asset purchases.

 

**4. Allowance for doubtful accounts**

 
|                                     |   | **(dollars in thousands)** |   |
|------------------------------------------|--------|----------------------------|--------|
| Balance at March 28, 1999                |   | $                          | 166    |   |
| Additions charged to costs  and expenses |   | 218                        |   |
| Deductions                               |   | (27                        | )      |
| Balance at April 2, 2000                 |   | 357                        |   |
| Additions charged to costs  and expenses |   | 797                        |   |
| Deductions                               |   | (502                       | )      |
| Balance at April 1, 2001                 |   | 652                        |   |
| Additions charged to costs  and expenses |   | 7                          |   |
| Deductions                               |   | (310                       | )      |
| Balance at March 31, 2002                |   | $                          | 349    |   |

 

Fiscal 2001 includes the reserve andwrite-off of approximately $375,000 of receivables from Tully’s EuropeB.V.  InFebruary 2000, the Company participated in the formation of Tully’s EuropeB.V., resulting in an approximate 50% interest.  In the fourth quarter of Fiscal 2001, three of the four storesoperated by Tully’s Europe B.V. were closed because of continued operatinglosses.  As a result, the Company wroteoff its $600,000 investment in and $375,000 of trade receivables from Tully’sEurope B.V.  During Fiscal 2002, theCompany and its joint venture partner sold the remaining store location andliquidated the joint venture.

 

**5. Inventories**

 

Inventories consist ofthe following:

 
|                         |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|------------------------------|--------|----------------------------|--------|--------------------|--------|
|                         |   | **(dollars in thousands)** |   |
| Coffee                       |   |                       |   |               |   |
| Unroasted                    |   | $                          | 531    |               | $      | 3,014 |   |
| Roasted                      |   | 657                        |   | 773                |   |
| Other goods held for sale    |   | 568                        |   | 735                |   |
| Packaging and other supplies |   | 502                        |   | 406                |   |
| Total                        |   | $                          | 2,258  |               | $      | 4,928 |   |

 

**6. Investments**

 

Short-terminvestments consist of available-for-sale securities, which are subject tosignificant risk of changes in value. The Company’s short-term investmentbalance consists of the common stock of Tully’s Coffee Japan.  Management determines the appropriateclassification of these securities at the time of acquisition and reevaluatessuch designation at each balance sheet date. Investments, which have been classified as a current asset, representsecurities which management anticipates will be sold within the next twelvemonths.  These investments aredenominated in Japanese yen and are translated at the exchange rate on the balancesheet date.  Gains from the sales ofsecurities are calculated based on the first-in, first-out basis. Unrealizedgains and losses on available-for-sale securities are excluded from the resultsof

 

44

----

 

operations and arereported as a component of other comprehensive income (loss).

 

During Fiscal 2002, the Company sold 626 shares of Tully’s Coffee Japancommon stock for net proceeds of $3,025,000. Through June 28, 2002, the Company sold an additional 493 shares ofTully’s Coffee Japan common stock and received net proceeds of $1,813,000. On June 28, 2002, the Company owned five shares ofTully’s Coffee Japan common stock with a market value of approximately $20,000.

 

AtApril 1, 2001, the Company owned 824 shares of Tully’s Coffee Japan,representing approximately a five percent ownership in what was then a privatecompany.  The Company accounted for thisinvestment at cost, and included its investment in other assets (see Note7).  In July 2001, Tully’s Coffee Japancompleted an initial public offering on the Japan NASDAQ.  As a result of this offering, the Companyreclassified its investment as marketable securities at market value, with theresulting unrealized gain reflected in other comprehensive income.

 

**7. Other assets**

 

Other assetsconsist of the following:

 
|                                     |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|------------------------------------------|--------|----------------------------|--------|--------------------|--------|
|                                     |   | **(dollars in thousands)** |   |
| Security deposits                        |   | $                          | 311    |               | $      | 328 |   |
| Prepaid deferred licensing  expenses     |   | 394                        |   | —             |   |
| Investment in Tully’s Coffee  Japan |   | —                     |   | 182                |   |
| Other                                    |   | 18                         |   | 24                 |   |
| Total                                    |   | $                          | 723    |               | $      | 534 |   |

 

**8. Property and equipment**

 

Property andequipment consist of the following:

 
|                                             |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|--------------------------------------------------|--------|----------------------------|--------|--------------------|--------|
|                                             |   | **(dollars in thousands)** |   |
| Facility under capital lease                     |   | $                          | 88     |               | $      | 88 |   |
| Machinery and equipment                          |   | 9,252                      |   | 9,422              |   |
| Leasehold improvements                           |   | 16,282                     |   | 19,141             |   |
| Furniture and fixtures                           |   | 4,379                      |   | 4,733              |   |
| Software                                         |   | 905                        |   | 866                |   |
|                                             |   | 30,906                     |   | 34,250             |   |
| Less: Accumulated  depreciation and amortization |   | (10,609                    | )      | (7,905             | )      |
| Total                                            |   | $                          | 20,297 |               | $      | 26,345 |   |

 

In connection withthe asset purchases of the Coffee Station and Marsee Baking stores, the Companyacquired property and equipment of $1,633,000 in Fiscal 2001.

 

In the fourthquarter of Fiscal 2002 and 2001, the Company recorded charges to expense ofapproximately $2,301,000 and $3,309,000, respectively, due to the impairment ofcertain long-lived assets. (see Note 10).

 

Accumulateddepreciation related to a facility held under capital lease as of March 31,2002 and April 1, 2001 was $47,000 and $44,000, respectively.

 

45

----

 

**9. Goodwill and intangible assets**

 

Goodwill and other intangible assets consist of thefollowing:

 
|                             |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|----------------------------------|--------|----------------------------|--------|--------------------|--------|
|                             |   | **(dollars in thousands)** |   |
| Goodwill                         |   | $                          | 4280   |               | $      | 5163 |   |
| Leasehold interests              |   | 278                        |   | 559                |   |
| Lease commissions                |   | 240                        |   | 282                |   |
| Trademark and logo design  costs |   | 407                        |   | 407                |   |
| Covenants not to compete         |   | 371                        |   | 371                |   |
| Other                            |   | 23                         |   | 23                 |   |
|                             |   | 5,599                      |   | 6,805              |   |
| Less accumulated  amortization   |   |                       |   |               |   |
| Goodwill                         |   | (708                       | )      | (1,062             | )      |
| Other intangible assets          |   | (199                       | )      | (394               | )      |
| Total                            |   | $                          | 4,692  |               | $      | 5,349 |   |

 

In connection withthe asset purchases of the Coffee Station and Marsee Baking stores in Fiscal2001, the Company recorded goodwill and intangibles of approximately $464,000and $605,000, respectively.  Additionally,in the fourth quarter of Fiscal 2002 and 2001, the Company recorded a goodwillimpairment of approximately $49,000 and $1,120,000, respectively (see Note 10).

 

**10. Impairment of long-lived assets**

 

During the fourth quarter of Fiscal 2002, the Company recognized anon-cash impairment loss of $2,350,000. Of the total impairment loss, $49,000represents impairment of goodwill and other assets (see Note 8) and $2,301,000relates to impairment of leasehold improvements and equipment.  The impact of the tragedies of September 11,2001 and the general economic downturn on the Company’s retail markets, capitalconstraints and continued losses indicated that an updated review of theindividual stores was required.  An impairmentwas identified based on this review.  Inorder to determine the impairment, considerable management judgment isnecessary to estimate discounted future cash flows.  Accordingly, actual results could vary significantly from suchestimates.

 

During Fiscal 2001, the Company recognized a non-cash impairment loss of$5,006,000.  Of the total impairmentloss, $1,697,000 represented impairment of goodwill and other assets, includingthe losses related to Tully’s Europe B.V.(see Note 4), and $3,309,000 related to impairment of leasehold improvementsand equipment.  The effects of a slowingeconomy, capital constraints and continued losses indicated that a closerreview of the individual stores was required. An impairment was identified based on this review.

 

46

----

 

**11. Income taxes**

 

Deferred incometaxes reflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting and income taxpurposes.  The significant components ofdeferred tax assets and liabilities are as follows:

 
|                                                          |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|---------------------------------------------------------------|--------|----------------------------|--------|--------------------|--------|
|                                                          |   | **(dollars in thousands)** |   |
| Deferred tax assets                                           |   |                       |   |               |   |
| Net operating loss  carryforwards                             |   | $                          | 8,836  |               | $      | 12,014 |   |
| Stock options                                                 |   | 1,859                      |   | 1,518              |   |
| Deferred licensing revenue                                    |   | 5,717                      |   | —             |   |
| Unrealized loss on  investments                               |   | 39                         |   | —             |   |
| Property and equipment                                        |   | 746                        |   | —             |   |
| Asset impairment, store  closures and lease termination costs |   | 2,089                      |   | 2,432              |   |
| Deferred lease costs                                          |   | 792                        |   | 361                |   |
| Allowance for doubtful  accounts                              |   | 124                        |   | 177                |   |
| Accrued vacation                                              |   | 120                        |   | 198                |   |
| Other                                                         |   | 31                         |   | 75                 |   |
| Total deferred tax assets                                     |   | 20,353                     |   | 16,775             |   |
|                                                          |   |                       |   |               |   |
| Deferred tax liabilities                                      |   |                       |   |               |   |
| Property and equipment                                        |   | —                     |   | (93                | )      |
| Total deferred tax  liabilities                               |   | —                     |   | (93                | )      |
|                                                          |   |                       |   |               |   |
| Less: Valuation allowance                                     |   | (20,353                    | )      | (16,682            | )      |
| Net deferred tax asset                                        |   | $                          | — |               | $      | — |   |

 

At March 31, 2002, the Company had tax netoperating loss carryforwards of approximately $23,578,000 that expire between2012 and 2022.

 

The Company’s ability to use its net operatinglosses to offset future income could be subject to restrictions enacted in theUnited States Internal Revenue Code of 1986 as amended. These restrictionslimit future use of net operating loss and credit carryforwards if certainstock ownership changes occur.

 

A reconciliation of the statutory federal incometax rate to the Company’s effective income tax rate is as follows:

 
|                                        |   | **2002** |   | **2001** |   | **2000** |   |
|---------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Federal statutory rate                      |   | (34.0    | )%     | (34.0    | )%     | (34.0    | )%     |
| State income taxes, net of  federal benefit |   | (1.6     | )%     | (1.6     | )%     | (1.6     | )%     |
| Change in tax rate                          |   | —   |   | —   |   | —   |   |
| Other                                       |   | 1.9      | %      | 1.3      | %      | 2.8      | %      |
| Valuation allowance                         |   | 33.7     | %      | 34.3     | %      | 32.8     | %      |
|                                        |   | —   | %      | —   | %      | —   | %      |

 

Because of theCompany’s net operating losses, no tax expense or benefit has been allocated toother comprehensive income.

 

47

----

 

**12. Accrued liabilities**

 

Accrued liabilities consist of the following:

 
|                                               |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|----------------------------------------------------|--------|----------------------------|--------|--------------------|--------|
|                                               |   | **(dollars in thousands)** |   |
| Employee wages and taxes                           |   | $                          | 750    |               | $      | 1,139 |   |
| Professional fees and  services                    |   | 191                        |   | 691                |   |
| Accrued lease termination  and store closure costs |   | 852                        |   | 1,345              |   |
| Underwriting fees on  preferred stock sales        |   | —                     |   | 599                |   |
| Accrued real estate and  property taxes            |   | 455                        |   | 232                |   |
| Other                                              |   | 770                        |   | 1,021              |   |
| Total                                              |   | $                          | 3,018  |               | $      | 5,027 |   |

 

During 2001, placement agent fees/commissions of $1,198,000were incurred on the sale of the Company’s Series B Preferred Stock, of which$599,000 was paid in cash during Fiscal 2001, with the remaining balance to bepaid in the form of warrants to purchase common stock.  During Fiscal 2002, the Company issuedwarrants to purchase 239,629 shares of common stock in payment of thisobligation.  As of April 2, 2000, theCompany accrued $1,555,000 for underwriting fees due on the sale of theCompany’s Series A Preferred stock, payable in Series A Preferred Stock.  In May 2000, the Company and the brokeragreed to settle this liability through the issuance of warrants to purchase621,933 shares of common stock at $0.01 per share and310,997 shares of common stock at $0.33 per share.  At the time of settlement, the value of thewarrants calculated using the Black-Scholes model was $2,280,000.  The Company recorded the excess value of thewarrants of $725,000 as additional stock issuance costs with an increase toadditional paid-in capital in May 2000.

 

**13. Bank line of credit**

 

On June 15, 2000, the Company signed a$6,000,000 bank line-of-credit agreement, which was amended on February 16,2001 (the “Loan Agreement”) with a maturity date of July 1, 2001.  This Loan Agreement replaced a previousagreement and included substantially the same terms.  As of April 1, 2001, the outstanding balance under the LoanAgreement was $5,500,000, bearing interest at the prime lending rate plus 1/2% (8.5% at April 1,2001).  The linewas collateralized by all of the Company’s assets, and was guaranteed by twodirectors.   The two directors were paida guarantee fee in the aggregate amount of one percent (1.0%) of the line’smonthly average balance.   As payment ofthis loan guarantee fee, the Company issued stock options for 105,112 shares ofcommon stock in Fiscal 2002, for 287,676 shares in Fiscal 2001, and 190,948shares in Fiscal 2000, with an estimated fair market value of $209,000,$669,000 and $428,000, respectively.

 

On October 1, 2001, the Company fully repaid itsbank line of credit and terminated the Loan Agreement.

 

48

----

 

**14. Long-term debt**

 

Long-term debt consists of the following:

 
|                                                                                                                                                                                                                      |   | **March 31,  2002**        |   | **April 1,  2001** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|--------------------|--------|
|                                                                                                                                                                                                                      |   | **(dollars in thousands)** |   |
| Notes payable in monthly  installments of $20,000 as of March 31, 2002, including interest ranging from  3.25% to 12.0%, maturing September 2002 through June 2005, collateralized by  various equipment                  |   | $                          | 173    |               | $      | 385 |   |
| Note payable in monthly  installments of $14,000 through May 2002                                                                                                                                                         |   | 28                         |   | 194                |   |
| Note payable in monthly  installments of $26,000 as of March 31, 2002, including interest at 5.8%,  through September 2002, collateralized by unearned or return insurance  premiums, accrued dividends and loss payments |   | 133                        |   | 146                |   |
|                                                                                                                                                                                                                      |   | 334                        |   | 725                |   |
| Less: Current portion                                                                                                                                                                                                     |   | (308                       | )      | (515               | )      |
| Total                                                                                                                                                                                                                     |   | $                          | 26     |               | $      | 210 |   |

 

Future principal payments on long-term debt are asfollows (dollars in thousands):

 
| **Fiscal year** |   |   |   |   |
|-----------------|--------|--------|--------|--------|
| 2003            |   | $      | 308    |   |
| 2004            |   | 20     |   |
| 2005            |   | 5      |   |
| 2006            |   | 1      |   |
| Total           |   | $      | 334    |   |

 

#### ***15.  Convertible promissory note***

 

In December 2000, the Company issued a convertiblenote in the principal amount of $3,000,000 to an affiliate of a director of theCompany.  At any time prior to theearlier of January 2, 2005 or repayment of the note, the note isconvertible into Series A Preferred Stock or common stock in the event that allshares of Series A Preferred Stock have been converted to common stock.  The conversion rate is the lesser of $2.50per share or the price per share of the most recent offering price, public orprivate, of common stock.  For each$100,000 of debt outstanding on each January 1st, the Companywill issue warrants to purchase 8,000 shares of common stock to the note holderin lieu of interest on the outstanding principal balance.  The warrants have an exercise price of $0.01and are exercisable for ten years from the issuance dates thereof.

 

On January 1, 2001, the Company issuedwarrants to purchase 240,000 shares of common stock in accordance with theterms of the note. The fair value of the notes was determined to be $2,544,000and the warrants, which have exercise prices below the fair value of therelated common stock, were determined to have a fair value of approximately$456,000, using the Black Scholes valuation model.

 

Upon issuance, the note was immediately convertibleinto Series A Preferred Stock at the note holder’s option and was thereforedeemed to have a beneficial conversion feature in the amount of $456,000. Thebeneficial conversion feature is analogous to interest and will be allocated tointerest expense over the life of the note. The unamortized portion of the beneficial conversion feature was$293,000 at March 31, 2002 and $407,000 at April 1, 2001, and is recorded as adiscount to the debt

 

Since the issuance of the note, the Company hasrecorded additional non-cash interest expense in recognition of the additionalwarrants issued in lieu of cash interest payments.  On January 1, 2002, the Company issued warrants to purchase240,000 shares of common stock in accordance with the terms of the note.  The warrants, which have an exercise priceof $.01 per share, were determined to have a fair value of approximately$480,000, using the Black Scholes valuation model.

 

49

----

 

This amount was recorded as a deferred charge that willbe amortized to interest expense.

 

Due to the amortizationof the beneficial conversion feature and of the warrants, the Company recordeda non–cash charge to interest expense of $565,000 in Fiscal 2002 and$163,000 in Fiscal 2001.

 

**16. International Licenses andDeferred Licensing Revenue**

 

In April 2001, theCompany granted UCC Ueshima Coffee Company, LTD (“UCC”) an exclusive, perpetuallicense to use Tully’s business names, trademarks and other intellectualproperty rights to develop and operate specialty coffee stores throughout Asia,except for Japan, and received a $12,000,000 license fee.  The Company has accounted for this paymentas deferred licensing revenue and is amortizing this amount into income on astraight-line basis over seven years, the term of the prepaid royalties underthe agreement.  Commencing in April2009, UCC is required to pay the Company a royalty and service fee based uponthe aggregate net revenues of the stores that UCC is then operating under the Tully’sbusiness name, and all other sales of products or services made under theTully’s business names and trademarks in Asia (other than Japan).

 

The Company has license and supply agreements withTully’s Coffee Japan.  Under the licenseagreement, as amended in Fiscal 2002, the licensee has the right to use theTully’s trademark, brand name and products in Japan in operating andfranchising retail stores and engaging in wholesale coffee sales.  Tully’s Coffee Japan is required to paylicensing fees to the Company based upon the franchised store revenues.  The supply agreement, as amended duringFiscal 2001, allowsTully’s Coffee Japan to roast Tully’s coffee in Japan and to purchase othersupplies and materials from sources other than the Company, subject to qualityand pricing requirements.  Tully’sCoffee Japan is required to pay a fee to the Company based upon the volume ofcoffee roasted in Japan.

 

In consideration, and in connection with theformation of Tully’s Coffee Japan, the Company received 824 shares of Tully’sCoffee Japan stock.  On October 1, 2001, the Company received$4,200,000 in cash and 300 additional shares of Tully’s Coffee Japan commonstock (valued at $1,771,000 on that date) in connectionwith the amendment of its supply agreement with Tully’s Coffee Japan.  The Company has accounted for the October 1,2001 payment as deferred licensing revenue and is amortizing this amount intoincome on a straight-line basis over fifteen years, the estimated life of theagreement.

 

**17. Related party notes payable**

 

During the fourth quarter of Fiscal 2001, onedirector loaned the company $250,000 and one stockholder loaned the Company$100,000.  In April 2001, threedirectors loaned the Company an aggregate of $1,000,000.  In April 2001, the Company repaid thestockholder loan of $100,000 plus interest. These notes payable were collateralized by various Company assets andprovided for interest rates ranging from prime plus 1⁄2 percent to prime plus onepercent.  In July 2001, $250,000 of thedirector notes payable was paid and in November 2001 the Company repaid theremaining $1,000,000 of director notes payable.  Total interest paid on these five notes in Fiscal 2002 was$57,000.

 

**18. Related-party transactions**

 

During Fiscal 2001 and 2000, the Company paidapproximately $445,000 and $75,000, respectively, to a company controlled bythe Company’s chairman and former chief executive officer (the “Chairman”) forreal estate services provided in connection with the Company’s new stores, theCompany’s corporate expenses paid by that company and advances made to theChairman.  In addition, during Fiscal2001 and 2000 the Company made charitable contributions of approximately$241,000 and $42,000, respectively, on behalf of a foundation organized by theChairman (the “Foundation”).  As aresult of these payments and contributions, at April 1, 2001, the Company had areceivable of approximately $601,000 from its Chairman and the Foundation.  In August 2001 the Chairman and theFoundation repaid these receivables in full, plus interest at the rate of primeplus one percent per annum.

 

During Fiscal 2001 and 2000, the Company paid$25,000 and $70,000, respectively, to O’Keefe & Associates, an executivesearch firm controlled by the brother of the Chairman, in conjunction with twoexecutive search assignments.

 

Prior to its repayment (see Note 13), the Company’sline of credit was guaranteed by the Chairman and a director in considerationfor a combined guarantee fee of one percent (1.0%) of the line’s monthly averagebalance. In Fiscal 2002, 2001 and 2000, the Company issued options to purchasean aggregate of 105,112, 287,676 and 190,948 shares of common stock

 

50

----

 

with an estimated fair market value of $210,000, $869,000and $428,000, respectively, to the guarantors in consideration for theirguarantee.

 

A director of the Company is of counsel with a lawfirm that provides legal services to the Company.  During Fiscal 2002, 2001 and 2000, the Company incurred fees andcosts of $317,000 (of which approximately $116,000 was payable at March 31,2002), $309,000 (of which $147,000 was payable at April 1, 2001), and $170,000,respectively, related to services performed for the Company by the law firm.

 

**19. Store closure and leasetermination costs**

 

During Fiscal 2002, the Company closed twelve stores due to poorperformance.  These stores representedapproximately 2.1% of the Company’s Fiscal 2002 revenues.  A $1,583,000 charge was recorded againstoperations during the year, of which $498,000 was recorded in the fourthquarter of Fiscal 2002.

 

During Fiscal 2001, the Company closed four stores due to poorperformance.  These stores representedapproximately 1.9% of the Company’s Fiscal 2001 revenues.

 

Store closure and lease termination costs for Fiscal 2002 and 2001 areas follows (dollars in thousands):

 
|                                                     |   | **2002** |   | **2001** |   |
|----------------------------------------------------------|--------|----------|--------|----------|--------|
| Write-off of property and  equipment from store closures |   | $        | 524    |     | $      | 1,194 |   |
| Lease termination costs                                  |   | 1,059    |   | 1,426    |   |
| Total                                                    |   | $        | 1,583  |     | $      | 2,620 |   |

 

The Company also had unopened retail store locations for which leaseshad been signed.  During Fiscal 2001 andthe first quarter of Fiscal 2002, the Company determined that it would notdevelop a total of 19 retail locations for which leases had been signed but thestores had not yet been built because current projected models did not meetmanagement’s financial criteria and due to capital constraints.  Through June 20, 2002, sixteen of these 19leases had been terminated, and one store location is scheduled to open inFiscal 2003.  Remaining estimated leasetermination costs, which include rents and broker fees, of approximately$852,000 at March 31, 2002 were determined using management’s best estimate.  Rent for these unopened stores wasapproximately $221,000 and $169,000 during Fiscal 2002 and 2001, respectively,and is included in marketing, general and administrative expenses.

 

**20. Commitments and contingencies**

 

***Leasecommitments***

 

The Company leases retail and office space underoperating leases, which expire through 2016. The leases provide for minimumannual payments, contingent rentals based upon gross sales and, in certaincases, escalation clauses and options to renew.  Rental expense is recorded on a straight-line basis over therespective terms of the leases. Rental expense under these leases wasapproximately $6,639,750, $5,291,000, and $3,046,000 for Fiscal 2002, 2001 and2000, respectively.  Contingent rentalexpense was approximately $167,000, $172,000, and $211,000 for Fiscal 2002,2001 and 2000, respectively and is recognized as incurred.  The Company’s Chairman has guaranteedperformance under one of the Company’s leases.

 

In connection with certain leases, lessors havegranted tenant improvement allowances to the Company.  These amounts, included in liabilities under the caption“deferred lease costs,” are amortized into income on a straight-line basis overthe life of the related lease.  Alsorecorded in deferred lease costs is the “stepped rent” excess of rental expensecomputed on a straight-line basis over the actual rent payments required by theterms of the Company’s leases.

 

The Company leases approximately 220,000 squarefeet, which currently houses administrative and executive offices (see Note 28 “Subsequent Events(Unaudited)” for information related to the amendment of this lease).  Thelease has a ten-year term with two five-year options to renew.  In February 2001, the Company received$1,000,000 from the lessor as reimbursement for company-paid tenantimprovements, which is being repaid to the lessor in the form of increasedrents over the remaining life of the lease. Annual rent payments under the lease are approximately $792,000 forfiscal years 2002 through 2005, $911,000 for fiscal years 2006 through 2010 and$114,000 for fiscal year 2011.  On March19, 2002, the Company signed an early termination letter agreement(“Termination Letter”) with the lessor. The Termination Letter provides that, in event that the lessor finds areplacement tenant or buyer to occupy the premises the lease will terminateupon 150

 

51

----

 

days notice, and the Company would be required torelocate its operations.  In this event,the unamortized balance of the tenant improvement reimbursement will continueto be an obligation of Tully’s, and will be converted to an installment notepayable with monthly payments of $14,994 through May 2010.  The installment note will bear interest atthe rate of twelve percent (12%) per annum.

 

The Company has subleased to third parties certainspace through 2008. Sublease income under contract are summarized as follows:

 
| **Fiscal year**            |   |   |       |
|----------------------------|--------|--------|------------|
| **(dollars in thousands)** |   |   | ** ** |
| 2003                       |   | $      | 119        |   |
| 2004                       |   | 114    |       |
| 2005                       |   | 116    |       |
| 2006                       |   | 116    |       |
| 2007                       |   | 81     |       |
| Thereafter                 |   | 84     |       |
| Total                      |   | $      | 630        |   |

 

Minimum future rental payments under noncancellableoperating leases as of March 31, 2002 (including leases for unopened storelocations) are summarized as follows:

 
| **Fiscal year**             |   |   |       |   |
|-----------------------------|--------|--------|------------|--------|
| **(dollars in  thousands)** |   |   | ** ** |
| 2003                        |   | $      | 5,324      |   |
| 2004                        |   | 5,124  |       |
| 2005                        |   | 5,053  |       |
| 2006                        |   | 4,919  |       |
| 2007                        |   | 4,398  |       |
| Thereafter                  |   | 11,612 |       |
| Total                       |   | $      | 36,430     |   |

 

Minimum future rental payments under capital leasesas of March 31, 2002 are summarized as follows:

 
| **Fiscal year**                                                   |   |   |       |
|-------------------------------------------------------------------|--------|--------|------------|
| **(dollars in  thousands)**                                       |   |   | ** ** |
| 2003                                                              |   | $      | 33         |   |
| 2004                                                              |   | 31     |       |
| 2005                                                              |   | 22     |       |
| 2006                                                              |   | 21     |       |
| 2007                                                              |   | 19     |       |
| Thereafter                                                        |   | 194    |       |
| Total minimum lease payment                                       |   | 320    |       |
| Less: Amount representing  interest                               |   | (193   | )          |
| Present value of net minimum  lease payments under capital leases |   | $      | 127        |   |

 

During Fiscal 2000, the Company entered into anasset purchase agreement with third parties to assume leases for certainlocations, purchase assets such as equipment and leasehold improvements andobtain non-compete agreements from the sellers. In the aggregate, the Companypaid $610,000 in cash and issued 152,089 shares of common stock, valued at$2.25 per share, to the sellers in connection with the purchase agreements.

 

52

----

 

***Sponsorship commitments***

 

The Company has sponsorship agreements with PacBellStadium in San Francisco and Safeco Field in Seattle expiring onOctober 31, 2002 and December 31, 2003, respectively, that providefor certain advertising and marketing rights in exchange for annual fees. Theremaining annual fee under the PacBell Stadium agreement is $950,000 for Fiscal2003 (see Note 28).  The annual feesunder the Safeco Field agreement are approximately $505,000 in Fiscal 2003 and$520,000 in Fiscal 2004 (with additional charges for any tickets, food serviceand other incidentals provided to Tully’s).

 

***Purchase commitments***

 

From time to time, the Company may enter intoforward commitments for the purchase of green coffee that may only be availablein small quantities. As of March 31, 2002, the Company had approximately$2,700,000 in fixed-price purchase commitments for Fiscal 2003. The Companybelieves, based on relationships established with its suppliers, that the riskof non-delivery on such purchase commitments is remote.

 

***Contingencies***

 

In the ordinary course of its business, the Companymay become involved in legal proceedings from time to time. The Company was notaware of any pending legal proceedings, which, in the opinion of management,would adversely affect its financial position, results of operations or cashflows.

 

**21. Stock options**

 

***Company Stock Incentive Plan***

 

In 1994, the Company adopted a Stock Incentive Plan(the “1994 Plan”) whereby the Company may issue incentive or nonqualified stockoptions to employees and directors. Stock options are granted solely at the discretion of the Board ofDirectors of the Company and are issued at a price, as determined by the Boardof Directors, ranging from $0.01 through the estimated fair market value of thestock at the date of grant.  The term ofeach option granted is for such period as determined by the Board of Directors,but not more than ten years from date of grant. Options are nontransferable andmay generally be exercised based on a vesting schedule determined by the Boardof Directors.  The 1994 Plan providesfor acceleration of outstanding options under certain conditions, includingcertain changes in control of the Company. In August 1999 the Company’s stockholders approved an amended plan,which established the maximum number of shares issuable under the 1994 Plan andthe Employee Stock Purchase Plan (see Note 23) at 4,200,000.

 

***Founder’s StockOption Plan***

 

In addition to options granted under the 1994 Plan,the Company’s chairman and founder has granted options to purchase shares ofhis stock to employees and third parties (the “Founder’s Plan”). During Fiscal2002, 2001 and 2000 the founder granted options to purchase 9,800, 62,000 and274,875 shares, respectively, of common stock at an exercise price of $0.01 pershare.  Options outstanding under theFounder’s Plan at March 31, 2002 were 1,704,317. The options were issued fromthe founder’s shares rather than newly issued shares of the Company to avoiddiluting the other stockholders.  Theseoptions have vesting periods ranging from immediate vesting to five yearvesting and have a twenty-five year life. Although the Company did not grant the options, generally acceptedaccounting principles require that the Company record an expense related tothese grants.  Accordingly, in Fiscal2002, 2001 and 2000 the Company recorded an increase to additional paid-incapital and a non-cash charge to compensation expense of $20,000, $153,000 and$619,000, respectively.

 

***All Plans***

 

Non-cash stock option compensation expense underthese two plans (including employees and directors and also third parties underthe Founder’s Plan) totaled $259,000, $782,000 and $1,208,000 for Fiscal 2002,2001 and 2000, respectively. Additionally, in consideration for a guarantee onits line of credit, the Company issued stock options under the 1994 Plan to theguarantors (see Note 13).

 

The Company has adopted the disclosure-onlyprovisions SFAS No. 123 for options granted to employees. Accordingly, nocompensation cost has been recognized for stock options issued to employees atfair market value under the plans. Had compensation cost for the Company’sstock option plans been determined based on the fair value at the grant date ofthe awards, consistent with the provisions of SFAS No. 123, the Company’snet loss and loss per share would have been increased to the pro forma amountsindicated below (in thousands, except per share data):

 

53

----

 
|                                     |   | **Years ended**                                    |    |
|------------------------------------------|--------|----------------------------------------------------|---------|
|                                     |   | **March 31,********2002**                          |    | **April 1,********2001** |   | **April 2,********2000** |   |
|                                     |   | **(dollars in thousands, except per  share data)** |    |
| Net loss-as reported                     |   | $                                                  | (11,152 | ) | $ | (25,057 | ) | $ | (8,066 | ) |
| Net loss-pro forma                       |   | $                                                  | (11,260 | ) | $ | (25,296 | ) | $ | (8,320 | ) |
| Basic and diluted loss per  common share |   |                                               |    |   |   |   |   |
| As reported                              |   | $                                                  | (0.69   | ) | $ | (1.59 | ) | $ | (1.15 | ) |
| Pro forma                                |   | $                                                  | (0.69   | ) | $ | (1.60 | ) | $ | (1.17 | ) |

 

Thefair values of the options granted were estimated on the date of grant usingthe Black-Scholes option valuation model based on the following assumptionsused for grants in Fiscal 2002, 2001 and 2000:

 
|                    |   | **Years  ended**    |   |
|-------------------------|--------|---------------------|--------|
|                    |   | **March 31,  2002** |   | **April 1,  2001** |   | **April 2,  2000** |   |
| Risk free interest rate |   | 4.57% to 5.39       | %      | 5.03% to 6.17 | % | 5.44% to 6.59 | % |
| Expected lives          |   | 3-5 years           |   | 3-5 years |   | 5-10 years |   |
| Expected volatility     |   | 80                  | %      | 80 | % | 0% to 70 | % |

 

Stockoption activity (including grants under the Founder’s Plan) under all plans forFiscal 2002, 2001 and 2000 is summarized as follows:

 
|                    |   | **Number of  shares** |   | **Weighted-  average  exercise  price** | ** ** |
|-------------------------|--------|-----------------------|--------|-----------------------------------------|------------|
| Balance, March 28, 1999 |   | 2,854,033             |   | $                                       | 0.43       |   |
| Granted                 |   | 1,139,929             |   | 0.44                                    |       |
| Forfeited               |   | (117,015              | )      | 0.60                                    |       |
| Exercised               |   | (12,850               | )      | 0.01                                    |       |
| Balance, April 2, 2000  |   | 3,864,097             |   | 0.43                                    |       |
| Granted                 |   | 572,525               |   | 0.44                                    |       |
| Forfeited               |   | (269,976              | )      | 1.44                                    |       |
| Exercised               |   | (70,390               | )      | 0.25                                    |       |
| Balance, April 1, 2001  |   | 4,096,256             |   | 0.37                                    |       |
| Granted                 |   | 184,662               |   | 0.01                                    |       |
| Forfeited               |   | (306,810              | )      | 1.34                                    |       |
| Exercised               |   | (27,726               | )      | 0.01                                    |       |
| Balance, March 31, 2002 |   | 3,946,382             |   | $                                       | 0.28       |   |

 

AtMarch 31, 2002, options for 2,242,065 shares were outstanding under the 1994Plan (leaving 1,957,935 shares available for grant under the 1994 Plan and theEmployee Stock Purchase Plan) and options for 1,704,317 shares were outstandingunder the Founder’s Plan.  In May 2002,the Company granted options for 1,000,000 shares under the employment agreementwith its new CEO.  As of March 31, 2002,April 1, 2001 and April 2, 2000 options for 3,839,186, 3,777,044 and 3,143,348shares, respectively, were exercisable. Outstanding stock options aresummarized as follows:

 

54

----

 
|                                      |   | **March 31,********2002** |   | **April 1,********2001** |   | **April 2,********2000** |   |
|-------------------------------------------|--------|---------------------------|--------|--------------------------|--------|--------------------------|--------|
| Issued under the 1994 Plan                |   |                      |   |                     |   |                     |   |
| Employees and Directors                   |   | 1,089,830                 |   | 1,334,666                |   | 1,407,358                |   |
| Directors, for Loan Guarantees            |   | 1,152,235                 |   | 1,047,123                |   | 759,447                  |   |
| Total Outstanding under 1994 Plan         |   | 2,242,065                 |   | 2,381,789                |   | 2,116,805                |   |
| Outstanding under the Founder’s Plan |   | 1,704,317                 |   | 1,714,467                |   | 1,697,292                |   |
|                                      |   |                      |   |                     |   |                     |   |
| Total Outstanding Stock Options           |   | 3,946,382                 |   | 4,096,256                |   | 3,864,097                |   |

 
|                                                                                                                                                 |   | **2002**   |   | **2001**                                 |   | **2000**   |    |
|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|--------|------------------------------------------|--------|------------|---------|
|                                                                                                                                                 |   | **Shares** |   | **Weighted-  average********fair value** |   | **Shares** |    | **Weighted-  average********fair value** |   | **Shares** |   | **Weighted-  average********fair value** |   |
|                                                                                                                                                 |   |       |   |                                     |   |       |    |   |   |   |   |   |   |
| Weighted-average fair value  of options granted during the year whose exercise price was less than the  fair value of the stock on the date of grant |   | 184,662    |   | $                                        | 1.99   |       | 465,625 |   | $ | 2.11 |   | 922,604 |   | $ | 2.24 |   |
| Weighted-average fair value  of options granted during the year whose exercise price was equal to the fair  value of the stock on the date of grant  |   | —     |   | —                                   |   | 106,900    |    | $ | 1.20 |   | 217,325 |   | $ | 0.77 |   |
| Total                                                                                                                                                |   | 184,662    |   |                                     |   | 572,525    |    |   |   | 1,139,929 |   |   |   |
|                                                                                                                                                      |        |            |        |                                          |        |            |         |  |  |  |  |  |  |  |  |  |

 

Thefollowing table summarizes information about fixed–price optionsoutstanding at March 31, 2002 under the 1994 Plan (it excludes optionsexercisable under the Founder’s Plan, which will not effect the outstandingshares, or provide cash proceeds to the Company, if exercised):

 
| **Range of********exercise prices** |   | **Options outstanding**                    |                    | **Weighted-average********remaining********contractual life** |                                       | **Options exercisable** |   |
|-------------------------------------|--------|--------------------------------------------|-------------------------|---------------------------------------------------------------|--------------------------------------------|-------------------------|--------|
| **Number  outstanding**             |   | **Weighted-average********exercise price** | **Number  exercisable** |                                                          | **Weighted-average********exercise price** |
|                                |   | **(years)**                                | ** **              |
|                                |   |                                       |                    |                                                          |                                       |                    |   |   |   |   |   |
| $0.01                               |   | 1,656,720                                  |                    | $                                                             | 0.01                                       |                    | 7.58   |   | 1,636,720 |   | $ | 0.01 |   |
| 0.33                                |   | 25,555                                     |                    | 0.33                                                          |                                       | 1.35                    |   | 25,555 |   | 0.33 |   |
| 1.50                                |   | 97,363                                     |                    | 1.50                                                          |                                       | 4.0                     |   | 97,363 |   | 1.50 |   |
| 1.75                                |   | 96,361                                     |                    | 1.75                                                          |                                       | 5.0                     |   | 77,000 |   | 1.75 |   |
| 1.78                                |   | 200,000                                    |                    | 1.78                                                          |                                       | 6.71                    |   | 200,000 |   | 1.78 |   |
| 2.25                                |   | 151,600                                    |                    | 2.25                                                          |                                       | 6.85                    |   | 92,965 |   | 2.25 |   |
| $2.50                               |   | 14,466                                     |                    | 2.50                                                          |                                       | 8.29                    |   | 5,266 |   | 2.50 |   |
| Total                               |   | 2,242,065                                  |                    |                                                          |                                       |                    |   | 2,134,869 |   |   |   |
|                                     |        |                                            |                         |                                                               |                                            |                         |        |  |  |  |  |  |  |

 

**22. Stockholders’ equity**

 

***Preferred stock***

 

InDecember 2000, the Company concluded an offering to accredited investors ofSeries B Preferred Stock.  TheSeries B Preferred Stock is junior in liquidation preference to theSeries A Preferred Stock and to a stated dollar amount of liquidationpreference for the holders of the common stock.   The Company sold 4,990,709 shares of Series B Preferred Stockand received aggregate proceeds of approximately $12,477,000.  Theholders of shares of Series B Preferred Stock are eligible to receivedividends, when and if such dividends are declared by the Company’s Board ofDirectors, in amounts and on such terms and conditions as the Board ofDirectors, in its discretion, may provide.

 

55

----

 

InFiscal 1999, the Company issued 6,217,480 shares of Series A PreferredStock.  In Fiscal 2000, the Company’sArticles of Incorporation were amended to increase the number of authorized sharesof Series A Preferred Stock from 10,000,000 to 17,500,000.  During Fiscal 2000, the Company completed aSeries A Preferred Stock accredited investor financing. The per unit offeringprice was $10.00 and each unit consisted of 4 shares of the Company’s Series APreferred Stock and a warrant to purchase two shares of the Company’s CommonStock at an exercise price of $0.33 per share. Proceeds of $22.9 million were received from the offering and 2,290,196units were sold.  The warrants have a10-year life. The Series A Preferred Stock is convertible into one shareeach of common stock at the option of the stockholder, has preference overcommon stock upon liquidation of the Company, and has the right to participatein any dividend payable on the common stock. The Preferred Stock also hasvoting rights. Each share of Series A Preferred Stock is automaticallyconvertible into one share of the Company’s common stock if the Company makes a“Qualified Offering” of its common stock. A Qualified Offering is defined as anoffering of the Company’s common stock in excess of $15,000,000 made pursuantto a registration statement filed under the Securities Act of 1933.

 

***Common stock andWarrants***

#####  

During Fiscal 2002, warrantsto purchase 7,500 shares of common stockwere exercised at $0.33 per share.

#####  

During Fiscal 2001, warrantsto purchase 525,625 shares of common stock were exercised.  The Company issued warrants to purchase1,172,900 shares of common stock, at exercise prices ranging from $0.01 to $0.33 per share.  The weighted average exerciseprice of these warrants is $0.09 per share. The weighted-average fair value ofthe warrants on the date of grant was$2.41 for Fiscal 2001.

 

Inconnection with the sale of Series A Preferred Stock during Fiscal 2000,the Company issued warrants to purchase 4,580,392 shares of common stock at anexercise price of $0.33 per share in Fiscal 2000. During Fiscal 2000, warrantsto purchase 799,074 shares of common stock were exercised. The exercise priceof the warrants at the date of issuance was below the fair market value of thecommon stock and is therefore considered an “in the money” or beneficialconversion feature. Accounting for the issuance of convertible preferred stockwith a nondetachable beneficial conversion feature at the date of issuerequires that the conversion feature be recognized and measured in thefinancial statements by allocating a portion of the preferred stock offeringproceeds to additional paid in capital. The discount resulting from theallocation of the proceeds to the beneficial conversion feature is analogous toa dividend and is recognized as a return to preferred stockholders from thedate of issuance through the date the warrants are exercisable.

 

As aresult of the aforementioned accounting, the Company allocated $8,794,000 ofthe preferred stock proceeds to additional paid in capital in Fiscal 2000. Asthe warrants were exercisable upon issuance, the entire allocation wasrecognized as a preferred dividend through a charge to retained earnings and acredit to preferred stock. The weighted–average fair value of thewarrants on the date of grant was $2.08 for Fiscal 2000.

 

The Company had warrantsoutstanding to purchase 8,009,552 and 7,537,423 shares of common stock as ofMarch 31, 2002 and April 1, 2001, respectively.

 

**23. Stock purchase plan**

 

In2000, the stockholders approved the Employee Stock Purchase Plan (the “PurchasePlan”). The Purchase Plan qualifies under Section 423 of the InternalRevenue Code. The Company has authorized up to 4,200,000 shares of common stockto be offered under the Purchase Plan and 1994 Stock Option Plan combined. Noofferings have yet occurred under the Purchase Plan.  Under the Purchase Plan, eligible employees will be entitled topurchase shares of common stock from the Company through payroll deductions ofup to 10% of base compensation, at a price per share equal to 85% of the lesserof the fair market value of the Company’s common stock as of the first day(grant date) or the last day (purchase date) of each six-month offering periodunder the Purchase Plan.

 

Acommittee appointed by the Board will administer the Purchase Plan.  Any employee who is customarily employed forat least 20 hours per week and more than five months in a calendar year bythe Company, or by any majority-owned subsidiary designated from time to timeby the Board, and who does not own 5% or more of the total combined votingpower or value of all classes of the Company’s outstanding capital stock, willbe eligible to participate in the Purchase Plan.

 

**24. Employee 401(k) savings plan**

 

DuringFiscal 2000, the Company adopted a 401(k) savings plan for employees.Eligible employees may contribute

 

56

----

 

up to 20% of theirsalaries to the plan. Eligible employees are employees over the age of 18 whohave been employed by the Company for six months. There is no mandatory Companymatch.  Most plan administrative costsare paid by the 401(k) savings plan.

 

**25. Segment Reporting**

 

The Company presentssegment information in accordance with Statement of Financial AccountingStandards No. 131, “Disclosures about Segments of an Enterprise andRelated Information,” (“SFAS 131”), which established reporting and disclosurestandards for an enterprise’s operating segments. Operating segments aredefined as components of an enterprise for which separate financial informationis available and regularly reviewed by the Company’s senior management.

 

Previouslythe Company reported two business units, but is now reporting three units (SeeNote 1).  The Company is organized intothree business units: (1) its Retail division, which includes its domesticstore operations, (2) its Wholesale division, which sells to domestic customersin the supermarket, food service, office coffee service, restaurant andinstitutional channels, and which also handles the Company’s mail order sales,and (3) its International division which sells products and materials to theCompany’s international licensees and manages the international licensing ofthe Tully’s brand and the related royalty programs.

 

Theaccounting policies of the operating segments are the same as those describedin the summary of significant accounting policies in Note 1.  Operating income/(loss) represents earningsbefore interest income and expense.

 

Thetables below present information by operating segment:

 
|                                 |   | **Years Ended**            |    |
|--------------------------------------|--------|----------------------------|---------|
|                                 |   | **March 31, 2002**         |    | **April 1, 2001** |   | **April 2, 2000** |   |
|                                 |   | **(dollars in thousands)** |    |
| Revenues                             |   |                       |    |   |   |   |   |
| Retail store division                |   | $                          | 41,477  |   | $ | 35,759 |   | $ | 24,062 |   |
| Wholesale division                   |   | 5,116                      |    | 4,783 |   | 3,194 |   |
| International division(1)            |   | 4,857                      |    | 1,560 |   | 442 |   |
| Corporate and other                  |   | 8                          |    | — |   | — |   |
| Total Revenues                       |   | $                          | 51,458  |   | $ | 42,102 |   | $ | 27,698 |   |
|                                 |   |                       |    |   |   |   |   |
| Operating income/(loss)              |   |                       |    |   |   |   |   |
| Retail store division(2)             |   | $                          | (3,381  | ) | $ | (7,700 | ) | $ | 1,022 |   |
| Wholesale division                   |   | 329                        |    | (4 | ) | 252 |   |
| International division               |   | 2,535                      |    | 89 |   | 83 |   |
| Corporate and other  expenses(3)     |   | (12,834                    | )       | (16,738 | ) | (9,347 | ) |
| Interest and other, net(4)           |   | 2,199                      |    | (704 | ) | (76 | ) |
| Net Loss                             |   | $                          | (11,152 | ) | $ | (25,057 | ) | $ | (8,066 | ) |
|                                 |   |                       |    |   |   |   |   |
| Depreciation and  amortization       |   |                       |    |   |   |   |   |
| Retail store division                |   | $                          | 3,114   |   | $ | 2,844 |   | $ | 1,615 |   |
| Wholesale division                   |   | 282                        |    | 311 |   | 78 |   |
| International division               |   |                       | **      |   | ** | 3 |   |
| Corporate and other expenses         |   | 1,204                      |    | 1,238 |   | 852 |   |
| Total depreciation and  amortization |   | $                          | 4,600   |   | $ | 4,393 |   | $ | 2,548 |   |

 

----

** not material – less than $1,000

 

(1)     For Fiscal 2002,International division revenues include the amortization of fees received underthe agreements with UCC and Tully’s Coffee Japan (See Note 16).  Therewere no such transactions during Fiscal 2001 and 2000.

 

(2)     In Fiscal 2002 and 2001, theRetail division operations include adjustments for impairment of long-livedassets of $2,350,000 and $5,006,000, respectively, and for amounts required to close stores and terminate store leases duringthe respective periods totaling $498,000 and $2,620,000,respectively.  (See Notes 10 and 19)

 

57

----

 

(3)     In Fiscal 2001, unallocatedcorporate expenses includes the write-off of Tully’s Europe B.V joint ventureand its related trade receivables of $1,036,000, marketing and charitablecontributions of $2,692,000, and professional fees and services of $1,603,000.

 

(4)     Interest and other, netincludes $2,887,000 for the realized gain from the sale of Tully’s Coffee Japancommon stock during Fiscal 2002.  Therewere no stock sales during Fiscal 2001 and 2000.

 

**26.  4th Quarter Adjustments**

 

During the fourth quarter of Fiscal 2002 and 2001,the following adjustments were recorded (dollars in thousands):

 
|                                                                       |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Impairment of long-lived  assets                                           |   | $        | 2,350  |     | $      | 5,006 |   |
| Store closures and lease  termination costs                                |   | 498      |   | 2,151    |   |
| Write-off of Tully’s Europe  B.V. joint venture and trade receivables |   | —   |   | 1,036    |   |
| Professional fees and  services                                            |   | —   |   | 647      |   |
| Total                                                                      |   | $        | 2,848  |     | $      | 8,840 |   |

 

**27.Selected Quarterly Financial Data (Unaudited)**

 

Summarized quarterly financial information for Fiscal2002 and Fiscal 2001 is as follows.  TheCompany’s sales are moderately seasonal.

 
|              |   | **1st Qtr**                                        |   | **2nd Qtr** |   | **3rd Qtr** |   | **4th Qtr** |   | **Total** |   |
|-------------------|--------|----------------------------------------------------|--------|-------------|--------|-------------|--------|-------------|--------|-----------|--------|
|              |   | **(dollars in thousands, except  per share data)** |   |
| **Fiscal 2002**   |   |                                               |   |        |   |        |   |        |   |      |   |
| Net Revenues      |   | $                                                  | 12,909 |        | $      | 13,102      |   | $           | 13,244 |      | $      | 12,203 |   | $ | 51,458 |   |
| Gross Profit      |   | 6,197                                              |   | 6,215       |   | 6,472       |   | 6,669       |   | 25,553    |   |
| Net (Loss) Income |   | (3,648                                             | )      | (2,791      | )      | 42          |   | (4,755      | )      | (11,152   | )      |
| EPS               |   |                                               |   |        |   |        |   |        |   |      |   |
| Basic and Diluted |   | $                                                  | (0.23  | )           | $      | (0.17       | )      | $           |   | *         | $      | (0.29 | ) | $ | (0.69 | ) |
|              |   |                                               |   |        |   |        |   |        |   |      |   |
| **Fiscal 2001**   |   |                                               |   |        |   |        |   |        |   |      |   |
| Net Revenues      |   | $                                                  | 8,794  |        | $      | 9,619       |   | $           | 11,453 |      | $      | 12,236 |   | $ | 42,102 |   |
| Gross Profit      |   | 4,172                                              |   | 4,456       |   | 5,910       |   | 5,059       |   | 19,597    |   |
| Net Loss          |   | (2,881                                             | )      | (2,701      | )      | (3,504      | )      | (15,971     | )      | (25,057   | )      |
| EPS               |   |                                               |   |        |   |        |   |        |   |      |   |
| Basic and Diluted |   | $                                                  | (0.19  | )           | $      | (0.17       | )      | $           | (0.22  | )         | $      | (1.06 | ) | $ | (1.59 | ) |

 

----

*  Less than$0.01

 

**28.    Subsequent Events (Unaudited)**

 

***New credit facility and amendment of lease***

 

On November 1, 2002, the Company entered into a newcredit facility with Kent Central LLC (“KCL”), which is secured bysubstantially all of the Company’s assets and guaranteed by certain directorsand stockholders of the Company (the “financial backers” or “guarantors”).  The KCL credit facility allows the Company to borrow up to $2,000,000 through October31, 2003.  The terms of thecredit facility, and a related agreement among the Company and the guarantors,include provisions that, among other things, restrict the Company’s ability toincur additional secured debt or liens and to sell, lease or transferassets.  Other provisions of theseagreements would require accelerated repayment of the borrowed amounts incertain circumstances, including the issuance of new equity, certain mergersand changes and control, certain sales of assets, and upon certain changes orevents relating to the guarantors.  The KCL credit facilityand related agreements permit the Company to enter into an additional borrowingfacility of up to $1.0 million with another lender,

 

58

----

 

subject to the consentof KCL and the guarantors.  Thisadditional facility may be secured by the Company’s accounts receivable andinventory, in which case KCL would subordinate interest in that collateral tothat of the new lender.  The Company isevaluating possible lenders for this additional secured borrowing and expectsto enter into such a facility as part of its Fiscal 2003 financing strategy.

 

The lender, KCL, is also lessor of the building thathouses the Company’s headquarters, roasting plant and distribution facilities,under a ten-year lease that expires in May 2010.  The parties agreed to amend this lease in connection with theestablishment of the new credit facility. When the Company first occupied the leased property in Fiscal 2001, thelessor funded $1,000,000 of tenant improvements to the property, and the leasewas amended at that time to reimburse the lessor for the improvement allowancethrough increased lease payments.  As aresult, in Fiscal 2001 the Company recorded $1,000,000 as a deferred lease costliability, and has been amortizing this liability as rent was paid.  Under the provisions of the new KCL creditfacility and the lease amendment, the parties agreed to add the unamortizedtenant improvement allowance of $890,037 to the borrowed principal amount underthe credit facility and to reduce the monthly rental for the remainder of thelease term by approximately $16,000 per month. In addition, the amended lease provides that the lessor may, at itsoption, terminate the lease early by giving the Company 150 days written noticeof termination.  Although the lessor haslisted the property for sale or lease, the Company is unaware of any currentintention by the lessor to terminate the lease and expects to continue itstenancy under the terms of the amended lease. However, if the lessor were to terminate the lease early, therecoverability of the Company’s leasehold improvements at the facility would beimpaired; such leasehold improvements had a net book value of $1,342,000 atDecember 29, 2002.

 

Borrowings under the new KCL credit facility bearinterest at prime less 1⁄2%, and a 3% loan fee is to be paid annually.  This new credit facility allows the Companyto borrow up to $2,000,000 through October 31, 2003, in addition to the$890,037 unamortized tenant improvement allowance that was transferred to thecredit facility from the lease and that is due on April 29, 2005.  In consideration for providing the guaranties, theCompany will issue to the financial backers warrants to purchase shares ofcommon stock, at an exercise price of $0.05 per share.  If the Company were to fully borrow to thelimit of the guaranties, the Company would annually issue warrants for 740,640shares of common stock.  The Companywill recognize these non-cash loan guaranty costs as a financing expense basedupon the fair value at the date of grant of the warrants  The Company also has agreed to indemnify theguarantors in connection with the guaranties and has granted each of them asecurity interest in substantially all of the Company’s assets (subordinated tothe security interest of KCL).

 

***Goodwill impairment charge from adoption ofSFAS 142***

 

During the twenty-six weekperiod ended September 29, 2002, the Company adopted the full provisionsof SFAS 142.  SFAS 142 requires that companies performperiodic evaluations of potential impairment of goodwill, with the initialassessment to be completed during the first six months of the year in whichSFAS 142 is first applied.  During thefiscal quarter ended September 29, 2002, Tully’s performed an evaluation of itsgoodwill, and determined that an impairment of $3,018,000 should be recorded asof April 1, 2002 related to the Company’s Retail division operations inCalifornia and Oregon.  As provided inSFAS 142, this impairment charge has been retroactively recorded as thecumulative effect of a change in accounting principle as of the beginning ofFiscal 2003.  The change in carryingamount of goodwill as of April 1, 2002 is as follows (dollars in thousands):

 

| Balance as of March 31, 2002                                                                                                 |   | $      | 3,572 |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|--------|-------|--------|
| Transition impairment  adjustment recorded as the cumulative effect of a change in accounting  principle as of April 1, 2002 |   | (3,018 | )     |
| Balance as of April 1, 2002  after retroactive adjustment                                                                    |   | $      | 554   |   |

 

***Amendment to sponsorship agreement***

 

As described in Note 21, the Company has a sponsorshipagreement with the San Francisco Giants for PacBell Stadium in San Franciscothat providesfor certain advertising and marketing rights in exchange for annual feespayable by Tully’s.  The PacBell Stadiumagreement was to expire on October 31, 2002 and provided for fees payable byTully’s of $950,000 for Fiscal 2003. During August 2002, the parties extended the term of the agreementthrough October 31, 2003 with an aggregate fee payable by Tully’s of $1,100,000for the two years ($825,000 payable in Fiscal 2003 and $275,000 payable inFiscal 2004), and with a reduced level of marketing benefits during Fiscal2004.  Based upon the provisions of theamended PacBell Stadium agreement, the charge to expense will be $675,000 forFiscal 2003 and $425,000 for Fiscal 2004.

 

59

----

 

***Internationalassignment of Spinelli property rights***

 

InSeptember 2002, the Company assigned its intellectual property rights outsideof the United States relating to its Spinelli brand, including the trademarksand related goodwill, to Spinelli Pte. Ltd. (“SPL”), the licensee of theCompany’s Spinelli brand in Singapore and Taiwan.  Under the agreement, SPL agreed to pay $500,000 to theCompany.  The Company received $250,000from SPL during September 2002, and expects to receive the balance of thepurchase price in March 2003.  TheCompany retains certain rights with respect to the use of the Spinelli brandand related intellectual property in the United States and Japan.  The $500,000 purchase price, lessapproximately $40,000 of costs, was reported as “other income” in the secondquarter of Fiscal 2003.

 

**ITEM 9.****                                              ****CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL****DISCLOSURE**

 

None.

 

60

----

 

**PART III**

 

**ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

 

Thefollowing table sets forth certain information with respect to the directorsand executive officers of the Company as of March 31, 2002.

 
| **Name**             |   | **Age** |   | **Position**                                           |   |
|----------------------|--------|---------|--------|--------------------------------------------------------|--------|
| Tom T. O’Keefe  |   | 48      |   | Chairman of the Board                                  |   |
|                 |   |    |   |                                                   |   |
| Anthony J. Gioia     |   | 52      |   | Chief Executive Officer, President and Director        |   |
|                 |   |    |   |                                                   |   |
| Kristopher S. Galvin |   | 49      |   | Chief Financial Officer, Vice President and  Secretary |   |
|                 |   |    |   |                                                   |   |
| Graham Anderson      |   | 69      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| Kimberly J. Beach    |   | 45      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| Larry A. Culver      |   | 60      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| Marc Evanger         |   | 47      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| Kevin G. Fortun      |   | 47      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| Lawrence L. Hood     |   | 43      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| George Hubman        |   | 59      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| Richard J. Padden    |   | 49      |   | Director                                               |   |
|                 |   |    |   |                                                   |   |
| James Cameron Towne  |   | 59      |   | Director                                               |   |

 

**Tom T. O’Keefe—Chairman of the Board, Founder.**  Tom T. O’Keefe founded Tully’sin 1992 and has served as a director and chairman of the board since that date.Mr. O’Keefe served as chief executive officer of Tully’s from 1992 until March2001.  Mr. O’Keefe is alsopresident and chief executive officer of O’Keefe Development Corporation, areal estate development and investment firm he founded. Tom and his wife Cathyhave been actively involved in local and national community organizations forover 20 years.  In 1983, the O’Keefe’sco-founded the Patrons of Cystic Fibrosis, a local guild of volunteers workingto support cystic fibrosis research in Washington.  Mr. O’Keefe is a previous national board member, a formerpresident and event chairman of the Cystic Fibrosis Foundation.  Tom and Cathy are the recipients of the 1996Breath of Life Award from the Patrons of Cystic Fibrosis and 2000 Living andGiving Award in from the Juvenile Diabetes Foundation of Seattle.  Mr. O’Keefe’s charitable efforts focuslargely on children in the community. Mr. O’Keefe is presently serving as a board member to the Boys and GirlsClub of Bellevue, Children’s Hospital Foundation, Leukemia & LymphomaSociety Seattle Chamber of Commerce, Virginia Mason Hospital and is on theBoard of Governors of the Columbia Tower Club and is the Chairman of thecapital campaign for the Museum of Flight.

 

**Anthony Gioia****- President and Chief Executive Officer and Director.**  Mr.Gioia was named president and CEO of Tully’s in May of 2002, and wasalso appointed a director of the Company. Prior to joining Tully’s, Mr. Gioiawas the president, CEO, and a director of Southwest Supermarkets, LLC (“SWS”)in Phoenix, AZ, from 1999 to December 2001. SWS was one of the leading ethnic grocery chains in the southwest with38 stores, generating approximately $300 million in annual revenue and wasowned by a leveraged buy-out firm.  InDecember 2001, SWS was sold to another supermarket chain through a reorganizationunder Chapter 11.  From 1990 to 1998,Mr. Gioia served at Baskin-Robbins, USA in Glendale, Calif., and was an officerof Dunkin’ Donuts, in Randolph, Mass., both divisions of Allied Domecq, QSR,where he held the positions of senior vice president and then president ofBaskin-Robbins.  In 1986 Mr. Gioiaco-founded Wolfgang Puck Food Company in Santa Monica, Calif., where he heldthe position of chief operating officer (COO) until 1990.

 

61

----

 

**Kristopher S. Galvin – VicePresident,****Chief Financial Officer and Secretary.**  Mr. Galvin joined Tully’s Coffee inFebruary 2002 as vice president, chief financial officer and secretary.  From 1995 to December 2001, Mr. Galvinserved first as CFO for Deposit Payment Protection Systems, Inc. (a subsidiaryof Deluxe Corporation) for five years and in 2001 became Vice President forRetail Product Management for a company spun-off from Deluxe Corporation,eFunds Corporation, which provides electronic payment and risk managementservices to major retailers and financial institutions.  Previously, he was CFO of three PacificNorthwest retail chains- Pay’n Save Drug Stores (1984-1992), Seattle LightingFixture Co. (1992-1994) and Ballard Computer (1994-1995).  During 1975 to 1984 he was a CPA with theaudit practice of Price Waterhouse.

 

**Graham S.Anderson - Director.**  Mr. Anderson is former chairman andpresident of the Pettit-Morry Company, a regional insurance brokerage.  Mr. Anderson serves on the boards of directorsfor a variety of companies including The Commerce Bank, Janss Center and isformer chairman of the National Association of Insurance Brokers.  Mr. Anderson has served as a director ofTully’s since February 1994.

 

**Kimberly J. Beach - Director. **Ms. Beach served Tully’sas chieffinancial officer and secretary from October 2001 through February 2002.  Ms. Beach was appointed as a director inMarch 2002.  From 1997 to 1999 sheserved as chief financial officer with Seattle Coffee Company (SCC).  SCC is a national specialty coffee roaster,retailer and wholesaler with two brands, Seattle’s Best Coffee and TorrefazioneItalia.  During her tenure, SCC wasacquired by AFC Enterprises, Inc.  From1994 to 1997, Ms. Beach served as chief financial officer with Todo, Inc., atwenty-unit restaurant chain, until World Wrapps acquired the company.  From 1985 to 1994, Ms. Beach served as chieffinancial officer for Capital Realty Corp., a real estate development company.  Ms. Beach was with Arthur Young &Company from 1978 to 1984.

 

**LarryCulver - Director.**  Mr. Culver founded Inn Ventures, Inc., ahotel development and management company, in 1982.  Mr. Culver has been recognized by numerous organizations for hisaccomplishments and innovative leadership including being the recipient of the“Inn of the Year Award”, “Hotelier of the Year Award” and a finalist forseveral of Marriott International’s highest awards.  He serves on various boards of directors of civic and charitygroups such as Big Brothers and Big Sisters of King County (past president,board of directors, and executive committee); Northwest Harvest Food Drive;Fred Hutchinson Cancer Research; Washington State University’s Board ofTrustees; Washington State University’s Foundation; and Washington State University’sAdvisory Board for School of HRA.  Mr.Culver has served as a director of Tully’s since February 1998.

 

**Marc Evanger -****Director****.**  Mr.Evanger served as interim president and chief executive officer of Tully’s fromJuly 2001 through May 2002.  Mr. Evangerhas been a director of the Company since March 1999.  Mr. Evanger joined Tully’s in December 1998 as vicepresident—corporate planning and development, a part-time position. From 1984to 1998 Mr. Evanger was with Quality Food Centers (QFC), a regional supermarketcompany, most recently as senior vice president of finance and administrationand chief financial officer, which position he held from 1987 to 1998. From1978 to 1984, Mr. Evanger was with Price Waterhouse & Company.Mr. Evanger is currently a director of Car Toys, Inc., a retailer ofspecialty automotive sound systems and cellular, Childhaven and theBoys & Girls Club of Bellevue and is active in other charitable andcommunity activities.

 

**Kevin G.Fortun - Director. **Mr.Fortun founded Stockpot Soups in 1978 and served as its president and chiefexecutive officer from 1978 to 1998. Stockpot Soups, which manufactures and distributes fresh refrigeratedsoups, sauces, entrees, gravies, stews and chili’s throughout the United Statesand abroad, was sold to the Campbell Soup Company in 1998.  Currently, Mr. Fortun is self-employed.  Mr. Fortun is co-owner and a board member ofRide the Ducks, a Seattle based entertainment tour company. Mr. Fortun waselected as a director in March 2001.

 

**Lawrence L.Hood - Director.****** Mr.Hood is a principal and managing partner of Pacific Portfolio Consulting, L.P.,an independent, fee only investment advisory firm.  Between 1987 and 1992, Mr. Hood was a principal in charge of theinvestment division of Kibble & Prentice, Inc., a regional financialservices firm.  Mr. Hood served as adirector for A-Sport, Inc., a manufacturer and distributor of water sportsbrands and snowboards and is a past member of the Charles Schwab AdvisoryBoard.    Mr. Hood has served as a directorof Tully’s since February 1994.

 

**GeorgeHubman - Director**.**** Mr. Hubman retired as vice president of salesand marketing at WRQ in December 1993. Mr. Hubman was co-founder of WRQ and held that position since thecompany’s formation in 1981.  Prior toWRQ, Mr. Hubman’s career included sales positions with Hewlett Packard and IBM.He currently sits on the boards of directors of Horizon Broadcasting andChildhaven.  He is a past president ofWashington State University’s College of Business and Economics advisorycommittee.  Mr. Hubman has served asdirector of Tully’s since February 1994.

 

**Richard J.Padden - Director**.  Mr. Padden is of counsel to the law firm ofCarney Badley Smith & Spellman, P.S. Mr. Padden is a founder, principal and board member of Grays HarborPaper, LP, a principal and board member of

 

62

----

 

SafeWorks, L.L.C, amanufacturer and distributor of safety and powered access equipment company,and owner of Northwest Container Services, Inc. an intermodal logisticcompany.  Mr. Padden is a past presidentof the Washington Chapter of Cystic Fibrosis and is a founder and pastpresident of the Patrons of Cystic Fibrosis Guild.  Mr. Padden has served as a director of Tully’s since February1994.

 

**James Cameron Towne - Director**. Mr. Towne has been chairman of Greenfield Development Corporation, areal estate remediation and development company, since 1995.  From 1982 to 1995, he was president, chiefexecutive officer or chairman of various companies, including Osteo SciencesCorporation, Photon Kinetics, Inc., MCV Corporation, Metheus Corporation andMicrosoft Corporation.  From 1993through 1998, he was president of the board of Overlake School. Mr. Towne alsoserves on the board of directors of Cutter & Buck, a specialty sportswearand outerwear clothing retailer, and Monowave Corporation, a privately heldspeech recognition software company. Mr. Towne has served as a director of Tully’s since February 1998.

 

**Section 16(a) Beneficial Ownership ReportingCompliance**

 

Section16(a) of the Securities Exchange Act of 1934, as amended, requires that Tully’sdirectors, executive officers and greater-than-10% stockholders file reportswith the Securities and Exchange Commission reporting their initial beneficialownership of Tully’s equity securities and any subsequent changes to theirrespective security holdings.  They alsomust provide Tully’s with copies of these reports.  During Fiscal 2002, the following reporting persons failed tofile on a timely basis the Statement of Changes of Beneficial Ownership on Form4 as set forth below: Mr. O’Keefe had 20 transactions and was late in filingten statements of changes; Mr. Anderson had 14 transactions and was late infiling ten statements of changes; Mr. Culver had 15 transactions and was latein filing eight statements of changes; Mr. Evanger had 14 transactions and waslate in filing ten statements of changes; Mr. Fortun had nine transactions andwas late in filing seven statements of changes; Mr. Hood had 20 transactionsand was late in filing ten statements of changes; Mr. Hubman had 19transactions and was late in filing ten statements of changes; Mr. Padden had19 transactions and was late in filing ten statements of changes; Mr. Towne had20 transactions and was late in filing eleven statements of changes; and Ms.Beach had one transaction and was late in filing one statement of changes.

 

63

----

 

**ITEM 11.  EXECUTIVE COMPENSATION**

 

The following tablediscloses compensation paid to Tully’s chief executive officers during Fiscal2002 (the “Named Executive Officers”). No other executive officer of the Company received salary and bonus that exceeded $100,000during Fiscal 2002.

 

**SUMMARY COMPENSATION TABLE**

** **
|                                      |   |      |   |                    |    | **Long-Term  Compensation Awards Securities  Underlying  Options(#)** |                        |   |   |
|-------------------------------------------|--------|-----------|--------|-------------------------|---------|-----------------------------------------------------------------------|-----------------------------|--------|--------|
| **Name and Principal Positions**          |   | **Year**  |   | **Annual Compensation** |    |                                                                  | **All Other  Compensation** |   |
| **Salary**                                |   | **Bonus** |
| Marc Evanger                              |   | 2002      |   | $                       | 192,885 |                                                                  | —                      |   | 7,250  |   | — |   |
| Interim President and Chief Executive     |   | 2001      |   | $                       | 52,000  |                                                                  | —                      |   | 3,500  |   | — |   |
| Officer and Director (1)                  |   | 2000      |   | $                       | 52,000  |                                                                  | —                      |   | 1,000  |   | — |   |
|                                      |   |      |   |                    |    |                                                                  |                        |   |   |   |   |
| Jamie Colbourne                           |   | 2002      |   | $                       | 15,385  |                                                                  | —                      |   | — |   | — |   |
| President and Chief Executive Officer (2) |   |      |   |                    |    |                                                                  |                        |   |   |   |   |

 

----

(1)          Mr. Evanger served as interim president andchief executive officer of the Company for the period from July 14, 2001through May 2002.

 

(2)          Mr. Colbourne served as chief executiveofficer and president of the Company for the period March 27, 2001 throughJuly 13, 2001.

 

*Option Grants in Fiscal 2002*

 

The following table provides information relating to stock optionsawarded to the Named Executive Officers during Fiscal 2002:

 
| **Name**        |   | **Number of   Securities   Underlying   Options  Granted  (# of Shares)** |   | **% of Total Options  Granted to   Employees in   fiscal year  2002** |   | **Exercise or  Base Price********($/Sh)** |   | **Expiration  Date** |     | **Grant Date  Present Value(1)** |   |
|-----------------|--------|---------------------------------------------------------------------------|--------|----------------------------------------------------------------------------|--------|-------------------------------------------|--------|----------------------|----------|----------------------------------|--------|
| Marc Evanger    |   | 7,250                                                                     |   | 0.4                                                                        | %      | $                                         | 0.01   | (2)                  | 4/1/2011 |                             | $      | 14,464 |   |
| Jamie Colbourne |   | —                                                                    |   | —                                                                     |   | —                                    |   | —               |     | —                           |   |
|                 |        |                                                                           |        |                                                                            |        |                                           |        |                      |          |                                  |        |  |  |

 

----

(1)          The present value of thestock options was estimated on their date of grant using the Black-Scholesoption pricing model with the following weighted average assumptions:  (a) risk-free interest rate of 6%; and (b)expected life of 10 years.

(2)          The fair market value atdate of grant was $2.00 per share.

 

## *Aggregated OptionValues as of Fiscal Year-End 2002*

 

The following tableprovides information regarding the aggregate number of options exercised duringFiscal 2002, by the Named Executive Officers and the number of shares subjectto both exercisable and unexercisable stock options as of March 31, 2002.

 

64

----

 

**Aggregated Option Exercises in Fiscal Year 2002**

**and 2002 Year-End Option Values**

** **
| **Name**        |   | **Shares Acquired  on  Exercise** |       | **Value  Realized  ($)** |       | **Number of Securities  Underlying Unexercised  Options at End of Fiscal  Year 2002** |       | **Value of Unexercised In-The  Money Options at End of  Fiscal Year 2002(1)** |       |
|-----------------|--------|-----------------------------------|------------|--------------------------|------------|---------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
|            |   |                              | ** ** |                     | ** ** | **Exercisable**                                                                       | ** ** | **Unexercisable**                                                             | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| Marc Evanger    |   | —                            |       | —                   |       | 413,750                                                                               | (2)        | —                                                                        |       | $ | 469,363 |   | — |   |
| Jamie Colbourne |   | —                            |       | —                   |       | —                                                                                |       | —                                                                        |       | — |   | — |   |
|                 |        |                                   |            |                          |            |                                                                                       |            |                                                                               |            |  |  |  |  |  |

 

----

(1)                                  The stock options were granted with exerciseprices ranging from $0.01 to $2.25 per share. The value was determined using a fair market value of $2.00 per share ascompared to the exercise price at grant.

 

(2)                                  Includes options to purchase 201,500 sharesof common stock granted by Company’s chairman, Tom T. O’Keefe under theFounder’s Stock Option Plan (see Note 21 to the Consolidated FinancialStatements).

 

## ***CompensationCommittee Interlocks and Insider Participation***

 

During Fiscal 2002,management compensation issues generally were reviewed and approved by theCompensation Committee, which was composed of Messrs. Hubman and Anderson, bothof whom are non-employee directors.  DuringFiscal 2002, no executive officer of the Company served on the board ofdirectors or compensation committee of another entity that had an executiveofficer serve on Tully’s Board or its Compensation Committee.

 

Tom T.O’Keefe, the Chairman of the Board, and George Hubman, a director andstockholder, guaranteed the Company’s bank line of credit in return for acombined guarantee fee of one percent (1.0%) of the line’s monthly averagebalance. In exchange for the guarantee, the Company issued stock options to theguarantors with an exercise price of $.01 per share for 105,112 shares (2002),287,676 shares (2001) and 190,948 shares (2000) of common stock with anestimated fair market value of $209,000, $669,000 and $428,000, respectively.  The line of credit was repaid on October 1,2001.

 

RichardPadden, a director of the Company, is of counsel with the law firm, CarneyBadley Smith & Spellman, which provides legal services to the Company.  During Fiscal 2002, 2001 and 2000, theCompany incurred costs of $317,000 (of which approximately $116,000 was payableat March 31, 2002), $309,000, and $170,000, respectively, related to servicesperformed by the law firm.

 

## ***DirectorCompensation***

 

The directors of Tully’s receive no cash compensationfor serving on the board of directors, but are reimbursed for reasonableexpenses incurred in attending board and committee meetings.  Each director is entitled to receive a grantof non-qualified options under the Company’s 1994 Common Stock Option Plan topurchase 500 shares and 250 shares of Tully’s common stock, respectively, foreach board meeting and board committee meeting that the director attends.  Each option has an exercise price of $0.01per share, a term of ten years and is fully vested upon grant.  In accordance with this policy, duringFiscal 2002, the members of the board received options to purchase an aggregateof 69,750 shares.

 

**Employment Agreements andCompensatory Arrangements**

 

Tully’s generally does not enter into employmentagreements or written compensatory arrangements with its employees, includingthe Named Executive Officers.  Followingthe end of Fiscal 2002, the Company entered into an employment agreement withits new chief executive officer and president pursuant to which that officerwill receive annual compensation of $250,000 in Fiscal 2003, certain stockoption grants and potential bonus payments.

## * *

## ***Report of Compensation Committee onExecutive Compensation***

 

*Executive Compensation Philosophy*

 

The compensation committee of the board of directorswas composed of two outside directors (George Hubman and Graham Anderson)during Fiscal 2002.  Marc Evanger wasappointed to the committee on May 23, 2002, and serves as its chairman.  The compensation committee is responsible forevaluating compensation levels and compensation

 

65

----

 

programs for executives and for making recommendations to the boardregarding appropriate compensation awards for executive management.  During Fiscal 2000, the compensationcommittee commissioned Watson Wyatt, a leading human resources consulting firm,to review and develop the Company’s executive compensation program.

 

The executive compensation program of the Company isdesigned to attract, retain and motivate executive officers capable of leadingthe Company to meet its business objectives, to enhance long-term stockholdervalue and to reward executive management based on contributions to both theshort and long term success of the Company.  The compensation committee’s philosophy is for the Company to usecompensation policies and programs that align the interests of executivemanagement with those of the stockholders and to provide compensation programsthat create incentives for and reward both the short and long term performanceof the executive officers based on the success of the Company in meeting itsbusiness objectives.

 

*ExecutiveCompensation Components*

 

*BaseSalary*. Recommendations for base salaries for executive officers are made atlevels believed by the compensation committee to be sufficient to attract andretain qualified executive officers based on the stage of development of theCompany and the market practices of other companies.  A change in base salary of an executive officer is based on anevaluation of the performance of the executive, prevailing market practices andthe performance of the Company as a whole. In determining recommended base salaries, the compensation committee notonly considers the short term performance of the Company, but also the successof the executive officers in developing and executing the Company’s strategicplans, developing management employees and exercising leadership in thedevelopment of the Company.

 

*IncentiveBonus*.  Thecompensation committee believes that a portion of the total cash compensationfor executive officers should be based on the Company’s success in meeting itsshort-term performance objectives and contributions by the executive officersthat enable the Company to meet its long-term objectives, and has structuredthe executive compensation program to reflect this philosophy.  This approach creates a direct incentive forexecutive officers to achieve desired short-term corporate goals that alsofurther the long-term objectives of the Company, and places a portion of eachexecutive officer’s annual compensation at risk.

 

*StockOptions*.  Thecompensation committee believes that equity participation is a key component ofthe Company’s executive compensation program. Stock options are awarded by the board of directors to executiveofficers primarily based on potential contributions to the Company’s growth anddevelopment and marketplace practices. These awards are designed to retain executive officers and to motivatethem to enhance stockholder value by aligning the financial interests ofexecutive officers with those of stockholders. Stock options provide an effective incentive for management to createstockholder value over the long term because the full benefits of the optiongrants cannot be realized unless an appreciation in the price of the Company’scommon stock occurs over a number of years.

 

*ChiefExecutive Officer Compensation.*  In assembling the ChiefExecutive Officer’s compensation package, the Committee pursued the objectivesdiscussed above, worked within the framework and guidance of the Watson Wyattcompensation review performed in Fiscal 2000, considered the individualperformance of the Chief Executive Officer and the cash resources and needs ofthe Company.

 

*CompensationCommittee*

Marc Evanger, Chairman

Graham S. Anderson

George Hubman

 

66

----

 

**ITEM 12.  SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The following table setsforth certain information regarding the ownership of Tully’s common stock, Series AStock and Series B Stock as of May 31, 2002, by: (i) each director;(ii) the Named Executive Officers; (iii) all executive officers anddirectors of the Company as a group; and (iv) all stockholders known bythe Company to be beneficial owners of more than five percent of its votingsecurities:

 
|                                                          |   | **Common Stock**            |   | **Series A Preferred** |   | **Series B Preferred**       |   |
|---------------------------------------------------------------|--------|-----------------------------|--------|------------------------|--------|------------------------------|--------|
|                                                          |   | **Beneficial Ownership(1)** |   | **Percent  Of  Total** |   | **Beneficial  Ownership(1)** |   | **Percent********Of  Total** |   | **Beneficial Ownership(1)** |   | **Percent********Of Total** |   |
| Tom T. O’Keefe                                           |   | 5,495,901                   | (2)    | 32.3                   | %      | 0                            |   | * |   | 0 |   |   | * |
| Keith McCaw                                                   |   | 4,723,885                   | (3)    | 22.5                   | %      | 3,200,000                    | (4)    | 19.3 | % | 0 |   |   | * |
| George Hubman                                                 |   | 1,770,698                   | (5)    | 10.3                   | %      | 200,000                      |   | 1.3 | % | 0 |   |   | * |
| Kevin G. Fortun                                               |   | 545,000                     | (6)    | 3.2                    | %      | 280,000                      |   | 1.8 | % | 120,000 |   | 2.4 | % |
| Graham S. Anderson                                            |   | 495,834                     | (7)    | 3.0                    | %      | 40,000                       |   |   | * | 0 |   |   | * |
| Marc Evanger                                                  |   | 430,600                     | (8)    | 2.6                    | %      | 10,000                       |   |   | * | 0 |   |   | * |
| Lawrence L. Hood                                              |   | 185,445                     | (9)    | 1.1                    | %      | 10,000                       |   |   | * | 40,000 |   |   | * |
| Richard J. Padden                                             |   | 142,667                     | (10)   |                   | *      | 20,000                       |   |   | * | 0 |   |   | * |
| Larry A. Culver                                               |   | 80,500                      | (11)   |                   | *      | 40,000                       |   |   | * | 0 |   |   | * |
| James C. Towne                                                |   | 53,750                      | (12)   |                   | *      | 20,000                       |   |   | * | 0 |   |   | * |
| Jamie S. Colbourne                                            |   | 15,000                      | (13)   |                   | *      | 10,000                       |   |   | * | 0 |   |   | * |
| Kimberly J. Beach                                             |   | 500                         | (14)   |                   | *      | 0                            |   |   | * | 0 |   |   | * |
| Anthony J. Gioia                                              |   | 0                           |   |                   | *      | 0                            |   |   | * | 0 |   |   | * |
|                                                          |   |                        |   |                   |   |                         |   |   |   |   |   |   |   |
| Executive officers and  directors as a group (11 persons)(15) |   | 9,000,145                   |   | 46.8                   | %      | 620,000                      |   | 4.0 | % | 160,000 |   | 3.2 | % |

 

----

*              Lessthan 1%.

 

(1)          Beneficial ownership is determined in accordance with the rules andregulations of the Securities and Exchange Commission and generally requiresthat the stockholder have voting or investment power with respect to thesecurities in question. Shares of common stock issuable upon exercise orconversion of options, warrants or Series A and Series B Stock thatare exercisable or convertible within 60 days of May 31, 2002 are deemedto be beneficially owned by the holder of such securities but are notoutstanding for the purpose of computing the percentage ownership of any otherstockholder. Unless otherwise indicated in the footnotes to this table andsubject to community property laws where applicable, the Company believes thateach stockholder named in this table has sole voting and investment power withrespect to the shares indicated as beneficially owned thereby. As of May 31,2002, the Company had 16,320,614 shares of Common Stock, 15,378,264 shares ofSeries A Convertible Preferred Stock, and 4,990,709 shares ofSeries B Convertible Preferred Stock issued and outstanding.

 

(2)          Includes 1,696,042 shares of common stocksubject to currently exercisable purchase options granted by Mr. O’Keefe toemployees and third parties, 42,500 shares of common stock held by the O’KeefeChildren’s Trust, and an aggregate of 676,813 shares of common stock that Mr.O’Keefe has the right to acquire pursuant to options and warrants exercisablewithin 60 days of May 31, 2002.

 

(3)          Includes anaggregate of 1,480,550 shares of Common Stock that Mr. McCaw has the rightto acquire pursuant to options and warrants exercisable within 60 days ofMay 31, 2002 and 3,200,000 shares of Series A Convertible Preferred Stock.

 

(4)          Assumes theconversion of a promissory note held by an affiliate Mr. McCaw into1,200,000 shares of Series A Convertible Preferred Stock.

 

(5)          Includes an aggregate of 697,667 shares ofcommon stock that Mr. Hubman has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002 and 200,000 shares ofconvertible Series A Preferred Stock.

 

67

----

 

(6)          Includes an aggregate of 145,000 shares of commonstock that Mr. Fortun has the right to acquire pursuant to options and warrantsexercisable within 60 days of May 31, 2002. Also includes 280,000 and 120,000 shares of convertible Series A andSeries B Preferred Stock, respectively.

 

(7)          Includes an aggregate of 49,500 shares ofcommon stock that Mr. Anderson has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002 and 40,000 shares ofconvertible Series A Preferred Stock.

 

(8)          Includes an aggregate of 418,750 shares ofcommon stock that Mr. Evanger has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002 and 10,000 shares ofconvertible Series A Preferred Stock.

 

(9)           Includes an aggregate of 36,000 shares ofcommon stock that Mr. Hood has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002.  Also includes 10,000 convertible Series A Stock. Additionally,includes 40,000 shares of convertible Series B Preferred Stock and 27,223shares of common stock owned by PPC 401K Profit Sharing Plan, a plan owned bypartnership in which Mr. Hood is a principal and managing partner.

 

(10)     Includes an aggregate of 39,500 shares ofcommon stock that Mr. Padden has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002 and 20,000 shares ofconvertible Series A Preferred Stock.

 

(11)     Includes an aggregate of 32,500 shares ofcommon stock that Mr. Culver has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002 and 40,000 shares ofconvertible Series A Preferred Stock.

 

(12)     Includes an aggregate of 27,750 shares ofcommon stock that Mr. Towne has the right to acquire pursuant to options andwarrants exercisable within 60 days of May 31, 2002 and 20,000 shares ofconvertible Series A Preferred Stock.

 

(13)     Includes 500 shares of common stock thatMs. Beach has the right to acquire pursuant to options exercisable with 60 daysof May 31, 2002.

 

(14)     Includes an aggregate of 15,000 shares ofcommon stock that Mr. Colbourne has the right to acquire pursuant to optionsand warrants exercisable within 60 days of May 31, 2002 and 20,000 shares ofconvertible Series A Preferred Stock.

 

(15)     Totals excludeKeith McCaw and Jamie S. Colbourne, as they are no longer directors orexecutive officers.

 

### **ITEM 13.  CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS**

 

During Fiscal 2001 and 2000, theCompany made charitable contributions for the benefit of Tully’s of approximately$241,000 and $42,000, respectively, on behalf of a foundation organized by the Chairman  (the“Foundation”).  As a result of thesepayments and contributions, at April 1, 2001 and April 2, 2000, theCompany had receivables of approximately $601,000 and $231,000 from itsChairman and the Foundation, respectively. These receivables, including interest that accrued at an interest rateof prime plus one percent per annum on the outstanding balance of thereceivables, were paid to the Company in August 2001 by the Chairman and theFoundation, respectively.

 

The Company’s line of credit was guaranteed by theChairman and George Hubman, a director, in consideration for a guarantee fee ofone percent (1.0%) of the line’s monthly average balance. In Fiscal 2002, theCompany issued options to purchase an aggregate of 105,112 shares of commonstock with an estimated fair market value of $209,000, to the guarantors inconsideration for their guarantee.  Theline of credit was repaid on October 1, 2001.

 

Richard Padden, a director of theCompany, is of counsel with the law firm, Carney Badley Smith & Spellman,which provides legal services to the Company. During Fiscal 2002, the Company incurred fees and costs of $317,000 (ofwhich approximately $116,000 was payable at May 31, 2002), related to servicesperformed for Tully’s by the law firm.

 

Duringthe fourth quarter of Fiscal 2001, one director loaned the company$250,000.  In April 2001, threedirectors loaned the Company an aggregate of $1,000,000.  These notes payable and interest totaling$56,000 were repaid in Fiscal 2002

 

68

----

 

In December 2000,the Company issued a convertible note in the principal amount of $3,000,000 toan affiliate of the Keith McCaw, who was, at the time of issuance, a directorof the Company and beneficial owner of more than 5% of the Company’s commonstock.  At any time prior to the notematurity date (January 2, 2005) or repayment of the note, the note isconvertible into Series A Preferred Stock or common stock in the event that allshares of Series A Preferred Stock have been converted to common stock.  The conversion rate is the lesser of $2.50per share or the price per share of the most recent offering price, public orprivate, of common stock.  For each$100,000 of debt outstanding on each January 1st, the Companywill issue warrants to purchase 8,000 shares of common stock to the note holderin lieu of interest on the outstanding principal balance.  The warrants have an exercise price of $0.01and are exercisable for ten years from the issuance dates thereof.  On both January 1, 2001 and January 2,2002 the Company issued warrants to purchase 240,000 shares of common stock inaccordance with the terms of the note.

 

69

----

 

**PART IV**

 

**ITEM 14.****                                             ****EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM8-K**

 

(a)                                  The following documentsare filed as part of this Amended Annual Report on Form 10-K/A:

 

1.**                                      ****Financial Statements** - The followingfinancial statements are included in Part II, Item 8 of this AmendedAnnual Report on Form 10-K/A:

 

Consolidated Balance Sheets – March 31, 2002 andApril 1, 2001;

 

Consolidated Statements of Operations for the yearsended March 31, 2002, April 1, 2001 and April 2, 2000;

 

Consolidated Statements of Other Comprehensive Lossfor the years ended March 31, 2002, April 1, 2001 and April 2, 2000;

 

Consolidated Statements of Changes in Stockholders’Equity for the years ended March 31, 2002, April 1, 2001 and April 2, 2000;

 

Consolidated Cash Flow Statements for the yearsended March 31, 2002, April 1, 2001 and April 2, 2000;

 

Notes to Consolidated Financial Statements; and

 

Report of Independent Accountants

 

2.**                                      ****Financial Statement Schedules -**All schedules have been omitted, as they areeither not required or not applicable or because the information required to bepresented is included in the Consolidated Financial Statements and relatednotes

 

3.**                                      ****Exhibits**

 

(a)                                  The exhibits listedbelow are filed as part of, or incorporated by reference into, this AmendedAnnual Report on Form 10-K/A..

 
|   | **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                              |
|--------|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 3.1                 |   | Amended and Restated  Articles of Incorporation of Tully’s Coffee Corporation (incorporated by reference to the Company’s Annual  Report on Form 10-K for the year ended April 1, 2001, as filed with the  Commission on October 19, 2001)                                                                    |   |
|   |                |   |                                                                                                                                                                                                                                                                                                                         |   |
|   | 3.1.1               |   | Articles of Amendment of the  Restated Articles of Incorporation containing the Statement of Rights and  Preferences of Series B Preferred Stock (incorporated by reference to the Company’s Annual Report on  Form 10-K for the year ended April 1, 2001, as filed with the Commission  on October 19, 2001) |   |
|   |                |   |                                                                                                                                                                                                                                                                                                                         |   |
|   | 3.2                 |   | Amended Bylaws of Tully’s  Coffee Corporation (incorporated by reference to the Company’s Annual Report  on Form 10-K for the year ended March 31, 2002, as filed with the  Commission on July 1, 2002)                                                                                                       |   |
|   |                |   |                                                                                                                                                                                                                                                                                                                         |   |
|   | 4.1                 |   | Description of capital stock  contained in the Amended and Restated Articles of Incorporation (see Exhibit  3.1) (incorporated by reference to the Company’s Registration Statement on  Form 10, as filed with the Commission on July 27,1999)                                                                     |   |

 

70

----

 
|   | 4.2    |   | Description of rights of  security holders contained in the Bylaws (see Exhibit 3.2) (incorporated  by reference to the Company’s Registration Statement on Form 10, as  filed with the Commission on July 27,1999)                                                                                |   |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 4.3    |   | Form of common stock  warrants issued in Series A Convertible Preferred Stock financing  (incorporated by reference to the  Company’s Registration Statement on Form 10, as amended and filed with  the Commission on July 3, 2000)                                                                |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 4.4    |   | Form of Registration Rights  Agreement with Series A Preferred Shareholders (incorporated by reference to  the Company’s Registration Statement on Form 10, as amended and filed  with the Commission on July 3, 2000.)                                                                                 |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 4.5    |   | Convertible Promissory Note, dated December 14, 2000  between Tully’s and KWM Investments LLC (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended December 31, 2000, as filed with Commission on February 20,  2001)                       |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 4.6    |   | Convertible Promissory Note Subscription Agreement,  dated December 14, 2000 between Tully’s and KWM Investments LLC (incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended  December 31, 2000, as filed with Commission on February 20, 2001) |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 4.7    |   | Form of Common Stock Purchase Warrant issued with the  Convertible Promissory Note (incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended  December 31, 2000, as filed with Commission on February 20, 2001)                                        |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 4.8    |   | Registration Rights Agreement, dated December 14, 2000  between Tully’s and KWM Investments LLC (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended December 31, 2000, as filed with Commission on February 20,  2001)                     |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 10.1   |   | Tully’s Coffee Corporation Amended and Restated 1994  Stock Option Plan (incorporated by reference to the Company’s Quarterly  Report on Form 10-Q for the quarter ended September 26, 1999, as  filed with the Commission on November 15, 1999)                                              |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 10.2   |   | Tully’s Coffee Corporation 1999 Employee Stock Purchase  Plan  (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the quarter  ended September 26, 1999, as filed with the Commission on November 15,  1999)                                                 |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 10.3   |   | Lease Agreement between  Tully’s and Kent Central, LLC, as amended   (Incorporated by reference to the Company’s Annual Report on  Form 10-K for the year ended April 2, 2000, as filed with the  Commission on July 3, 2000)                                                            |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 10.4   |   | Third Lease Amendment  between Tully’s and Kent Central, LLC, dated November 7, 2000 (incorporated by reference to the Company’s  Quarterly Report on Form 10-K for the year ended April 1, 2001, as filed  with the Commission on October 19, 2001)                                               |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 10.5   |   | Fourth Lease Amendment  between Tully’s and Kent Central, LLC, dated February 21, 2001 (incorporated by reference to the Company’s  Quarterly Report on Form 10-K for the year ended April 1, 2001, as filed  with the Commission on October 19, 2001)                                             |   |
|   |   |   |                                                                                                                                                                                                                                                                                                              |   |
|   | 10.6   |   | Fifth  Lease Amendment between Kent Central, LLC and Tully’s Coffee  Corporation  (incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the quarter ended September 29, 2002, as filed with the  Commission on November 13, 2002))                                        |   |

 

71

----

 
|   | 10.7   |   | Tully’s Coffee Exclusive  License Agreement, dated April 11, 2001 between Tully’s and UCC Ueshima Coffee  Company, LTD.  (incorporated by reference to the Company’s  Current Report on Form 8-K, dated March 12, 2001, as filed with the  Commission on May 2, 2001)                                                                                                                                                              |   |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.8   |   | Tully’s Coffee License  Agreement, dated April 26, 2001, between Tully’s Coffee Corporation and  Tully’s Coffee Japan, Ltd. (incorporated  by reference to the Company’s Current Report on Form 8-K, dated  April 26, 2001, as filed with the Commission on February 12, 2002,  and subject to a request for confidential treatment filed separately with the  Securities and Exchange Commission)                       |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.9   |   | First Amendment to Tully’s  Coffee License Agreement dated October 1, 2001 between the Tully’s Coffee  Corporation and Tully’s Coffee Japan, Ltd. (incorporated  by reference to the Company’s Current Report on Form 8-K, dated  April 26, 2001, as filed with the Commission on February 12, 2002,  and subject to a request for confidential treatment filed separately with the  Securities and Exchange Commission) |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.10  |   | Second Amendment to Tully’s  Coffee License Agreement dated February 14, 2002 between the Tully’s Coffee  Corporation and Tully’s Coffee Japan, Ltd. (incorporated by reference to the  Company’s Annual Report on Form 10-K for the year ended March 31, 2002,  as filed with the Commission on July 1, 2002 and subject to a request for  confidential treatment filed separately with the Securities and Exchange  Commission)  |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.11  |   | Supply Agreement, dated April 26, 2001, between Tully’s Coffee Corporation and  Tully’s Coffee Japan, Ltd. (incorporated by  reference to the Company’s Current Report on Form 8-K, dated  April 26, 2001, as filed with the Commission on February 12, 2002,  and subject to a request for confidential treatment filed separately with the  Securities and Exchange Commission)                                             |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.12  |   | First Amendment to Supply  Agreement dated October 1, 2001 between the Tully’s Coffee Corporation and  Tully’s Coffee Japan, Ltd. (incorporated by reference to the  Company’s Current Report on Form 8-K, dated April 26, 2001, as  filed with the Commission on February 12, 2002, and subject to a request for  confidential treatment filed separately with the Securities and Exchange  Commission)                      |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.13  |   | Second Amendment to Supply  Agreement dated February 14, 2002 between the Tully’s Coffee Corporation and  Tully’s Coffee Japan, Ltd. (incorporated by reference to the Company’s Annual  Report on Form 10-K for the year ended March 31, 2002, as filed with the  Commission on July 1, 2002 and subject to a request for confidential  treatment filed separately with the Securities and Exchange Commission)                        |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.14  |   | Employment Agreement between Anthony J. Gioia and  Tully’s Coffee Corporation, dated May 13, 2002 (incorporated by reference to the Company’s Annual Report on  Form 10-K for the year ended March 31, 2002, as filed with the  Commission on July 1, 2002)                                                                                                                                                                                  |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.15  |   | Tully’s Coffee Corporation  Employment Summary dated June 21, 2002 for Kristopher S. Galvin (incorporated by reference to the Company’s  Annual Report on Form 10-K for the year ended March 31, 2002, as filed  with the Commission on July 1, 2002)                                                                                                                                                                                        |   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |
|   | 10.16  |   | Promissory Note in favor of Kent Central, LLC, dated November 1, 2002 (incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 29, 2002,  as filed with the Commission on November 13, 2002)                                                                                                                                                                                                    |   |

 

72

----

 
|   | 10.17  |   | General Security Agreement dated November 1, 2002 between Tully’s Coffee  Corporation and Kent Central, LLC (incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the  quarter ended September 29, 2002, as filed with the Commission on November  13, 2002)    |   |
|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |   |                                                                                                                                                                                                                                                                                                    |   |
|   | 10.18  |   | Form  of Guarantee for Guarantors under the Promissory Note and General Security  Agreement dated November 1, 2002(incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the quarter ended September  29, 2002, as filed with the Commission on November 13, 2002)    |   |
|   |   |   |                                                                                                                                                                                                                                                                                                    |   |
|   | 10.19  |   | Agreement  dated November 1, 2002 between Tully’s Coffee Corporation and Guarantors  re Kent Central Financing  (incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the quarter ended September 29, 2002,  as filed with the Commission on November 13, 2002) |   |
|   |   |   |                                                                                                                                                                                                                                                                                                    |   |
|   | 99.1*  |   | Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act  of 2002                                                                                                                                                                                                         |   |
|   |   |   |                                                                                                                                                                                                                                                                                                    |   |
|   | 99.2*  |   | Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act  of 2002                                                                                                                                                                                                         |   |

 

----

|   |   | *      | Filed herewith |
|--------|--------|--------|----------------|
|   |   |   | (b)            | Current Reports on  Form 8-K. |
|   |   |   |           |   |
|   |   |   |           | Form 8-K, dated February 12, 2002 – Item 5 – Other Events, related to a license and supply agreement dated  April 26, 2001 (as amended October 1, 2002) between the Company and Tully’s  Coffee Japan, Ltd. (“TCJ”).  Tully’s granted  TCJ the rights to operate,  directly and through franchisees, specialty stores in Japan; and the right to  use certain assets of the Company, including certain of its business names  and trademarks in connection with operating stores in Japan.  Additionally, Tully’s granted TCJ the  exclusive rights to make wholesale sales of roasted coffee beans and ground  coffee in Japan. |
|   |   |   |           |   |
|   |   |   |           | Item 9 – Regulation FD Disclosure, certain forward-looking statements  made by the Company at the annual meeting of the stockholders. |
|        |        |        |                |  |  |

 

73

----

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized, in Seattle, Washington onFebruary 11, 2003.

 

 
|   | **TULLY’S COFFEE CORPORATION** |
|--------|-------------------------------------|
|   |                                |   |
|   | By:                                 | /s/ Kristopher S. Galvin |
|   |                                | Vice President, Chief Financial Officer and  SecretarySigning on behalf of the Registrant and as principal financial and  accounting officer |

 

74

----

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this Report has beensigned below by the following persons on February 11, 2003 on behalf of theRegistrant and in the capacities indicated:

 
| **Signature**            |   | **Title**                                                                                           |
|--------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                     |   |                                                                                                |
| /s/ Anthony J. Gioia     |   | President, Chief Executive Officer and Director                                                     |
| Anthony J. Gioia         |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ Tom T. O’Keefe  |   | Chairman of the Board                                                                               |
| Tom T. O’Keefe      |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ Arthur Buerk         |   | Director                                                                                            |
| Arthur Buerk             |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ Larry Culver         |   | Director                                                                                            |
| Larry Culver             |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ Marc Evanger         |   | Director                                                                                            |
| Marc Evanger             |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ Larry Hood           |   | Director                                                                                            |
| Larry Hood               |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ George Hubman        |   | Director                                                                                            |
| George Hubman            |   |                                                                                                |
|                     |   |                                                                                                |
| /s/ Kristopher S. Galvin |   | Vice President, Chief Financial Officer and  Secretary (principal accounting and financial officer) |
| Kristopher S. Galvin     |   |                                                                                                |

 

75

----

 

##### **CERTIFICATION PURSUANT TO**

**18 U.S.C. SECTION 1350**

**AS ADOPTED PURSUANT TO**

**SECTION302 OF THE SARBANES-OXLEY ACT OF 2002**

 

**CERTIFICATIONS**

 

I, Anthony J. Gioia, certify that:

 

1.             I have reviewed this amended annualreport on Form 10-K/A of Tully’s Coffee Corporation;

 

2.             Based on my knowledge, this annualreport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

3.             Based on my knowledge, thefinancial statements, and other financial information included in this annualreport, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report;

 

4.             The registrant’s other certifyingofficer and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)             designed such disclosure controls and procedures toensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this annual report is being prepared;

 

b)            evaluated the effectiveness of the registrant’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this annual report (the “Evaluation Date”); and

 

c)             presented in this annual report our conclusions aboutthe effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.             The registrant’s other certifyingofficer and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a)             all significant deficiencies in the design or operationof internal controls which could adversely affect the registrant’s ability torecord, process, summarize and report financial data and have identified forthe registrant’s auditors any material weaknesses in internal controls; and

 

b)            any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant’sinternal controls; and

 

6.             The registrant’s other certifyingofficer and I have indicated in this annual report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

Date: February 11, 2003.

 
| /s/  Anthony J. Gioia             |   |
|----------------------------------------|--------|
|                                   |   |
| Anthony J. Gioia                       |   |
| President and Chief  Executive Officer |   |

 

76

----

 

**CERTIFICATION PURSUANT TO**

**18 U.S.C. SECTION 1350**

**AS ADOPTED PURSUANT TO**

**SECTION302 OF THE SARBANES-OXLEY ACT OF 2002**

 

**CERTIFICATIONS**

 

I, Kristopher S. Galvin, certify that:

 

1.             I have reviewed this amended annualreport on Form 10-K/A of Tully’s Coffee Corporation;

 

2.             Based on my knowledge, this annualreport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

3.             Based on my knowledge, thefinancial statements, and other financial information included in this annualreport, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report;

 

4.             The registrant’s other certifyingofficer and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)             designed such disclosure controls and procedures toensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this annual report is being prepared;

 

b)            evaluated the effectiveness of the registrant’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this annual report (the “Evaluation Date”); and

 

c)             presented in this annual report our conclusions aboutthe effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.             The registrant’s other certifyingofficer and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a)             all significant deficiencies in the design or operationof internal controls which could adversely affect the registrant’s ability torecord, process, summarize and report financial data and have identified forthe registrant’s auditors any material weaknesses in internal controls; and

 

b)            any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant’sinternal controls; and

 

6.             The registrant’s other certifyingofficer and I have indicated in this annual report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

Date: February 11, 2003

 
| /s/ Kristopher S. Galvin                |   |
|-----------------------------------------|--------|
|                                    |   |
| Kristopher S. Galvin                    |   |
| Chief Financial and  Accounting Officer |   |

 

77

----