**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-K**




**(Mark
                One)**x
            **Annual
                Report Pursuant to Section 13 of 15(d) of the Securities Exchange
                Act of
                1934**For
                the fiscal year ended:**December
                30, 2007**Oro
            **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: 0-28258









**SHELLS
      SEAFOOD RESTAURANTS, INC.**


(Exact
      name of registrant as specified in its charter)





**DELAWARE**
            **65-0427966**(State
                or other jurisdiction of
              incorporation
                or organization)
            (I.R.S.
                Employer
              Identification
                No.)**16313
                North Dale Mabry Highway, Suite 100,**
              **Tampa,
                Florida**
            **33618**(Address
                of principal executive offices)
            (Zip
                Code)





**(813)
      961-0944**


(Registrant’s
      telephone number, including area code)





Securities
      registered pursuant to Section 12(b) of the Act:




[
            Title
                of each class
            
            Name
                of each exchange on which registered
            ][
            Common
                Stock, $0.01 par value per share
            
            OTC
                Bulletin Board
            ]





Securities
      registered pursuant to Section 12(g) of the Act:


Common
      Stock, $0.01 par value per share.





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.


Yes o    No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act.


Yes o    No x





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days. Yes x No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant's knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. o







Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting company.
      See
      the definitions of “large accelerated filer”, “accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act (Check
      one): Large
      Accelerated Filer o


Accelerated
      Filer o Non-accelerated
      filer oSmaller
      Reporting Company x





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


Yes o  60;  No x





As
      of
      July 1, 2007 (the last business day of the registrant’s most recently completed
      second fiscal quarter), the aggregate market value of the registrant’s common
      stock held by non-affiliates of the registrant (which for these purposes
      excludes directors, executive officers, and ten-percent holders of stock) was
      $1,364,000 based on the closing sale price as reported on the Over-the-Counter
      Bulletin Board.





Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as of the latest practicable date.




Class
            
            Outstanding
                at February 26, 2008Common
                Stock, $0.01 par value per share
            
            23,537,948
                shares





**DOCUMENTS
      INCORPORATED BY REFERENCE**




Document
              
              Parts
                  Into WhichIncorporatedAnnual
                  Report to Stockholders for the Fiscal Year Ended December 30, 2007
                  (Annual
                  Report)
              
              Parts
                  I, II, and IVProxy
                  Statement for the Annual Meeting of Stockholders scheduled to be
                  filed
                  with the SEC within 120 days after the end of the fiscal year ended
                  December 30, 2007 (Proxy Statement)
              
              Part
                  III









**FORWARD
      LOOKING STATEMENTS**





When
      used
      in this Annual Report on Form 10-K, the words "believes", “intends”,
      "anticipates", "expects", and similar expressions are intended to identify
      forward-looking statements. These statements are subject to certain risks and
      uncertainties, which could cause actual results to differ materially from those
      projected.





In
      addition to seasonal fluctuations, the Company’s quarterly and annual operating
      results are affected by a wide variety of other factors that could materially
      and adversely affect revenues and profitability, including changes in consumer
      preferences, tastes and eating habits; increases in food, labor and other
      operating costs; the availability of food acceptable to our quality standards
      at
      acceptable prices; the availability of qualified labor; national, regional
      and
      local economic and weather conditions; international economic, cultural and
      political conditions; ** promotional
      timings and seasonality; demographic trends and traffic patterns; changes in
      travel and tourism tendencies, particularly in light of world events;
      competition from other restaurants and food service establishments; availability
      of third party financing to fund capital or operating activities, if required;
      changes in personnel, including senior management; and the timing, costs and
      charges relating to restaurant openings, closings and remodelings. As a result
      of these and other factors, the Company may experience material fluctuations
      in
      future operating results on a quarterly or annual basis, which could materially
      and adversely affect its business, financial condition and stock price.
      Furthermore, this document and other documents filed by the Company with the
      Securities and Exchange Commission (“SEC”) contain certain forward-looking
      statements with respect to the business of the Company and the industry in
      which
      it operates. These forward-looking statements are subject to certain risks
      and
      uncertainties, including those mentioned above, which may cause results to
      differ significantly from these forward-looking statements. The Company
      undertakes no obligation to update these forward looking statements on a regular
      basis. An investment in the Company involves various risks, including those
      mentioned above and those that are detailed from time-to-time in the Company’s
      SEC filings.





Any
      forward-looking statements included in this Annual Report reflect our beliefs
      only as of the date of this document. We do not undertake any obligation to
      publicly release the results of any revisions to these forward-looking
      statements which may be made to reflect events or circumstances after the date
      of this document or to reflect the occurrence of unanticipated events, unless
      we
      are required to do so by law.


2





**SHELLS
      SEAFOOD RESTAURANTS, INC.**





**INDEX
      TO ANNUAL REPORT ON FORM 10-K**


**For
      the Fiscal Year Ended December 30, 2007**





**TABLE
      OF CONTENTS**


**Page
                  No.****PART
                  I**Item
                  1. Business
              4Item
                  1A. Risk Factors
              12Item
                  1B. Unresolved Staff Comments
              20Item
                  2. Properties
              21Item
                  3. Legal Proceedings
              21Item
                  4. Submission of Matters to a Vote of Security Holders
              22**PART
                  II**Item
                  5. Market for Registrant’s Common Equity, Related Stockholder Matters and
                  Issuer Purchases of Equity Securities
              22Item
                  6. Selected Financial Data
              26Item
                  7. Management’s Discussion and Analysis of Financial Condition and Results
                  of Operation
              28Item
                  7A. Quantitative and Qualitative Disclosures About Market
                  Risk
              38Item
                  8. Financial Statements and Supplementary Data
              39Item
                  9. Changes in and Disagreements With Accountants on Accounting
                  and
                  Financial Disclosure
              40Item
                  9A(T). Controls and Procedures
              40Item
                  9B. Other Information
              41**PART
                  III**Item
                  10. Directors, Executive Officersand
                  Corporate Governance
              42Item
                  11. Executive Compensation
              42Item
                  12. Security Ownership of Certain Beneficial Owners and
                  Management and Related Stockholder Matters
              42Item
                  13. Certain Relationships and Related Transactions,
                  and Director Independence
              42Item
                  14. Principal Accounting Fees and Services
              42**PART
                  IV**Item
                  15. Exhibits and Financial Statement Schedules
              43Signatures
              48


3


**PART
      I**





**ITEM
      1. BUSINESS**





Shells
      Seafood Restaurants, Inc. was incorporated under the laws of the State of
      Florida in April 1993 and was reincorporated under the laws of the State of
      Delaware in April 1996. Effective December 1994, Shells, Inc., a company
      incorporated under the laws of the State of Florida, was merged with and into
      our company and became our wholly-owned subsidiary.





**Concept
      and Strategy**





Shells
      is
      a full-service, casual dining seafood concept designed to appeal to a broad
      range of customers by providing generous portions of high-quality seafood at
      reasonable prices, warm, friendly service, and a relaxed, appealing atmosphere.
      Shells restaurants feature a wide selection of seafood items, including shrimp,
      oysters, clams, scallops, crawfish, mussels, lobster, crab and daily fresh
      fish
      specials, cooked to order in a variety of ways: steamed, sautéed, grilled,
      blackened and fried. In addition, our restaurants offer a wide selection of
      signature pasta dishes, appetizers, salads, and desserts and full bar service.
      All Shells restaurants are open for lunch and dinner.





As
      of
      December 30, 2007, our fiscal year end, we owned 19 Shells restaurants, owned
      a
      51% ownership interest in one Shells restaurant and managed three additional
      licensee-owned Shells restaurants pursuant to contractual arrangements. All
      of
      our restaurants are located in Florida.





We
      believe that the seafood segment of the restaurant industry in which Shells
      operates has greater growth opportunities than other, more crowded casual dining
      segments. While there have been additional competitors entering this market
      in
      recent years, the number of regional and national chains serving this market
      is
      still relatively small. We believe that seafood consumption will continue to
      increase given that seafood’s healthful aspects are regularly touted by
      scientific studies and subsequent media coverage.





The
      original Shells model of serving low-price seafood in a no-frills atmosphere
      began to face difficulties in the late ‘90s with heightened consumer demands for
      flavor, quality, variety and atmosphere. New competitors entered the market
      to
      meet these demands and Shells did not keep pace. In addition, our company
      finances were weakened by a difficult Midwest expansion and the physical
      condition of several restaurants began to deteriorate.





Since
      late 2003, we worked to update and strategically reposition the Shells concept
      by elevating the freshness, quality and variety of our food, improving our
      service levels and significantly enhancing our atmosphere through remodeling
      our
      restaurants. We implemented a two-tier pricing strategy that was intended to
      expand our ability to profitably build check average and sales. We continue
      to
      adapt our menu to maintain the price to value relationship, which Shells is
      known for, primarily through our seafood pastas and fried entrees. We have
      re-engineered our product sourcing, menu offerings and seasonal promotions
      to
      allow us to also deliver fresher, higher-quality seafood combinations and
      premiere menu items, such as lobster, at competitive prices. We leverage the
      quality, freshness and variety attributes through our marketing
      efforts.





Enhancing
      our ability to execute these concept improvements, we recruited new operations
      talent into our company and continuously focus on maintaining high operating
      standards throughout our restaurants.


4





Generating
      sales through improvements in guest traffic is critical to our future success.
      Since the fourth quarter of 2006, we have encountered an increasing erosion
      in
      guest traffic and sales as economic conditions in the state of Florida have
      worsened. Our initiatives throughout 2007 have focused on creating greater
      value
      in the food that we serve, reducing unnecessary costs within the company and
      redirecting our marketing strategies to better ensure
      effectiveness.





We
      are
      continuing to execute our turnaround strategy in a very challenging economic
      environment. We believe significant opportunities exist to both improve sales
      and profits, and ultimately to opportunistically expand our brand
      further.





In
      2007,
      we sold the Shells service marks and system in certain middle eastern countries
      to Food and Entertainment Company, LTD. in a 10-nation development agreement.
      This arrangement not only provides us with ongoing revenue from a related
      consulting and services agreement, but also builds our brand internationally
      and
      opens the door for future international development opportunities.





**Restaurant
      Locations**





Our
      managed and operated restaurants are located in the following Florida markets
      and cities/neighborhoods:





**Tampa/Sarasota**
            **Orlando**
            **South
                Florida**Brandon
            Daytona
                Beach
            KendallClearwater
                Beach
            Kissimmee
            Pembroke
                PinesHolmes
                Beach
            New
                Smyrna Beach
            SunriseRedington
                Shores
            OcalaSt.
                Pete Beach
            OrlandoSt.
                Petersburg
            Winter
                ParkWinter
                Haven
            MelbourneNorth
                TampaSarasotaSouth
                Tampa**West
                Palm Beach**
            **Fort
                Myers**Stuart
            Fort
                MyersWest
                Palm Beach





During
      2007, we closed two under-performing restaurants. We continuously review the
      performance of each restaurant’s unit economics and location, and regularly
      evaluate new real estate sites in Florida for potential expansion or relocation.


5





**Restaurant
      Operations**





**Management
      and Employees** .
      We
      currently employ three area directors. Each area director is responsible for
      the
      management of several restaurants, including management development, recruiting,
      training, quality of operations and unit profitability. The staff of a typical
      restaurant consists of one general manager, two or three assistant managers
      and
      approximately 60 other employees. Restaurant management and area directors
      participate in a bonus program based upon the financial results of their
      particular restaurant or restaurants.




**Recruitment
      and Training.** We
      believe that attaining continuously high service standards will better allow
      us
      to achieve long-term and sustainable success. We make substantial investments
      in
      the training and development of our managers, recognizing the direct
      relationship between this and strong restaurant-level performance. We generally
      recruit managers with significant experience in the full-service sector of
      the
      restaurant industry.





During
      their training, managers are taught all aspects of the quality of our products
      and service. We focus on food safety and food handling procedures, hospitality,
      our operating standards, and cost management methods. In addition, we provide
      week-long workshops for our managers with additional training in employee
      relations, guest satisfaction, operating systems and career
      development.





Our
      recruiting efforts focus on identifying and hiring individuals with a strong
      service and teamwork orientation. Our restaurant staffs are trained in each
      location by certified trainers in both the front and back of the house. We
      work
      diligently to retain our managers and employees, recognizing that greater tenure
      has positive benefits on the service we provide to guests, as well as managing
      quality and costs effectively.





**Restaurant
      Reporting.** We
      maintain financial and accounting controls for each restaurant through a central
      accounting system. Our financial systems and controls allow us to access each
      restaurant's sales, inventory costs and other financial data on a real-time
      basis, enabling both store-level management and senior management to quickly
      react to changing sales trends, to effectively manage food, beverage and labor
      costs, to minimize theft, and to improve the quality and efficiency of
      accounting and audit procedures. Store level management performs weekly
      inventories and manages weekly operating results versus budget.





**Purchasing.** Obtaining a reliable supply of quality ingredients with a primary focus on
      seafood at competitive prices is critical to our success. We have formed
      long-term relationships with several suppliers, manufacturers and harvesters
      of
      seafood. We purchase in bulk both fresh and frozen seafood and certain
      other supplies used in restaurant operations. In addition, Shells' menu has
      been
      designed to feature seafood varieties with stable sources of supply, as well
      as
      to provide flexibility to adjust to shortages and to take advantage of
      occasional purchasing opportunities. We believe our diverse menu selection
      helps
      minimize the effects of shortages of most seafood products. We generally have
      been able to anticipate and react to fluctuations in food costs through selected
      menu price adjustments, purchasing seafood directly from numerous suppliers
      and
      promoting certain alternative menu selections in response to availability and
      price of supply.




Performance
      Food Group of Florida has been our primary distributor since October 2002.
      Performance Food Group purchases and takes delivery of the products that we
      contract for purchase, according to our specifications and subject to our
      quality assurance inspections.  Based on purchase orders initiated by our
      restaurants, Performance Food Group then sells the food products to us on a
      cost plus basis, and distributes the food products directly to our
      restaurants. From time-to-time, at our direction to facilitate a forward
      purchase opportunity, Performance Food Group acquires inventory in excess
      of normal recurring restaurant delivery and re-supply, which approximates 30
      days supply.  We pay interest on inventory holdings above 60-day supply
      levels, at a fixed interest rate of 7.8% per annum.  In addition,
      Performance Food Group procures, on our behalf, many of our operating
      supplies, and distributes and sells these products to the individual restaurants
      at agreed upon price mark-ups.


6





**Quality
      Control.** We
      maintain a continuous quality assurance inspection program for all of our
      seafood and protein purchases. Each shipment of frozen seafood or other protein
      is inspected through statistical sampling methods upon receipt at Performance
      Food Group’s distribution center for quality and conformity to our written
      specifications, prior to delivery to the restaurants.  Fresh fish and
      produce are also inspected on a random basis by our quality control inspector.
      Randomly, we also inspect the facilities and vehicles in which these products
      are processed, stored, or shipped to our restaurants.  In addition, fresh
      fish purchased by our individual restaurants must be purchased from one of
      our approved suppliers and is inspected by a restaurant manager at the time
      of
      delivery. As part of our training program, restaurant employees are educated
      as
      to the correct handling and proper physical characteristics of each
      product.




Our
      area
      directors, general managers and assistant managers are all responsible for
      properly training hourly employees and for ensuring that Shells restaurants
      are
      operated in accordance with strict health, quality and food safety standards.
      Compliance with our quality standards is monitored by on-site visits and formal
      inspections by the area directors. We believe that our inspection procedures
      and
      employee training practices help to maintain high standards of quality and
      safety of the food and service we provide.




**Advertising
      and Marketing**





Our
      marketing efforts leverage the use of billboard, newspaper, radio and television
      advertising to raise awareness of the Shells brand and to inform new and
      existing customers about our promotions. The fact that our restaurants are
      generally clustered in particular media markets helps us obtain cost-effective
      advertising. We also stage in-store promotions and various local marketing
      efforts to help our restaurants partner with their communities.





Across
      most major markets, our broad scale marketing initiatives included network
      television, radio, outdoor signage, newspaper, concentrated internet and direct
      mail campaigns. The 2007 marketing initiatives focused on value offerings with
      the Florida economy slowing down. Using several forms of media, the value
      message was driven by radio, TV, print and email marketing programs. We also
      continued our local store marketing program, providing all of our restaurants
      with resources to take advantage of an array of sales-building initiatives.
      This
      included couponing initiatives targeted at increasing guest traffic, to go
      sales, price point discount offers and local school and community
      events.





Based
      upon the positive impact on sales from the use of radio in 2006, we continued
      with radio advertising in 2007 in all markets, adding the Ft. Myers and West
      Palm Beach markets in the first quarter and part of the second quarter of the
      2007. The message was delivered via DJ endorsements and personal spokespersons
      in each market. The radio was coupled with in restaurant events including live
      broadcasts and giveaways.





The
      marketing medium was changed in the second quarter of 2007, when sales continued
      to decline. With a limited budget we were able to create a new television
      commercial that associated our brand with images of plated food and images
      of
      the restaurant full of people. The commercials included a $9.99 offering, which
      targeted the value driven guest. We supported the on-air advertising with
      in-store point-of-purchase promotions.


7





We
      continue to use Dunn and Company as our advertising agency. Dunn and Company
      is
      responsible for all creative and media buying services for Shells. The agency
      assists us with various branding elements, including menu and store
      point-of-purchase promotion materials.





**Joint
      Venture and Third-Party Owned Restaurants**





The
      Shells restaurant system currently consists of (i) 19 restaurants that are
      wholly owned by us; (ii) one restaurant, in Melbourne, Florida, in which we
      have
      a 51% ownership interest, and (iii) three restaurants that we manage and
      operate, but do not own. In addition to the equity interest in the Melbourne
      restaurant, we receive a management and licensing fee of 6% of the restaurant
      sales.





Two
      of
      the managed restaurants are managed and operated by us pursuant to agreements,
      originally entered into in July 1993. Pursuant to these agreements, we provide
      management services and license proprietary information required to operate
      these restaurants in return for a percentage of each restaurant's sales. The
      agreements, as amended in October 2001, provide for a 4% management fee until
      such time as sales return to near 1999 levels, and then increasing to a 6%
      fee.
      Of the total management fee received, 2% of sales is placed in escrow and
      disbursed to a third party to satisfy each managed restaurants’ requirement to
      make third party royalty payments. The management agreements generally grant
      us
      authority to determine the programs and policies affecting the day-to-day
      operations of each of these managed restaurants, have a remaining term of
      approximately 17 years, and provide that the third-party owners are responsible
      for funding all restaurant expenses, including food and beverage costs,
      staffing, training, recruiting, inventory, working capital, and capital
      investment.





We
      operate the third managed restaurant pursuant to an oral agreement requiring
      that the restaurant is operated in conformity with the policies and procedures
      established by us for Shells restaurants. Consistent with the amended management
      agreement for our other managed restaurants, beginning in October 2001, we
      receive a net management fee of 2% of the restaurant's sales.




In
      the
      past, the enforceability of these management and license agreements has been
      questioned by certain of the licensees. Although we believe the agreements
      are
      enforceable, there can be no assurance that the agreements will not be
      challenged in the future, and, if challenged, that the agreements will be
      determined to be enforceable.





**International
      Restaurants**





In
      December 2007, we entered into an agreement to sell our marks and system in
      certain middle eastern countries to Food and Entertainment Co., LTD, an entity
      owned by the Alhokair Group, a company domiciled in the Kingdom of Saudi Arabia.
      We sold the development rights to Food and Entertainment to open 10 restaurants
      over a 10-year period, solely within a territory to initially consist of the
      Kingdom of Saudi Arabia, Egypt, Jordan, Qatar, Oman, Bahrain, United Arab
      Emirates, Kuwait, Pakistan, India and based on additional performance criteria,
      Tunisia and Morocco.





In
      conjunction with such sale of our marks and system, we also entered into an
      agreement to provide technical consulting and support services to Food and
      Entertainment for a 10-year period, with two options to renew, at the election
      of Food and Entertainment, for additional five year periods. The technical
      and
      support services to be provided under such agreements include restaurant design,
      operations, training, product sourcing and menu engineering for which we receive
      a fee of 1% of Food and Entertainment’s gross sales of its Shells restaurants in
      operation, payable monthly. The first international restaurant is under
      development and is scheduled to open in 2008. ******


8





**Competition**





The
      restaurant industry is intensely competitive with respect to price, service,
      location, food quality and variety, and there are many well-established
      competitors with substantially greater financial and other resources. These
      competitors include national, regional and local full-service casual dining
      chains, some of which specialize in or offer seafood products. We also face
      competition from a broad range of other restaurants and foodservice
      establishments, including full-service and quick service restaurants, which
      specialize in a variety of cuisines. Some of our competitors have been in
      existence for substantially longer periods than we have, and may be better
      established in the markets where we have our restaurants. In addition, we
      believe that the full-service casual dining segment is likely to attract a
      significant number of new entrants, some offering seafood products. We believe
      Shells is competitively positioned within the industry due to our relative
      value
      proposition and points of differentiation, as discussed previously.





**Government
      Regulation**





We
      are
      subject to extensive federal, state and local government regulation by various
      governmental agencies, including state and local licensing, zoning, land use,
      construction and environmental regulations and various regulations relating
      to
      the sale of food and alcoholic beverages, sanitation, disposal of refuse and
      waste products, public health, safety and fire standards. Our restaurants are
      subject to periodic inspections by governmental agencies to ensure conformity
      with these regulations. Difficulties or failure in obtaining required licensing
      or other regulatory approvals could delay or prevent the opening of a new
      restaurant, and the suspension of, or inability to renew, a license at an
      existing restaurant could adversely affect our operations. Restaurant operating
      costs are also affected by other government actions beyond our control,
      including annual increases in minimum hourly wage requirements, such as those
      that were implemented in Florida beginning in 2005. Other measures largely
      beyond our control that can impact operating costs include workers compensation
      and property insurance rates, health care insurance costs and unemployment
      and
      other taxes.





Approximately
      14% of our revenue is attributable to the sale of alcoholic beverages. Alcoholic
      beverage control regulations require each of our restaurants to apply to a
      state
      authority and, in certain locations, county or municipal authorities for a
      license or a permit to sell alcoholic beverages on the premises. Typically,
      licenses must be renewed annually and may be revoked or suspended for cause
      at
      any time. Alcoholic beverage control regulations relate to numerous aspects
      of
      daily operations of our restaurants, including minimum age of patrons and
      employees, hours of operation, wholesale purchasing, inventory control and
      handling, storage and dispensing of alcoholic beverages. The failure of a
      restaurant to obtain or retain liquor or food service licenses would adversely
      affect the restaurant’s operations.





We
      are
      also subject to "dram-shop" statutes, which generally provide a person injured
      by an intoxicated person the right to recover damages from an establishment
      that
      wrongfully served alcoholic beverages to the intoxicated person. We carry liquor
      liability insurance coverage as part of our existing comprehensive general
      liability insurance.


9




Our
      restaurants are subject to federal and state minimum wage laws governing such
      matters as working conditions, overtime and tip credits. A significant number
      of
      our restaurant personnel are paid at rates related to the state minimum wage
      which exceeds the federal rate and, accordingly, further increases in Florida’s
      minimum wage rate could increase our labor costs.





The
      Americans with Disabilities Act prohibits discrimination in employment and
      public accommodations on the basis of disability. Under the Act, including
      in
      situations where we elect to acquire or purchase a restaurant, we could be
      required to expend funds to modify our restaurants to better provide service
      to,
      or make reasonable accommodations for the employment of, disabled
      persons.





**Service
      Marks and Proprietary Information**





We
      have
      registered the service mark "Shells" with the Secretary of the State of Florida
      and the “Shells” service mark and “jumping fish” logo with the United States
      Patent and Trademark Office. In addition, Food and Entertainment Co., LTD is
      in
      the process of registering the “Shells” service mark in the Kingdom of Saudi
      Arabia. We believe that our service marks have significant value and are
      essential to our ability to create demand for, and brand awareness of, our
      restaurants. There can be no assurance, however, that our service marks do
      not
      or will not violate the proprietary rights of others, that they would be upheld
      if challenged or that we would not be prevented, in such an event, from using
      our service marks, any of which could have a material adverse affect on us.
      Although there can be no assurance that we will have the financial resources
      necessary to enforce or defend our service marks, we have vigorously opposed,
      and intend to continue to oppose vigorously, any infringement of our service
      marks.





We
      also
      rely on trade secrets and proprietary knowledge and employ various methods
      to
      protect our concepts and recipes. These methods may not afford complete
      protection, and there can be no assurance that others will not independently
      develop similar knowledge or obtain access to our knowledge, concepts and
      recipes.





**Employees**





As
      of
      December 30, 2007, we employed approximately 850 persons, of whom approximately
      120 were management or administrative personnel employed on a salaried basis
      and
      730 were employed in non-management restaurant positions on an hourly basis.
      Approximately 370 employees are employed on a full-time basis. We consider
      our
      employee relations to be good. No employees are covered by a collective
      bargaining agreement.





**Our
      Executive Officers**





Our
      executive officers are:




Name
            
            Age
            
            PositionGuy
                C. Kathman
            
            51
            
            Vice
                President of OperationsWarren
                R. Nelson
            
            56
            
            Interim
                President, Chief Financial Officer, Treasurer and
                Secretary




10


**Guy
      C. Kathman** has been
      our Vice-President of Operations since joining Shells in September 2003. From
      2001 to 2003, Mr. Kathman was employed by Posados Café as a General Manager.
      From 1997 to 2001, Mr. Kathman was employed by Brinker International, On the
      Border Restaurants, as a Regional Director of Operations.





**Warren
      R. Nelson** currently serves as our interim President to which he was appointed on February
      29, 2008. Mr. Nelson has served as Executive Vice-President of Finance, Chief
      Financial Officer, Treasurer, and Secretary, since June 1993. Mr. Nelson is
      also
      Treasurer and a member of the Board of Trustees for a non-profit, the Florida
      Chapter of the ALS Association.





Our
      board
      of directors has adopted a Code of Business Conduct and Ethics that applies
      to
      our board members, as well as our principal executive officer and principal
      financial officer, and our other officers and employees. This Code of Business
      Conduct and Ethics is available on our web site, at www.shellsseafood.com.
      We
      intend to satisfy the amendment and waiver disclosure requirements under
      applicable securities regulations by posting any amendments of, or waivers
      to,
      the Code of Business Conduct and Ethics on our web site. A copy of our Code
      of
      Business Conduct and Ethics will be sent without charge upon request in writing
      addressed to us at: 16313 N. Dale Mabry Hwy, Suite 100, Tampa, Florida 33618,
      c/o Secretary.




11


**Item
      1A. Risk Factors**





*The
      risks and uncertainties described below are not the only risks we face. In
      addition to the following risk factors, we refer you to those risk factors
      described elsewhere in this Annual Report on Form 10K and in various of our
      publicly reported documents. Further risks and uncertainties not presently
      known
      to us, or that we currently believe are immaterial, could also impair our
      business operations.*




*Keep
      these risk factors in mind when you read "forward-looking" statements elsewhere
      in this Form 10K. These are statements that relate to our expectations for
      future events and time periods. Generally, the words "anticipate," ”believe,”
"expect," "intend" and similar expressions identify forward-looking statements.
      Forward-looking statements involve risks and uncertainties. Future events and
      circumstances could differ significantly from those associated with the
      forward-looking statements.*





***We
      have continuing capital requirements and a history of
      losses.*** Historically, our cash requirements have exceeded our cash flow from operations.
      This has been due to costs associated with developing and opening restaurants,
      as well as the operating performance of certain restaurants. We have experienced
      operating and net losses during the majority of the recent prior years. As
      of
      December 30, 2007, we had a working capital deficiency of $4,712,000 and a
      cash
      balance of $458,000. In 2007, we incurred a net loss of $4,400,000, and we
      invested $439,000 in property and equipment. As of December 31, 2006, we had
      a
      working capital deficiency of $4,446,000 and a cash balance of $734,000. In
      2006, we incurred a net loss of $3,002,000, and we invested $1,774,000 in
      property and equipment. In addition, in 2007, we experienced a significant
      decline in sales and customer traffic. There are no assurances that our
      strategies will reverse the recent trend in sales and customer traffic declines
      as necessary to meet our contemplated cash flow requirements. There can be
      no
      assurances that further losses will not be experienced in the future.





***Our
      independent registered public accounting firm has indicated substantial doubt
      about our ability to continue as a “going concern.”*** Our
      current independent registered public accounting firm, in their report with
      respect to our financial statements as of December 30, 2007 includes a “going
      concern” opinion.  As discussed in Note 1 to the audited financial
      statements, we have incurred significant losses for the years ended December
      30,
      2007, December 31, 2006 and January 1, 2006, have an accumulated deficit,
      and have a secured promissory note which is due in May 2008. Sufficient
      liquidity to satisfy working capital requirements, make the scheduled debt
      reduction under the promissory note if the maturity date is not extended, and
      repay other debt obligations; is dependent primarily on the realization of
      cash
      flow from operations and obtaining alternative financing sources. There can
      be
      no assurances that these initiatives will be successful.  Because of these
      conditions, our independent registered public accounting firm has raised
      substantial doubt about our ability to continue as a going concern.





***Operating
      expenses may increase.*** Since
      2005, we have incurred annual increases in labor costs due to the Florida
      minimum wage rate increase. Many of our commodity and operating costs have
      increased in 2007, generally stemming from escalating fuel costs. The cost
      of
      utilities continues to rise due to increasing energy costs. Insurance expenses
      increased mostly as a result of the hurricanes in 2004 and 2005. However, we
      have seen recent moderation in insurance costs, to include reductions in costs
      in 2008. Due to the significant increase in real estate market values throughout
      Florida, we also have incurred significant increases in real estate taxes
      generally over the past several years. We have seen a moderation in recent
      real
      estate tax trends, as the real estate market in Florida has significantly
      weakened relative to the state’s economy. In addition, certain of our leases are
      coming up for renewal or expiring over the next several years. Increases in
      rent
      expense may occur as a result of renewing current leases or negotiating new
      lease terms. There can be no assurances that any future increases in menu
      pricing or guest traffic will be adequate to compensate for these and any other
      operating cost increases.




12


***We
      may be unable to repay certain of our debts when they
      mature*** .
      Certain
      of our investors have funded a $1,440,000 line of credit which matures in May
      2008. In March 2007, the maturity date of the line of credit was extended from
      May 23, 2007 to May 23, 2008 at a fee of 7% of the $1,440,000 borrowed. There
      are no assurances that such investors will continue to extend the maturity
      date
      on this note or that adequate financing options will be available to us when
      necessary or at terms that we find acceptable.




We
      have a
      promissory note outstanding through Colonial Bank, for the financing of our
      joint venture restaurant, located in Melbourne, Florida. As of December 30,
      2007, we owed $607,000 on the principal balance of this note, which matures
      in
      September 2012. Additionally, on January 16, 2008, we entered into a line of
      credit agreement with Colonial Bank, pursuant to which we have borrowed $140,000
      of the $350,000 available under the credit line. The line of credit facility
      matures on September 19, 2008 and is secured by a $1,050,000 letter of credit
      with Food and Entertainment Co., LTD.




Each
      of
      the notes relating to the restaurant property, the $1,440,000 line of credit,
      and the $350,000 line of credit are secured by certain of our assets. Any
      failure by us to pay these debts as they mature would allow holders of these
      debts to seize and sell certain of our assets to satisfy the amounts owed to
      them.




***Our
        ability to use net operating loss carryforwards and general business credits
        to
        reduce future tax payments may be further limited if there are additional
        changes in ownership of Shells*** **.** As
        of
        December 30, 2007, for federal income tax purposes, we had approximately
        $12,317,000 of net operating loss carryforwards, or NOLs, available to reduce
        taxable income in future years and approximately $3,969,000 of general business
        credits to carry forward. We believe that a substantial amount of these NOLs
        and
        credits are currently subject to an annual limitation under sections 382
        and 383
        of the Internal Revenue Code of 1986, as amended, as a result of ownership
        changes in 2002 and our sale of additional equity in 2005 to persons previously
        unassociated with our company. We
        estimate the limit to NOLs and credit carryforwards that may be used against
        taxable income to be approximately $75,000 per year for NOLs occurring prior
        to
        the 2002 ownership change, and $665,000 per year for NOLs occurring prior
        to the
        2005 ownership change. Any portion of the annual limitation amounts not utilized
        in any year will carry forward to the following year, subject to a 15 to
        20 year
        limitation. Any additional sale of equity may result in further restricting
        our
        ability to utilize NOLs or credit carryforwards.




***Substantial
      dilution to our stockholders is possible*** *.* As
      of
      March 10, 2008, there were outstanding 23,538,000 shares of common stock, and
      warrants, options or other convertible securities outstanding to purchase an
      additional 12,434,000 shares of common stock, including options and warrants
      representing 10,570,000 shares of common stock at an average exercise price
      of
      $1.04 per share.




Over
      the
      last five years, we raised $11.3 million through issuing securities, including
      warrants and preferred stock convertible as of March 10, 2008 into 7,614,000
      shares of our common stock. As of March 10, 2008, 18,493,000 shares of our
      common stock have been issued relating to these warrants and preferred stock.
      Many of these securities have anti-dilution protection provisions, which will
      become operative upon our issuance of additional securities at below specified
      dollar amounts.




In
      March
      2005, we amended our certificate of incorporation to increase the total number
      of authorized shares of our common stock from 20,000,000 shares to 40,000,000
      shares. Subsequently, in June 2005, our stockholders approved a further increase
      of the total number of authorized shares of our common stock from 40,000,000
      shares to 58,000,000 shares. We
      may
      require additional financing in 2008. Certain forms of capital raising may
      result in substantial additional dilution to our existing stockholders. In
      addition, we expect to issue a substantial number of shares of our common stock
      or stock options to any person hired as our new Chief Executive
      Officer.




13




***Control
      is concentrated among a few individuals*** .
      Frederick R. Adler, James Adler, Bruce Galloway and Trinad Capital, significant
      stockholders, together with members of our board of directors and executive
      management team, are beneficial owners of record, in the aggregate, of
      approximately 62.9%
      of
      our outstanding voting shares, consisting of Common Stock and Series B
      Convertible Preferred Stock, as of March 10, 2008 and are able to control the
      business and affairs of our company, including the election of our directors
      and
      decisions regarding any proposed dissolution, merger or sale of our assets.




***We
      depend on key personnel.*** Our
      success is largely dependent upon our executive management and other key
      personnel. The loss of the services of one of our executives or other key
      personnel could materially adversely affect us. Our success may also depend
      on
      our ability to attract and retain qualified management restaurant industry
      personnel.




***Operating
      results may require the closure of additional
      restaurants*** **.** If we
      experience prolonged periods of unfavorable operating results at any existing
      restaurants, view the prospects for a restaurant to be less than satisfactory,
      or do not renew a restaurant lease due to its operating results, we may elect
      to
      close or relocate restaurants. The lack of success or closing of any of our
      restaurants could have an adverse effect upon our financial condition and
      results of operations. We closed 16 restaurants during 2001, of which 14 were
      located in the Midwest and two were located in Florida. We closed one restaurant
      in 2002, three restaurants in 2004 and one restaurant in 2005. Additionally,
      in
      2005, we relocated one restaurant to a higher volume location and opened two
      new
      restaurants. In 2007, we closed two restaurants. We continually monitor the
      operations and financial performance with respect to certain of our other
      existing restaurants. Many of our costs are fixed, and a reduction in the number
      of units open for operation results in decreased sales leverage.




***Our
      operating results fluctuate seasonally because of our geographic concentration
      in Florida.*** We
      experience significant fluctuations in our quarter-to-quarter operating results
      because of factors including the seasonal nature of our business and weather
      conditions in Florida, which may be severe periodically and may include damaging
      hurricanes.





Our
      restaurants are all located in Florida and can be affected by the health of
      Florida’s economy in general, and of the tourism industry in particular, which
      can further be affected by anticipated world events, as well as economic trends.
      In addition, while the majority of our restaurants are located primarily in
      residential areas in Florida, many of our restaurants are located in seasonal
      tourist areas.





Our
      restaurant sales generally increase from January through April and June through
      August, the peaks of the Florida tourism season, and generally decrease from
      September through mid-December. In addition, because of our present geographic
      concentration, adverse publicity relating to our restaurants or adverse weather
      conditions could have a more pronounced adverse affect on our operating results
      than if our restaurants were more geographically dispersed. Adverse weather
      conditions or a decline in tourism in Florida, or in general economic
      conditions, which would likely affect the Florida economy or tourism industry,
      particularly during the time of peak sales, could materially adversely affect
      our operations and prospects. Because of the seasonality of our business, our
      results for any quarter are not necessarily indicative of the results that
      may
      be achieved for a full year.


14




***Future
      hurricanes may be a risk to us.*** **** In
      recent
      years, the effects of hurricanes on the local economies in Florida and other
      states in the Gulf of Mexico region have been significant. During the third
      and
      fourth quarters of 2004 and the fourth quarter of 2005, we incurred substantial
      business and property losses as a result of several hurricanes that struck
      Florida. Property damage or interruption of operations from any future
      hurricanes may have a material adverse effect on our business and
      profitability.


***Revenue
      from international operations may not be realized.*** In
      December 2007, we entered into an agreement to sell our marks and system in
      certain middle eastern countries to Food and Entertainment Co., LTD. Concurrent
      with the sale of our service marks, we entered into a ten year technical
      consulting and services agreement with Food and Entertainment Co., LTD for
      which
      we are to receive 1% of gross sales from the Shells restaurants operated by
      Food
      and Entertainment Co. While we require that Food and Entertainment Co. maintain
      a non-revocable letter of credit sufficient to protect our ability to collect,
      we cannot assure you that the amounts provided under the letter of credit will
      be adequate to fully compensate us under certain conditions of default, if
      incurred. We can not assure you that international cultural, economic or
      political conditions will not interrupt the operations of Shells international
      locations or affect the enforceability of the technical consulting and services
      agreement.





***The
      supply and quality of our seafood may fluctuate.*** **** In
      recent
      years, the availability of certain types of seafood has fluctuated. This has
      resulted in a corresponding fluctuation in prices. We maintain both long and
      short-term contracts with the majority of our suppliers. We contract products
      direct with the manufacturer, where appropriate. In addition, we have an
      agreement which expires on October 31, 2008 with Performance Food Group to
      warehouse and distribute, on a cost plus agreement, the majority of our seafood
      supplies and to procure, distribute and store other supplies for us. We believe
      that our relationships with Performance Food Group and our other suppliers
      are satisfactory and that alternative sources are readily available. However,
      the loss of our relationship with Performance Food Group or other suppliers
      could materially adversely affect us. Additionally, there can be no assurance
      that we will be able to reach an agreement upon contract renegotiation with
      Performance Food Group on terms that are acceptable to us, or at all.





Some
      species of seafood have become subject to adverse publicity because of claims
      of
      contamination by lead, mercury or other chemicals that may exist in the ocean
      or
      in an aquaculture environment. This can adversely affect both market demand
      and
      supply for these food products. Customer demand may also be negatively impacted
      by reports of medical or other risks resulting from eating particular types
      of
      seafood. We maintain a continuous quality assurance inspection program for
      all
      of our seafood and protein purchases. However, we cannot assure you that seafood
      contamination or consumer perception of inadequate seafood quality, in the
      industry in general or as to us specifically, will not have a material adverse
      affect on us. Our failure to obtain adequate supplies of seafood, which meet
      our
      quality specifications at acceptable prices or problems or difficulties
      resulting from the contamination of seafood, in general, or at any of our
      restaurants in particular, will have a material adverse effect on our operations
      and profitability.





***Food
      borne illness may occur in the market place, or to us
      specifically.*** Even
      though we maintain a strict quality assurance inspection program, we cannot
      assure you that these procedures will successfully detect food contamination.
      We
      can also not assure you that a food borne illness occurring anywhere else in
      the
      market place will not have a material adverse affect on our business and
      profitability. Historically, seafood may be particularly susceptible to these
      kinds of food-borne illnesses.


15


***Our
      expenses for food commodity costs fluctuate.*** Our
      profitability depends, in part, on our ability to anticipate and to react to
      increases in food costs. We have limited control over these costs, many of
      which
      have increased in 2007 due to rising costs of manufacturing and transportation.
      Specifically, our dependence on frequent deliveries of seafood, produce, dairy
      and other products means we are at greater risk of shortages or interruptions
      in
      supply because of adverse weather or other conditions. This could adversely
      affect the availability and cost of these items. Also, substantial price
      increases imposed by our suppliers in the absence of alternative sources of
      supply in a timely manner, could have a material adverse affect on
      us.


We
      have
      been able to anticipate and react to fluctuations in food costs by:





•
            adjusting
                selected menu prices;





•
            purchasing
                seafood directly from numerous suppliers; and





•
            promoting
                alternative menu selections in response to price and availability
                of
                supply.





However,
      we cannot assure you that we will be able to continue to anticipate and respond
      to supply and price fluctuations, or that we will not be subject to
      significantly increased costs. A shortage of available seafood at prices that
      are acceptable to us could cause our cost of sales to increase. Because of
      our
      value oriented pricing structure, this could materially adversely affect our
      operations and profitability. In addition, seafood suppliers and processors
      are
      subject to a program of inspection by the Food and Drug Administration.
      Government tariffs may also be applied to certain imported products. These
      programs may increase our seafood costs and / or decrease availability as
      seafood suppliers’ and processors’ delivered costs in complying with these
      programs may increase.





***Our
      industry is highly competitive.*** ** The
      restaurant industry, particularly the full-service casual dining segment, is
      highly competitive. We compete in the areas of:





•
            price;




•
            service;




•
            food
                quality, including taste, freshness, healthfulness and nutritional
                value;




•
            location;
                and




•
            atmosphere.




We
      have
      numerous well-established competitors, some of which dominate the industry.
      These competitors possess substantially greater financial, marketing, personnel
      and other resources than we do. Many of our competitors have achieved
      significant brand name and product recognition. They also engage in extensive
      advertising and promotional programs, both generally and in response to efforts
      by additional competitors to enter new markets or introduce new products. Our
      competitors include national, regional and local full-service casual dining
      chains, many of which specialize in or offer seafood products.





We
      believe that the full-service casual dining segment is likely to attract a
      significant number of new entrants, some offering seafood products. We also
      expect to face competition from a broad range of other restaurants and food
      service establishments. These include full-service, quick-service and fast
      casual food restaurants, which specialize in a variety of menu offerings. In
      addition, the full-service restaurant industry is characterized by the frequent
      introduction of new food products, which are accompanied by substantial
      promotional campaigns. In recent years, numerous companies in the full-service
      restaurant industry have introduced products, including seafood, intended to
      capitalize on growing consumer preference for food products that are, or are
      perceived to be, healthy, nutritious, and low in calories, carbohydrates or
      fat
      content. We expect that we will be subject to increasing competition from
      companies whose products or marketing strategies address these consumer
      preferences. While we believe that we offer a broad variety of quality seafood
      products, we cannot assure that:




16


•
            consumers
                will be able to distinguish our products from competitive
                products;





•
            substantially
                equivalent food products will not be introduced by our competitors;
                or





•
            we
                will be able to compete
                successfully.





***Many
      factors affect our industry.*** **** We must
      respond to various factors affecting the restaurant industry,
      including:





•
            changes
                in consumer preferences, tastes and eating habits;





•
            demographic
                trends and traffic patterns;





•
            increases
                in food, labor and other operating costs;





•
            inflation;
                and





•
            national,
                regional and local economic conditions and the affect of world events,
                in
                general, and the tourism industry in
                particular.





***Our
      insurance coverage may not be adequate.*** **** We
      maintain insurance, including insurance relating to personal injury, in amounts,
      which we currently consider adequate. Nevertheless, a partially or completely
      uninsured claim against us, if successful, could materially adversely affect
      us.
      Additionally, the insurance market in Florida, particularly property and
      business interruption, had sustained significant losses during 2005 and 2004
      hurricane seasons. Adequate insurance coverage has become more difficult to
      acquire and the costs associated with such coverage may become economically
      prohibitive. If we are unable to obtain adequate insurance coverage, or if
      we do
      not have sufficient cash or financing available to pay the insurance premiums,
      it could cause us to be uninsured for certain perils which could materially
      affect us.





***We
      face risks associated with government regulation.*** **** We are
      subject to extensive state and local government regulation by various agencies,
      including:





•
            state
                and local licensing, zoning, land use, construction and environmental
                regulations;




•
            various
                regulations relating to the sale of food and alcoholic
                beverages;




•
            regulations
                relating to sanitation, disposal of refuse and waste
                products;




•
            regulations
                relating to public health; and




•
            safety
                and fire standards.




Our
      restaurants are inspected periodically by governmental agencies to ensure
      conformity with these regulations. The suspension of, or inability to renew
      a
      license at an existing restaurant would adversely affect our operations. A
      significant percentage of our revenue and operating income comes from sales
      of
      alcoholic beverages. State and local regulation of the sale of alcoholic
      beverages require us to obtain a license or permit for each of our restaurants.
      The failure of a restaurant to obtain or retain a license to serve liquor could
      materially adversely affect our operations. In addition, our failure or
      difficulty in obtaining required licensing or other regulatory approvals could
      delay or prevent new restaurant openings.




17


Restaurant
      operating costs are also affected by other government actions, which are beyond
      our control, including increases in:





•
            minimum
                hourly wage requirements;




•
            workers
                compensation insurance rates;




•
            health
                care insurance costs;




•
            other
                insurance costs, including general liability and property;
                and




•
            unemployment
                and other taxes.




In
      May
      2005, the minimum wage rate in Florida increased by $1.00 per hour. Tipped
      employees also received the $1.00 per hour wage increase under this new law.
      In
      January 2006, 2007 and 2008, the minimum wage rate in Florida increased another
      $0.25, $0.27 and $0.12 per hour, respectively, with tipped employees also
      receiving the full wage increase. At the beginning of each year, the minimum
      wage in Florida will increase further based on the U.S. Department of Labor,
      Bureau of Labor Statistics cost of living index. Such payroll cost increases
      can
      have a significantly adverse affect on our company. Menu price increases and
      other actions have been and are required to negate the affect of these wage
      increases. There can be no assurances that such measures expected to be taken
      by
      our company will be successful to adequately offset these additional payroll
      costs, or will be accepted without adverse reaction by our
      customers.





Furthermore,
      the Americans with Disabilities Act may require us to make certain modifications
      to certain of our restaurants to meet specified access and use requirements.
      These and other initiatives could adversely affect our results of operations.





***We
      may have liability for sales of alcoholic beverages.*** We are
      also subject to “dram-shop” statutes. These statutes generally provide a person
      injured by an intoxicated person the right to recover damages from an
      establishment that wrongfully served alcoholic beverages to the intoxicated
      person. In certain states, statutes also provide that a vendor of alcoholic
      beverages may be held liable in a civil cause of action for injury or damage
      caused by or resulting from the intoxication of a minor under certain
      conditions. In addition, significant national attention is currently focused
      on
      the problem of drunk driving, which could result in the adoption of additional
      legislation. This could increase our potential liability for damage or injury
      caused by our customers.





***We
      may not be able to protect our service marks and proprietary
      information.*** We own
      two United States registrations for the service marks that we use, including
      the
      name *“Shells.”* We
      believe that our service marks have significant value and are essential to
      our
      ability to create demand for and awareness of our restaurants. We cannot assure
      you, however, that our service marks:





•
            do
                not or will not violate the proprietary rights of
                others;





•
            would
                be upheld if challenged; or





•
            that
                we would not be prevented from using our service
                marks.




18





Any
      of
      these occurrences could materially adversely affect us. In addition, we cannot
      assure you that we will have the financial resources necessary to enforce or
      defend our service marks. We believe that we own all of our intellectual
      property and that the management and license agreements to which we are a party
      are enforceable. In the past, the enforceability of these management and license
      agreements has been questioned by certain of the licensees. Although we believe
      the agreements are enforceable, there can be no assurance that the agreements
      will not be challenged in the future, and, if challenged, that the agreements
      will be determined to be enforceable and the managed restaurants will be
      restricted from using the Shells service marks independent of us.





We
      also
      rely on trade secrets and proprietary knowledge. We employ various methods
      to
      protect our concepts and recipes. However, these methods may not completely
      protect us. We cannot assure you that others will not independently develop
      similar knowledge or obtain access to our knowledge, concepts and recipes.
      Although we generally enter into confidentiality agreements with our executives
      and managers, we cannot assure you that these agreements will adequately protect
      our trade secrets. We also may incur additional risks that may be associated
      with the registration of our service marks in the Kingdom of Saudi Arabia and
      other foreign countries by Food and Entertainment Co., LTD.





***Absence
      of Dividends.*** **** We have
      never paid cash dividends on our common or preferred stock and do not anticipate
      paying any cash dividends in the foreseeable future. In addition, our debt
      financings prohibit the payment of cash dividends and any future financing
      agreements may also prohibit the payment of cash dividends.





***Provisions
      with Potential Anti-Takeover Effect.*** **** Our
      certificate of incorporation provides that we may issue up to 2,000,000 shares
      of preferred stock from time-to-time in one or more series. The board of
      directors is authorized to determine the rights, preferences, privileges and
      restrictions granted to and imposed upon any wholly unissued series of preferred
      stock. The board is authorized to fix the number of shares of any series of
      preferred stock and the designation of any such series, without any vote or
      action by our stockholders. The board may authorize and issue preferred stock
      with voting, dividend, liquidation, conversion or other rights that could
      adversely affect the voting power or other rights of the holders of our common
      stock. In addition, the potential issuance of preferred stock may have the
      effect of delaying, deferring or preventing a change in control, may discourage
      bids for our common stock at a premium over the market price of the common
      stock
      and may adversely affect the market price of the common stock.





On
      October 24, 2001, we issued 66,862 shares of Series A 5% Convertible Preferred
      Stock, par value $0.01 per share, pursuant to an exemption from registration
      under Section 4(6) of the Securities Act of 1933, as amended, in consideration
      for the cancellation of $669,000 of trade indebtedness by trade creditors of
      our
      company. As of March
      10,
      2008, we had 22,694 shares of Series A Preferred Stock outstanding.




19


On
      May
      24, 2005, we issued 461,954 units in a private placement. Each unit consisted
      of
      (i) one share of our Series B Convertible Preferred Stock convertible into
      20
      shares of our common stock, subject to adjustment under certain circumstances,
      and (ii) a warrant to purchase 10 shares of our common stock at an exercise
      price of $1.30 per share. In addition, we issued a warrant to purchase 37,651
      units (consisting of 37,651 shares of our Series B Convertible Preferred Stock
      and warrants to purchase 376,510 shares of our common stock) at a purchase
      price
      of $15.00 per unit to the placement agent in our May 2005 financing. As of
      March 10, 2008, we had 87,552 shares of Series B Preferred Stock outstanding.
      The Series B Convertible Preferred Stock contains voting and anti-dilutive
      rights. The Series B Preferred Stock votes together with our common stock on
      an
“as-converted” basis as a single class on all actions to be taken by our
      stockholders. Without the consent of a majority of the outstanding Series B
      Preferred Stock, we cannot alter or change adversely the powers, preferences
      or
      rights given to the Series B Preferred Stock, authorize or create any class
      of
      stock ranking as to a distribution of assets upon a liquidation event senior
      to
      or pari passu with the Series B Preferred Stock, issue any additional shares
      of
      the Series A Preferred Stock, or alter or change the powers, preferences or
      rights given to the Series A Preferred Stock. Upon any dissolution, liquidation,
      merger, consolidation, reorganization or other series of transactions, under
      certain conditions, the holders of Series B Preferred Stock are entitled to
      be
      paid out of our assets legally available for distribution to our stockholders,
      before any payment is made to the holders of our common stock.





**ITEM
      1B. UNRESOLVED STAFF COMMENTS**





None




20


**ITEM
      2. PROPERTIES**





We
      lease
      6,800 square feet of space in Tampa, Florida for our executive offices. The
      annual rent payable under the lease, which expires October 31, 2008, is
      approximately $102,000. We have agreed with the landlord to renew this lease
      at
      a reduced square footage through at least October 31, 2009.





All
      but
      one of our existing restaurants in operation are leased properties. In the
      future, we intend to lease most of our properties but may from time-to-time
      acquire restaurant locations based on individual site evaluations. Each of
      our
      leases provides for a minimum annual rent and certain of these leases require
      additional rental payments to the extent sales volumes exceed specified amounts.
      Generally, we are required to pay the cost of insurance, taxes and a portion
      of
      the landlord's operating costs to maintain common areas. Restaurant leases
      have
      initial terms averaging 12 years and renewal options averaging 16 years, and
      rents averaging $21.00 per square foot.





**ITEM
      3. LEGAL PROCEEDINGS**





On
      August
      1, 2006, we were advised by our subtenant, Famous Dave’s RIBS-U, Inc., that they
      discontinued operations of the restaurant located in Streamwood, Illinois and
      have ceased remitting rent payments required by the sublease. The subtenant
      has
      requested discussions on settlement for a lease termination. Such restaurant
      closure is a condition of default under the sublease as well as the master
      lease
      between Shells and the ultimate landlord, 948 Barrington Road Partnership.
      The
      parties are continuing efforts to seek a suitable tenant replacement. The
      financial implications to Shells are undetermined at this time. If necessary,
      we
      intend to pursue our rights against Famous Dave’s RIBS-U, Inc., as appropriate
      to protect our interest.





On
      March
      13, 2007 and on July 16, 2007, summons were served from the circuit court in
      Kane County, Illinois, naming the Spring Hill Mall, L.L.C., the primary
      landlord, as plaintiff. The suit relates to a restaurant lease in
      Carpentersville, Illinois. Under this lease, we are a sub-tenant to Chi-Chi’s,
      Inc., who filed bankruptcy in 2003 and subsequently rejected the lease. Since
      2000, we have been further subleasing this property to Famous Dave’s RIBS-U,
      Inc. Under such terms, we partially subsidize lease payments. Since 2003, we
      have been negotiating with Spring Hill Mall for a buyout of our obligations
      under the various subleases. Under the suit, Spring Hill Mall sought payment
      of
      rent, occupancy, and related charges totaling $147,000 with the addition of
      interest and fees related to the suit. In February 2008, Spring Hill Mall and
      Shells jointly agreed to a settlement plan, whereby we will pay monthly to
      Spring Hill Mall amounts aggregating $177,840, which include amounts due in
      arrears as well as future amounts due from us through the term of the lease
      ending December 2010. Under the settlement agreement, we will maintain
      responsibility for leasehold obligations until December 2010.





On
      January 31, 2008, a summons was served from the Supreme Court of the State
      of
      New York, County of New York, naming 320 West 13th Street, LLC as plaintiff.
      This suit was brought against, among others, Jay A. Wolf, a member of our Board
      of Directors, and various entities allegedly controlled by Mr. Wolf, including
      Shells Seafood Restaurants, Inc. We believe we were wrongly named in this suit
      and are seeking to have our company removed as a defendant.





On
      February 27, 2008, a summons was served from the circuit court in Volusia
      County, Florida, naming Coconuts of Daytona Beach, Inc. as plaintiff. The suit
      relates to a lease with our subsidiary, Shells of Daytona Beach, Inc. (currently
      known as America’s Favorite Seafood, Inc.), of furniture, fixtures and equipment
      assigned on July 12, 1989. The plaintiff alleges that we have breached the
      agreement, as we discontinued making payments under the contract at or about
      April 2007. We believe the case is without merit and will defend it vigorously.




21


In
      the
      ordinary course of business, we are and may be a party to various legal
      proceedings, the outcomes of which, singly or in the aggregate, are not
      currently expected to be material to our financial position, results of
      operations or cash flows.





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





None.





**PART
      II**





**ITEM
      5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
      ISSUER PURCHASES OF EQUITY SECURITIES**





Our
      common stock is traded on the over-the-counter bulletin board under the symbol
      “SHLL”. The following table sets forth the closing high and low price per share
      of our common stock as reported by the OTC bulletin board, for the periods
      presented.





These
      over-the-counter market quotations reflect inter-dealer prices, without retail
      markup, mark-down or commission and may not necessarily represent actual
      individual transactions.





**Fiscal 2006**First
                quarter
            
            $
            1.01
            
            $
            0.86Second
                quarter
            
            $
            0.90
            
            $
            0.70Third
                quarter
            
            $
            0.82
            
            $
            0.58Fourth
                quarter
            
            $
            0.75
            
            $
            0.51





**Fiscal 2007**First
                quarter
            
            $
            0.75
            
            $
            0.45Second
                quarter
            
            $
            0.47
            
            $
            0.15Third
                quarter
            
            $
            0.23
            
            $
            0.11Fourth
                quarter
            
            $
            0.19
            
            $
            0.08





Our
      authorized capital stock consists of 58,000,000 shares of common stock, par
      value $0.01 per share, and 2,000,000 shares of preferred stock, par value $0.01
      per share. **** The
      number of stockholders of record of our common stock on March 20, 2008 was
      approximately 235. Our stock price as of March 20, 2008 was $0.11.





**Dividend
      Policy**





We
      have
      never declared or paid any cash dividends on our common or preferred stock.
      All
      future earnings are expected to be retained by us for the operation and
      development of our business. Accordingly, we do not anticipate paying cash
      dividends on the common or preferred stock in the foreseeable future.





During
      fiscal 2005, we recorded a non-cash charge of $1,735,000 to recognize as a
      deemed dividend the warrants and beneficial conversion feature of our Series
      B
      Convertible Preferred Stock issued in May 2005.




22


**Equity
      Compensation Plans**





Securities
      authorized for issuance under equity compensation plans as of December 30,
      2007
      were as follows:




Number of securities to be
              issued upon exercise of
              outstanding options,
              warrants, and rights
            
            Weighted-average
              exercise price of
              outstanding options,
              warrants and rights
            
            Number of securities
              remaining available for future
              issuance under equity
              compensation plans
              (excluding securities reflected
              in column [a])Plan
                category
            
            [a]
            
            [b]
            
            [c]Equity
                compensation plans approved by security holders (1)
            
            
            9,666,152
            
            $
            1.06
            
            
            136,375Equity
                compensation plans not approved by security holders (2)
            
            
            903,528
            
            $
            0.85
            
            
            -Total
            
            
            10,569,680
            
            
            
            
            
            136,375





(1)
            
            Consists
                of (i) stock options issued under the Stock Option Plan for Non-Employee
                Directors, 1995 Employee Stock Option Plan, 1996 Employee Stock Option
                Plan and the 2002 Equity Incentive Plan, (ii) warrants to purchase
                4,619,540 shares of common stock, exercisable through May 24, 2010,
                issued
                on May 24, 2005 in connection with the Series B Preferred Stock offering,
                at an exercise price of $1.30 per share, and (iii) warrants to purchase
                1,129,530 shares of common stock granted to the placement agent in
                our May
                2005 private financing as a portion of their fees in the form of
                a warrant
                to purchase 37,651 units (consisting of 37,651 shares of our Series
                B
                Convertible Preferred Stock and warrants to purchase 376,510 shares
                of our
                common stock) at a purchase price of $15.00 per unit.(2)
            
            Consists
                of a stock option grant to purchase 903,528 shares of common stock
                pursuant to a Stock Option Agreement dated November 14, 2005 by and
                between Leslie J. Christon, our former President and Chief Executive
                Officer, and the Company. Ms. Christon ceased to be employed by Shells
                on
                February 29, 2008. In accordance with the terms of such option agreement,
                the option remains exerciseable until May 29,
                2008.





The
      number of securities and type of plans available for future issuance of stock
      options as of December 30, 2007 was:




Options for Common Shares:Plan Name
            
            Authorized
            
            Exercised
            
            Outstanding
            
            Expired
            
            AvailableStock
                Option Plan for Non-Employee Directors
            
            
            150,000
            
            
            0
            
            
            30,000
            
            
            120,000
            
            
            01995
                Employee Stock Option Plan
            
            
            840,000
            
            
            11,000
            
            
            98,500
            
            
            730,500
            
            
            01996
                Employee Stock Option Plan
            
            
            101,000
            
            
            11,001
            
            
            58,007
            
            
            31,992
            
            
            02002
                Equity Incentive Plan
            
            
            4,096,472
            
            
            229,522
            
            
            3,730,575
            
            
            0
            
            
            136,575Total
                stock options
            
            
            5,187,472
            
            
            251,523
            
            
            3,917,082
            
            
            882,492
            
            
            136,575





Our
      board
      of directors decreased the authorized shares under our 2002 Equity Incentive
      Plan by 903,528 shares effective November 14, 2005, concurrent with the stock
      option to purchase 903,528 shares granted outside the Plan to Leslie J.
      Christon, our former President and Chief Executive Officer.





Stock
      options exercised consist of (i) 1,000 shares of common stock issued from
      options exercised in 2007 by employees, (ii) 9,466 shares of common stock issued
      from options exercised in 2006 by employees, (iii) 26,600 shares of common
      stock
      issued from options exercised in 2005 by employees, (iv) 42,666 shares of common
      stock issued from options exercised in 2004 by employees, (v) 160,790 shares
      of
      common stock issued in 2003 to key employees pursuant to our fiscal year 2002
      management bonus plan, and (vi) 11,001 shares of common stock issued from
      options exercised by employees prior to 2001.




23


The
      1995
      Employee Stock Option Plan expired in September 2005 on its tenth anniversary
      as
      provided in the plan document. Options to purchase 98,500 shares of common
      stock
      remain outstanding under this plan, and expire on the tenth anniversary of
      their
      issuance, the last of which options expire in May 2011, if not previously
      exercised.





The
      1996
      Employee Stock Option Plan expired in 2006 on its tenth anniversary as provided
      in the plan document. Options to purchase 58,007 shares of common stock remain
      outstanding under this plan, and expire on July 1, 2012, if not previously
      exercised.





24




**STOCK
      PRICE PERFORMANCE**




*The
      following Stock Price Performance Graph shall not be deemed incorporated by
      reference by any general statement incorporating by reference this proxy
      statement into any filing under the Securities Act of 1933 or under the
      Securities Exchange Act of 1934, except to the extent Shells specifically
      incorporates this information by reference, and shall not otherwise be deemed
      filed under such Acts.*





The
      following graph compares cumulative total return of our common stock with the
      cumulative total return of (i) the Russell 2000 Index and (ii) the Nations
      Restaurant News Stock Index (the “Peer Index”). The graph assumes (a) $100 was
      invested on December 29, 2002 (the first day of our fiscal 2003) in each of
      our
      common stock, the stocks comprising the Russell 2000 Index and the stocks
      comprising the Peer Index, and (b) the reinvestment of dividends, if any.




**COMPARISON
      OF CUMULATIVE TOTAL RETURN AMONG**


**SHELLS
      SEAFOOD RESTAURANTS, INC., RUSSELL 2000 INDEX,**


**AND
      NATIONS RESTAURANT NEWS STOCK INDEX**





Shells Logo




25




**ITEM
      6. SELECTED FINANCIAL DATA**





The
      following table sets forth selected historical consolidated financial data
      for
      Shells. This consolidated financial data should be read in conjunction with
      "Management's Discussion and Analysis of Financial Condition and Results of
      Operations" and the Consolidated Financial Statements and Notes thereto included
      elsewhere in this Form 10-K. (The amounts are presented in thousands, except
      earnings per share, shares outstanding, number of restaurants data, and
      percentage information).





Year
            
            Year(53 Weeks)
            
            (52 Weeks)Year (52 Weeks) Ended
            
            Ended
            
            EndedDecember 30,
            
            December 31,
            
            January 1,
            
            January 2,
            
            December 28,2007
            
            2006
            
            2006
            
            2005
            
            2003**Statement
                of Operations Data:**REVENUESRestaurant
                sales
            
            $
            41,305
            
            $
            47,673
            
            $
            44,335
            
            $
            41,393
            
            $
            43,881Management
                fees
            
            
            139
            
            
            156
            
            
            152
            
            
            171
            
            
            165International
                fees
            
            
            15
            
            
            -
            
            
            -
            
            
            -
            
            
            -Total
                revenues
            
            
            41,459
            
            
            47,829
            
            
            44,487
            
            
            41,564
            
            
            44,046RESTAURANT
                OPERATING COSTS:Food
                and beverage
            
            
            13,469
            
            
            15,363
            
            
            14,671
            
            
            14,051
            
            
            14,467Labor
            
            
            12,938
            
            
            14,722
            
            
            13,757
            
            
            12,935
            
            
            13,845Other
            
            
            12,373
            
            
            12,948
            
            
            11,374
            
            
            10,123
            
            
            11,117Depreciation
                and amortization
            
            
            1,789
            
            
            2,199
            
            
            1,499
            
            
            1,058
            
            
            1,077Pre-opening
                expenses
            
            
            -
            
            
            -
            
            
            758
            
            
            -
            
            
            -Provision
                for impairment of assets
            
            
            1,270
            
            
            1,242
            
            
            -
            
            
            105
            
            
            360Total
                restaurant operating costs
            
            
            41,839
            
            
            46,474
            
            
            42,059
            
            
            38,272
            
            
            40,866RESTAURANT
                OPERATING (LOSS) INCOME
            
            
            (380
            )
            
            1,355
            
            
            2,428
            
            
            3,292
            
            
            3,180General
                and administrative expenses
            
            
            3,560
            
            
            3,821
            
            
            4,015
            
            
            3,249
            
            
            3,387(LOSS)
                INCOME FROM OPERATIONS
            
            
            (3,940
            )
            
            (2,466
            )
            
            (1,587
            )
            
            43
            
            
            (207
            )OTHER
                (EXPENSE) INCOME:Lease
                buy-out
            
            
            -
            
            
            212
            
            
            600
            
            
            -
            
            
            -Provision
                for impairment of assets due to lease buy-out
            
            
            -
            
            
            -
            
            
            (211
            )
            
            -
            
            
            -Interest
                expense, net
            
            
            (296
            )
            
            (332
            )
            
            (413
            )
            
            (1,154
            )
            
            (463
            )Other
                (expense) income, net
            
            
            (5
            )
            
            (173
            )
            
            30
            
            
            33
            
            
            (100
            )Total
                other (expense) income, net
            
            
            (301
            )
            
            (293
            )
            
            6
            
            
            (1,121
            )
            
            (563
            )LOSS
                  BEFORE ELIMINATION OF MINORITY PARTNER
                  INTEREST AND INCOME TAXES
            
            
            (4,241
            )
            
            (2,759
            )
            
            (1,581
            )
            
            (1,078
            )
            
            (770
            )ELIMINATION
                OF MINORITY PARTNER INTEREST
            
            
            (159
            )
            
            (243
            )
            
            (271
            )
            
            (266
            )
            
            (264
            )LOSS
                BEFORE INCOME TAX BENEFIT
            
            
            (4,400
            )
            
            (3,002
            )
            
            (1,852
            )
            
            (1,344
            )
            
            (1,034
            )Income
                tax benefit (1)
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -NET
                  LOSS BEFORE PREFERRED
                  STOCK DIVIDEND
            
            
            (4,400
            )
            
            (3,002
            )
            
            (1,852
            )
            
            (1,344
            )
            
            (1,034
            )Deemed
                dividend associated with warrants and beneficial conversion feature
                of
                preferred stock
            
            
            -
            
            
            -
            
            
            (1,735
            )
            
            -
            
            
            -NET
                LOSS APPLICABLE TO COMMON STOCK
            
            $
            (4,400
            )
            $
            (3,002
            )
            $
            (3,587
            )
            $
            (1,344
            )
            $
            (1,034
            )




26




Fiscal Years EndedDecember 30,
            
            December 31,
            
            January 1,2007
            
            2006
            
            2006**Earnings
                per Share Data:**Basic
                and diluted net loss per share
            
            $
            (0.21
            )
            $
            (0.18
            )
            $
            (0.24
            )**Shares
                Outstanding Data:**Basic
                and diluted weighted average
            
            
            20,920
            
            
            16,665
            
            
            14,796**Operating
                Data:**Number
                of restaurants (at end of period):Company-owned
                restaurants (2)
            
            
            20
            
            
            22
            
            
            22Licensed
                restaurants
            
            
            3
            
            
            3
            
            
            323
            
            
            25
            
            
            25Average
                annual sales per Company-owned and joint venture restaurant open
                for full
                period (3)
            
            $
            2,025
            
            $
            2,167
            
            $
            1,998(Decrease)
                increase in Company-owned and joint venture restaurant same store
                sales
                (3)
            
            
            -11.4
            %
            
            3.8
            %
            
            7.0
            %





December 30,
            
            December 31,
            
            January 1,
            
            January 2,
            
            December 28,2007
            
            2006
            
            2006
            
            2005
            
            2003**Balance
                Sheet Data:**Working
                capital (deficiency)
            
            $
            (4,712
            )
            $
            (4,446
            )
            $
            (4,842
            )
            $
            (4,639
            )
            $
            (3,606
            )Total
                assets
            
            
            11,479
            
            
            13,837
            
            
            17,438
            
            
            13,519
            
            
            11,616Long-term
                debt, less current portion
            
            
            658
            
            
            172
            
            
            1,001
            
            
            2,239
            
            
            1,558Long-term
                debt, related party, less current portion
            
            
            -
            
            
            1,527
            
            
            809
            
            
            1,495
            
            
            2,267Minority
                partner interest
            
            
            539
            
            
            522
            
            
            472
            
            
            442
            
            
            466Preferred
                stock
            
            
            1
            
            
            4
            
            
            5
            
            
            -
            
            
            1Stockholders'
                equity
            
            
            361
            
            
            4,339
            
            
            7,190
            
            
            502
            
            
            1,183




(1)
            
            The
                effective tax rates for fiscal years 2007, 2006, 2005, 2004 and 2003
                include the effects of recognizing valuation allowance adjustments
                relating to tax benefits. There was no benefit or provision for income
                taxes in 2007, 2006, 2005, 2004 or 2003. The valuation allowance
                in 2007,
                2006, 2005, 2004 and 2003 was increased by $1,777, $2,821, $252,
                $210 and
                $596, respectively, in each such year reserving for all tax assets
                that
                were deemed non-realizable.(2)
            
            Includes
                one joint venture restaurant in which we own a 51% equity interest.
                Two
                locations were closed in 2007, and two locations were opened, one
                was
                relocated and one was closed in 2005.(3)
            
            Includes
                only restaurants open during the full fiscal year reported and also
                open
                for a full comparable fiscal year and at least the full six months
                prior
                thereto. Sales data for closed stores is included through the end
                of the
                month prior to closing. Sales data is temporarily excluded if a store
                is
                closed for at least 30 days. Same store sales are calculated on a
                comparable calendar period basis for the periods
                compared.





27


**ITEM
      7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATIONS**





**General**




In
      fiscal
      year 2007, Shells experienced an increasingly difficult operating environment.
      Declining economic conditions in Florida, the state where all of our restaurants
      are located, have been most challenging for casual dining restaurants in
      general. As the economy has continued to soften, consumers have responded in
      tightening their discretionary spending patterns. The collapse of the housing
      market in Florida, one of the worst hit states in the United States, has
      dramatically weighed in on consumer sentiment. The price of fuel has increased
      sharply, adversely affecting dining out decisions, as well as travel and
      tourism. Many areas of commodity and operating costs have risen sharply in
      the
      latter part of 2007, due to the trickle down affect of escalating fuel costs.
      Another increase in the state minimum wage also pushed labor costs higher for
      the third consecutive year. Insurance, property tax and utilities costs, after
      reaching historic plateaus in 2006, have generally remained constant at these
      levels through 2007, with only minimal relief.





The
      decline in same store sales was a cumulative -11.4% for fiscal 2007. We
      recognize that our guests are being affected themselves by this difficult
      economic climate, and that they are now, more than ever, highly selective with
      their dining dollars. Restaurants that are able to offer high-quality menu
      offerings that are relevant to consumers, at a compelling value, will win the
      guest’s business and their loyalty. We continue to focus on initiatives to
      improve every aspect of the dining experiences of our guests. We always take
      great pride in the freshness and quality of the seafood that we serve. We have
      repositioned our menu offerings to drive those items that provide the greatest
      value proposition. We have taken measures to reduce costs by better attaining
      delivery and preparation efficiencies, without affecting either the quality
      of
      our products served or our operating standards.





Throughout
      2007, we continued to seek to remove those elements of cost within the
      organization that were non-essential to our mission of building guest traffic.
      With a limited marketing budget, we continued to fine-tune our marketing
      strategies to seek the optimal, most cost effective means of delivering our
      message to a targeted audience.





Despite
      the many challenges facing Shells, we are greatly committed to our turnaround
      strategy. Our primary objective is to reverse the trend in negative customer
      traffic, by attracting new and former guests to experience our great quality
      seafood at more favorable price points. In addition, we are committed
      to achieving further cost reductions, offsetting those external influences
      caused by the economy. We will continue to aggressively address both our top
      and
      bottom line pressures. We will also seek both traditional and non-traditional
      means to fund our cash flow requirements.





In
      2007,
      we sold the rights for the Shells brand for certain middle eastern countries
      to
      Food and Entertainment Co., LTD. in a 10-nation development agreement within
      the
      Middle East. This arrangement not only provides us with ongoing revenue from
      the
      consulting and services agreement, but also builds our brand internationally
      and
      opens the door for future international development opportunities.





There
      are
      no assurances that our strategies will drive improvements in sales and customer
      traffic needed to meet anticipated cash flow requirements and restore our
      profitability. It is also uncertain whether future financing options, which
      may
      be needed to execute our strategies, will be available, on terms that would
      be
      acceptable to us, or at all.




28


The
      following table sets forth, for the periods indicated, the percentages that
      the
      items in our Consolidated Statements of Operations bear to total revenues or,
      where indicated, restaurant sales.




Fiscal
                Years EndedDecember
                30,
            
            December
                31,
            
            January
                1,2007
            
            2006
            
            2006REVENUESRestaurant
                sales
            
            
            99.7
            %
            
            99.7
            %
            
            99.7
            %Management
                fees
            
            
            0.3
            %
            
            0.3
            %
            
            0.3
            %International
                fees
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %Total
                revenues
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %RESTAURANT
                OPERATING COSTSCost
                of sales (1)
            
            
            32.6
            %
            
            32.2
            %
            
            33.1
            %Labor
                and other related expenses (1)
            
            
            31.3
            %
            
            30.9
            %
            
            31.0
            %Other
                restaurant operating expenses(1)
            
            
            30.0
            %
            
            27.2
            %
            
            25.7
            %Depreciation
                and amortization (1)
            
            
            4.3
            %
            
            4.6
            %
            
            3.4
            %Pre-opening
                expenses (1)
            
            
            0.0
            %
            
            0.0
            %
            
            1.7
            %Provision
                for impairment of assets (1)
            
            
            3.1
            %
            
            2.6
            %
            
            0.0
            %Total
                restaurant costs (1)
            
            
            101.3
            %
            
            97.5
            %
            
            94.9
            %Restaurant
                operating (loss) income (1)
            
            
            -0.9
            %
            
            2.8
            %
            
            5.5
            %General
                and administrative expenses
            
            
            8.6
            %
            
            8.0
            %
            
            9.0
            %LOSS
                FROM OPERATIONS
            
            
            -9.5
            %
            
            -5.2
            %
            
            -3.6
            %Lease
                buy-out
            
            
            0.0
            %
            
            0.4
            %
            
            1.3
            %Provision
                for impairment of assets due to lease buy-out
            
            
            0.0
            %
            
            0.0
            %
            
            -0.5
            %Interest
                expense, net
            
            
            -0.7
            %
            
            -0.7
            %
            
            -0.9
            %Other
                (expense) income, net
            
            
            0.0
            %
            
            -0.4
            %
            
            0.1
            %Total
                other (expense) income
            
            
            -0.7
            %
            
            -0.7
            %
            
            -0.0
            %Loss
                before elimination of minority interests
            
            
            -10.2
            %
            
            -5.8
            %
            
            -3.6
            %Elimination
                of minority partner interest
            
            
            -0.4
            %
            
            -0.5
            %
            
            -0.6
            %Net
                loss before preferred stock dividend
            
            
            -10.6
            %
            
            -6.3
            %
            
            -4.2
            %Deemed
                  dividend associated with warrants and beneficial
                  conversion feature of preferred stock
            
            
            0.0
            %
            
            0.0
            %
            
            -3.9
            %Net
                loss applicable to common stock
            
            
            -10.6
            %
            
            -6.3
            %
            
            -8.1
            %




(1)
      as a
      percentage of restaurant sales




29


**Results
      of Operations**


***Fiscal
      Year 2007 versus Fiscal Year 2006***




Total
      revenues for the fiscal year 2007 were $41,459,000 as compared to $47,829,000
      for fiscal year 2006. The $6,370,000 or 13.3% decrease in revenues was primarily
      due to an 11.4% decrease in comparable store sales and the loss of weeks of
      operations due to the closure and disposition of two restaurants in 2007. Our
      revenues consisted of restaurant sales of our company-owned restaurants;
      management and licensing fees on sales at the managed restaurants; and
      international fees related to the sale of Shells marks and system in certain
      middle eastern countries. The decrease in same store sales was the result of
      a
      decline in customer traffic of 14.5% partially offset by a 3.6% increase in
      average customer check, which was affected by menu price increases and changes
      in menu mix. Our food sales and liquor sales accounted for 86% and 14% of
      revenues for 2007 and 87% and 13% of revenues for 2006, we believe, due in
      part
      to the increased emphasis and additional menu items promoted in the wine and
      liquor categories. Comparisons of same store sales includes only restaurants
      open during the full fiscal year shown and open for a full comparable fiscal
      year and at least the full six months prior thereto. Sales data for closed
      stores is included through the end of the month prior to closing. Sales data
      is
      temporarily excluded if a store is closed for at least 30 days. Same store
      sales
      are calculated on a comparable calendar period basis.





The
      cost
      of restaurant sales as a percentage of restaurant sales increased to 32.6%
      for
      2007 from 32.2% for 2006. This 0.4% increase in cost of sales as a percentage
      of
      sales primarily related to enhancing many of our menu items in the first quarter
      of 2007 and higher dairy and other commodity costs, partially offset by an
      increase in liquor sales as a percentage of total sales. The cost of restaurant
      sales generally consists of the cost of food, beverages, freight, and paper
      and
      plastic goods used in food preparation and carry-out orders.





Labor
      and
      other related expenses as a percentage of restaurant sales increased to 31.3%
      in
      2007 as compared to 30.9% in 2006. We benefited from non-recurring reductions
      in
      benefits and taxes relating to workers compensation insurance reserve
      reductions, and corresponding refunds from prior years’ experiences of $20,000
      and $107,000 in 2007 and 2006, respectively, of which $20,000 and $96,000 were
      allocated to restaurant labor costs. Exclusive of the non-recurring items,
      labor
      and other related expenses as a percentage of restaurant sales were 31.4 %
      and
      31.1% for 2007 and 2006, respectively. This increase of 0.3% as a percentage
      of
      sales primarily was due to the decrease of operating leverage as reflected
      by
      the reduction in sales volume and the impact of the annual increase in the
      Florida minimum wage. Labor and other related expenses generally consist of
      restaurant hourly and management payroll, benefits, taxes and workers’
compensation insurance.





Other
      restaurant operating expenses were $12,373,000 or 30.0% of restaurant sales
      for
      2007 as compared with $12,948,000, or 27.2% of restaurant sales for 2006. This
      unfavorable variance of 2.8% as a percentage of restaurant sales was primarily
      due to the decrease in operating leverage as reflected by the reduction of
      sales
      volume, and to a lesser extent, utilities and insurance costs. Other restaurant
      operating expenses generally consist of advertising, costs associated with
      area
      directors, non-food supplies, repairs and maintenance, rent and other occupancy
      costs, insurance and utilities.




Depreciation
      and amortization expense was $1,789,000 or 4.3% as a percentage of restaurant
      sales for 2007 and $2,199,000 or 4.6% as a percentage of restaurant sales for
      2006. The 0.3% decrease as a percentage of restaurant sales was due to the
      impairment of assets in the fourth quarter of 2006 and the second quarter of
      2007, as well as the sale of a restaurant property in the fourth quarter of
      2006
      and closures of two restaurants in the second and fourth quarters of
      2007.




30




In
      2007,
      we recorded a provision in operating expenses for the impairment of assets
      totaling $1,270,000 or 3.1% of restaurant sales relating to the write-down
      of
      assets at one restaurant to their estimated fair value in accordance with
      Financial Accounting Standards Board Statement No. 144. The write-down was
      necessitated by the then current period operating losses and the projected
      deficiency of cash flow of the restaurant. In 2006, we recorded a provision
      in
      operating expenses for the impairment of assets totaling $1,242,000 or 2.6%
      of
      restaurant sales.





General
      and administrative expenses were $3,560,000 or 8.6% of revenues and $3,821,000
      or 8.0% of revenues in 2007 and 2006, respectively. The $261,000 decrease from
      the prior year is primarily related to a decrease in administrative salary
      expense of $401,000, partially offset by an increase in stock option expense
      of
      $197,000. General and administrative expenses relate to the operations of all
      Shells restaurants owned by us and management services that we provide to the
      managed restaurants.




Net
      interest expense was $296,000 in 2007 compared to $332,000 in 2006. The $36,000
      decrease in net interest expense in 2007 from 2006 was generally due to the
      retirement of debt in October 2006 in conjunction with the completion of a
      sale
      of a restaurant property, partially offset by additions in interest expense
      on
      the line of credit with related parties and an increase in the amount financed
      on the Melbourne property.




Other
      expense, net, in 2007 was $5,000, compared to other expense, net, in 2006 of
      $173,000. Exclusive of non-recurring items, other expense was $27,000 in 2007
      and $111,000 in 2006. In 2007, we recognized a gain of $85,000 from the
      VisaCheck/MasterMoney Antitrust Settlement and a $6,000 gain on the disposal
      of
      assets related to the sale of the leasehold interest in two locations, partially
      offset by a lease renewal cost of $39,000 and $30,000 in closed store expenses.
      In 2006, we recognized a loss on disposal of assets of $39,000 from the
      write-down of fixed assets replaced during remodeling and $23,000 related to
      the
      settlement of lease obligations on a closed location.




As
      a
      result of the factors discussed above, the loss from operations for 2007 was
      $3,940,000 as compared to a loss from operations of $2,466,000 for 2006.
      Exclusive of non-recurring items, our loss from operations was $2,672,000 for
      2007 compared to $1,331,000 for 2006. Net loss applicable to common stock for
      2007 was $4,400,000 compared to $3,002,000 for 2006. Exclusive of non-recurring
      items, the net loss in 2007 was $3,154,000 compared to a net loss in 2006 of
      $2,017,000.





***Fiscal
      Year 2006 versus Fiscal Year 2005***




Total
      revenues for the fiscal year 2006 were $47,829,000 as compared to $44,487,000
      for fiscal year 2005. The $3,342,000 or 7.5% increase in revenues was primarily
      due to a 3.8% increase in comparable store sales and the net additional weeks
      of
      operations in 2006 of two restaurants opened and one restaurant closed in 2005,
      partially offset by one fewer restaurant under management in fiscal 2005. Our
      revenues consisted of restaurant sales of our company-owned restaurants and
      management and licensing fees on sales at the managed restaurants. The increase
      in same store sales was the result of a 6.7% increase in average customer check,
      which was affected by menu price increases and changes in menu mix. Customer
      traffic declined by 2.7% in 2006 compared to 2005, which was affected by
      unfavorable trends in the fourth quarter. Our food sales and liquor sales
      accounted for 87% and 13% of revenues for 2006 and 88% and 12% of revenues
      for
      2005, we believe, due in part, to the increased emphasis and additional menu
      items promoted in the wine and liquor categories. In 2005, we incurred estimated
      sales losses of $204,000, due to hurricane-related business interruption.
      Adjusting for estimated hurricane-related sales losses in 2005, same store
      sales
      in 2006 would have increased by 3.3% over the prior year.




31




The
      cost
      of restaurant sales as a percentage of restaurant sales decreased to 32.2%
      for
      2006 from 33.1% for 2005. This 0.9% improvement in cost of sales as a percentage
      of sales primarily related to higher menu pricing implemented to offset the
      effect of the Florida minimum wage increases, an increase in liquor sales as
      a
      percentage of total sales, and gains derived from better operational controls
      over food and beverage costs.





Labor
      and
      other related expenses as a percentage of restaurant sales decreased to 30.9%
      in
      2006 as compared to 31.0% in 2005. We benefited from non-recurring reductions
      in
      benefits and taxes relating to workers compensation insurance reserve
      reductions, and corresponding refunds from prior years’ experiences of $107,000
      and $344,000 in 2006 and 2005, respectively, of which $96,000 and $330,000
      were
      allocated to restaurant labor costs. Exclusive of the non-recurring items,
      labor
      and other related expenses as a percentage of restaurant sales were 31.1% and
      31.8% for 2006 and 2005, respectively. This improvement of 0.7% as a percentage
      of restaurant sales primarily related to a reduction in workers’ compensation
      insurance premiums and unemployment taxes and a decrease in restaurant labor
      expense due to improved operational efficiencies, offset partially by minimum
      wage increases.





Other
      restaurant operating expenses were $12,948,000, or 27.2% of restaurant sales
      for
      2006, as compared with $11,374,000, or 25.7% of restaurant sales for 2005.
      This
      unfavorable variance of 1.5% as a percentage of restaurant sales was primarily
      due to increased utilities, insurance and occupancy costs, as affected by
      property taxes, partially offset by a decrease in advertising costs.




Depreciation
      and amortization expense was $2,199,000 or 4.6% as a percentage of restaurant
      sales, for 2006 and $1,499,000, or 3.4% as a percentage of restaurant sales,
      for
      2005. The 1.2% increase as a percentage of restaurant sales was due to
      additional restaurant remodels and new and relocated restaurants, subsequent
      to
      the third quarter of 2005.




There
      were no pre-opening expenses in 2006 compared to $758,000, or 1.7% of restaurant
      sales in 2005, related to new locations in Clearwater Beach and St. Petersburg
      and the relocation of our Stuart restaurant to a higher volume site. Pre-opening
      expenses relate to the costs incurred prior to opening a new restaurant location
      primarily for training, advertising, occupancy and legal costs.





In
      2006,
      we recorded a provision in operating expenses for the impairment of assets
      totaling $1,242,000 or 2.6% of restaurant sales relating to the write-down
      of
      assets at one restaurant to their estimated fair value in accordance with
      Financial Accounting Standards Board Statement No. 144. The write-down was
      necessitated by the then current period operating losses and the projected
      deficiency of cash flow of the restaurant. There was no provision recorded
      in
      operating expenses in 2005 relating to the impairment of assets.





General
      and administrative expenses were $3,821,000 or 8.0% of revenues and $4,015,000
      or 9.0% of revenues in 2006 and 2005, respectively. The decrease from the prior
      year is primarily related to decreases in manager training expenses, legal
      expenses, and recruiting, partially offset by increases in stock option expense.
      General and administrative expenses relate to the operations of all Shells
      restaurants owned by us and management services that we provide to the managed
      restaurants.




In
      April
      2006, we recognized $212,000 of net cash proceeds in a non-recurring transaction
      related to the sale of an option embedded in the Ocala restaurant lease
      agreement to a new landlord. In January 2005, we entered into an agreement
      with
      our landlord in St. Pete Beach, Florida, whereby the landlord paid $600,000
      to
      us for an option to buy-out the lease upon 60 days notice to us. To-date, no
      termination notice has been received from the landlord. We recorded a pre-tax
      charge of $211,000 relating to the write-down of impaired assets to their
      estimated fair value in accordance with Financial Accounting Standards Board
      Statement No. 144 relating to the expected shortened lease period as potentially
      affected by the lease buy-out option.




32




Net
      interest expense was $332,000 in 2006 compared to $413,000 in 2005. The $81,000
      decrease in net interest expense in 2006 from 2005, was generally due to the
      retirement of debt in May 2005 in conjunction with our then private financing
      transaction and the retirement of debt in October 2006 in conjunction with
      the
      completion of a sale of a restaurant property, partially offset by additions
      in
      interest on the line of credit with related parties and the bank credit
      facility.




Other
      expense, net, in 2006 was $173,000, compared to other income, net, in 2005
      of
      $30,000. In 2006, exclusive of non-recurring items, other expense was $111,000
      in 2006 and $13,000 in 2005. In 2006, we recognized a loss on disposal of assets
      of $39,000 from the write-down of fixed assets replaced during remodeling and
      $23,000 related to the settlement of lease obligations on a closed location.
      In
      2005, we recognized a non-recurring gain of $793,000 on a property sale,
      partially offset by non-recurring expenses of (i) $472,000 in losses on disposal
      of assets primarily related to restaurant remodeling, (ii) $100,000 lease
      termination fee for the early termination of a lease in Stuart, Florida, (iii)
      $98,000 in hurricane-related expenses, net of insurance recoveries, and (iv)
      $80,000 in financing costs related to a line of credit fee paid to our
      investors.




As
      a
      result of the factors discussed above, the loss from operations for 2006 was
      $2,466,000 as compared to a loss from operations of $1,587,000 for 2005.
      Exclusive of non-recurring items, our loss from operations was $1,331,000 for
      2006 compared to $1,168,000 for 2005. Net loss before preferred stock dividend
      for 2006 was $3,002,000 compared to $1,852,000 for 2005. Exclusive of
      non-recurring items, the net loss in 2006 was $2,017,000 compared to $1,865,000
      for 2005.





The
      deemed dividend in 2005 associated with warrants and beneficial conversion
      feature of our Series B Convertible Preferred Stock of $1,735,000 related to
      the
      May 2005 private placement financing transaction when we issued Series B
      Convertible Preferred Stock and warrants to purchase common stock. This one-time
      implied preferred stock dividend was recorded through accumulated
      deficit.




33


**Liquidity
      and Capital Resources**





In
      2007,
      we incurred a significant loss from operations due to a sharp decrease in sales
      in our existing restaurants, coupled with rising commodity, operating and labor
      costs and already existing historically high utility rates, property taxes
      and
      insurance costs. We recorded a provision of $1,270,000 for impairments of assets
      recognized in the second and fourth quarters of 2007. Similarly in 2006, we
      recorded a provision of $1,242,000 for asset impairments. Given the external
      challenges we continued to face in 2007, which increased our costs as a
      percentage of revenues, we took measures to reduce expenses and improve
      efficiencies in those areas of costs that were within our control, such as
      cost
      of sales, labor and general and administrative expenses.





In
      March
      2005, certain of our investors provided us a $1,600,000 revolving line of
      credit, which was originally due to mature on the earlier of March 31, 2006
      or
      the closing of a financing providing us not less than $1,600,000 of net
      proceeds. The investors received a fee of $80,000 for establishing the credit
      line. Amounts drawn under the line of credit bear interest at the rate of 15%
      per annum, payable 8% monthly in arrears and 7% deferred until the maturity
      date. Upon completion of the financing in May 2005 described below, the maturity
      date was extended to May 23, 2007. In March 2007, the maturity date was further
      extended to May 23, 2008 for an extension fee equal to 7% of the outstanding
      line of credit which was paid with 224,000 shares of our common stock, with
      a
      recognized transaction cost of $101,000. At the time of the extension, the
      amount available to be drawn under the revolving line of credit was reduced
      to
      the then current amount borrowed of $1,440,000. In October 2005, we utilized
      $800,000 of the line of credit to fund the acquisition and opening costs of
      two
      new restaurant locations. In June 2006, we utilized an additional $640,000
      of
      the revolving line of credit to fund remaining remodeling costs and working
      capital requirements.





In
      December 2005, we secured a six-month, $500,000 bank credit facility for which
      the full amount was immediately drawn on to fund remodeling. In April 2006,
      we
      recognized $212,000 in net cash proceeds related to the sale of an option
      embedded in the lease agreement of our restaurant property in Ocala, Florida.
      In
      October 2006, we completed a sale and simultaneous leaseback of our restaurant
      property in New Smyrna Beach, Florida, at a sales price of $1,333,000 in which
      we received net cash proceeds of $885,000, after transaction costs and
      retirement of a $324,000 note on the property. We also simultaneously retired
      the $500,000 bank credit facility, which had at that time been extended in
      anticipation of the New Smyrna transaction being completed.





In
      December 2007, we entered into an agreement to sell our marks and system in
      certain middle eastern countries to Food and Entertainment Co., LTD, an entity
      owned by the Alhokair Group, a company domiciled in the Kingdom of Saudi Arabia.
      We sold the development rights to Food and Entertainment to open 10 restaurants
      over a 10-year period, solely within a territory to initially consist of the
      Kingdom of Saudi Arabia, Egypt, Jordan, Qatar, Oman, Bahrain, United Arab
      Emirates, Kuwait, Pakistan, India and based on additional performance criteria,
      Tunisia and Morocco. The purchase price for such rights was $1,750,000. We
      received $700,000 upon the execution of the agreement and $350,000 in January
      2008, and will receive an additional $350,000 in each of April 2008 and July
      2008. The purchase price is supported by an irrevocable letter of credit in
      the
      amount of $1,050,000, which expires in October 2008.





In
      conjunction with such sale of our marks and system, we also entered into an
      agreement to provide technical consulting and support services to Food and
      Entertainment for a 10-year period, with two additional five-year options at
      the
      election of Food and Entertainment. Technical and support services to be
      provided under the agreement include restaurant design, operations, training,
      product sourcing and menu engineering for which we receive a fee of 1% of Food
      and Entertainment’s gross sales of its Shells restaurants in operation, payable
      monthly. Upon expiration of the initial $1,050,000 letter of credit, and
      continuing for the duration of the technical consulting and support services
      agreement, Food and Entertainment has agreed to provide us with a $500,000
      irrevocable letter of credit.




34




The
      following table presents a summary of our cash flows for the last three fiscal
      years (in thousands):


2007
              
              2006
              
              2005Net
                  cash (used in) provided by operating activities
              
              $
              (275
              )
              $
              38
              
              $
              1,477Net
                  cash provided by (used in) investing activities
              
              
              54
              
              
              (278
              )
              
              (5,518
              )Net
                  cash (used in) provided by financing activities
              
              
              (55
              )
              
              (387
              )
              
              3,052Net
                  decrease in cash
              
              $
              (276
              )
              $
              (627
              )
              $
              (989
              )
 As
        of
        December 30, 2007, our current liabilities of $7,122,000 exceeded our current
        assets of $2,410,000, resulting in a working capital deficiency of $4,712,000.
        In comparison, as of December 31, 2006, our working capital deficiency was
        $4,446,000. Our operating leverage decreased slightly, primarily due to an
        $981,000 increase in current liabilities and a $276,000 lower cash balance
        than
        last year, mostly offset by a $1,073,000 increase in other current assets
        reflecting the receivable outstanding from the transaction with Food and
        Entertainment. The increase in current liabilities, in large part, related
        to
        the reclassification of $1,627,000 in related party notes and deferred interest
        payable, which is scheduled to mature on May 23, 2008. As a partial offset,
        current maturities of long-term debt decreased by $400,000 due to the
        refinancing of the Melbourne note. Additionally, accrued expenses and accounts
        payable decreased by $257,000 and $102,000 from the prior year, respectively.
        Historically, we have generally operated with negative working capital as
        a
        result of investing current assets into non-current property and equipment,
        as
        well as the turnover of restaurant inventory relative to more favorable vendor
        terms in accounts payable.





Our
      year-end cash position decreased $276,000, from $734,000 as of December 31,
      2006
      to $458,000 as of December 30, 2007. The decrease in cash mostly related to
      cash
      used in operating activities of $275,000, resulting from the operating loss
      in
      2007. Cash provided by investing activities of $54,000, reflected $493,000
      in
      proceeds from the sale of assets relating to the dispositions of the Coral
      Springs and Davie restaurants, mostly offset by capital expenditures of
      $439,000. Cash used in financing activities of $56,000 reflected $1,682,000
      in
      debt repayment and $142,000 in minority partner distributions, mostly offset
      by
      $1,768,000 in proceeds from the issuance of debt related primarily to short-term
      insurance premium financing and the refinancing of the Melbourne note.





On
      December 7, 2004, we completed a financing to include $2,375,000 principal
      amount of debentures and warrants to purchase 1,187,500 shares of our common
      stock. We received net proceeds of $2,010,000 from the financing. We paid
      interest at 12% and late payment penalties through May 23, 2005 when the
      debentures were retired by repayment in cash or conversion into our Series
      B
      Preferred Stock. Repayments in cash consisted of principal of $2,055,000, plus
      interest and penalties of $177,000. Debentures converted into our Series B
      Preferred Stock consisted of $320,000 principal plus interest and penalties
      of
      $28,000. The warrants were exercisable until December 7, 2007 at an exercise
      price of $0.60 per share. These warrants have expired without being exercised.
      As compensation for their services as placement agent in the debenture offering
      and future consulting services to us, the placement agent received cash fees
      and
      warrants with terms substantially identical to those received by the investors.
      The placement agent warrants have also expired without being
      exercised.




35




In
      October 2002, we refinanced through Colonial Bank two of our restaurant
      locations, Melbourne and Winter Haven, with notes of $635,000 and $667,000,
      respectively, both notes maturing in October 2007 with 15-year principal
      amortization schedules. In September 2005, we completed a sale and leaseback
      transaction of the Winter Haven location, providing net cash proceeds of
      $981,000, after repayment of the bank note mortgage and a second secured note.
      Upon repayment of the Winter Haven note, we ceased to be subject to the prior
      bank loan covenant provisions. In September 2007, we refinanced the $407,000
      outstanding balance of the promissory note securing the Melbourne property.
      Additionally, the note was increased to $607,000, of which $200,000 funded
      a
      significant portion of the Melbourne restaurant remodeling.





We
      have
      incurred significant losses from operations, an accumulated deficit, and secured
      promissory notes which are scheduled to mature in May 2008, that raise
      substantial doubt about our ability to continue as a going concern. Sufficient
      liquidity to satisfy the debt obligations under these promissory notes if the
      maturity dates are not further extended, coupled with meeting other debt
      obligations; is dependent primarily on the realization of cash flow from
      operations, additional scheduled payments to be received from the transaction
      with Food and Entertainment and obtaining alternative financing sources. There
      can be no assurances that these initiatives will be successful. Our independent
      registered public accounting firm has included an explanatory paragraph in
      their
      report on our financial statements, stating that these statements have been
      prepared assuming that we will continue as a going concern and that our
      recurring losses from operations and net working capital deficiency raise
      substantial doubt about our ability to continue as a going concern.




36




**Contractual
      Obligations**





As
      of
      December 30, 2007, our contractual obligations were:




Payments due by periodTotal
            
            < 1 yr
            
            1 - 3 yrs
            
            4 - 5 yrs
            
            > 5yrsLong-term
                debt (1)
            
            $
            881,629
            
            $
            223,340
            
            $
            119,153
            
            $
            539,136
            
            $
            -Capital
                lease obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Operating
                lease obligations (2)
            
            
            23,146,571
            
            
            2,753,128
            
            
            5,145,869
            
            
            4,407,784
            
            
            10,839,790Purchase
                obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Other
                debt obligations reflected on the balance sheet under GAAP
                (3)
            
            
            1,626,504
            
            
            1,626,504
            
            
            -
            
            
            -
            
            
            -Total
            
            $
            25,654,704
            
            $
            4,602,972
            
            $
            5,265,022
            
            $
            4,946,920
            
            $
            10,839,790





(1)
            
            Consists
                of long-term debt as reported in Note 7 of the Notes to Consolidated
                Financial Statements.(2)
            
            Consists
                of operating leases primarily for real estate.(3)
            
            Consists
                of related party debt due in 2008.




**Quarterly
      Fluctuation of Financial Results**





The
      restaurant industry in general is seasonal, depending on restaurant location
      and
      the type of food served. We have experienced fluctuations in our
      quarter-to-quarter operating results due, in large measure, to our concentration
      of restaurants in Florida. Business in Florida is influenced by seasonality
      due
      to various factors, which include but are not limited to weather conditions
      in
      Florida relative to other areas of the U.S., the health of Florida's economy
      and
      the effect of world events in general, and the tourism industry in particular.
      Our restaurant sales are generally highest from January through April and June
      through August, the peaks of the Florida tourism season, and generally lower
      from September through mid-December. Many of our restaurant locations are in
      coastal cities, where sales are significantly dependent on tourism and its
      seasonality patterns.





In
      addition, quarterly results have been substantially affected by the timing
      of
      restaurant closings, openings and remodelings. Because of the seasonality of
      our
      business and the impact of restaurant closings, openings and remodelings,
      results for any quarter are not generally indicative of the results that may
      be
      achieved for a full fiscal year on an annualized basis and cannot be used to
      indicate financial performance for the entire year.




**New
        Accounting Pronouncements**
  In
        December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS
        No. 141 (revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R
        establishes principles and requirements for an acquiring entity to recognize
        and
        measure in its financial statements the identifiable assets acquired, the
        liabilities assumed, any noncontrolling interest in the acquiree and the
        goodwill acquired. SFAS 141R expands on required disclosures to improve the
        statement users’ abilities to evaluate the nature and financial effects of
        business combinations. SFAS 141R is effective for fiscal years beginning
        after
        December 15, 2008. We are currently evaluating the potential impact, if
        any, of the adoption of SFAS 141R on our Consolidated Financial Statements.
  In
        December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
        Consolidated Financial Statements—an amendment of ARB No. 51 (“SFAS 160”).
        SFAS 160 requires that a noncontrolling interest in a subsidiary be reported
        within equity and the amount of consolidated net income attributable to the
        noncontrolling interest be identified in the consolidated financial statements.
        SFAS 160 calls for consistency in the manner of reporting changes in the
        parent’s ownership interest and requires fair value measurement of any
        noncontrolling equity investment retained in a deconsolidation. SFAS No.
        160 also establishes disclosure requirements that clearly identify and
        distinguish between the interests of the parent and the interests of the
        noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning
        after December 15, 2008. We are currently evaluating the potential impact,
        if any, of the adoption of SFAS 160 on our Consolidated Financial Statements.
  In
        February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
        Financial Assets and Financial Liabilities (“SFAS 159”), which gives entities
        the option to measure eligible financial assets, and financial liabilities
        at
        fair value on an instrument by instrument basis, that are otherwise not
        permitted to be accounted for at fair value under other accounting standards.
        The election to use the fair value option is available when an entity first
        recognizes a financial asset or financial liability. Subsequent changes in
        fair
        value must be recorded in earnings. This statement is effective as of the
        beginning of a company’s first fiscal year after November 15, 2007. The
        adoption of this Statement is not expected to have a material effect on our
        Consolidated Financial Statements.
  In
        September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
        (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring
        fair value in accordance with generally accepted accounting principles, and
        expands disclosures about fair value measurements .
        SFAS
        157 is effective for fiscal years beginning after November 15, 2007. The
        adoption of this Statement is not expected to have a material effect on our
        Consolidated Financial Statements.





**Impact
      of Inflation and Price Changes**





We
      have
      not operated in a highly inflationary period and management does not believe
      that inflation has had a material affect on sales or expenses through 2007.
      As
      expenses increase, such as the annual increases in the minimum wage rate in
      Florida and the recent significant increases in commodity costs, utilities,
      occupancy costs, and insurance, we expect to recover increased costs by
      increasing prices, to the extent permitted by competition, or by operating
      our
      business more efficiently and modifying our menu and promoting other less cost
      sensitive products. Many food products purchased by us are affected by commodity
      pricing and are, therefore, subject to unpredictable price volatility. Extreme
      changes in commodity prices and/or long-term changes, including operating
      expenses, could affect us adversely. From time-to-time, competitive
      circumstances could limit menu price flexibility, and in those cases margins
      would be negatively impacted by increased commodity prices.




37




**ITEM
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





We
      have
      limited exposure to market risk from changes in interest rates on debt and
      changes in commodity prices. Our exposure to interest rate risk is limited
      due
      to the fixed interest rates on our current debt instruments.




38




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





INDEX
      TO
      CONSOLIDATED FINANCIAL STATEMENTS





Report
                of Independent Registered Public Accounting Firm
            
            F-1Consolidated
                Balance Sheets
            
            F-2Consolidated
                Statements of Operations
            
            F-3Consolidated
                Statements of Stockholders’ Equity
            
            F-4Consolidated
                Statements of Cash Flows
            
            F-5Notes
                to Consolidated Financial Statements
            
            F-8




39




**REPORT
      OF IDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





To
      the
      Board of Directors and Stockholders


Shells
      Seafood Restaurants, Inc. and Subsidiaries


Tampa,
      Florida





We
      have
      audited the accompanying consolidated balance sheets of Shells Seafood
      Restaurants, Inc. and Subsidiaries (the "Company") as of December 30, 2007
      and
      December 31, 2006 and the related consolidated statements of operations,
      stockholders' equity and cash flows for the fiscal years ended December 30,
      2007
      (52 weeks), December 31, 2006 (52 weeks) and January 1, 2006 (52 weeks). These
      consolidated financial statements are the responsibility of company's
      management. Our responsibility is to express an opinion on these consolidated
      financial statements based on our audits.




We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the
      consolidated financial statements are free of material misstatement. The company
      is not required to have, nor were we engaged to perform, an audit of its
      internal control over financial reporting. Our audits included consideration
      of
      internal control over financial reporting as a basis for designing audit
      procedures that are appropriate in the circumstances, but not for the purpose
      of
      expressing an opinion on the effectiveness of the company’s internal control
      over financial reporting. Accordingly, we express no such opinion. An audit
      also
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the consolidated financial statements. An audit also includes
      assessing the accounting principles used and significant estimates made by
      management, as well as evaluating the overall financial statement presentation.
      We believe that our audits provide a reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of the Company as of December
      30, 2007 and December 31, 2006 and the results of its operations and cash flows
      for the fiscal years ended December 30, 2007 (52 weeks), December 31, 2006
      (52
      weeks) and January 1, 2006 (52 weeks) in conformity with accounting principles
      generally accepted in the United States of America.





The
      accompanying consolidated financial statements have been prepared assuming
      the
      Company will continue as a going concern. As more fully described in Note 1,
      the
      Company has incurred recurring losses from operations, has an accumulated
      deficit and has a secured promissory note due in fiscal 2008. These conditions
      raise substantial doubt about the Company’s ability to continue as a going
      concern. Management’s plans in regard to these matters are also described in
      Note 1. The consolidated financial statements do not include any adjustments
      to
      reflect the possible effects on the recoverability and classification of assets
      or the amounts and classification of liabilities that may result from the
      outcome of this uncertainty.




/s/
      Kirkland, Russ, Murphy & Tapp P.A.


Clearwater,
      Florida


March
      28,
      2008




F-1




**SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**





December 30,
            
            December 31,2007
            
            2006**ASSETS**Cash
            
            $
            457,754
            
            $
            734,122Inventories
            
            
            446,521
            
            
            543,183Other
                current assets
            
            
            1,456,965
            
            
            383,598Receivables
                from related parties, net
            
            
            48,780
            
            
            34,305Total
                current assets
            
            
            2,410,020
            
            
            1,695,208Property
                and equipment, net
            
            
            6,073,218
            
            
            9,170,821Goodwill
            
            
            2,474,407
            
            
            2,474,407Other
                assets
            
            
            509,164
            
            
            481,641Prepaid
                rent
            
            
            12,009
            
            
            14,629TOTAL
                ASSETS
            
            $
            11,478,818
            
            $
            13,836,706**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Accounts
                payable
            
            $
            3,145,797
            
            $
            3,248,031Accrued
                expenses
            
            
            1,786,675
            
            
            2,043,678Sales
                tax payable
            
            
            164,188
            
            
            225,639Current
                portion of unearned revenue
            
            
            174,996
            
            
            -Notes
                and deferred interest payable to related parties
            
            
            1,626,504
            
            
            -Current
                portion of long-term debt
            
            
            223,340
            
            
            623,526Total
                current liabilities
            
            
            7,121,500
            
            
            6,140,874Notes
                and deferred interest payable to related parties
            
            
            -
            
            
            1,527,453Long-term
                debt, less current portion
            
            
            658,289
            
            
            171,847Unearned
                revenue, less current portion
            
            
            1,560,421
            
            
            -Deferred
                rent
            
            
            1,238,121
            
            
            1,135,873Total
                liabilities
            
            
            10,578,331
            
            
            8,976,047Minority
                partner interest
            
            
            539,020
            
            
            521,876STOCKHOLDERS’
                EQUITY:Preferred
                stock, $0.01 par value; authorized 2,000,000 shares;Series
                A - 22,694 shares issued and outstanding
            
            
            227
            
            
            227Series
                B - 87,552 and 373,849 shares issued and outstanding
            
            
            876
            
            
            3,738Common
                stock, $0.01 par value; authorized 58,000,000 shares;23,537,948
                and 17,586,988 shares issued and outstanding, respectively
            
            
            235,379
            
            
            175,870Additional
                paid-in-capital
            
            
            25,626,153
            
            
            25,259,714Accumulated
                deficit
            
            
            (25,501,168
            )
            
            (21,100,766
            )Total
                stockholders’ equity
            
            
            361,467
            
            
            4,338,783TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY
            
            $
            11,478,818
            
            $
            13,836,706





**See
      notes to consolidated financial statements and report of independent registered
      public accounting firm.**




F-2




**SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**




Fiscal
                  Years EndedDecember
                  30,
              
              December
                  31,
              
              January
                  1,2007
              
              2006
              
              2006REVENUES
              
              $
              41,458,939
              
              $
              47,829,608
              
              $
              44,487,348RESTAURANT
                  OPERATING COSTS:Food
                  and beverage
              
              
              13,468,912
              
              
              15,363,255
              
              
              14,670,554Labor
              
              
              12,938,233
              
              
              14,722,437
              
              
              13,756,895Other
              
              
              12,373,414
              
              
              12,948,385
              
              
              11,374,609Depreciation
                  and amortization
              
              
              1,789,195
              
              
              2,199,499
              
              
              1,498,656Pre-opening
                  expenses
              
              
              -
              
              
              -
              
              
              758,168Provision
                  for impairment of assets
              
              
              1,269,685
              
              
              1,242,000
              
              
              -Total
                  restaurant operating costs
              
              
              41,839,439
              
              
              46,475,576
              
              
              42,058,882RESTAURANT
                  OPERATING (LOSS) INCOME
              
              
              (380,500
              )
              
              1,354,032
              
              
              2,428,466General
                  and administrative expenses
              
              
              3,560,458
              
              
              3,821,155
              
              
              4,014,675LOSS
                  FROM OPERATIONS
              
              
              (3,940,958
              )
              
              (2,467,123
              )
              
              (1,586,209
              )OTHER
                  (EXPENSE) INCOME:Lease
                  buy-out
              
              
              -
              
              
              212,198
              
              
              600,000Provision
                  for impairment of assets due to lease buy-out
              
              
              -
              
              
              -
              
              
              (211,000
              )Interest
                  expense, net
              
              
              (295,463
              )
              
              (331,814
              )
              
              (413,012
              )Other
                  (expense) income, net
              
              
              (4,837
              )
              
              (173,114
              )
              
              29,587Total
                  other (expense) income, net
              
              
              (300,300
              )
              
              (292,730
              )
              
              5,575LOSS
                    BEFORE ELIMINATION OF MINORITY PARTNER
                    INTEREST
              
              
              (4,241,258
              )
              
              (2,759,853
              )
              
              (1,580,634
              )ELIMINATION
                  OF MINORITY PARTNER INTEREST
              
              
              (159,144
              )
              
              (242,990
              )
              
              (271,112
              )NET
                  LOSS BEFORE PREFERRED STOCK DIVIDEND
              
              
              (4,400,402
              )
              
              (3,002,843
              )
              
              (1,851,746
              )Deemed
                    dividend associated with warrants and beneficial conversion feature
                    of preferred stock(See
                    Note 12, Series B Convertible Preferred Stock)
              
              
              -
              
              
              -
              
              
              (1,735,169
              )NET
                  LOSS APPLICABLE TO COMMON STOCK
              
              $
              (4,400,402
              )
              $
              (3,002,843
              )
              $
              (3,586,915
              )NET
                  LOSS PER SHARE OF COMMON STOCK:Basic
                  and diluted
              
              $
              (0.21
              )
              $
              (0.18
              )
              $
              (0.24
              )WEIGHTED
                    AVERAGE NUMBER OF SHARES OFCOMMON
                    STOCK OUTSTANDING:Basic
                  and diluted
              
              
              20,920,360
              
              
              16,665,209
              
              
              14,796,278





**See
      notes to consolidated financial statements and report of independent registered
      public accounting firm**


F-3


**SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY**





PREFERRED
                STOCK
            
            
            
            
            
            ADDITIONALSeries
                A
            
            Series
                B
            
            COMMON
                STOCK
            
            PAID-IN
            
            ACCUMULATEDShares
            
            Amount
            
            Shares
            
            Amount
            
            Shares
            
            Amount
            
            CAPITAL
            
            DEFICIT
            
            TOTALBalance
                at January 2, 2005
            
            
            35,275
            
            $
            353
            
            
            -
            
            $
            -
            
            
            8,565,406
            
            $
            85,654
            
            $
            14,926,627
            
            $
            (14,511,008
            )
            $
            501,626Net
                loss before preferred stock dividend
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,851,746
            )
            
            (1,851,746
            )Preferred
                  stock issued in private placement financing, net of issuance
                  costs
            
            
            -
            
            
            -
            
            
            461,954
            
            
            4,620
            
            
            -
            
            
            -
            
            
            5,787,018
            
            
            -
            
            
            5,791,638Issuance
                costs, private placement financing
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (123,872
            )
            
            -
            
            
            (123,872
            )Series
                B Preferred Stock warrant issued to placement agent for private placement
                financing
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            123,872
            
            
            -
            
            
            123,872Deemed
                  dividend for warrants and beneficial conversion feature of preferred
                  stock (See Note 12)
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,735,169
            
            
            (1,735,169
            )
            
            -Preferred
                stock converted
            
            
            (11,544
            )
            
            (116
            )
            
            (18,104
            )
            
            (181
            )
            
            419,800
            
            
            4,198
            
            
            (3,901
            )
            
            -
            
            
            -Warrants
                exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            7,123,011
            
            
            71,230
            
            
            2,226,153
            
            
            -
            
            
            2,297,383Warrant
                valuation reserve
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            440,000
            
            
            -
            
            
            440,000Stock
                options exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            26,600
            
            
            266
            
            
            11,246
            
            
            -
            
            
            11,512Balance
                at January 1, 2006
            
            
            23,731
            
            $
            237
            
            
            443,850
            
            $
            4,439
            
            
            16,134,817
            
            $
            161,348
            
            $
            25,122,312
            
            $
            (18,097,923
            )
            $
            7,190,413Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (3,002,843
            )
            
            (3,002,843
            )Stock
                option expense under SFAS 123R
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            124,677
            
            
            -
            
            
            124,677Preferred
                stock converted
            
            
            (1,037
            )
            
            (10
            )
            
            (70,001
            )
            
            (701
            )
            
            1,405,205
            
            
            14,052
            
            
            (13,341
            )
            
            -
            
            
            -Warrants
                exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            37,500
            
            
            375
            
            
            22,125
            
            
            -
            
            
            22,500Stock
                options exercised
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            9,466
            
            
            95
            
            
            3,941
            
            
            -
            
            
            4,036Balance
                at December 31, 2006
            
            
            22,694
            
            $
            227
            
            
            373,849
            
            $
            3,738
            
            
            17,586,988
            
            $
            175,870
            
            $
            25,259,714
            
            $
            (21,100,766
            )
            $
            4,338,783Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,400,402
            )
            
            (4,400,402
            )Stock
                option expense under SFAS 123R
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            321,566
            
            
            -
            
            
            321,566Preferred
                stock converted
            
            
            -
            
            
            -
            
            
            (286,297
            )
            
            (2,862
            )
            
            5,725,960
            
            
            57,259
            
            
            (54,397
            )
            
            -
            
            
            -Common
                stock issued for extension of line of credit
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            224,000
            
            
            2,240
            
            
            98,560
            
            
            -
            
            
            100,800Issuance
                of common stock
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,000
            
            
            10
            
            
            710
            
            
            -
            
            
            720Balance
                at December 30, 2007
            
            
            22,694
            
            $
            227
            
            
            87,552
            
            $
            876
            
            
            23,537,948
            
            $
            235,379
            
            $
            25,626,153
            
            $
            (25,501,168
            )
            $
            361,467





**See
      notes to consolidated financial statements and report of independent registered
      public accounting firm.**


F-4


**SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





Fiscal
                Years EndedDecember
                30,
            
            December
                31,
            
            January
                1,2007
            
            
            2006
            
            
            2006OPERATING
                ACTIVITIES:Net
                loss
            
            $
            (4,400,402
            )
            $
            (3,002,843
            )
            $
            (1,851,746
            )Adjustments
                to reconcile net loss to net cash (used in) provided by operating
                activities:Depreciation
                and amortization
            
            
            1,769,624
            
            
            2,199,499
            
            
            1,498,656Stock
                compensation expense
            
            
            720
            
            
            -
            
            
            -Stock
                option expense
            
            
            321,566
            
            
            124,677
            
            
            -Lease
                buy-out option
            
            
            -
            
            
            (212,198
            )
            
            (600,000
            )Provision
                for impairment of assets
            
            
            1,269,685
            
            
            1,242,000
            
            
            211,000Gain
                on sale of restaurant
            
            
            -
            
            
            -
            
            
            (792,969
            )(Gain)
                loss on disposal of fixed assets
            
            
            (12,602
            )
            
            10,359
            
            
            472,318Minority
                partner interest
            
            
            159,144
            
            
            242,990
            
            
            271,112Changes
                in operating assets and liabilities:Change
                in current assets and liabilities
            
            
            (1,394,718
            )
            
            (860,524
            )
            
            2,767,808Changes
                in other assets and liabilities:Decrease
                (increase) in prepaid rent
            
            
            2,620
            
            
            28,161
            
            
            (306,286
            )Decrease
                (increase) in other assets
            
            
            19,276
            
            
            55,710
            
            
            (16,869
            )Increase
                (decrease) in deferred interest payable to related parties
            
            
            99,051
            
            
            78,751
            
            
            (230,239
            )Increase
                in unearned revenue
            
            
            1,735,417
            
            
            -
            
            
            -Increase
                in deferred rent
            
            
            156,056
            
            
            131,913
            
            
            54,964Total
                adjustments
            
            
            4,125,839
            
            
            3,041,338
            
            
            3,329,495Net
                cash (used in) provided by operating activities
            
            
            (274,563
            )
            
            38,495
            
            
            1,477,749INVESTING
                ACTIVITIES:Proceeds
                from sale of assets
            
            
            493,307
            
            
            1,494,987
            
            
            2,243,859Purchase
                of property and equipment
            
            
            (439,368
            )
            
            (1,773,547
            )
            
            (7,762,226
            )Net
                cash provided by (used in) investing activities
            
            
            53,939
            
            
            (278,560
            )
            
            (5,518,367
            )FINANCING
                ACTIVITIES:Proceeds
                from the issuance of stock
            
            
            -
            
            
            26,536
            
            
            4,963,916Proceeds
                from debt financing
            
            
            1,767,823
            
            
            1,886,742
            
            
            1,951,750Repayment
                of debt
            
            
            (1,681,567
            )
            
            (2,106,586
            )
            
            (3,623,227
            )Minority
                partner distributions
            
            
            (142,000
            )
            
            (193,245
            )
            
            (240,600
            )Net
                cash (used in) provided by financing activities
            
            
            (55,744
            )
            
            (386,553
            )
            
            3,051,839Net
                decrease in cash
            
            
            (276,368
            )
            
            (626,618
            )
            
            (988,779
            )CASH
                AT BEGINNING OF PERIOD
            
            
            734,122
            
            
            1,360,740
            
            
            2,349,519CASH
                AT END OF PERIOD
            
            $
            457,754
            
            $
            734,122
            
            $
            1,360,740





**See
      notes to consolidated financial statements and report of independent registered
      public accounting firm.**


F-5


**SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(continued)**




Fiscal
                Years EndedDecember
                30,
            
            December
                31,
            
            January
                1,2007
            
            2006
            
            2006Cash
                (outflows) flows from changes in current assets and
                liabilities:Inventories
            
            $
            96,662
            
            $
            (44,208
            )
            $
            (102,152
            )Receivables
                from related parties
            
            
            (14,475
            )
            
            80,180
            
            
            (5,008
            )Other
                current assets
            
            
            (1,073,367
            )
            
            (18,371
            )
            
            131,951Accounts
                payable
            
            
            (102,234
            )
            
            (734,122
            )
            
            1,670,569Accrued
                expenses
            
            
            (239,853
            )
            
            (123,969
            )
            
            1,029,441Sales
                tax payable
            
            
            (61,451
            )
            
            (20,034
            )
            
            43,007Change
                in current assets and liabilities
            
            $
            (1,394,718
            )
            $
            (860,524
            )
            $
            2,767,808Supplemental
                disclosure of cash flow information:Cash
                paid for interest
            
            $
            195,132
            
            $
            258,165
            
            $
            399,916Hurricane-related
                insurance recoveries
            
            $
            -
            
            $
            49,336
            
            $
            375,283Financing
                costs, line of credit
            
            $
            -
            
            $
            -
            
            $
            80,000Cash
                paid for income taxes
            
            $
            -
            
            $
            -
            
            $
            -





Non-cash
      operating, investing and financing activities:




·
            Financing
                costs of $100,800 for the issuance of 224,000 shares of our common
                stock
                relating to the extension of the related party line of credit was
                applied
                to Common Stock and Paid in Capital in the first quarter of
                2007.




·
            Accruals
                for bonuses of $17,150 and $7,733 offset reductions in depreciation
                expense in 2007 and 2006,
                respectively.




·
            Deferred
                rent of $53,808 and $119,275 was reduced to offset the loss on disposal
                of
                restaurants in December 2007 and November 2005,
                respectively.




·
            During
                October 2006, gain on the sale-leaseback of our New Smyrna Beach
                location
                of $95,297 was deferred and will be amortized over the 20-year lease
                life
                of the property.




·
            A
                capitalized lease obligation of $123,687 was reclassified to deferred
                rent
                in conjunction with the Ocala lease buy-out in April 2006 and will
                be
                amortized over the 20-year lease life of the
                property.




·
            Warrant
                valuation reserves of $440,000 were applied to Paid in Capital in
                September 2005 upon the registration of the underlying common stock
                with
                the Securities and Exchange
                Commission.




·
            Warrant
                valuation reserves of $284,364 and $223,000 relating to the exercise
                of
                warrants were applied to Paid in Capital in the first and second
                quarters
                of 2005, respectively.




·
            Principal
                on related party debt of $500,000 ($1,000,000 aggregate) was used
                by the
                noteholders to acquire common stock in conjunction with the exercise
                of
                warrants in each of March and May
                2005.




·
            Principal
                and accrued interest of $347,588 was used by the debenture holders
                to
                acquire Series B Preferred Stock in May
                2005.




·
            Principal
                and accrued interest on related party debt of $1,281,666 was used
                by the
                noteholders to acquire Series B Preferred Stock in May
                2005.





**See
      notes to consolidated financial statements and report of independent registered
      public accounting firm.**





F-6




**SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(continued)**







·
            Deemed
                dividend of $1,735,169 for warrants and the beneficial conversion
                feature
                of Series B Preferred Stock was recorded relative to the May 2005
                private
                financing transaction.




·
            An
                issuance cost of $123,872 was recorded for a warrant issued to the
                placement agent in the May 2005 private financing
                transaction.




·
            Accounts
                receivable of $359,860, as of January 2, 2005, for hurricane-related
                insurance recoveries was applied to reduce the $499,795 gain from
                hurricane-related insurance recoveries, resulting in $139,935 proceeds
                from hurricane-related insurance
                recoveries.




**See
      notes to consolidated financial statements and report of independent registered
      public accounting firm.**




F-7




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





**Basis
      of Presentation** –
      At December 30, 2007, Shells Seafood Restaurants, Inc. and Subsidiaries managed
      and operated 23 full-service, casual dining seafood restaurants in Florida
      under
      the name "Shells".





Shells
      was incorporated on April 29, 1993 and began operations in August 1993 when
      it
      purchased from Shells, Inc. the service mark "Shells”, as well as all other
      intangible and tangible assets necessary to operate a restaurant chain under
      the
      name "Shells". Shells subsequently acquired Shells, Inc. effective December
      29,
      1994.





The
      accompanying consolidated financial statements have been prepared in accordance
      with accounting principles generally accepted in the United States of America
      (GAAP) including the assumption of a going concern basis which contemplates
      the
      realization of assets and the settlement of liabilities and commitments in
      the
      normal course of business. We incurred a net loss of $4,400,000 for the fiscal
      year ended December 30, 2007, had negative working capital as of December 30,
      2007 of $4,712,000 and had an accumulated deficit as of December 30, 2007 of
      $25,501,000. Cash used in operations for the fiscal year ended December 30,
      2007
      was $275,000. We have secured promissory notes, which are due in May 2008.
      Sufficient liquidity to make the scheduled debt payment under these promissory
      notes if the maturity date is not extended, or under our other debt obligations,
      is dependent primarily on the realization of cash flow from operations,
      additional scheduled payments to be received from the transaction with Food
      and
      Entertainment and obtaining alternative financing sources. There can be no
      assurances that these initiatives will be successful. The accompanying
      consolidated financial statements do not include any adjustment that might
      result from the outcome of this uncertainty.





Despite
      the many challenges facing Shells, we are greatly committed to our turnaround
      strategy. Our primary objective is to reverse the trend in negative customer
      traffic, by attracting new and lapsed guests to experience our great quality
      seafood at more favorable price points. In addition, we are committed to further
      drive down costs, offsetting those external influences caused by the economy.
      We
      will continue to aggressively address both our top and bottom line pressures.
      We
      will also seek both traditional and non-traditional means to funding our cash
      flow requirements. There are no assurances that our strategies will drive
      improvements in sales and customer traffic needed to meet anticipated cash
      flow
      requirements and restore our profitability. It is also uncertain whether future
      financing options, which may be needed to execute our strategies, will be
      available, on terms that would be acceptable to us, or at all.





**Principles
      of Consolidation** —
      The consolidated financial statements include the accounts and operations of
      Shells and its wholly owned subsidiaries as well as a joint venture partnership
      in which we are a general partner owning a 51% equity interest. All material
      intercompany balances and transactions between the entities have been eliminated
      in consolidation.





**Fiscal
      Year** —
      Our fiscal year is the 52 or 53 weeks ending the Sunday nearest to December
      31.
      Each of our fiscal years ended December 30, 2007 (“fiscal year 2007”), December
      31, 2006 (“fiscal year 2006”), and January 1, 2006 (“fiscal year 2005”) was 52
      weeks.





**Use
      of Estimates** —
      The preparation of the consolidated financial statements in conformity with
      accounting principles generally accepted in the United States of America
      requires management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities and disclosure of contingent assets and
      liabilities at the date of the consolidated financial statements and the
      reported amounts of revenues and expenses during the reporting period. Actual
      results could differ from those estimated.




F-8




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**




**Revenue
      Recognition** —
Our
      revenues are recorded in three categories: restaurant operations, management
      fees and international fees.




Our
      restaurant revenues are retail sales at company-owned or joint-venture
      restaurants. Management fee revenue includes revenue from licensed restaurants
      that are managed and operated by us in return for a percentage of each
      restaurant's sales. International fee revenue includes the recognition of
      revenue from the sale of our marks and system in certain middle eastern
      countries in conjunction with a technical consulting and support services
      agreement over a 10 year period.




Sales
      by
      company-operated restaurants are recognized when food and beverage items are
      sold. Our restaurant sales are reported net of sales taxes collected from
      guests, which are remitted to the appropriate taxing authorities. Management
      fees are earned as a percentage of each restaurant's sales and are recognized
      in
      the period in which the sales are reported to have occurred. International
      fees
      are recognized over the ten year period of the related technical consulting
      and
      support services agreement which is when we have performed substantially all
      services required by the sale of service marks and system agreement.




In
      addition, we record a liability in the period in which a gift card is issued
      and
      proceeds are received. As gift cards are redeemed, this liability is reduced
      and
      revenue is recognized. We recognize gift card breakage income when the
      likelihood of the redemption of the gift card becomes remote.





**Inventories** —
      Inventories consist of food (primarily seafood), beverages and supplies and
      are
      recorded at the lower of cost or market. Cost is determined using the first-in,
      first-out (FIFO) method. We utilize a third party to hold and distribute certain
      products. Such inventory is not recorded by us, nor is the risk of ownership
      transferred to us until our individual restaurants receive product.





**Property
      and Equipment** —
      Property and equipment are stated at cost less the provision for impairment
      and
      are depreciated using the straight-line method over the estimated useful lives
      of the assets. Buildings are depreciated over their estimated useful life of
      30
      years. Leasehold improvements are depreciated over the shorter of the lease
      term
      or the estimated useful life and range from two to 20 years. Useful lives for
      equipment, furniture and fixtures, automobiles, and signs range from three
      to 10
      years.





**Leases** —
      We  recognize
      rent expense for our leased restaurants on a straight-line basis over the
      expected lease term, including cancelable option periods as described below.
      Within the provisions of certain of our leases, there are rent holidays and/or
      escalations in payments over the base lease term, as well as renewal periods.
      The effects of the holidays and escalations have been reflected in rent expense
      on a straight-line basis over the expected lease term, which includes cancelable
      option periods when it is deemed to be reasonably assured that we would incur
      an
      economic penalty for not exercising the option. The lease term commences on
      the
      date when we have the right to control the use of the leased property, which
      is
      typically before rent payments are due under the terms of the lease. Many of
      our
      leases have renewal periods totaling five to 20 years, exercisable at our
      option, and require payment of property taxes, insurance and maintenance costs
      in addition to the rent payments. The consolidated financial statements reflect
      the same lease term for amortizing leasehold improvements as we use to determine
      capital versus operating lease classifications and in calculating straight-line
      rent expense for each restaurant. Percentage rent expense is generally based
      upon sales levels and is accrued at the point in time we determine that it
      is
      probable that such sales levels will be achieved. Our judgments related to
      the
      probable term for each restaurant affect the classification and accounting
      for
      leases as capital versus operating, the rent holidays and escalation in payments
      that are included in the calculation of straight-line rent and the term over
      which leasehold improvements for each restaurant facility are amortized. These
      judgments may produce materially different amounts of depreciation, amortization
      and rent expense than would be reported if different assumed lease terms were
      used.




F-9




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**Goodwill** —
      The excess of the cost over the fair value of the net assets resulting from
      the
      acquisition of Shells, Inc. was recognized as goodwill. During 2002, we adopted
      Financial Accounting Standards Board (“FASB”) Statement No. 142, whereby
      goodwill is evaluated periodically for possible impairment and written down
      to
      fair value, if impaired.




**Impairment
      of Long-lived Assets** —
      Property and equipment, goodwill and other intangible assets are reviewed
      annually or whenever events or changes in circumstances indicate that the
      carrying amount of the asset may not be recoverable by the assets estimated
      future undiscounted cash flows. See Note 16 for additional
      information.





**Income
      Taxes** —
      We use the asset and liability method which recognizes the amount of current
      and
      deferred income taxes payable or refundable at the date of the financial
      statements as a result of all events that have been recognized in the financial
      statements and as measured by the provisions of enacted tax laws. See Note
      13
      for additional information.





In
      July
      2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, and
      Related Implementation Issues (“FIN 48”). FIN 48 clarifies the accounting for
      uncertainty in income taxes recognized in our financial statements in accordance
      with FASB No. 109, Accounting for Income Taxes. FIN 48 prescribes a
      recognition threshold and measurement attribute for a tax position taken or
      expected to be taken in a tax return. FIN 48 also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. We adopted FIN 48 effective January 1,
      2007. The adoption of FIN 48 did not have a material effect on our Consolidated
      Financial Statements.





**Stock-Based
      Compensation and Other Equity Instruments** —
Prior
      to fiscal year 2006, we followed Accounting Principles Board (“APB”) Opinion No.
      25, “Accounting for Stock Issued to Employees,” and related interpretations, in
      accounting for our stock-based compensation plans, rather than the alternative
      fair value accounting method provided for under SFAS No. 123, “Accounting for
      Stock-Based Compensation,” as amended. Accordingly, prior to 2006, we did not
      record stock-based compensation expense for stock options issued to employees
      in
      fixed amounts with exercise prices at least equal to the fair value of the
      underlying common stock on the date of grant.





F-10


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





The
      following table illustrates the effect on net income and earnings per share
      for
      fiscal year 2005, if we had applied the fair value recognition provisions of
      FASB Statement No. 123, *Accounting
      for Stock-Based Compensation* ,
      to
      stock-based employee compensation.




Fiscal Year EndedJanuary 1,2006Net
                    loss applicable to common stock, as reported
                
                $
                (3,586,915
                )Add:
                    Stock-based employee compensation expense included in reported
                    net loss
                    applicable to common stock, net of related tax effects
                
                
                -Deduct:
                    Total stock-based employee compensation expense determined under
                    fair
                    value based method for all awards, net of related tax
                    effects
                
                
                (502,948
                )Pro
                    forma net loss applicable to common stock
                
                $
                (4,089,863
                )Net
                    loss per share of common stock:Basic
                    and diluted—as reported
                
                $
                (0.24
                )Basic
                    and diluted—pro forma
                
                $
                (0.28
                )




Effective
      at the beginning of our fiscal year 2006, we adopted the fair value model for
      recognizing compensation expense for employee stock options in accordance with
      SFAS No. 123R, “Share-Based Payment,” which has the effect of reducing our
      reported net income and net income per share.





We
      account for transactions in which services are received in exchange for equity
      instruments issued based on the fair value of such services received from
      non-employees or of the equity instruments issued, whichever is more reliably
      measured, in accordance with SFAS No. 123R and Emerging Issues Task Force
      (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to
      Other than Employees for Acquiring, or in Conjunction with Selling, Goods or
      Services.” We account for transactions in which we issue convertible securities
      in accordance with EITF Issues No. 98-05, “Accounting for Convertible Securities
      with Beneficial Conversion Features or Contingently Adjustable Conversion
      Ratios” and EITF Issues No. 00-27, “Application of Issue No. 98-05 to Certain
      Convertible Instruments.”





**Net
      Loss per Share of Common Stock** —
      Net loss per common share is computed in accordance with FASB No. 128 “Earnings
      Per Share”, which requires companies to present basic earnings per share and
      diluted earnings per share. Basic net loss per share of common stock is computed
      by dividing net loss applicable to common stock by the weighted average number
      of shares of common stock outstanding. Diluted net loss per share of common
      stock is computed by dividing net loss applicable to common stock by the
      weighted average number of shares of common stock and common stock equivalents
      outstanding. No common stock equivalents were included in the computation of
      diluted net loss per common share for fiscal years 2007, 2006 or 2005 as the
      effect was anti-dilutive.




F-11




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**Fair
      Value of Financial Instruments** —
      The estimated fair value of amounts reported in the consolidated financial
      statements have been determined by using available market information and
      appropriate valuation methodologies. The carrying value of all current assets
      and current liabilities approximates fair value because of their short-term
      nature. The carrying value of long-term debt approximates fair value based
      upon
      quoted market information as available. As judgment is involved, the estimates
      are not necessarily indicative of the amounts that could be realized in a
      current market exchange.




**New
      Accounting Pronouncements**  – In
      December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS
      No. 141 (revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R
      establishes principles and requirements for an acquiring entity to recognize
      and
      measure in its financial statements the identifiable assets acquired, the
      liabilities assumed, any noncontrolling interest in the acquiree and the
      goodwill acquired. SFAS 141R expands on required disclosures to improve the
      statement users’ abilities to evaluate the nature and financial effects of
      business combinations. SFAS 141R is effective for fiscal years beginning after
      December 15, 2008. We are currently evaluating the potential impact, if
      any, of the adoption of SFAS 141R on our Consolidated Financial Statements.




In
      December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
      Consolidated Financial Statements—an amendment of ARB No. 51 (“SFAS 160”).
      SFAS 160 requires that a noncontrolling interest in a subsidiary be reported
      within equity and the amount of consolidated net income attributable to the
      noncontrolling interest be identified in the consolidated financial statements.
      SFAS 160 calls for consistency in the manner of reporting changes in the
      parent’s ownership interest and requires fair value measurement of any
      noncontrolling equity investment retained in a deconsolidation. SFAS No.
      160 also establishes disclosure requirements that clearly identify and
      distinguish between the interests of the parent and the interests of the
      noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning
      after December 15, 2008. We are currently evaluating the potential impact,
      if any, of the adoption of SFAS 160 on our Consolidated Financial Statements.




In
      February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
      Financial Assets and Financial Liabilities (“SFAS 159”), which gives entities
      the option to measure eligible financial assets, and financial liabilities
      at
      fair value on an instrument by instrument basis, that are otherwise not
      permitted to be accounted for at fair value under other accounting standards.
      The election to use the fair value option is available when an entity first
      recognizes a financial asset or financial liability. Subsequent changes in
      fair
      value must be recorded in earnings. This statement is effective as of the
      beginning of a company’s first fiscal year after November 15, 2007. The
      adoption of this Statement is not expected to have a material effect on our
      Consolidated Financial Statements.




In
      September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
      (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring
      fair value in accordance with generally accepted accounting principles, and
      expands disclosures about fair value measurements .
      SFAS
      157 is effective for fiscal years beginning after November 15, 2007. The
      adoption of this Statement is not expected to have a material effect on our
      Consolidated Financial Statements.





**NOTE
      2. LIQUIDITY**





Our
      company’s working capital deficit increased to $4,712,000 in 2007 from
      $4,446,000 in 2006, and our cash position at December 30, 2007 decreased to
      $458,000 from $734,000 on December 31, 2006. Capital expenditures in 2007
      totaled $439,000. In 2007, we received proceeds from the sale of assets totaling
      $493,000, which mostly related to the sale of our leasehold interests in two
      restaurant properties in the second and fourth quarters of 2007.




F-12




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





In
      March
      2005, our investors provided us a $1,600,000 revolving line of credit, which
      was
      originally due to mature on the earlier of March 31, 2006 or the closing of
      a
      financing providing us not less than $1,600,000 of net proceeds. The investors
      received a fee of $80,000 for extending the credit line. Amounts drawn under
      the
      line of credit bear interest at the rate of 15% per annum, payable 8% monthly
      in
      arrears and 7% deferred until the maturity date. Upon completion of the $6.9
      million financing in May 2005, the maturity date was extended to May 23, 2007.
      In October 2005, we utilized $800,000 of the line of credit to fund the
      acquisition and opening costs of two new restaurant locations.




In
      June
      2006, we utilized an additional $640,000 of the revolving line of credit to
      fund
      remaining remodeling costs and working capital requirements. On March 30, 2007,
      the total amount of the line of credit was reduced to $1,440,000, and the
      maturity date was further extended to May 23, 2008 at a fee of 7% of the
      $1,440,000 borrowed, or $101,000, payable through the issuance of 224,000 shares
      of our common stock, based on the closing stock price on that date of $0.45
      per
      share.





In
      December 2005, we secured a six-month, $500,000 bank credit facility for which
      the full amount was immediately drawn on to fund remodeling. In April 2006,
      we
      recognized $212,000 in net cash proceeds related to the negotiation of an option
      embedded in the lease agreement of our restaurant property in Ocala, Florida,
      to
      a new landlord FRI Fish, LLC. In October 2006, we completed a sale and
      simultaneous leaseback of our restaurant property in New Smyrna Beach, Florida
      in which we received net cash proceeds of $885,000. We also simultaneously
      retired the $500,000 bank credit facility, which had at that time been extended
      in anticipation of the New Smyrna transaction being completed.





In
      September 2007, we refinanced the $407,000 promissory note securing the
      Melbourne property, which was due to mature in October 2007. Additionally,
      the
      note was increased to $607,000, of which $200,000 funded a significant portion
      of the Melbourne restaurant remodeling. The loan, which bears a fixed rate
      of
      interest at 7.91%, is for a term of five years with required monthly principal
      payments based on a 15 year amortization schedule, and a balloon payment in
      September 2012. The principal balance owed on this note as of December 30,
      2007
      was $607,000.





In
      December 2007, we entered into an agreement to sell our marks and system to
      Food
      and Entertainment Co., LTD, an entity owned by the Alhokair Group, a company
      domiciled in the Kingdom of Saudi Arabia. We sold development rights to Food
      and
      Entertainment to open 10 restaurants over a 10-year period, solely within a
      territory to initially consist of the Kingdom of Saudi Arabia, Egypt, Jordan,
      Qatar, Oman, Bahrain, United Arab Emirates, Kuwait, Pakistan, India and based
      on
      additional performance criteria, Tunisia and Morocco. The sales price was
      $1,750,000. We received $700,000 at execution; with $350,000 due and paid in
      January 2008, $350,000 due in April 2008 and $350,000 due in July 2008.





In
      conjunction with the sale of our marks and system, we also entered into an
      agreement to provide technical consulting and support services to Food and
      Entertainment for a 10-year period, with two additional five-year options at
      the
      election of Food and Entertainment. Technical and support services include
      restaurant design, operations, training, product sourcing and menu engineering;
      at a fee of 1% of Food and Entertainment’s gross sales of its Shells restaurants
      in operation, payable monthly.





F-13




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





We
      also
      received from Food and Entertainment an irrevocable letter of credit in the
      amount of $1,050,000, to expire in October 2008. Thereafter, and continuing
      for
      the duration of the technical consulting and support services agreement, a
      $500,000 irrevocable letter of credit will be provided to us.





**NOTE
      3. CASH AND OTHER CURRENT ASSETS**





**Concentrations:**


**(a)**
            **Credit
                Risk -**Cash
                balances are maintained in a financial institution located in Florida.
                Occasionally, deposits exceed amounts insured by the Federal Deposit
                Insurance Corporation.


**(b)**
            **Supplies**-
                We acquire a significant amount of our food products utilized in
                the
                preparation of our menu items from a limited number of sources. During
                the
                2007, 2006 and 2005 fiscal years, approximately 42%, 43% and 42%,
                respectively, of related purchases were made from 10
                suppliers.


**(c)**
            **Allowance
                for Doubtful Accounts**–
                We estimate the allowance for uncollectible accounts based on the
                aging of
                the receivables due from related parties. Those receivables that
                are
                deemed uncollectible are charged against the allowance for doubtful
                accounts.




Other
      current assets consist of the following:




December
                30,
            
            December
                31,2007
            
            2006Prepaid
                expenses
            
            $
            401,720
            
            $
            359,103Accounts
                receivable
            
            
            1,050,000
            
            
            -Other
                current assets
            
            
            5,245
            
            
            24,495$
            1,456,965
            
            $
            383,598





**NOTE
      4. PROPERTY AND EQUIPMENT**





Property
      and equipment consist of the following:




December
                30,
            
            December
                31,2007
            
            2006Leasehold
                improvements
            
            $
            6,286,756
            
            $
            7,818,971Equipment
            
            
            3,918,444
            
            
            3,884,837Furniture
                and fixtures
            
            
            4,531,906
            
            
            4,797,285Land
                and buildings
            
            
            822,838
            
            
            826,338Signage
            
            
            520,087
            
            
            640,143Automobiles
            
            
            234,542
            
            
            257,77516,314,573
            
            
            18,225,349Less
                    accumulated depreciation and amortization
            
            
            (10,241,355
            )
            
            (9,054,528
            )$
            6,073,218
            
            $
            9,170,821





F-14





SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





Depreciation
      expense was $1,716,000 in fiscal 2007 compared to $2,190,000 in fiscal 2006
      and
      $1,478,000 in fiscal 2005. During 2007, 2006 and 2005, disposals of fixed assets
      relating to restaurant closing, restaurant remodeling and the sale-leaseback
      transactions resulted in the retirement of $500,000, $409,000 and $2,276,000,
      respectively, in accumulated depreciation.





During
      the second quarter of 2007, an asset write-down of $609,000 was recorded to
      reduce property and equipment relating to the St. Petersburg, Florida location.
      During the fourth quarter of 2007, an asset write-down of $345,000, $155,000
      and
      $160,000 was recorded to reduce the property and equipment related to the
      Kissimmee, Winter Haven and Winter Park locations, respectively. These asset
      impairments were necessitated by a reduction in our estimates of the future
      cash
      flows of these locations due to the unfavorable economic conditions of the
      location or market area. During the fourth quarter of 2006, an asset write-down
      of $942,000 was recorded to reduce property and equipment relating to the
      Clearwater Beach, Florida location. This asset impairment was necessitated
      by
      changes in our estimates and a reduction in the estimated lease life due to
      unfavorable economic conditions of the location.





**NOTE
      5. GOODWILL, PREPAID RENT AND OTHER ASSETS**





Goodwill
      relating to the 1994 merger of Shells, Inc. is evaluated annually for
      impairment. The evaluation compares the estimated value of the Company’s net
      assets excluding goodwill to the market value of the Company. At December 30,
      2007 and December 31, 2006, the market value of the Company exceeded the
      estimated market value of the Company’s net assets by an amount in excess of the
      carrying value of goodwill. As such, no impairment has been recognized. However,
      changes in factors and circumstances could result in an impairment of goodwill
      in the future.





Prepaid
      rent consists of the excess of purchase price over the fair value of assets
      acquired concurrent with a real estate operating lease for a restaurant
      location. During February 2005, we agreed to acquire for $843,000 the leasehold
      rights and personal property of a restaurant located in Clearwater Beach,
      Florida from Gold Coast Restaurants, Inc. (d/b/a Leverock's), out of bankruptcy
      proceedings. The prepaid rent was calculated at $338,000 and was to be amortized
      over the then estimated 16 year remaining life of the lease including all
      options to renew, leaving an unamortized balance as of January 1, 2006 of
      $322,000. During the fourth quarter of 2006, we determined that an asset
      impairment was necessitated by changes in our estimates and a reduction in
      the
      estimated lease life due to unfavorable economic conditions of the location.
      Accordingly, an asset write-down of $300,000 was recorded to reduce prepaid
      rent.





Other
      assets consist of certificates of deposit held by our bank as collateral for
      letters of credit for utility deposits, unamortized service marks and loan
      costs, as well as utility and other vendor deposits.


**NOTE
        6. ACCRUED EXPENSES**
  Accrued
        expenses consist of the following:


F-15




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**




December
                30,
            
            December
                31,2007
            
            2006Accrued
                payroll
            
            $
            617,709
            
            $
            837,085Unearned
                gift card revenue
            
            
            254,445
            
            
            333,558Other
            
            
            363,550
            
            
            276,361Public
                reporting costs
            
            
            252,070
            
            
            234,013Workers
                compensation
            
            
            156,551
            
            
            167,989Restaurant
                closing expenses
            
            
            94,234
            
            
            107,933Property
                taxes
            
            
            48,116
            
            
            86,739$
            1,786,675
            
            $
            2,043,678




F-16




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      7. LONG-TERM DEBT**





Long-term
      debt consists of the following:





December 30,
            
            December 31,2007
            
            2006$607,000
                promissory note with Colonial Bank collateralized by real property
                owned
                by the 51% owned joint venture. The interest rate is fixed at 7.91%.
                Payments are $5,770 monthly, with all unpaid principal due in September
                2012
            
            
            607,071
            
            
            -$635,000
                promissory note with Colonial Bank collateralized by real property
                owned
                by the 51% owned joint venture. Interest was payable monthly based
                on the
                bank's base rate. The unpaid principal balance was paid in full in
                September 2007.
            
            
            -
            
            
            438,271Finance
                agreement, collateralized by automobiles, principal and interest
                due
                monthly at $3,538 through June 2009, at 6.75% fixed interest
                rate.
            
            
            58,597
            
            
            138,117Finance
                agreement, collateralized by insurance policy, principal and interest
                due
                monthly through February 2008, at interest ranging from 5.95% to
                8.74%.
            
            
            114,872
            
            
            113,181Finance
                agreement, collateralized by computer equipment, principal and interest
                due monthly at $2,569 through June 2009, at 9.3% fixed interest
                rate.
            
            
            43,002
            
            
            65,954Finance
                agreement, collateralized by automobile, principal and interest due
                monthly at $818 through February 2010, at 8% fixed interest
                rate.
            
            
            19,436
            
            
            27,322Finance
                agreement, collateralized by automobile, principal and interest due
                monthly at $955 through February 2011, at 7.9% fixed interest
                rate.
            
            
            31,304
            
            
            -Capitalized
                lease agreement, collateralized by equipment, payable monthly at
                $517principal and interest through March 2009.
            
            
            7,347
            
            
            12,528881,629
            
            
            795,373Less
                current portion
            
            
            (223,340
            )
            
            (623,526
            )$
            658,289
            
            $
            171,847





The
      annual maturities of debt as of December 30, 2007 are as follows:





2008
            
            $
            223,3402009
            
            
            81,0292010
            
            
            38,1242011
            
            
            29,1212012
            
            
            510,015$
            881,629





The
      promissory note provided by Colonial Bank requires the Shells of Melbourne
      Joint
      Venture to maintain a minimum Debt Service Coverage Ratio. This covenant relates
      to the Joint Venture only, and the Joint Venture was in compliance as of
      December 30, 2007.




F-17





SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      8. RELATED PARTY DEBT AND RELATED PARTY TRANSACTIONS**





**Related
      Party Debt**





In
      March
      2005, Trinad Capital, L.P. (“Trinad”), Bruce Galloway and Frederick R. Adler
      provided us with a $1.6 million revolving line of credit, which was to mature
      on
      the earlier of March 31, 2006 or the closing of an aggregate amount of financing
      providing us not less than $1.6 million of net proceeds. Trinad Master Fund,
      Ltd., an affiliate of Trinad, Mr. Galloway and Mr. Adler are each security
      holders who beneficially own more than five percent of our common stock. Amounts
      drawn under the line of credit bear interest at the rate of 15% per annum,
      payable 8% monthly in arrears and 7% deferred until the maturity date. During
      2006, these investors received a fee of $80,000, in the aggregate, for extending
      the credit line to us, paid to each investor pro rata in accordance with each
      investor’s percentage interest (50% for Adler, 30% for Trinad and 20% for
      Galloway). In May 2005, these investors agreed to extend the maturity date
      under
      the line of credit to May 23, 2007 for no additional consideration. In March
      2007, the maturity date was further extended to May 23, 2008, and the total
      amount of the credit line was reduced to $1,440,000. As of December 30, 2007,
      we
      have drawn the full $1,440,000 of the available credit line. The funds were
      used
      to assist in the financing of two restaurant acquisitions in the fourth quarter
      of 2005 and to fund remaining remodeling costs and working capital requirements.




In
      March
      2005, Trinad and Galloway exercised warrants to purchase an aggregate of
      1,000,000 shares of our common stock at $0.50 per share. The aggregate proceeds
      of $500,000 were used to pay down the principal amount of their respective
      notes.





In
      May
      2005, we raised approximately $6.9 million in a private offering of our
      securities to accredited investors. The securities sold in the offering were
      units, each unit consisting of a share of our Series B Convertible Preferred
      Stock (initially convertible into 20 shares of our common stock, subject to
      certain specified adjustments, if applicable) and a warrant to purchase 10
      shares of our common stock at an exercise price of $1.30 per share. As part
      of
      this transaction, Mr. Adler used $500,000 principal amount of his note to
      exercise the warrants to purchase 1,000,000 shares of common stock, issued
      to
      him in August 2004; and Mr. Adler, Trinad and the Bruce Galloway, IRA R/O
      converted the remaining $1,000,000 aggregate amount of secured promissory notes
      held by them into units being sold in the offering. During October 2005, Trinad
      Capital, L.P. transferred all of its shares to an affiliate, Trinad Capital
      Master Fund, Ltd.





Notes
      and
      deferred interest payable to these related parties were:





December 30,
            
            December 31,2007
            
            2006Line
                of credit due May 23, 2008 bearing interest at 15%, of which 8% is
                payable
                monthly in arrears and 7% is deferred and payable when the principal
                is
                paid in full, owned by:Frederick
                R. Adler
            
            $
            800,000
            
            $
            800,000Bruce
                Galloway, IRA R/O
            
            
            160,000
            
            
            160,000Trinad
                Capital, L.P.
            
            
            480,000
            
            
            480,000Aggregate
                deferred interest to be payable on May 23, 2008
            
            
            186,504
            
            
            87,453$
            1,626,504
            
            $
            1,527,453





The
      deferred interest due at maturity, May 23, 2008, will be $227,000 on the
      $1,440,000 borrowing.




F-18


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**Related
      Party Transactions**





We
      manage
      two restaurants pursuant to a management and license agreement, which became
      effective July 1993. The management and license agreement of an additional
      restaurant was terminated in October 2005. These entities are deemed to be
      related parties based on our ability to influence the management and operating
      policies of the managed restaurants. We provide management services and license
      our proprietary information required to operate the restaurant for a management
      fee originally set at 6% of restaurant sales. Of the total management fee
      received, 2% of sales is placed in escrow and disbursed to satisfy each managed
      restaurant’s requirement to make third party royalty payments. The management
      agreements were amended in October 2001, reducing the management fee to 4%
      of
      restaurant sales until such time that cash flow for three consecutive months
      is
      at least 80% of the cash flow for the same respective periods in 1999. The
      management fee then becomes 5% of sales. The management fee increases to, and
      is
      maintained at, 6% of sales when cash flow for three consecutive months is at
      least 90% of cash flow for the same respective periods in 1999. The management
      agreements outline the respective owners’ ("licensees") responsibility for
      funding all restaurant expenses, including food and beverage costs, staffing,
      training, recruiting, inventories, working capital and capital expenditures.
      A
      third restaurant is operated by us, pursuant to an oral agreement requiring
      the
      restaurant to be operated in conformance with the policies and procedures
      established by management for Shells restaurants. Our management fee for the
      restaurant was originally set at 4% of the restaurant’s sales (exclusive of any
      escrowed royalty fees), and later was modified to 2% in October 2001. The
      aggregate management fees earned under these agreements was approximately
      $139,000, $156,000 and $152,000 for fiscal 2007, 2006 and 2005,
      respectively.





On
      August
      9, 2005, we entered into an agreement with Deborah Christen Corporation (“DCC”).
      Pursuant to this agreement, effective upon the occurrence of specific conditions
      precedent, including the execution of an agreement by Shells of Carrollwood
      Village, Inc. to abandon or terminate the sublicense agreement which granted
      it
      the use of the service marks in the trade area known as the Carrollwood Trade
      Area, and the management agreement with us for the operation of the “Shells”
restaurant, DCC agreed to grant us a license to use the service marks in
      the Carrollwood Trade Area.





On
      October 21, 2005, we entered into a termination agreement with Shells of
      Carrollwood Village, Inc., whereby they agreed to terminate (a) the management
      and license agreement in the Carrollwood Trade Area, and (b) the agreement
      pursuant to which we granted them an option to transfer all of its assets to
      us
      in exchange for shares of our common stock upon the occurrence of specified
      events. The restaurant previously managed by us under this terminated license
      agreement closed on October 31, 2005.  Upon the closing of the restaurant,
      the agreement we entered into with DCC on August 9, 2005 became effective.
      Under
      this agreement, we had until December 31, 2006 to open a “Shells” restaurant in
      the Carrollwood Trade Area, subject to certain monthly license fees beginning
      on
      April 1, 2006. Further, we agreed to pay DCC a license fee in the amount of
      two
      percent (2%) of the gross receipts of each “Shells” restaurant operated or
      sublicensed by us within the Carrollwood Trade Area. On December 20, 2006,
      we
      entered into an amendment to this agreement with DCC removing the December
      31,
      2006 deadline for the opening of a Shells Seafood Restaurant in the Carrollwood
      Trade Area. We will continue to pay predetermined license fees to DCC until
      such
      time as a Shells Seafood Restaurant has been opened in the Carrollwood Trade
      Area, or the option period expires per written notice from us. The aggregate
      license fees paid under this agreement was approximately $33,000 and $24,000
      for
      fiscal 2007 and 2006, respectively. On February 12, 2008, we terminated our
      agreement with DCC of August 9, 2005 as amended on December 20, 2006.




F-19


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





Effective
      July 1993, we entered into option agreements with three of our licensees, one
      of
      which terminated in October 2005. These agreements, further amended in August
      1995 and October 2001, documented the terms by which we can acquire the
      restaurant’s assets in exchange for a purchase price of six times the
      restaurants cash flow, less any liabilities assumed. The purchase price is
      to be
      paid in the form of shares of our common stock at the prevailing market price.
      The option is exercisable by either party upon Shells averaging a market
      capitalization, as defined, of $100,000,000 for 20 consecutive trading dates.
      The option has not been exercisable through December 30, 2007.





On
      December 28, 2004, we entered into a consulting agreement with Mr. Lawrence
      Wolf, the father of Jay Wolf, who is a member of our board of directors. The
      consulting agreement had a one year term, where Mr. Lawrence Wolf was to assist
      us in providing marketing services; including guidance toward building our
      creative strategy around the “Shells” brand positioning and providing support in
      coordinating our media production. As compensation, Mr. Lawrence Wolf received
      options, under our 2002 Equity Incentive Plan to purchase 130,000 shares of
      common stock at an exercise price of $0.83, the market price on the date of
      grant. The options became fully vested on the first anniversary of the grant
      date. The one-year contract with Mr. Lawrence Wolf was renewed in December
      2005,
      and an additional stock option grant to purchase 130,000 shares of common stock
      was awarded at an exercise price of $0.90 per share, the market price on the
      grant date, with a one-year vesting period. The one-year contract was not
      renewed in December 2006.





On
      September 29, 2005, we sold a certain property to Fortress Realty Investments,
      LLC at a sale price of approximately $1.67 million which was considered a fair
      value purchase amount. Concurrently, we leased a Shells Seafood Restaurant
      location at 1561 3rd Street in Winter Haven, Florida. The minimum lease term
      is
      20 years with a straight-line annual rent of $182,000. Subsequently, Fortress
      Realty Investments, LLC sold the Winter Haven property and assigned its interest
      as lessor to a third party. On April 27, 2006, we completed a lease buy-out
      transaction with Fortress Realty Investments, LLC, pursuant to which we
      transferred our interest in an option embedded in the lease agreement.
      Concurrently, we leased a Shells Seafood Restaurant location at 1561 3rd Street
      in Ocala, Florida. The minimum lease term is 20 years with a straight-line
      annual rent of $178,000. Subsequently, Fortress Realty Investments, LLC sold
      the
      Ocala property and assigned its interest as lessor to a third party. On October
      27, 2006, we completed a sale and leaseback transaction with Fortress Realty
      Investments, LLC, pursuant to which we sold and simultaneously leased back
      a
      Shells Seafood Restaurant location at 725 East 3 rd Avenue,
      New Smyrna Beach, Florida at a sale price of approximately $1.33 million which
      was considered a fair value purchase amount. The minimum lease term is 20 years
      with a straight-line annual rent of $145,000. Fortress Realty Investments is
      related to Drawbridge Global Macro Fund, L.P. which, after converting their
      shares of our Series B Preferred Stock, owned 1,333,340 shares of our common
      stock along with warrants to purchase 666,670 shares of our common stock.
      Drawbridge had been considered a greater than 5% owner of our
      stock.





**NOTE
      9. COMMITMENTS AND CONTINGENCIES**





With
      the
      exception of one operating restaurant, we conduct all of our operations and
      maintain administrative offices in leased facilities. Certain leases provide
      for
      us to pay for common area maintenance charges, insurance, and a proportionate
      share of real estate taxes. In addition, certain leases have escalation clauses
      and/or require additional rent based upon a percentage of the restaurant's
      sales
      in excess of stipulated amounts. Total rent expense under all leases was
      $4,008,000, $3,925,000 and $3,257,000 for fiscal 2007, 2006 and 2005,
      respectively, which included contingent rent of $44,000, $71,000 and $97,000,
      respectively. The approximate future minimum aggregate rental payments under
      such operating leases as of December 30, 2007 are as follows:




F-20


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





2008
            
            $
            2,753,1282009
            
            
            2,596,5402010
            
            
            2,549,3292011
            
            
            2,273,1592012
            
            
            2,134,625Thereafter
            
            
            10,839,790$
            23,146,571




These
      leases expire at various dates through the year 2026 and generally have renewal
      options for additional periods.





On
      August
      9, 2007, we entered into an Amended and Restated Employment Agreement (the
      “Amended Agreement”) with Leslie Christon, our former President and Chief
      Executive Officer, effective as of July 1, 2007. The Amended Agreement amended
      and restated in its entirety Ms. Christon’s employment agreement dated July 1,
      2005. Pursuant to the Amended Agreement, Ms. Christon’s salary was reduced from
      $300,000 to $275,000 per annum and her automobile allowance was increased from
      $1,000 per month to $1,200 per month. The Amended Agreement had an initial
      term
      of one year, and provided for automatic extensions of successive one-year
      periods, unless either party gave the other party written notice within 90
      days
      prior to the termination date.





The
      Amended Agreement provides, among other things, that Ms. Christon shall be
      entitled to severance upon her termination without cause or the failure of
      the
      Company to renew the Amended Agreement after its initial one-year term (a
“Severance Event”). On February 29, 2008, Ms. Christon employment with the
      Company ceased in a manner which qualified as a Severance Event. As such, Ms.
      Christon is entitled to receive the payment of her base salary and healthcare
      benefits for a period ending on the earlier of August 29, 2008 or the date
      on
      which she commences employment with another entity or person. Further, Ms.
      Christon has agreed not to compete with the Company for a period of time during
      which she is receiving severance payments.





Effective
      March 13, 2006, we entered into an agreement with Guy C. Kathman, our
      Vice-President of Operations and Warren R. Nelson, our interim President and
      Chief Financial Officer, to provide them with severance and other considerations
      to be paid upon a Change in Control of our Company (as defined in their
      respective agreements). Mr. Nelson is also a party to a letter agreement from
      the Board of Directors clarifying his severance arrangement if he is terminated
      without cause.





On
      August
      1, 2006, we were advised by our subtenant, Famous Dave’s RIBS-U, Inc., that they
      discontinued operations of the restaurant located in Streamwood, Illinois and
      have ceased remitting rent payments required by the sublease. The subtenant
      has
      requested discussions on settlement for a lease termination. Such restaurant
      closure is a condition of default under the sublease as well as the master
      lease
      between Shells and the ultimate landlord, 948 Barrington Road Partnership.
      The
      parties are continuing efforts to seek a suitable tenant replacement. The
      financial implications to Shells are undetermined at this time. If necessary,
      we
      intend to pursue our rights against Famous Dave’s RIBS-U, Inc., as appropriate
      to protect our interest.




F-21


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





On
      March
      13, 2007 and on July 16, 2007, summons were served from the circuit court in
      Kane County, Illinois, naming the Spring Hill Mall, L.L.C., the primary
      landlord, as plaintiff. The suit relates to a restaurant lease in
      Carpentersville, Illinois. Under this lease, we are a sub-tenant to Chi-Chi’s,
      Inc., who filed bankruptcy in 2003 and subsequently rejected the lease. Since
      2000, we have been further subleasing this property to Famous Dave’s RIBS-U,
      Inc. Under such terms, we partially subsidize lease payments. Since 2003, we
      have been negotiating with Spring Hill Mall for a buyout of our obligations
      under the various subleases. Under the suit, Spring Hill Mall sought payment
      of
      rent, occupancy, and related charges totaling $147,000 with the addition of
      interest and fees related to the suit. In February 2008, Spring Hill Mall and
      Shells jointly agreed to a settlement plan, whereby we will pay monthly to
      Spring Hill Mall amounts aggregating $177,840, which include amounts due in
      arrears as well as future amounts due from us through the term of the lease
      ending December 2010. Under the settlement agreement, we will maintain
      responsibility for leasehold obligations until December 2010.





On
      January 31, 2008, a summons was served from the Supreme Court of the State
      of
      New York, County of New York, naming 320 West 13th Street, LLC as plaintiff.
      This suit was brought against, among others, Jay A. Wolf, a member of our Board
      of Directors, and various entities allegedly controlled by Mr. Wolf, including
      Shells Seafood Restaurants, Inc. We believe we were wrongly named in this suit
      and are seeking to have our company removed as a defendant.





On
      February 27, 2008, a summons was served from the circuit court in Volusia
      County, Florida, naming Coconuts of Daytona Beach, Inc. as plaintiff. The suit
      relates to a lease with our subsidiary, Shells of Daytona Beach, Inc. (currently
      known as America’s Favorite Seafood, Inc.), of furniture, fixtures and equipment
      assigned on July 12, 1989. The plaintiff alleges that we have breached the
      agreement, as we discontinued making payments under the contract at or about
      April 2007. We believe the case is without merit and will defend it vigorously.




We
      are
      subject to legal proceedings, claims and liabilities that arose in the ordinary
      course of business. In the opinion of management, the amount of ultimate
      liability with respect to these actions will not materially affect our financial
      position, results of operations or cash flows.




F-22





SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      10. MINORITY PARTNER INTEREST**





We
      have a
      51% equity interest in a joint venture partnership that owns and operates the
      Shells restaurant located in Melbourne, Florida. We entered into the joint
      venture partnership in March 1994 with WLH Investments, Inc., a corporation
      owned by the wife of our then President, who was a Director of Shells until
      February 2002. As a condition of the partnership, WLH Investments contributed
      $400,000 in capital. Profits of the partnership are allocated as follows: (i)
      100% of the first $60,000 annually is allocated to WLH Investments, (ii) 100%
      of
      the next $60,000 is allocated to us and (iii) any excess over the $120,000
      is
      allocated 51% to us and 49% to WLH Investments. All losses are allocated in
      accordance with the ownership percentages.





Our
      share
      of the partnership profits was $163,000, $251,000 and $280,000 during fiscal
      2007, 2006 and 2005, respectively. In addition, the partnership paid us
      $158,000, $180,000 and $190,000 in fiscal 2007, 2006 and 2005, respectively,
      for
      management and license fees. The joint venture and management agreement outline
      the respective joint venture partner’s responsibility for funding all restaurant
      expenses, including food and beverage costs, staffing, training, recruiting,
      inventories, working capital, capital expenditures and principal and interest
      payments on loans and mortgages. The joint venture’s cash balance at fiscal year
      end was $142,000, $94,000 and $176,000 for 2007, 2006 and 2005,
      respectively.





The
      joint
      venture agreement, which was amended March 1995, contains a purchase option
      for
      us to purchase the WLH Investments interest or conversely, for WLH Investments
      to put their interest in the partnership to us, for a purchase price of
      $750,000, payable by the issuance of our common stock having a value of
      $750,000. The option is exercisable at any time following the date our common
      stock equals or exceeds $20 per share for a period of 20 consecutive trading
      days. The option has not been exercisable through December 30,
      2007.





**NOTE
      11. STOCKHOLDERS' EQUITY AND CONVERTIBLE DEBENTURES**





On
      December 7, 2004, we sold $2,375,000 principal amount of debentures and warrants
      to purchase 1,187,500 shares of our common stock. We received net proceeds
      of
      $2,010,000 from the sale. We paid interest at 12% and late payment penalties
      through May 23, 2005 when the debentures were retired by repayment in cash
      or
      conversion into our Series B Preferred Stock. Repayments in cash consisted
      of
      principal of $2,055,000 plus interest and penalties of $177,198. Debentures
      converted into our Series B Preferred Stock consisted of $320,000 principal
      plus
      interest and penalties of $27,588. The exercise price of the warrants and the
      number of underlying shares of common stock were subject to adjustment under
      certain circumstances. As compensation for their services as placement agent
      in
      the debenture offering and future consulting services to us, the placement
      agent
      received cash fees and warrants with terms substantially identical to those
      received by the investors. The warrants expired on December 7, 2007, and
      warrants to purchase 1,873,750 shares of our common stock expired
      unexercised.





On
      May
      24, 2005, in connection with the Series B Preferred Stock offering, we issued
      warrants to purchase common stock at an exercise price of $1.30 per share
      exercisable through May 24, 2010. As of December 30, 2007 and December 31,
      2006,
      there were 4,619,540 warrants outstanding to purchase shares of our common
      stock. Additionally, warrants to purchase 1,129,530 shares of common stock
      were
      granted to the placement agent as a portion of their fees in the form of a
      warrant to purchase 37,651 units (consisting of 37,651 shares of our Series
      B
      Convertible Preferred Stock and warrants to purchase 376,510 shares of our
      common stock) at a purchase price of $15.00 per unit. As of December 30, 2007,
      none of these warrants have been exercised.




F-23


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





To
      date,
      no dividends have been declared or paid on our common stock. In addition, our
      debt financings prohibit the payment of cash dividends and any future financing
      agreements may also prohibit the payment of cash dividends.





**NOTE
      12. CONVERTIBLE PREFERRED STOCK**





**Series
      A Convertible Preferred Stock —** On
      October 24, 2001, we issued 66,862 shares of Series A 5% Convertible
      Preferred Stock, par value $0.01 per share (the "Series A Preferred
      Stock"), pursuant to an exemption from registration under Section 4(6) of the
      Securities Act of 1933, as amended, in consideration for the cancellation of
      $669,000 of trade indebtedness to our trade creditors. The shares were issued
      exclusively to "accredited investors" as defined in Rule 501(a) under the
      Securities Act. We did not receive any cash proceeds in connection with the
      issuance of the Series A Preferred Stock.





Each
      share of Series A Preferred Stock is convertible by the holder into five
      shares of our common stock. The Series A Preferred Stock has a liquidation
      preference equal to $10.00 per share, plus any declared but unpaid dividends.
      Dividends on the Series A Preferred Stock, payable in cash at the rate of
      5% of the Liquidation Value ($10.00) per annum, are payable annually, when,
      as
      and if declared by our board of directors out of funds legally available for
      the
      payment of dividends. Dividends on the Series A Preferred Stock are not
      cumulative. To date, no dividends have been declared or paid on the Series
      A
      Preferred Stock.





During
      fiscal 2007, 2006 and 2005, investors converted an aggregate of 0, 1,037 and
      11,544 shares, respectively, of Series A Preferred Stock into 0, 5,185 and
      57,720 shares, respectively, of our common stock.





**Series
      B Convertible Preferred Stock —** In
      May
      2005, we issued 461,954 units of securities in a private placement offering
      to
      accredited investors generating gross proceeds of $6,929,000. Each unit
      consisted of one share of Series B Convertible Preferred Stock, par value $0.01
      per share (the “Series B Preferred Stock”), which is initially convertible into
      20 shares of our common stock, subject to certain specified adjustments under
      certain circumstances, and a warrant to purchase 10 shares of our common stock
      at an exercise price of $1.30 per share.





A
      non-cash implied dividend of $1,735,000 was recorded in conjunction with the
      private placement offering, consisting of a warrant valuation and a beneficial
      conversion feature. The beneficial conversion feature reflects a non-detachable
      in-the-money conversion feature of the Series B Preferred Stock as defined
      by
      the Emerging Issues Task Force Consensus No. EITF 98-5, “Accounting for
      Convertible Securities with Beneficial Conversion Features or Contingently
      Adjustable Conversion Features.”





The
      warrant to purchase 37,651 units (consisting of 37,651 shares of Series B
      Preferred Stock and warrants to purchase 376,510 shares of common stock) issued
      to the placement agent was valued at $124,000. The value was based upon the
      per
      unit fair market value of the securities issued to the investors in the
      transaction less the cash exercise price.


F-24


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





The
      Series B Preferred Stock votes together with our common stock on an
“as-converted” basis as a single class on all actions to be taken by our
      stockholders. Without the consent of a majority of the outstanding Series B
      Preferred Stock, we cannot alter or change adversely the powers, preferences
      or
      rights given to the Series B Preferred Stock, authorize or create any class
      of
      stock ranking as to a distribution of assets upon a liquidation event senior
      to
      or pari passu with the Series B Preferred Stock, issue any additional shares
      of
      the Series A Preferred Stock, or alter or change the powers, preferences or
      rights given to the Series A Preferred Stock. Upon
      any
      dissolution, liquidation, merger, consolidation, reorganization or other series
      of transactions, under certain conditions, the holders of Series B Preferred
      Stock are entitled to be paid out of our assets legally available for
      distribution to our stockholders, before any payment is made to the holders
      of
      our common stock. If
      dividends are declared payable on our common stock, then dividends shall be
      declared for the Series B Preferred Stock. All shares of Series B Preferred
      Stock issued and outstanding on May 23, 2015 will automatically be converted
      at
      that time into shares of our common stock.




During
      fiscal 2007, 2006 and 2005, investors converted 286,297, 70,001 and 18,104
      shares, respectively, of Series B Preferred Stock into 5,725,960, 1,400,020
      and
      362,080 shares, respectively, of our common stock.





**NOTE
      13. INCOME TAXES**





There
      were no provisions for income taxes for the fiscal years 2007, 2006 and 2005





Our
      effective tax rate is composed of the following for the fiscal years ended
      2007,
      2006 and 2005, respectively:




Fiscal Years EndedDecember 30,
            
            December 31,
            
            January 1,2007
            
            2006
            
            2006Federal
                statutory rate
            
            
            (35.0
            )%
            
            (35.0
            )%
            
            (34.0
            )%State
                income tax, net of federal benefit
            
            
            (3.6
            )
            
            (3.6
            )
            
            (2.8
            )FICA
                tip credits
            
            
            (5.4
            )
            
            (4.7
            )
            
            (6.6
            )Warrant
                grants
            
            
            -
            
            
            -
            
            
            -Valuation
                allowance and other adjustment
            
            
            44.0
            
            
            43.3
            
            
            43.4Revalue
                certain deferred tax assets
            
            
            -
            
            
            -
            
            
            -Other
            
            
            0.0
            
            
            0.0
            
            
            -Effective
                income tax benefit
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %





As
      of
      December 30, 2007, we had net operating loss carryforwards for federal income
      tax purposes of approximately $12,317,000 which expire between 2008 and 2027.
      We
      also had approximately $3,969,000 of general business credits to carry forward,
      which expire by 2022. We had an ownership change in 2002 and 2005 as defined
      by
      Internal Revenue Code Section 382, which limits a portion of the amount of
      net
      operating loss and credit carryforwards that may be used against taxable income.
      This limitation is approximately $75,000 per year for net operating losses
      incurred prior to the 2002 ownership change, and $665,000 per year for net
      operating losses incurred prior to the 2005 ownership change. Any portion of
      the
      annual limitation amount not utilized in any year will carry forward to the
      following year subject to a 15 to 20 year limitation. Approximately $6,050,000
      of our net operating loss carryforwards and approximately $3,082,000 of credits
      are subject to the annual limitation. Assuming maximum utilization in future
      years, we expect that approximately $4,600,000 in net operating loss
      carryforwards and approximately $2,700,000 in credits will expire without
      benefit to us.


F-25




SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





Deferred
      income taxes reflect the net income tax effects of temporary differences between
      the carrying amount of assets and liabilities for financial reporting purposes
      and the amounts used for income tax purposes. Significant components of our
      deferred income tax assets and liabilities are as follows:





December
                30, 2007Current
            
            Non-current
            
            TotalBasis
                difference in fixed assets and other assets
            
            $
            -
            
            $
            1,889,000
            
            $
            1,889,000Accrued
                liabilities
            
            
            253,000
            
            
            511,000
            
            
            764,000Net
                operating loss carryforwards
            
            
            -
            
            
            5,341,000
            
            
            5,341,000General
                business credits
            
            
            -
            
            
            3,969,000
            
            
            3,969,000253,000
            
            
            11,710,000
            
            
            11,963,000Valuation
                allowance
            
            
            
            
            
            
            
            
            (11,963,000
            )Net
                deferred tax assets
            
            
            
            
            
            
            
            
            -Involuntary
                conversion proceeds and service marks
            
            
            
            
            -$
            -




December
                31, 2006Current
            
            Non-current
            
            TotalBasis
                difference in fixed assets and other assets
            
            $
            8,000
            
            $
            1,410,000
            
            $
            1,418,000Prepaids
            
            
            -
            
            
            122,000
            
            
            122,000Accrued
                liabilities
            
            
            276,000
            
            
            404,000
            
            
            680,000Net
                operating loss carryforwards
            
            
            -
            
            
            4,373,000
            
            
            4,373,000General
                business credits
            
            
            -
            
            
            3,593,000
            
            
            3,593,000284,000
            
            
            9,902,000
            
            
            10,186,000Valuation
                allowance
            
            
            
            
            
            
            
            
            (10,186,000
            )Net
                deferred tax assets
            
            
            
            
            
            
            
            
            -Involuntary
                conversion proceeds and service marks
            
            
            
            
            -$
            -




January
                1, 2006Current
            
            Non-current
            
            TotalBasis
                difference in fixed assets and other assets
            
            $
            -
            
            $
            529,000
            
            $
            529,000Accrued
                liabilities
            
            
            298,000
            
            
            (294,000
            )
            
            4,000Net
                operating loss carryforwards
            
            
            -
            
            
            3,839,000
            
            
            3,839,000General
                business credits
            
            
            -
            
            
            3,205,000
            
            
            3,205,000298,000
            
            
            7,279,000
            
            
            7,577,000Valuation
                allowance
            
            
            
            
            
            
            
            
            (7,365,000
            )Net
                deferred tax assets
            
            
            
            
            
            
            
            
            212,000Involuntary
                conversion proceeds and service marks
            
            
            
            
            (212,000
            )$
            -





A
      valuation allowance to reduce the deferred tax assets reported is required
      if,
      based on the weight of the evidence, it is more likely than not that some
      portion or all of the deferred tax assets will not be realized. For the fiscal
      years ended 2007, 2006 and 2005, the net deferred tax asset is fully
      valued.




In
      July
      2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, and
      Related Implementation Issues (“FIN 48”). FIN 48 clarifies the accounting for
      uncertainty in income taxes recognized in a company’s financial statements in
      accordance with FASB No. 109, Accounting for Income Taxes. FIN 48
      prescribes a recognition threshold and measurement attribute for a tax position
      taken or expected to be taken in a tax return. FIN 48 also provides guidance
      on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. We adopted FIN 48 effective January 1,
      2007. The adoption of FIN 48 did not have a material effect on our Consolidated
      Financial Statements. For the year ending December 30, 2007, we had no uncertain
      tax positions.


F-26


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      14. STOCK-BASED COMPENSATION PLANS**





**Stock
      Option Plans** —
At
      December 30, 2007, we had one stock-based employee compensation plan that is
      more fully described below.





On
      September 11, 1995, our board of directors approved two employee stock option
      plans that have now both expired. The 1995 Employee Stock Option Plan, as
      amended, originally provided for the issuance of options to purchase up to
      a
      total of 840,000 shares of common stock. The 1996 Employee Stock Option Plan
      provided for the issuance of options to purchase a total of 101,000 shares
      of
      common stock. There were no options awarded under these plans during 2007 or
      2006. As of December 30, 2007, options to purchase an aggregate of 156,507
      shares of common stock were outstanding under the plans of which 127,503 were
      fully exercisable and 29,004 vest in future years. ****





On
      May
      20, 1997, our stockholders approved the Stock Option Plan for Non-employee
      Directors. The plan, as amended, authorized a total of 150,000 shares of common
      stock to be reserved for issuance under the plan. There was no activity in
      this
      Plan during 2007. As of December 30, 2007, options to purchase 30,000 shares
      of
      common stock were outstanding and exercisable under this plan. The plan expired
      on May 20, 2007.





On
      May
      21, 2002, our stockholders approved the 2002 Equity Incentive Plan allowing
      for
      grants of options to purchase up to 1,850,000 shares of common stock. On June
      22, 2005, our stockholders approved an amendment to increase the authorized
      grants to 5,000,000 shares of common stock. During November 2005, our board
      of
      directors reduced the number of shares available for issuance under the plan
      by
      903,528, to a total of authorized grants of 4,096,472 shares of common stock
      under the plan. The options generally vest over three years, one third annually
      on the anniversary date of the grant and have a maximum term of 10 years, except
      for those grants issued beginning in 2005, which have a maximum term of 7 years.
      During 2007, options for 676,000 shares of common stock were granted under
      this
      plan at prices ranging between $0.11 and $0.72 per share, the fair market value
      on the date of the grant, of which 469,000 options were granted to directors
      and
      officers. As of December 30, 2007, options to purchase 3,731,000 shares of
      common stock were outstanding of which 2,509,000 were exercisable.





On
      June
      22, 2005, the compensation committee and the board of directors approved the
      immediate acceleration of vesting of certain unvested and “out-of-the-money”
stock options with exercise prices equal to or greater than $0.85 per share
      previously awarded to our employees, including our executive officers, and
      our
      directors that were originally scheduled to vest during 2006. The acceleration
      of vesting was effective for stock options outstanding as of June 22, 2005.
      Options to purchase approximately 295,000 shares of common stock, or 18.5%
      of
      our outstanding unvested options (of which options to purchase approximately
      233,000 shares, or 14.6% of our outstanding unvested options were held by our
      executive officers and directors) were subject to the acceleration. The weighted
      average exercise price of the options subject to the acceleration was $1.10.




The
      purpose of the acceleration was to enable us to avoid recognizing compensation
      expense associated with these options in future periods in our consolidated
      statements of income, upon adoption of FASB Statement No. 123 R (Share-Based
      Payment) in January 2006. The pre-tax charge that we avoided in 2006 was
      approximately $87,000, based on the original vesting periods. We also believe
      that because many of the options to be accelerated have exercise prices in
      excess of the current market value of our common stock, these options have
      limited economic value and are not fully achieving their original objective
      of
      incentivizing compensation and employee retention.


F-27


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





During
      November 2005, we entered into a Stock Option Agreement with Leslie J. Christon,
      our former President and Chief Executive Officer, concurrent with her amended
      and restated employment agreement. The Stock Option Agreement granted options
      to
      purchase 903,528 shares of common stock at an exercise price of $0.85, the
      market value of our common stock on the date of the grant. The options vested
      as
      to 353,844 shares on December 31, 2005, and 274,842 on July 1, 2007.
      Additionally, Mrs. Christon was awarded a stock option to purchase 158,007
      shares of common stock from the stock compensation plans described above at
      an
      exercise price of $0.85 per share, of which 79,003 vested in July 2007. Upon
      termination of Mrs. Christon’s employment with our company on February 29, 2008,
      all of her unvested options to purchase 654,000 shares of common stock were
      forfeited and all of her vested options to purchase 1,605,000 shares of common
      stock will expire, if not exercised, within 90 days of the termination date
      of
      her employment.





Transactions
      during 2007 were as follows:





WeightedWeighted
            
            AverageAverage
            
            Remaining
            
            AggregateNumber of
            
            Exercise
            
            Contractual
            
            IntrinsicOptions
            
            Price
            
            Life (Years)
            
            ValueOutstanding
                at December 31, 2006
            
            
            4,383,293
            
            $
            0.86Granted
            
            
            675,817
            
            
            0.55Exercised
            
            
            -
            
            
            -Forfeited
            
            
            (238,500
            )
            
            0.92Outstanding
                at December 30, 2007
            
            
            4,820,610
            
            $
            0.86
            
            
            5.4
            
            $
            90Exercisable
                at December 30, 2007
            
            
            3,295,968
            
            $
            0.84
            
            
            5.2
            
            $
            20





The
      total
      intrinsic value (market value on date of exercise less exercise price) of
      options exercised during the fiscal years 2006 and 2005 was approximately $3,000
      and $16,000, respectively. The aggregate intrinsic value of options outstanding
      as of December 30, 2007, disclosed in the table above, represents the closing
      stock price on the last trading day of the year less the exercise price,
      multiplied by the number of in-the-money stock options outstanding. There
      was
      no excess cash tax benefit for the year ended December 30, 2007.




F-28


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**Stock-Based
      Compensation** –
Expense
      related to stock options issued to eligible employees under the Plans is
      recognized using a straight-line vesting schedule over the vesting period.
      Stock
      options generally vest over a period of 1 to 3 years and have contractual terms
      to exercise of 7 to 10 years. Stock option awards are valued based upon the
      Black-Scholes option-pricing model using the following assumptions:





Assumptions
                used in computing
            
            Quarter
                Endedfair
                value of option grants:
            
            December 30, 2007
            
            September 30, 2007
            
            July 1, 2007
            
            April 1, 2007Volatility
            
            
            218.7
            %
            
            101.7
            %
            
            55.4
            %
            
            26.6
            %Weighted-average
                estimated life
            
            
            3.5
                years
            
            
            3.5
                years
            
            
            3.5
                years
            
            
            3.5
                yearsWeighted-average
                risk-free interest rate
            
            
            3.50
            %
            
            4.41
            %
            
            4.76
            %
            
            4.68
            %Dividend
                yield
            
            
            0
            
            
            0
            
            
            0
            
            
            0





At
      December 30, 2007, there was $421,000 of unrecognized, pre-tax compensation
      expense related to stock options that will be recognized over a weighted-average
      period of two years. The weighted average grant date fair value of stock options
      granted during fiscal 2007, 2006 and 2005 was $0.55, $0.75 and $0.89,
      respectively.





F-29


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      15. EARNINGS (LOSS) PER SHARE**





The
      following table represents the computation of basic and diluted loss per share
      of common stock as required by FASB Statement No. 128:




Fiscal Years EndedDecember 30,
            
            December 31,
            
            January 1,2007
            
            2006
            
            2006Net
                loss attributable to common shareholders
            
            $
            (4,400,402
            )
            $
            (3,002,843
            )
            $
            (3,586,915
            )Weighted
                common shares outstanding
            
            
            20,920,360
            
            
            16,665,209
            
            
            14,796,278Basic
                net loss per share of common stock
            
            $
            (0.21
            )
            $
            (0.18
            )
            $
            (0.24
            )Effect
                of dilutive securities:Preferred
                stock
            
            
            -
            
            
            -
            
            
            -Warrants
            
            
            -
            
            
            -
            
            
            -Stock
                options
            
            
            -
            
            
            -
            
            
            -Diluted
                weighted common shares outstanding
            
            
            20,920,360
            
            
            16,665,209
            
            
            14,796,278Diluted
                net loss per share of common stock
            
            $
            (0.21
            )
            $
            (0.18
            )
            $
            (0.24
            )




Diluted
      net loss per common share excludes anti-dilutive stock options and warrants
      of
      11,338,000, 12,034,000 and 7,831,000 for fiscal 2007, 2006 and 2005,
      respectively. Additionally, the anti-dilutive effect of preferred stock of
      4,428,000, 8,491,000 and 5,884,000 has been excluded for fiscal 2007, 2006
      and
      2005, respectively.





**NOTE
      16. PROVISION FOR IMPAIRMENT OF ASSETS**





In
      accordance with FASB Statement No. 144, which superseded FASB Statement No.
      121,
      we identified certain long-lived assets as impaired. Impairment was recognized
      when the future undiscounted cash flows of certain assets were estimated to
      be
      less than the assets’ related carrying value. As such, the carrying values were
      written down to our estimates of fair value.





We
      recognized write-downs of $1,270,000, $1,242,000 (of which $300,000 reduced
      prepaid rent) and $211,000 during fiscal 2007, 2006 and 2005, respectively.
      We
      have five operating restaurants that have been previously written-down for
      impairment through December 30, 2007. The write-down in 2007 related to one
      restaurant with operating losses that had previously been written-down and
      three
      restaurants with operating losses that had not been previously written down.
      The
      write-down in 2006 related to one restaurant with operating losses that had
      not
      previously been written down. The write-down in 2005 related to one restaurant
      that was subject to a lease buy-out modification when we entered into an
      agreement with our landlord in St. Pete Beach, whereby on February 22, 2005,
      the
      landlord paid $600,000 to us for an option to buy-out the lease prior to its
      scheduled termination date. The fiscal 2007 and 2006 write-downs were
      necessitated by the then current period operating losses, as well as the
      projected undiscounted cash flows of the restaurants.


F-30


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      17. DEFINED CONTRIBUTION PLAN**





We
      have a
      defined contribution plan which meets the requirements of Section 401(k) of
      the
      Internal Revenue Code. All of our salaried employees with more than 90 days
      of
      service, who are at least 21 years of age, and who are not considered highly
      compensated, are eligible to participate in the plan. The plan allows for a
      discretionary matching contribution from us. Shells, which pays the plan
      expenses, has contributed $12,000 in discretionary contributions to
      date.





**NOTE
      18. ADVERTISING AND MARKETING**





We
      have
      incurred the following costs for television, radio, billboards and local store
      marketing:





Fiscal Years EndedDecember 30,
            
            December 31,
            
            January 1,2007
            
            2006
            
            2006Advertising
                and marketing expenses
            
            $
            1,210,000
            
            $
            1,351,000
            
            $
            1,770,000As
                a percentage of revenues
            
            
            2.9
            %
            
            2.8
            %
            
            4.0
            %





**NOTE
      19. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)**





The
      following tables present selected quarterly financial data for fiscal
      2007 and 2006 ,
      (in
      thousands, except per share data):




Fiscal
                Year 2007First
            
            Second
            
            Third
            
            FourthQuarter
            
            Quarter
            
            Quarter
            
            QuarterRevenues
            
            $
            13,435
            
            $
            11,481
            
            $
            8,979
            
            $
            7,564Income
                (loss) from operations
            
            
            137
            
            
            (1,109
            )
            
            (891
            )
            
            (2,078
            )Net
                income (loss) attributable to common stock
            
            
            35
            
            
            (1,152
            )
            
            (1,010
            )
            
            (2,274
            )Basic
                earnings (loss) per share
            
            $
            -
            
            $
            (0.06
            )
            $
            (0.05
            )
            $
            (0.10
            )Diluted
                earnings (loss) per share
            
            $
            -
            
            $
            (0.06
            )
            $
            (0.05
            )
            $
            (0.10
            )Net
                loss excluding non-recurring items (1)
            
            
            (11
            )
            
            (628
            )
            
            (1,010
            )
            
            (1,506
            )Basic
                and diluted loss per share excluding non-recurring
                items
            
            $
            -
            
            $
            (0.03
            )
            $
            (0.05
            )
            $
            (0.06
            )




Fiscal
                Year 2006First
            
            Second
            
            Third
            
            FourthQuarter
            
            Quarter
            
            Quarter
            
            QuarterRevenues
            
            $
            14,587
            
            $
            13,054
            
            $
            10,529
            
            $
            9,659Income
                (loss) from operations
            
            
            475
            
            
            (9
            )
            
            (806
            )
            
            (2,126
            )Net
                income (loss) attributable to common stock
            
            
            261
            
            
            (9
            )
            
            (962
            )
            
            (2,292
            )Basic
                earnings (loss) per share
            
            $
            0.02
            
            $
            (0.00
            )
            $
            (0.06
            )
            $
            (0.13
            )Diluted
                earnings (loss) per share
            
            $
            0.01
            
            $
            (0.00
            )
            $
            (0.06
            )
            $
            (0.13
            )Net
                income (loss) excluding non-recurring items (2)
            
            
            284
            
            
            (334
            )
            
            (962
            )
            
            (1,049
            )Diluted
                earnings (loss) per share excluding non-recurring items
            
            $
            0.01
            
            $
            (0.02
            )
            $
            (0.06
            )
            $
            (0.06
            )





(1)
            
            One-time
                non-recurring (income) charges were ($46,000), $524,000 and $768,000
                in
                the first, second and fourth quarters, respectively.(2)
            
            One-time
                non-recurring charges (income) were $23,000, ($325,000) and $1,242,000
                in
                the first, second and fourth quarters,
                respectively.


F-31


SHELLS
      SEAFOOD RESTAURANTS, INC. AND SUBSIDIARIES


**Notes
      to Consolidated Financial Statements**





**NOTE
      20. SUBSEQUENT EVENTS**





On
      January 16, 2008, we entered into a line of credit loan facility with Colonial
      Bank, N.A., for which we have borrowed $140,000 of the $350,000 available credit
      line. The loan carries a variable interest rate of 1% above the prime bank
      rate.
      The initial rate was 8.25%. The line of credit facility matures on September
      19,
      2008 and is secured by the $1,050,000 letter of credit with Food and
      Entertainment Co. The credit facility has been and will be used for working
      capital purposes.





On
      February 29, 2008, Leslie Christon, our former President and Chief Executive
      Officer, left our company to pursue other opportunities. She also resigned
      her
      membership from our Board of Directors. Warren Nelson was named interim
      President. We presently have an offer of employment outstanding with a candidate
      for the position of Chief Executive Officer. There is no certainty that such
      an
      offer will be accepted by the candidate, under the terms extended, or at all.
      Additionally, Christopher Ward resigned from his position as Vice President
      of
      Purchasing in February 2008.




F-32




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





None.





**ITEM
      9A(T). CONTROLS AND PROCEDURES**





(a)
            Evaluation
                of Disclosure Controls and
                Procedures:




We
      maintain "disclosure controls and procedures," as such term is defined under
      Securities Exchange Act Rule 13a-15(e) and Rule 15d-15(e), that are designed
      to
      ensure that information required to be disclosed in our Exchange Act reports
      is
      recorded, processed, summarized, and reported within the time periods specified
      in the SEC's rules and forms, and that such information is accumulated and
      communicated to our management, including our President and Chief Financial
      Officer, as appropriate, to allow timely decisions regarding required
      disclosures. In designing and evaluating the disclosure controls and procedures,
      our management recognized that any controls and procedures, no matter how well
      designed and operated, can provide only reasonable assurance of achieving the
      desired control objectives, and our management necessarily was required to
      apply
      its judgment in evaluating the cost-benefit relationship of such controls and
      procedures. As required by SEC Rule 13a-15(b), we have carried out an
      evaluation, as of the end of the period covered by this report, under the
      supervision and with the participation of our management, including our
      President and Chief Financial Officer, of the effectiveness of the design and
      operation of our disclosure controls and procedures. Based upon our evaluation
      and subject to the foregoing, the President and Chief Financial Officer
      concluded that our disclosure controls and procedures were effective in ensuring
      that material information relating to Shells is made known to the President
      and
      Chief Financial Officer by others within our company during the period in which
      this report was being prepared.





(b)
            Management’s
                Report on Internal Control Over Financial
                Reporting





Our
      management is responsible for establishing and maintaining effective internal
      control over financial reporting as defined in Rules 13a-15(f) and
      Rules 15d-15(f) of the Securities Exchange Act. Our internal control over
      financial reporting is designed to provide reasonable assurance regarding the
      reliability of our financial reporting and the preparation of published
      financial statements in accordance with generally accepted accounting
      principles. We believe, however, that a controls system, no matter how well
      designed and operated, cannot provide absolute assurance that the objectives
      of
      the controls systems are met, and no evaluation of controls can provide absolute
      assurance that all control issues and instances of fraud or error, if any,
      within a company have been detected.





Under
      the
      supervision and with the participation of our management, including our
      President and Chief Financial Officer, we conducted an evaluation of the
      effectiveness of our internal control over financial reporting as of
      December 30, 2007 based on the framework in  Internal
      Control—Integrated Framework issued by the Committee of Sponsoring Organizations
      of the Treadway Commission. Based on our evaluation under the framework in
      Internal Control—Integrated Framework, our management concluded that our
      internal control over financial reporting was effective as of December 30,
      2007.





This
      annual report does not include an attestation report of our registered public
      accounting firm regarding internal control over financial reporting.
      Management’s report was not subject to attestation by our registered public
      accounting firm pursuant to temporary rules of the Securities and Exchange
      Commission that permit us to provide only management’s report in this annual
      report.




40




(c)
            Changes
                in Internal Control Over Financial
                Reporting





There
      were no changes in our internal controls over financial reporting that occurred
      during our most recent fiscal quarter that have materially affected, or are
      reasonably likely to materially affect, our internal control over financial
      reporting.





**ITEM
      9B. OTHER INFORMATION**





None.




41


**PART
      III**





**ITEM
      10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNACE**





The
      information required by this Item concerning our executive officers, is set
      forth under the heading “Our Executive Officers” in Part I of this Annual Report
      on Form 10-K.





The
      information required by this Item is incorporated by reference to the Proxy
      Statement for our 2008 Annual Meeting of Stockholders to be filed with the
      SEC
      within 120 days after the end of the fiscal year ended December 30,
      2007.





**ITEM
      11. EXECUTIVE COMPENSATION**





The
      information required by this Item is incorporated by reference to the Proxy
      Statement for our 2008 Annual Meeting of Stockholders to be filed with the
      SEC
      within 120 days after the end of the fiscal year ended December 30,
      2007.





**ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS**





The
      information required by this Item is incorporated by reference to the Proxy
      Statement for our 2008 Annual Meeting of Stockholders to be filed with the
      SEC
      within 120 days after the end of the fiscal year ended December 30,
      2007.





**ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE**





The
      information required by this Item is incorporated by reference to the Proxy
      Statement for our 2008 Annual Meeting of Stockholders to be filed with the
      SEC
      within 120 days after the end of the fiscal year ended December 30,
      2007.





**ITEM
      14. PRINCIPAL ACCOUNTING FEES AND SERVICES**





The
      information required by this Item is incorporated by reference to the Proxy
      Statement for our 2008 Annual Meeting of Stockholders to be filed with the
      SEC
      within 120 days after the end of the fiscal year ended December 30,
      2007.


42


**ITEM
      15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES**





(a)
              Financial
                  Statements




(1)
      and
      (2)  See
      "Index to Financial Statements" at Item 8 of this Annual Report on Form 10-K.




(3)
              Exhibits
                  - Exhibits Nos. 10.1, 10.2, 10.4, 10.5, 10.15, 10.17, 10.22, 10.23,
                  10.24,
                  10.30, 10.31, 10.34, 10.35, 10.36, 10.37, 10.38 and 10.52 are management
                  contracts, compensatory plans or
                  arrangements.




**Number**
            
            **Description**3.1
            
            Certificate
                of Incorporation. (1)3.2
            
            Agreement
                and Plan of Merger, dated March 31, 1996, by and between Shells Seafood
                Restaurants, Inc., a Delaware Corporation, and Shells Seafood Restaurant,
                Inc., a Florida Corporation. (1)3.3
            
            By-laws.
                (1)3.4
            
            Certificate
                of Designations of Series A Convertible Preferred Stock.
                (2)3.5
            
            Certificate
                of Designations of Series B Convertible Preferred Stock.
                (6)3.6
            
            Certificate
                of Amendment, dated March 17, 2005. (8)3.7
            
            Certificate
                of Amendment, dated July 7, 2005. (8)4.1
            
            Specimen
                common stock certificate. (1)4.2
            
            Specimen
                Series B Convertible Preferred stock certificate. (8)10.1
            
            1996
                Employee Stock Option Plan. (1)10.2
            
            1995
                Employee Stock Option Plan. (1)10.3
            
            Agreement
                for Purchase and Sale of Assets, dated May 14, 1993, between Shells
                Seafood Restaurants, Inc. and Shells, Inc. (1)10.4
            
            1996
                Stock Option Plan for Non-Employee Directors. (2)10.5
            
            2002
                Equity Incentive Plan, as amended. (7)10.6
            
            First
                Amendment of Agreement and Plan of Merger, dated December 13, 1995,
                by and
                among Shells Seafood Restaurants, Inc., Shells Seafood Acquisition,
                Inc.
                and Shells, Inc. (1)10.7
            
            Joint
                Venture Agreement, dated March 1, 1994, between Shells of Melbourne,
                Inc.
                and WLH Investments, Inc. (1)10.8
            
            First
                Amendment to Joint Venture Agreement, effective as of March 31, 1995
                between Shells of Melbourne, Inc. and WLH Investments, Inc.
                (1)10.9
            
            Management
                and License Agreement, dated March 1, 1994, between Shells of Melbourne
                Joint Venture and Shells Seafood Restaurants, Inc (1)10.10
            
            Management
                and License Agreement, dated July 28, 1993, between Shells of North
                Tampa,
                Inc. and Shells Seafood Restaurants, Inc., as amended.
                (1)10.11
            
            Management
                and License Agreement, dated July 29, 1993, between Shells of Sarasota
                South, Inc. and Shells Seafood Restaurants, Inc., as amended.
                (1)10.12
            
            Amended
                Option Agreement, dated August 11, 1995 between Shells Seafood
                Restaurants, Inc. and Shells of North Tampa, Inc. (1)10.13
            
            Amended
                Option Agreement, dated August 16, 1995 by and between Shells Seafood
                Restaurants, Inc. and Shells of Sarasota South, Inc.
                (1)10.14
            
            Agreement
                for Consulting and Management Services and Licensing of Service Marks,
                dated October 4, 1989 by and between Ursula Collaud and Shells of
                Daytona
                Beach, Inc., as amended by the Stipulation of Settlement dated December
                2,
                1994. (1)10.15
            
            Form
                of Directors Indemnification Agreement.
                (1)


43




**Number**
            
            **Description**10.16
            
            Agreement
                for the purchase and sale of leases, leasehold improvements, restaurant
                assets, assigned contracts and restaurant licenses by Shells Seafood
                Restaurants, Inc. for the benefit of Islands Florida LP.
                (2)10.17
            
            Letter
                from board of directors, dated January 19, 2000, clarifying severance
                arrangement for Warren R. Nelson. (2)10.18
            
            Second
                Amendment to Management and License Agreement, dated October 4, 2001,
                between Shells Seafood Restaurants, Inc. and Shells of Sarasota South,
                Inc. (2)10.19
            
            Second
                Amendment to Management and License Agreement, dated October 4, 2001,
                between Shells Seafood Restaurants, Inc. and Shells of North Tampa,
                Inc.
                (2)10.20
            
            Loan
                agreement, dated October 25, 2002, between Shells of Melbourne, Joint
                Venture and Colonial Bank (previously known as Manufacturers Bank
                of
                Florida), in the renewal principal amount of $635,506.
                (2)10.21
            
            Distribution
                Agreement, dated October 20, 2005, between Shells Seafood Restaurants,
                Inc. and Performance Food Group, LLC. (3)10.22
            
            Amendment
                to the Non-Employee Director Stock Option Plan, as approved October
                23,
                2001. (2)10.23
            
            Amendment
                to the 1995 Employee Stock Option Plan, as approved October 23, 2001.
                (2)10.24
            
            Amended
                and Restated Employment Agreement, dated July 1, 2007, between Leslie
                J.
                Christon and Shells Seafood Restaurants, Inc. (17)10.25
            
            Form
                of Stock Purchase Warrant, dated December 7, 2004, in the aggregate
                of
                1,971,250 warrants to purchase shares of common stock.
                (5)10.26
            
            Form
                of Securities Purchase Agreement dated May 24, 2005, by and among
                Shells
                Seafood Restaurants, Inc. and the investor parties thereto.
                (6)10.27
            
            Form
                of Stock Purchase Warrant, issued in connection with May 24, 2005
                financing. (6)10.28
            
            Form
                of Placement Agent Warrant issued to JMP Securities LLC.
                (6)10.29
            
            Amendment
                No. 1 to Loan and Security Agreement, dated as of May 23, 2005.
                (6)10.30
            
            Form
                of Stock Option Agreement for Non-Employee Directors Pursuant to
                the
                Shells Seafood Restaurants, Inc. 2002 Equity Incentive Plan.
                (7)10.31
            
            Form
                of Stock Option Agreement for Employees Pursuant to the Shells Seafood
                Restaurants, Inc. 2002 Equity Incentive Plan. (7)10.32
            
            Agreement,
                dated August 5, 2005, by and between Shells Seafood Restaurants,
                Inc. and
                Deborah Christen Corporation regarding the Carrollwood trade area.
                (9)10.33
            
            Amendment
                No. 1, dated December 20, 2006, by and between Shells Seafood Restaurants,
                Inc. and Deborah Christen Corporation. (14)10.34
            
            Stock
                Option Agreement, dated November 14, 2005, by and between Shells
                Seafood
                Restaurants, Inc. and Leslie J. Christon. (10)10.35
            
            Amendment
                to the 2002 Equity Incentive Plan, dated November 14, 2005.
                (10)10.36
            
            Agreement,
                dated March 13, 2006, by and between Shells Seafood Restaurants and
                Warrant Nelson. (11)10.37
            
            Agreement,
                dated March 13, 2006, by and between Shells Seafood Restaurants and
                Guy
                Kathman. (11)


44




**Number**
            
            **Description**10.38
            
            Agreement,
                dated March 13, 2006, by and between Shells Seafood Restaurants and
                Chris
                Ward. (11)10.39
            
            Purchase
                and Sale Agreement, dated April 17, 2006, between the Shells Seafood
                Restaurants and FRI Fish, LLC for the Ocala, Florida location.
                (12)10.40
            
            Land
                and Building Lease, dated April 17, 2006, between the Shells Seafood
                Restaurants and FRI Fish, LLC for the Ocala, Florida location.
                (12)10.41
            
            Purchase
                and Sale Agreement, dated October 27, 2006, between the Shells Seafood
                Restaurants and FRI Fish, LLC for the New Smyrna Beach, Florida location.
                (13)10.42
            
            Land
                and Building Lease, dated October 27, 2006, between the Shells Seafood
                Restaurants and FRI Fish, LLC for the New Smyrna Beach, Florida location.
                (13)10.43
            
            Amendment
                No.2 to the Loan and Security Agreement, dated March 30, 2007.
                (15)10.44
            
            Lease
                Termination Agreement between the Company and Timothy D Cross, effective
                as of June 8, 2007. (16)10.45
            
            Shells
                Seafood Restaurants, Inc. Restaurant System Purchase Agreement, dated
                December 10, 2007. (18)10.46
            
            First
                Amendment to Shells Seafood Restaurants, Inc. Restaurant System Purchase
                Agreement, dated December 10, 2007. (18)10.47
            
            Second
                Amendment to Shells Seafood Restaurants, Inc. Restaurant System Purchase
                Agreement, dated December 10, 2007. (18)10.48
            
            Shells
                Seafood Restaurants, Inc. Technical Consulting and Support Services
                Agreement, dated December 10, 2007. (18)10.49
            
            First
                Amendment to Shells Seafood Restaurants, Inc. Technical Consulting
                and
                Support Services Agreement, dated December 10, 2007.
                (18)10.50
            
            Second
                Amendment to Shells Seafood Restaurants, Inc. Technical Consulting
                and
                Support Services Agreement, dated December 10, 2007.
                (18)10.51
            
            Line
                of Credit Agreement with Colonial Bank, dated January 16, 2008.
                (19)10.52
            
            Separation
                Agreement, dated March 10, 2008, between the Company and Leslie Christon.
                (20)14
            
            Code
                of Business Conduct and Ethics. (2)21.1
            
            Subsidiaries
                of the Registrant. (8)


_______________


(1)
                  Included
                      as an exhibit to our Registration Statement on Form S-1 and
                      incorporated
                      herein by reference (File No. 333-1600).
 (2)
                  Included
                      as an exhibit to our Annual Report on Form 10-K or 10-K/A for
                      the fiscal
                      year ended December 28, 2003 and incorporated herein by reference.
 (3)
                  Included
                      as an exhibit to our Annual Report on Form 10-K or 10-K/A for
                      the fiscal
                      year ended January 1, 2006 and incorporated herein by reference.
 (4)
                  Included
                      as an exhibit to our Quarterly Report on Form 10-Q for the
                      quarter ended
                      June 29, 2003 and incorporated herein by reference.
 (5)
                  Included
                      as an exhibit to our Current Report on Form 8-K dated December
                      9, 2004 and
                      incorporated herein by reference.
 (6)
                  Included
                      as an exhibit to our Current Report on Form 8-K dated May 23,
                      2005 and
                      incorporated herein by reference.
 (7)
                  Included
                      as an exhibit to our Current Report on Form 8-K dated May 28,
                      2005 and
                      incorporated herein by reference.
 (8)
                  Included
                      as an exhibit to our Registration Statement on Form S-1 dated
                      July 8, 2005
                      and incorporated herein by
                      reference.





45




(9)
              Included
                  as an exhibit to our Current Report on Form 8-K dated August 9,
                  2005 and
                  incorporated herein by reference.
 (10)
              Included
                  as an exhibit to our Current Report on Form 8-K dated November
                  14, 2005
                  and incorporated herein by reference.
 (11)
              Included
                  as an exhibit to our Current Report on Form 8-K dated March 13,
                  2006 and
                  incorporated herein by reference.
 (12)
              Included
                  as an exhibit to our Current Report on Form 8-K dated April 21,
                  2006 and
                  incorporated herein by reference.
 (13)
              Included
                  as an exhibit to our Current Report on Form 8-K dated November
                  2, 2006 and
                  incorporated herein by reference.
 (14)
              Included
                  as an exhibit to our Current Report on Form 8-K dated December
                  21, 2006
                  and incorporated herein by reference.
 (15)
              Included
                  as an exhibit to our Current Report on Form 8-K dated April 2,
                  2007 and
                  incorporated herein by reference.
 (16)
              Included
                  as an exhibit to our Current Report on Form 8-K dated June 14,
                  2007 and
                  incorporated herein by reference.
 (17)
              Included
                  as an exhibit to our Current Report on Form 8-K dated August 10,
                  2007 and
                  incorporated herein by reference.
 (18)
              Included
                  as an exhibit to our Current Report on Form 8-K dated December
                  10, 2007
                  and incorporated herein by reference.
 (19)
              Included
                  as an exhibit to our Current Report on Form 8-K dated January 16,
                  2008 and
                  incorporated herein by reference.
 (20)
              Included
                  as an exhibit to our Current Report on Form 8-K dated March 11,
                  2008 and
                  incorporated herein by
                  reference.




46




(b)
            Exhibits
                (currently being filed or not previously
                filed)




31.1
            Certification
                of President and Chief Financial Officer under Rule 13a-14(a)




32
            Certification
                of President and Chief Financial Officerunder
                Section 906





(c)
            Financial
                statement schedules (pursuant to Regulation S-X
                14a-3(b))




All
      financial statement schedules are omitted because they are inapplicable, not
      required or the information is indicated elsewhere in the consolidated financial
      statements or the notes thereto.




47


**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.





Date:
                March 28, 2008
            SHELLS
                SEAFOOD RESTAURANTS, INC.By:
            /s/
                  Warren R. NelsonWarren
                R. Nelson
              President,
              Chief
                Financial Officer, Treasurer and Secretary
              (Principal
                Executive and Financial Officer)




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report had
      been
      signed by the following persons on behalf of the registrant and in the
      capacities and on the dates indicated.





**Signature**
            
            **Title**
            
            **Date**/s/
                Warren R. NelsonWarren
                R. Nelson
            
            President,
                Chief Financial Officer, Treasurer and
              Secretary
              (Principal
                Executive and Financial Officer)
            
            March
                28, 2008/s/
                  Philip R. ChapmanPhilip
                R. Chapman
            
            Chairman
                of the Board
            
            March
                28, 2008/s/
                  Michael R. GoldingMichael
                R. Golding
            
            Director
            
            March
                28, 2008/s/
                Gary L. HermanGary
                L. Herman
            
            Director
            
            March
                28, 2008/s/
                  Christopher D. IllickChristopher
                D. Illick
            
            Director
            
            March
                28, 2008/s/
                  Jay A. WolfJay
                A. Wolf
            
            Director
            
            March
                28, 2008




48